1. Goods, Services and Value Chains
OPERATIONS MANAGEMENT
Goods, Services and Value Chains
CHAPTER 3
Measuring Performance in Operations
DAVID A. COLLIER
AND
JAMES R. EVANS
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western
Operations Management, 2e/Ch. 3 Measuring Performance in Operations
©2007 Thomson South-Western 1

2. Chapter 3 Learning Objectives
To understand the principal types of performance measures used in organizations and by operations managers and to be able to identify important measures and indicators to manage and improve business performance.
To understand the importance of evaluating relationships and cause-and-effect linkages among performance measures and approaches that companies use to understand such relationships.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

3. Chapter 3 Learning Objectives
To understand the characteristics of a good measurement system and how to select appropriate measures to support operations.
To understand how measurement systems are integrated into comprehensive models of business performance as a basis for better design and improvement of operations.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

4. Chapter 3 Measuring Performance in Operations
Introduction
Managers make many important decisions that affect how an organization provides value to its customers.
To know if decisions are effective and to guide the organization on a daily basis, they need a means of understanding performance at all levels of the organization as well as in operations.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

5. Chapter 3 Measuring Performance in Operations
Introduction
Good decisions are facilitated through measurement, the act of quantifying the performance criteria of organizational units, goods and services, processes, people, and other business activities.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

6. Chapter 3 Measuring Performance in Operations
Introduction
Key questions related to measurement in
operations include:
How should we measure the performance of goods and services?
How should we measure the performance of processes throughout the value chain?
How should we measure overall organizational performance and how does it relate to internal operations?
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

7. Chapter 3 Measuring Performance in Operations
The Scope of Performance Measurement
Good performance measures enable
managers to control processes and make
decisions on the basis of facts, not opinions.
Selecting the right measures—not too many
and not too few is a very important decision
that all managers must make.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

8. Chapter 3 Measuring Performance in Operations
The Scope of Performance Measurement
The list below details various categories of
Performance measurements.
Time
Flexibility
Innovation and learning
Productivity
Financial
Customer and market
Safety
Quality
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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9. The Scope of Business and Operations Performance Measurement
Exhibit 3.1
The Scope of Business and Operations Performance Measurement
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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10. Chapter 3 Measuring Performance in Operations
Financial Measures
Often take top priority in for-profit organizations.
Traditional financial measures include revenue, return on investment, operating profit, pretax profit margin, asset utilization, growth, earnings per share, and other liquidity measures.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

11. Chapter 3 Measuring Performance in Operations
Financial Measures
Cost of quality is not used in most organizations; it measures what poor quality is costing an organization.
Nonprofit organizations focus more on minimizing costs and maximizing value to their target markets, customers, and society.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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12. Chapter 3 Measuring Performance in Operations
Customer and Market Measures
An effective customer-satisfaction measurement system provides a company with customer ratings of specific goods and service features and indicates the relationship between those rating and the customer’s likely future buying behavior.
Measured in three areas: 1) goods quality, 2) service quality, and 3) response time.
Other customer focused measures include: customer complaints, loyalty, customer retention, warranty claims, service guarantee claims, service upsets/failures.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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13. Chapter 3 Measuring Performance in Operations
Safety
Measuring safety is vital to all organizations, as the well- being of its employees and customers should be an organization's principal concern.
Performance measures include accident rates, parts per million of arsenic in public water supply, or security in a hotel room.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

14. Chapter 3 Measuring Performance in Operations
Safety
OM Spotlight: Dana Corporation
Safety integrated with continuous quality improvement
If an accident happens the entire facility is shut down.
Factory lost time accident rates were 39 times lower than comparable factories.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

15. Chapter 3 Measuring Performance in Operations
Quality
Quality measures the degree to which the output of a process meets customer requirements.
Goods quality relates to the physical performance and characteristics of a good.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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16. Chapter 3 Measuring Performance in Operations
Quality
A common measure of goods quality is the number of defects per unit, which is computed by dividing the total number of defects found by the number of items examined.
Nonconformities per unit are often reported as rates per thousand or million, and the measure dpmo—defects per million opportunities—is often used.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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17. Chapter 3 Measuring Performance in Operations
There are many dimensions of quality including:
Performance: a good’s primary operating characteristics. Example-- automobile brakes stop the vehicle.
Features: bells and whistles. Example- - reclining seats.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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18. Chapter 3 Measuring Performance in Operations
There are many dimensions of quality including:
Reliability: probability of the manufactured good working over a certain time. Example—vehicle engine always starts on cold days.
Conformance: the degree to which characteristics match preestablished standards. Example—vehicle door does not leak water.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

19. Chapter 3 Measuring Performance in Operations
Quality
There are many dimensions of quality including (continued):
Durability: use before it physically deteriorates. Example—auto corrosion.
Serviceability: speed, courtesy and competence of repair work. Example— vehicle oil change.
Aesthetics: how good a manufactured good looks, feels, sounds, tastes, or smells. Example—vehicle’s style and color.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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20. Chapter 3 Measuring Performance in Operations
Another Way to Think About Quality
Critical defect -- one that judgment and experience indicate will surely result in hazardous or unsafe conditions for individuals using or experiencing the good or service.
Major defect -- one that is not critical but is likely to materially reduce the usability of the good or service for its intended purpose.
Minor defect -- one that is not likely to materially reduce the usability of the good or service for its intended purpose.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

21. Chapter 3 Measuring Performance in Operations
Quality
Service quality is consistently meeting or exceeding customer expectations and service delivery system performance for all service encounters.
Tangibles -- physical facilities, uniforms, equipment, vehicles, and appearance of employees (i.e., the physical evidence).
Reliability -- ability to perform the promised service dependably and accurately.
Responsiveness -- willingness to help customers and provide prompt recovery to service upsets.
Assurance -- knowledge and courtesy of the service-providers, and their ability to inspire trust and confidence in customers.
Empathy – caring attitude and individualized attention provided to its customers.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

22. Chapter 3 Measuring Performance in Operations
Service Quality
Every service encounter provides an opportunity for error. Errors in service creation and delivery are sometimes called service upsets or service failures.
In services, a measure of quality analogous to defects per unit is errors per million opportunities (epmo).
Environmental quality focuses on designing and controlling work processes to improve the environment.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

23. Chapter 3 Measuring Performance in Operations
Service Quality
Example epmo: A hotel might determine that there are 100 opportunities for error during the hotel check-in process and yesterday the hotel had 200 check-ins so the total opportunities for error is 20,000.
A total of 40 service upsets were recorded by well-trained hotel check-in staff for an error rate of 40/20,000 or 2 per thousand, which is equivalent to 2,000 epmo.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

24. Chapter 3 Measuring Performance in Operations
Time
Time relates to two types of performance measures:
the speed of doing something (average) and
the reliability of doing something (variance).
Processing time is the time it takes to perform some task.
Queue time is a fancy word for wait time—the time spent waiting.
Cycle time refers to the time it takes to accomplish one cycle of a process that performs work.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

25. Chapter 3 Measuring Performance in Operations
Time
Manufacturing lead time represents the time between the release of an order to production and shipment to the customer.
Purchasing lead time is the time required to obtain the purchased item, including order preparation, supplier lead time, transportation, and receiving and storage.
Sometimes processing, cycle, and lead time are used interchangeably making things confusing in the real world. Always ask for a definition of these terms to see how the organization is using it.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

26. Chapter 3 Measuring Performance in Operations
Flexibility
Flexibility is the ability to adapt quickly and effectively to changing requirements.
Goods and service design flexibility is the ability to develop a wide range of customized goods and services to meet different or changing customer needs.
Volume flexibility is the ability to respond quickly to changes in the volume and type of demand.
OM Spotlight: Nissan Flexibility
Builds five models in one assembly factory.
They use modular assemblies.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

27. Chapter 3 Measuring Performance in Operations
Innovation and Learning
Innovation refers to the ability to create new and unique goods and services that delight customers and create competitive advantage.
Learning refers to creating, acquiring, and transferring knowledge and modifying the behavior of employees in response to internal and external change.
“Microsoft is always two years away from failure.” Bill Gates.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

28. Chapter 3 Measuring Performance in Operations
Productivity
Productivity = Quantity of Output/Quantity of Input
Productivity is often confused with efficiency or effectiveness.
Efficiency is the degree to which a process generates outputs with the minimal consumption of inputs or generates a maximum amount of outputs for a given amount of inputs.
Effectiveness is achieving the organization's objective, mission, or goal through the eyes of the customer; that is, doing the right things efficiently.
Productivity is more closely associate with value as defined in Chapter 1.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

29. Chapter 3 Measuring Performance in Operations
Productivity
Productivity = Quantity of Output/Quantity of Input
Productivity is expressed in one of three forms:
Total Productivity = Total Output/Total Input
Multifactor Productivity = Total Output/Subset of Inputs
Partial Factor Productivity = Total Output/Single Input
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

30. Examples of Partial Productivity Measures
Exhibit 3.2
Examples of Partial Productivity Measures
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

31. Productivity Calculations for Miller Chemicals
Exhibit 3.3
Productivity Calculations for Miller Chemicals
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

32. Computing Productivity Indexes for Miller Chemicals
Exhibit 3.4
Computing Productivity Indexes for Miller Chemicals
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

33. Chapter 3 Measuring Performance in Operations
Linking Internal and External Performance Measures
Managers must understand the cause-and-effect linkages between key measures of performance. These relationships often explain the impact of operational performance on external results.
The quantitative modeling of cause-and-effect relationships between external and internal performance criteria is called interlinking.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

34. Chapter 3 Measuring Performance in Operations
Linking Internal and External Performance Measures
Another example of an interlinking model is the financial value of a loyal customer (VLC), which quantifies the total revenue or profit each target market customer generates over some time frame.
By multiplying the VLC times the absolute number of customers gained or lost, the total market value can be found.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

35. Interlinking Internal and External Performance Measures
Exhibit 3.5
Interlinking Internal and External Performance Measures
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

36. Chapter 3 Measuring Performance in Operations
Designing Performance Measurement Systems for Operations
What makes a good performance measurement system for operations?
Good performance measures are actionable, providing the basis for decisions at the level at which they are applied.
To generate useful operational performance measures a systematic process is required.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

37. Chapter 3 Measuring Performance in Operations
Designing Performance Measurement Systems for Operations
Identify all customers of the value chain and determine their requirements and expectations.
Define the work process that provides the good or service.
Define the value-adding activities and outputs that compose the process.
Develop specific performance measures.
Evaluate the performance measures to ensure their usefulness.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

38. Example of a Pizza Ordering and Delivery Process
Exhibit 3.6
Example of a Pizza Ordering and Delivery Process
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

39. Chapter 3 Measuring Performance in Operations
Models of Organizational Performance
Malcolm Baldrige National Quality Award Framework
Balanced Scorecard
Value Chain Model
Service-Profit Model
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

40. Chapter 3 Measuring Performance in Operations
Models of Organizational Performance
The first two models (Baldrige Award and Balanced Scorecard) provide more of a ‘big picture’ or organizational performance.
The last two provide more detailed frameworks for operations managers.
It is important to understand these big picture models because operations managers must communicate with all functional areas.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

41. Chapter 3 Measuring Performance in Operations
Malcolm Baldrige National Quality Award Framework
Organizations receive the awards in each of the original categories of manufacturing, small business, service, and nonprofit education and health care.
Primary purpose of the program is to provide a framework for performance excellent through self-assessment to understand the organization’s strengths and weaknesses.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

42. Exhibit 3.7
Malcolm Baldrige National Quality Award Model of Organizational Performance
Source: 2005 Malcolm Baldrige National Quality Award Criteria, U.S. Dept. of Commerce
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

43. Exhibit 3.8
Example OM-Related Questions in Baldrige Categories 4, 5, and 6, (slide 2)
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

44. Exhibit 3.8
Example OM-Related Questions in Baldrige Categories 4, 5, and 6, (slide 1)
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

45. Chapter 3 Measuring Performance in Operations
The Balanced Scorecard Model
Consists of four performance perspectives:
Financial
Customer
Innovation and Learning
Internal
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

46. The Balanced Scorecard Performance Categories and Linkages
Exhibit 3.9
The Balanced Scorecard Performance Categories and Linkages
Source: Kaplan R. S., and Norton, D. P., “The Balanced Scorecard—Measures That Drive Performance,” Harvard Business Review, January–February 1992, p. 72.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

47. Chapter 3 Measuring Performance in Operations
The Value Chain Model
Evaluates performance throughout the value chain: synchronized network of processes including suppliers and inputs, processes and associated resources, goods and service outputs and outcomes, customers and their market segments, synchronized information and feedback loops, and management of value chain.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

48. Examples of Value Chain Performance Measurements
Exhibit 3.10
Examples of Value Chain Performance Measurements
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

49. Chapter 3 Measuring Performance in Operations
Service-Profit Chain Model
Most applicable to service environments.
Model is based on a set of cause-and-effect linkages between internal and external performance and defines the key performance measurements on which service-based firms should focus.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

50. The Service-Profit Chain Model
Exhibit 3.11
The Service-Profit Chain Model
Source: Adapted from J. L. Heskett, T. O. Jones, G. W. Loveman, W. E. Sasser, Jr., Jr., and L. A. Schlesinger, “Putting the Service-Profit Chain to Work,” Harvard Business Review, March–April 1994, pp
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

51. IBM AS/400 Division Performance Measure Correlations (1984–1994 Data)
Exhibit 3.12
IBM AS/400 Division Performance Measure Correlations (1984–1994 Data)
Source: Steven H. Hoisington and Tse-His Huang, “Customer Satisfaction and Market Share: An Empirical Case Study of IBM’s AS/400 Division,” in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

52. IBM AS/400 Division Interlinking Model
Exhibit 3.13
IBM AS/400 Division Interlinking Model
Source: Steven H. Hoisington and Tse-His Huang, “Customer Satisfaction and Market Share: An Empirical Case Study of IBM’s AS/400 Division,” in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

53. How do the units compare?
Chapter 3 Solved Problem #1
Solved Problem # 1 Question:
Costs, revenue, and other relevant information for two nursing units that admit and treat similar patients during a 6-month period are shown in Exhibit 3.14.
Compare the total dollar value of inputs for each unit, total productivity, and the partial-productivity measure of direct nursing labor productivity.
How do the units compare?
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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54. Nursing Unit Productivity Analysis
Exhibit 3.14
Nursing Unit Productivity Analysis
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

55. Chapter 3 Solved Problem #1
Answer:
Total Productivity:
Unit A: 1.12
Unit B: Unit A is more productive than Unit B by 17.9%.
Partial-productivity:
Unit A: 6.47
Unit B: Unit A is also more productive based on labor (partial) productivity.
These productivity ratios assume that
quality is the same in both nursing units.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

56. Chapter 3 Solved Problem #2
A factory department consists of three types of employees: laborers earning $10 per hour, machine operators earning $15 per hour, and machinists earning $30 per hour. For a certain job, over two periods, the performance shown below was collected:
Type of Labor Hours per Period
Employee Period 1 Period 2
Laborer
Machine operator
Machinist
Output increased by 20 percent in period 2. How has productivity changed?
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

57. Chapter 3 Solved Problem #2
Solution:
Because labor costs are given, we will use a total labor-cost productivity measure. With no knowledge of actual output figures, we index output for period 1 as 100 and for period 2 as 120 (or 1.0 and 1.2, for example). Then we divide the output index for each period by the sum of the input costs to obtain the productivity measure. The total labor costs for each period are shown below.
Period 1 Period 2
Laborer $200 $160
Machine operator $180 $240
Machinist $180 $330
Total $560 $730
The productivity index for period 1 is 100/560 = ; for period 2 it is 120/730 = The relative change in productivity in period 2 is ( )/ = , or a decline of percent. Management should identify possible reasons factory productivity decreased in period 2 and work to fix or improve the problem or situation.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

58. Chapter 3 Solved Problem #3
A steel company produces long, thin sheets of steel called coils that each weigh 10 to 15 tons. The slitting operation involves cutting the coils into smaller widths. An average of 5,000 tons per month is sold. The scrap rate from this operation is 3 percent. Material costs are $600 per ton. It takes .75 hours of labor at a rate of $20 per hour to produce one ton sold.
How many tons per month must be produced to meet the sales demand?
b. What annual savings would result from decreasing the scrap rate from 3 percent to 2 percent?
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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59. Chapter 3 Solved Problem #3
Solution:
The required production to make 5,000 tons of good steel with a 3 percent scrap rate is 5,000/( ) = 5,155 tons (not 5,000 times 1.03!).
b. The required production to make 5,000 tons of good steel with a 2 percent scrap rate is 5,000/.98 = 5,102 tons. If the scrap rate is 3 percent, the additional 155 tons per month requires $93,000 ($600/ton*155 tons) in material and (.75)(20)(155) = $2,325 in labor, for a total of $95,325.
If the scrap rate is 2 percent, the additional 102 tons costs $61,200 in material and $1,530 in labor, for a total of $62,730. The difference incurred by reducing the scrap rate from 3 to 2 percent is $32,595 per month, or $391,140 annually. Even a small improvement in internal failure costs can result in big savings!
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

60. Chapter 3 Solved Problem #4
What is the value of a loyal customer (VLC) in the small contractor target market segment who buys an electric drill on average for $100 every 4 years, when the gross margin on the drill averages 50 percent, and the customer retention rate is 60 percent? What if the customer retention rate increases to 80 percent?
What is a 1 percent change in market share worth to the manufacturer if it represents 100,000 customers? What do you conclude?
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
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61. Chapter 3 Solved Problem #4
Solution:
If customer retention rate is 60 percent, the average customer defection rate = (1- customer retention rate). Thus, the customer defection rate is 40 percent, or The average buyers life cycle is 1/0.4 = 2.5 years. The repurchase frequency is every four years or 0.25 (1/4). Therefore,
VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/0.4) = $31.25 per year
The value of a 1 percent change in market share = (100,000 customers)*($31.25/customer/year) = $ 3,125,000.
If customer retention rate is 80 percent, the average customer defection rate is 0.2, and the average buyers life cycle is 1/0.2 = 5 years. Then,
VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/.2) = $62.50 per year
Thus, the value of a 1 percent change in market share = (100,000 customers)* ($62.50/customer/year) = $ 6,500,000.
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

62. Exhibit 3.15
Greyhound Insurance Company Case: Sample of Check Processing Performance Data
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western

63. Exhibit 3.16
BankUSA Case: Sample Internal and External Credit Card Division Performance Data
Operations Management, 2e/Ch. 2 Measuring Performance in Operations
©2007 Thomson South-Western