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Title: Management Techniques
Description: All you need to be successful in business management.
Description: All you need to be successful in business management.
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Hndbk Management Tech PB
8/11/06
2:43 pm
Page 1
Michael Armstrong
Now in a revised third edition, this best-selling guide to modern management
techniques is an essential resource for managers in all departments and across all
industries
...
Written in an accessible, easy-to-read style and supported by diagrams throughout,
this is essential reading for managers and a key text for business and management
students
...
95
US $55
...
kogan-page
...
uk
Kogan Page US
525 South 4th Street, #241
Philadelphia PA 19147
USA
Business and management
A Handbook of
MANAGEMENT
TECHNIQUES
REVISED 3RD EDITION
REVISED
3RD EDITION
Michael
Armstrong
Michael Armstrong’s books have sold over 500,000 copies worldwide and have
been translated into more than 20 languages
...
His internationally best-selling books include A Handbook of
Human Resource Management Practice, The Handbook of Management and
Leadership (with Tina Stephens), How to be an Even Better Manager, Strategic
Human Resource Management, Performance Management and Reward
Management (with Helen Murlis)
...
”
Economics and Business Book Review
A COMPREHENSIVE GUIDE TO
ACHIEVING MANAGERIAL EXCELLENCE
AND IMPROVED DECISION MAKING
i
A Handbook of
MANAGEMENT
TECHNIQUES
ii
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Publisher’s note
Every possible effort has been made to ensure that the information contained in
this book is accurate at the time of going to press, and the publishers and author
cannot accept responsibility for any errors or omissions, however caused
...
First published in Great Britain and the United States in 1986 by Kogan Page Limited
Second edition 1993
Third edition 2001
Revised third edition 2006
Apart from any fair dealing for the purposes of research or private study, or criticism or review, as permitted under the Copyright, Designs and Patents Act 1988,
this publication may only be reproduced, stored or transmitted, in any form or by
any means, with the prior permission in writing of the publishers, or in the case of
reprographic reproduction in accordance with the terms and licences issued by the
CLA
...
kogan-page
...
uk
525 South 4th Street, #241
Philadelphia PA 19147
USA
© Michael Armstrong, 1986, 1993, 2001, 2006
The right of Michael Armstrong to be identified as the author of this work has been
asserted by him in accordance with the Copyright, Designs and Patents Act 1988
...
Library of Congress Cataloging-in-Publication Data
Armstrong, Michael, 1928A handbook of management techniques : a comprehensive guide to achieving
managerial excellence and improved decision making / Michael Armstrong – Rev
...
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ISBN 0-7494-4766-4
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1
Capital investment cash flows
The process of programme budgeting
Possible educational objectives for an education authority
The process of human resource planning
An IQ normal curve
Job evaluation programme
Salary survey data presented graphically
Design of a new grade and pay structure
Analysis of salary structure policy and practice in relation
to market rates
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1 The components of systematic training
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2 Training needs – areas and methods
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2 A decision matrix
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4 Example of a decision tree
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6 An algorithm used for fault analysis
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1 Flow chart describing the procedural logic involved in
simulating stock behaviour
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1 Histogram showing number of calls of a given length at
half-minute intervals
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1 Basic network sequence
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3 A dummy activity introduced to avoid a dangling activity
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5 Incorrectly drawn parallel activities
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7 An incorrect closed loop
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9 Use of a dummy activity to clarify the sequence of events
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Construction of a line of balance
Programme progress chart
Relationship between ratios
Life policy – underwriting flow chart
Therblig symbols
Multiple activity chart
Questioning approach
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List of Tables
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Marketing control data
Typical operations decisions
Different attitudes introduced by TQM
Relating the layout to the process
Trading account
Profit-and-loss account
Operating cash budget
Finance budget
Example of a cash-flow statement
Reconciliation of operating profit to net cash inflow from
operating activities
Comparison of full and marginal costing
Standard cost profile
Weekly flexible budget for assembly shop
Departmental operating statement
Responsibility accounting for controllable costs
Extract from present value table
Calculation of net present value (NPV)
Expected value calculation
An example of points rating
Advantages and disadvantages of different grade and
pay structures
Salary cost return
Comparison of contingent pay schemes
Example of sensitivity analysis
Completion schedule
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xv
Preface to the Revised
Third Edition
This edition of A Handbook of Management Techniques revises and updates
the techniques described in the previous editions to take account of the
considerable developments that have taken place over the past 20 years
...
These sections greatly reflect the changes brought about by new technology and its impact on modern management practices
...
Areas of management such as
corporate planning, marketing, management accounting and operation
research, which make considerable use of related techniques, may be
termed disciplines
...
In each of these areas of skills, procedures and activities, however,
management techniques play an important part, either generally in
2 ᔡ Introduction
helping to solve problems, or particularly by enabling things to be done
more effectively
...
CHARACTERISTICS OF MANAGEMENT
TECHNIQUES
All management techniques are systematic and, in one sense or another,
analytical
...
These characteristics are
discussed below
...
Because they are
systematic, techniques ensure that each step required to deal with a situation is carried out in a prescribed manner
...
Analytical
Techniques are analytical in two senses
...
Second, and most importantly, techniques are usually analytical in the
sense that they subject complex situations to close and systematic examination, and resolve them into their key elements
...
Analysis concentrates on facts rather than opinions and provides a
precise structure and terminology which serves as a means of communication, enabling managers to make their judgements within a clearly
defined framework and in a concrete context
...
Most management decisions involve financial considerations, so
management techniques place monetary values on performance reports,
forecasts, plans and the control information needed to assess results
against budgets or targets
...
Mathematical models are created which provide a simplified representation of the real world which abstracts the features of the situation
relevant to the questions being studied
...
The right
or optimum choice is seldom obvious
...
They therefore
focus attention on what is likely to be the best course of action among the
competing alternatives which are available
...
Techniques such as market research,
forecasting, and job evaluation will use subjective methods to a degree
...
The analytical
framework provided by techniques in these areas will at least ensure that
any subjective element in the decision-making process is channelled and
subjected to the rigorous analysis which is characteristic of any properly
administered technique
...
The particular areas in which they are applied, as
described in this handbook, are:
1
...
General management as such is not a technique, but it
4 ᔡ Introduction
2
...
4
...
6
...
8
...
is a discipline which largely relies on management techniques to ensure
its success
...
Marketing management, which, as the crucial business generation
function in any company, relies heavily on techniques such as market
research, forecasting, product analysis and planning, pricing, and
marketing and sales planning and control
...
Financial management, where analytical, planning, budgeting and control
techniques play a vital part in ensuring that the organization has the
resources it needs and can afford, and that it uses them effectively
...
Information technology, which provides for computers and telecommunication systems to give the information, data-processing capacities and
facilities required in complex and fast-moving organizations
...
Planning and resource allocation, where the analytical techniques of
network planning and line of balance are used to plan projects and
calculate the resources required
...
BENEFITS
Management techniques provide a foundation for improved managerial
performance
...
They operate by means of a continuous cycle
of gathering and analysing factual data, formulating problems, selecting
objectives, identifying alternative courses of action, building new models,
weighing costs against performance and benefits, and monitoring
performance to point the way to corrective action and improvements
...
Techniques are only as good as the people who use them
...
Techniques such as
investment appraisal and risk analysis will put executives into the best
position possible to determine where they are going, but judgement is still
required
...
6
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7
Part 1
Marketing
Management
8
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9
2
Marketing Management:
An Overview
DEFINITION
Marketing is ‘the management process responsible for identifying, anticipating and satisfying customer requirements profitably’ (Chartered
Institute of Marketing)
...
As defined by Kotler,1 marketing management is: ‘The analysis,
planning, implementation, and control of programs designed to create,
build, and maintain beneficial exchanges and relationships with target
markets for the purpose of achieving organisational objectives
...
’ Marketing aims to decide what companies should do to achieve
that purpose and then to ensure that it is done
...
The target market is defined as the set of actual and
potential buyers of a product
...
ᔢ The product concept, which holds that consumers will favour those
products that offer the most quality, performance and features, and
therefore the organization should devote its energy to making
continuous product improvements
...
The limitations of these concepts are obvious
...
‘The customer is the only arbiter of quality – and an
improvement the customer cannot understand or doesn’t want is no kind
of improvement at all’ (Willsmer)
...
4 The danger of
being sales orientated is the pursuit of volume rather than profit
...
Selling is preoccupied with the seller’s need to convert
his product into cash; marketing with the idea of satisfying the needs of
the customer by means of the product and the whole cluster of things
associated with creating, delivering and finally consuming it
...
The four Ps in the
marketing mix are:
Marketing Management: An Overview ᔡ 11
ᔢ
ᔢ
ᔢ
ᔢ
Product – what is sold
...
Price – what goods or services are sold for
...
)
Promotion – how goods and services are promoted to customers through
communication and by other means
...
)
The other key marketing elements associated with the concept of marketing
mix are:
ᔢ Target marketing – the process of aiming marketing efforts to meet more
precisely the needs and wants of customers
...
ᔢ Positioning – distinguishing a brand from its competitors so that it
becomes the preferred brand in defined market segments
...
ANALYSIS, RESEARCH AND PLANNING
Marketing is an analytical process based on product life cycle analysis
(Chapter 3), the use of marketing information (Chapter 10), buyer
behaviour analysis (Chapter 11) and various forms of market research
(Chapters 12–14), and leading to systematic planning (see Chapters 17–19)
...
It will
also be concerned generally with the external environment, using techniques such as ‘PEST’ analysis covering:
ᔢ Political factors that might impinge on the operation of a business
...
Marketing has to be aware of these macro-environmental factors even though it has little control over them
...
A
company must monitor these economic factors at both domestic and
international levels so that it can be in a better position to capitalize
upon any opportunities and be aware of any threats in sufficient time to
take remedial action
...
In
some countries, the religious environment might also be a source of
opportunities or threats to companies doing business there
...
All of these can have a direct influence on the
marketing firm, particularly if its own methods of production, or the
products/services that it produces, are directly affected by, or actually
form, an integral part of the products that it offers to customers
...
BENEFITS
The potential benefits of marketing are that the company will:
ᔢ adopt a systematic approach to assessing and exploiting marketing
opportunities;
ᔢ view and organize its marketing activities from the consumer’s point of
view;
ᔢ identify, serve and satisfy a defined set of needs of a defined set of
customers;
ᔢ continually seek product improvements;
ᔢ continually develop and improve the way in which products are
presented and distributed to customers;
ᔢ operate on the basis of clearly defined plans and targets; and
ᔢ exercise control to ensure that the required results are achieved
...
Kotler, P, Marketing Management (12th edition), Prentice-Hall,
Englewood Cliffs, NJ, 2005
...
Levitt, T, The Marketing Imagination, Free Press, New York 1983
...
Willsmer, R L, The Basic Arts of Marketing, Business Books, London 1984
...
Heller, R, The Naked Market, Sidgwick & Jackson, London 1984
5
...
13
3
Product Life-cycle
Analysis
DEFINITION
The product life cycle is the sales pattern of growth and decline of a
product over a period of time
...
Product life-cycle analysis is the process of describing and forecasting
the pattern of sales for a product for a period of time or the whole of its life
...
1) and consists of four
distinct stages:
Stage 1: Introduction
...
Profits are probably
non-existent during this stage because of the costs of introducing the
product; promotional costs are high in proportion to sales, and costs per
unit of output are high because of low volume
...
1 A typical S-shaped product life cycle
Stage 2: Growth
...
If the new product is successful, the rate of sales growth gains
momentum as consumer/user demand expands following increased
knowledge and acceptance of the product because of advertising, sales
promotion and field sales effort
...
Profits increase
steadily during this period
...
When this stage is reached, the basic product concept
has gained considerable consumer acceptance
...
The
reduced rate of growth is partly caused by increased competition from
other companies either entering the market with new versions of the
product or attacking the market share achieved by the product through
more aggressive advertising, promotion, selling or pricing policies
...
During this stage profits stabilize or
decline because of increased marketing outlays to defend the product
against competition
...
The sales of most product forms and brands eventually
dip because of consumer shifts in tastes, increased competition, technological advances and the availability of substitute products
...
Purchases will tend to be of the
replacement type, but brand loyalties will progressively diminish if
nothing is done about it
...
The recycle (Figure 3
...
Sales begin to fall off, as in the typical cycle, but
are then regenerated as new applications, new product characteristics
or new users emerge
...
2
...
3)
...
This may occur when buyers take
some time to test and evaluate the product after their initial purchase
...
3
...
4)
...
The product is still in demand until a substitute
appears, when sales may decline dramatically
...
Figure 3
...
3 The humpback cycle
16 ᔡ Marketing Management
Figure 3
...
For existing company
products, the analysis provides a basis for forecasts of future sales and for
deciding on recycling actions
...
The analysis of the company’s own products covers:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
trends in sales volume;
trends in profit;
trends in market share – rate of market penetration;
economic trends (which may explain a growth or decline in sales);
the pattern of sales – who buys, where they buy, to what extent they are
first-time or repeat buyers;
ᔢ consumer opinions about the product derived from consumer surveys,
media comment or test-marketing; and
ᔢ the features of the product compared with what is available elsewhere
or is becoming available
...
In addition, it assesses the reasons why the
products are more or less competitive: price, advertising, promotion, sales,
distribution and servicing effectiveness, product features which are
uniquely attractive or increase the perceived value of the product
...
Introduction stage
ᔢ Increase advertising and promotional expenditure to accelerate growth
...
ᔢ Adjust promotional message and sales approaches in response to
analysis of consumer reactions
...
Growth stage
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
Improve quality
...
Extend market into new segments
...
Reduce prices to attract the next layer of price-sensitive buyers
...
Reposition brand to appeal to a larger or faster-growing segment
...
Modify product characteristics – new features, style improvements
...
Decline stage
ᔢ Maintain brand in the hope that competitors will withdraw their
products
...
ᔢ Terminate and withdraw the product
...
Forecasts can be made of future trends and the likely impact of
competition
...
Lifecycle analysis is a continuous process which enables the company to
review its marketing mix on the basis of a better understanding of the
performance of its product
...
APPROACHES TO PRICING
The four basic approaches to pricing are:
ᔢ The economist’s, which suggests that price is the medium through which
supply and demand are brought into equilibrium
...
ᔢ Market-based, which adopts a customer/demand focus
...
The economist’s approach is of purely theoretical interest
...
20 ᔡ Marketing Management
THE ACCOUNTANT’S APPROACH
The aim of the accountant’s approach is to seek a targeted rate of return on
investment for a specific level of sales
...
Cost-plus pricing
Cost-plus pricing (called mark-up pricing in retailing) means adding a
standard mark-up to the total cost of the product
...
If the
operating costs of the store are £4 per unit sold, the retailer’s profit margin
will be £1 or 10 per cent
...
However, prices should cover costs, so all pricing systems are, to that
degree, cost-related
...
Demand and the perceived value of
the product cannot be ignored, however
...
Standard cost pricing
Standard cost pricing is based on the cost standards developed in
management accounting systems
...
The steps taken to establish a standard cost price are as follows:
1
...
2
...
Pricing ᔡ 21
Again, this approach is also used in manufacturing and takes no account of
demand
...
The theory of marginal pricing is that, after a company’s total fixed and
variable costs have been covered by the existing volume of production, the
cost of producing an extra unit – of marginal production – will only
be the total variable cost of producing and selling it
...
Any amount by
which the selling price exceeds the variable cost of marginal outputs is
then an extra or marginal contribution to the company’s net profits and
fixed costs
...
Break-even analysis
Break-even analysis uses the concept of a break-even chart to develop a
system of target pricing in which the company tries to determine the price
that will produce the profit it is seeking
...
Break-even analysis determines fixed and variable costs and enables the
price-setter to investigate the profit implications of alternative price–
volume strategies
...
1, a break-even chart represents the following elements of costs and revenue:
total revenue
£
break-even point
variable costs
total costs
fixed costs
units
Figure 4
...
ᔢ Variable costs of labour and materials, etc, which increase in proportion
to volume
...
ᔢ Total revenue – the sales made to customers, which increase with output,
although as output increases, a company may have to trim its margins,
and revenue may then decline
...
Sales above this point will be profitable; below this point a loss will be
incurred
...
It is
therefore an essential technique for selecting the best policy, as long as
sufficient attention is paid to the demand curve
...
Target pricing
Target pricing techniques are based on break-even analysis
...
MARKET-BASED PRICING
Market-based pricing emphasizes price as a variable element of the
marketing mix
...
Value is included in this notion of price, and the underlying marketing theme is to set prices at ‘what the market will bear’
...
Companies
can employ many pricing tactics that might promote sales yet reduce
margins in the short term
...
Prices should
adopt a customer focus, and this will determine whether the product is
bought or not
...
Market share can be improved
through customer care, the delivery of value for money, quality and high
levels of service (response, delivery and after-sales service)
...
Penetration pricing
Penetration pricing involves setting prices at a sufficiently low level to
make them attractive to the mass market
...
An associated aim is to deter competitors
...
Setting-up costs are usually high and initial development costs are
recovered over a long period
...
Skimming
A skimming approach adopts a high-price strategy, charging what the
market will bear
...
This policy
is particularly attractive to a company with a new and unique product
...
Perceived value pricing
Perceived value pricing determines prices from assumptions made about
the beliefs that consumers have of the value of the product to them
...
If the company charges more than the buyer-recognized value, sales will
suffer
...
Psychological pricing
Many consumers use price as an indicator of quality
...
24 ᔡ Marketing Management
Price levels can be set just below a round figure, for example £9
...
00
...
Value for money can be emphasized by the effective presentation of
discounts and free offers
...
Promotional pricing
Promotional pricing is a method of clearing excess stocks or generating
high-volume sales by offering large discounts
...
COMPETITOR-RELATED PRICING SYSTEMS
Competitor-related pricing systems fix prices by reference to the going rate
– the level of competitors’ prices
...
The market is divided according to the levels of quality, service or
prestige provided by suppliers of the produce or service
...
The price leader is the market
leader with, usually, but not always, the highest sales in the sector
...
When using this approach, the company has to decide on its pricing
policy
...
On average their price is
better, their volume is greater and their unit costs are lower… [if] you want
to outsell everyone then get your price about 7 per cent above the average
...
It may then follow a policy
of parallel pricing by aligning its price increases with those of its
competitors
...
Two
variants of this approach are described below – competitive pricing and
discount pricing
...
Where possible, the aim would be to
Pricing ᔡ 25
set a slightly higher price than the price leader’s (say 7 per cent) and then
launch a marketing campaign to demonstrate that what Winkler calls a
‘discernible product difference’ exists
...
If the firm cannot compete on quality it may have to set slightly lower
prices or offer higher discounts of at least 10 per cent but not more than 15
per cent or so
...
It is advisable not to offer
discounts on a permanent basis
...
Considerations affecting pricing strategy
Product costs set a floor to the price but are not the only consideration
...
Competitors’ prices and the prices of substitutes provide an intermediate point that the company has to consider in
setting its price
...
The relative
elasticity of demand will influence the extent to which the company can
maintain the volume of unit sales after a price increase, or can increase
sales by means of a cut in prices
...
Winkler, J, Pricing for Results, Heinemann, London 1983
...
It distinguishes a
branded product or service from its competitors so that it becomes the
preferred brand in defined segments of the market
...
THE POSITIONING PROCESS
The five sequential steps in the process of positioning are:
ᔢ Carry out market research to gain understanding of consumer wants
and needs and to identify gaps (gap analysis) which existing, modified
or new company products or services could fill
...
ᔢ Establish the relevant attributes that are used by customers in the
segment evaluating and choosing between brands in this market
...
ᔢ Determine the positioning strategy
...
Attributes can be objective (for example colour or taste)
or subjective (for example brand name, ‘value for money’)
...
This is sometimes referred to as the unique
sales proposition (USP)
...
The process involves:
ᔢ identifying criteria, for example price and other attributes such as
colour and taste;
ᔢ identifying existing brands and analysing them by reference to the
criteria;
ᔢ mapping the brands;
ᔢ identifying any area in which existing brands are not placed – the
market gap
...
The strategy will determine where and how
the product or service will be positioned and leads to the development of
an overall marketing mix strategy
...
BENEFITS
Positioning is a means of achieving marketing objectives by ensuring that
the right product is developed at the right price in the right segment of the
market
...
Market segmentation divides the total market available to the
company into segments that can be targeted with specially developed and
marketed products and that can form the basis for positioning the product
in the market
...
ᔢ Benefits sought by customers – for example, quality, prestige, durability
and economy
...
The following
socio-economic group classification system is often used:
– A Upper middle class – higher managerial, administrative or professional people
...
– C1 Lower middle class – supervising, clerical and lower managerial
administrative or professional people
...
30 ᔡ Marketing Management
– D Working class – service and unskilled manual workers
...
ᔢ Buying behaviour – where people buy, their readiness to buy (degree of
awareness of the product), the amount they buy (light, medium and
heavy users) and their loyalty to the brand (hard core, shifting,
switchers)
...
Lifestyles are assessed by psychographics, which list variables under
three dimensions: activities, interests and opinions
...
SEGMENTATION BASES IN
ORGANIZATIONAL MARKETS
The term ‘organizational markets’ refers principally to organizational
buying behaviour
...
The ultimate objective is to satisfy the
needs of the company’s customers, be they intermediate manufacturers
further down the production chain or end customers
...
Here, the principal criterion is to
keep spending within predetermined budget limits that have been set
as part of previously agreed operational spending limits
...
BENEFITS
Segmentation concentrates the minds of those responsible for marketing
policies and plans to look for specific marketing opportunities and to
develop an appropriate marketing mix that fits in with the requirements of
identified market segments and the resources and skills of the company
...
PROCESS
The process of target marketing (note that the terms ‘target marketing’ and
‘market targeting’ are interchangeable) is the manipulation of the marketing
mix such that a distinctive product is made available for each chosen market
segment
...
When the segmentation process has taken place, each identified
segment must be assessed in order to decide whether or not it is worth
while serving as a profitable target market with its own distinctive
marketing mix
...
The company then has to decide
which potential segments to serve
...
It is this latter notion that
we explore in the next section
...
ᔢ Differentiated marketing – operating in several segments of the market
and designing separate offers for each
...
The decision will be influenced by the following factors:
ᔢ Company resources, which will determine the extent of coverage that is
achievable
...
ᔢ Product stage in the lifestyle – it might be appropriate to go for wide
coverage in the initial stages and to target specific segments as the
product matures
...
Target marketing strategies
The following strategies can be adopted for target marketing:
ᔢ Differentiated, where there are multiple marketing mixes for different
market segments
...
ᔢ Concentrated, which has one marketing mix for a segment of the entire
market
...
BENEFITS
Target marketing processes identify the particular direction the company
wants to follow in accordance with its understanding of market segmentation
...
33
8
Promotion
DEFINITION
Promotion activities are a key component of the marketing mix
...
They consist of:
ᔢ Selling, which is concerned with direct contact with customers
...
It is sometimes referred to as above the line, which is an advertising term that refers to the line above which the agency receives a
commission for placing the sponsor’s advertising
...
This is
referred to as below the line, as agencies do not receive commission here,
and a direct charge is made to the sponsor for the work performed
...
It relies for its
coverage on news or editorial about a company’s products/services and
obtaining such coverage is the province of PR
...
Selling involves identifying customers (proprietors) and then going
through a sales sequence to obtain an order
...
34 ᔡ Marketing Management
1
...
3
...
5
...
7
...
9
...
Preparation
...
Requirement identification
...
Handling objectives
...
Close
...
ADVERTISING (ABOVE-THE-LINE
PROMOTION)
Media advertising to potential or existing customers is about the products
or services on offer to them
...
Media scheduling
Media scheduling is the process of deciding what type of media to adopt
(TV, radio, cinema advertising, press, internet)
...
ᔢ Frequency, which is the number of times each person will have an
opportunity to see (OTS) or opportunity to hear (OTH)
...
ᔢ Television rating points (TVRs), which is the percentage of the target
viewing (or at least having the set on during a particular spot)
...
Budgets for media plans are prepared on the
basis of next year’s expectations of sales turnover as a result of the implementation of the marketing plan
...
Budgeting procedures
will be very different in the case of direct-response advertising, where
sales of the product depend entirely on a response directly from the
Promotion ᔡ 35
consumer to advertisements (termed ‘off the page’) or direct mail shots
...
Media planning
The media planning process consists of the following steps:
1
...
2
...
3
...
But
the planning process may indicate changes in direction or emphasis
that could result in modifications to the budget
...
Buying – using negotiating skill, research backup and ‘muscle’ to negotiate the best terms with the media
...
Evaluating
...
In this field, ‘split-run’ tests can be
run in certain media where different offers or styles are tested in
alternate (A or B) copies and the results can be compared directly
...
Market research involves
general research into consumer attitudes and responses, or particular
research into the reaction to an advertisement (reactions to proposed
campaigns can be pre-tested by qualitative research)
...
The problem is to isolate those factors other than
advertising that have affected sales
...
The media planner’s task is to assess the results of the evaluations and,
in so far as he or she considers them valid and reliable, to adjust the media
mix
...
The promotion is usually over a
limited period not normally lasting longer than six months, with the
majority lasting for a much shorter period
...
Using the same type too frequently can diminish its impact
...
Public relations
relies on editorial for its coverage, and this is based on press releases
...
BENEFITS
Promotion is a key element in the marketing mix
...
37
9
Distribution
DEFINITION
Distribution is the ‘P for place’ in the ‘four Ps’ of the marketing mix
...
DISTRIBUTION STRATEGY
The amount of market exposure required by companies formulates
channel policy and the choice of channel strategy will depend on:
ᔢ
ᔢ
ᔢ
ᔢ
the nature of the product or service;
the technical complexity of the product;
its servicing arrangements;
the image the company wishes to portray to consumers
...
The idea is that
maximum exposure at point of sale is the most important criterion
...
It is also used where retail facilities,
resources or image might have an impact on consumer impressions (for
example, expensive perfumes being sold in higher-class stores)
...
ᔢ Exclusive distribution to a limited number of retailers might be designed
to enhance the brand image of a product (for example, motor car distribution, whereby the retailer only distributes a single brand)
...
Determine the service output levels needed by customers
...
Look at the duties that channel members must perform to ensure
adequate delivery to end customers
...
Use economic or other measures to motivate channel members to carry
out their duties
...
Look for mechanisms for dealing with conflicts that might arise
between channel members
...
The internet is being
increasingly used
...
This depends on the franchiser having an idea, a powerful brand name, and a ‘secret process’ or
specialized equipment or goodwill that can attract customers
...
The franchisee then exploits that name, idea or
product and the commercial process is beneficial to both parties
...
There are also
Distribution ᔡ 39
specialist mail-order houses that deal with a limited range of lines that are
difficult to access in shops (such as specialist garden care materials)
...
LOGISTICS MANAGEMENT
Logistics management, also known as physical distribution management,
is concerned with obtaining materials from suppliers and storing,
processing, retrieving and delivering products to the customer
...
This is sometimes termed ‘the systems approach’ to distribution
management
...
The period of time between the placing of the order
and receipt of the goods is known as the ‘lead time’, and this varies for
different types of products and types of markets and industry
...
BENEFITS
It is not enough to have the right product or to promote it effectively
...
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10
Marketing Information
Systems
DEFINITION
A marketing information system provides the basis for marketing
planning
...
THE MARKETING INFORMATION SYSTEM
A marketing information system collects and analyses information to assist
marketing decision makers
...
The marketing information system operates as a decision support
system to the following four systems:
ᔢ The internal accounting system, which generates data as part of the
process of everyday business
...
This information can be used to measure efficiency ratios like
sales to selling expenses
...
If this system is to be of use in planning, monitoring and
control, marketing management needs to know how to use it effectively
...
The
type of information to which this refers is collected less formally than
marketing research, often in an ad hoc fashion
...
Marketing and other company staff come across information that may
seem inconsequential but that might be of use in marketing planning
...
Marketing intelligence is the formal process that marshals such
information together and feeds it into the information system
...
It is
their business to network effectively with people within the industry,
be they customers or competitors
...
ᔢ The marketing research system, which makes use of both secondary data
(already in existence) and primary data (collected for a specific research
purpose) through desk and field research
...
It does not produce new data, but takes
data from the other three component parts and enhances its value
...
The techniques applied to the data are
usually statistical in nature
...
Information collected from marketing research, marketing intelligence
and internally generated data can be used as inputs to sales forecasting
...
THE EXTERNAL MARKETING AUDIT
The external marketing audit is conducted by a process called environmental scanning
...
The
basic approach is known as ‘PEST’, which covers political, economic, sociocultural and technological factors
...
Marketing Information Systems ᔡ 43
BENEFITS
A marketing information system provides invaluable inputs to the
marketing planning process
...
Information on sales analysis is fed into the system
so decisions can be made as to whether or not forecast sales are being
achieved
...
The analysis has to be based on an understanding of the influences on buyer behaviour (individual or organizational) and uses various models
...
ᔢ Self-concept – consumers tend to make purchases that confirm their selfimage so that they can safeguard and boost it
...
ᔢ Perception – the analysis that identifies the meanings that buyers attach
to stimuli, how they distinguish between products and services, and
how these satisfy their needs
...
Potential
46 ᔡ Marketing Management
positive or negative attitudes need to be identified so that marketing
action such as repositioning can be taken
...
An alternative model is the buyer/decision sequence:
ᔢ problem recognition – establishing a need;
ᔢ information search – seeking ways of satisfying the need that can be
influenced by marketing;
ᔢ evaluation of alternatives – this can be influenced by promoting the
product or service;
ᔢ purchase decision – to purchase or not to purchase, based upon the
evaluation;
ᔢ post-purchase behaviour – the degree of satisfaction or dissatisfaction
will affect future purchasing decisions and sales tactics will aim to
produce a positive reaction
...
The roles
consist of:
ᔢ Users – people who work with, or use, the product
...
In some buying circumstances they help to mould the product
specification and in others their input is minimal
...
ᔢ Deciders – people with authority to make the purchasing decision
...
ᔢ Gatekeepers – personnel who control the flow of information to and from
buyers (for example, technical staff, secretarial staff who may arrange
appointments for buyers, junior purchasing personnel with whom
potential suppliers might have to liaise prior to contacting other
members of the decision-making unit (DMU))
...
They sometimes
assist in shaping the specification, but their main role is in supplier
liaison and selection
...
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12
Marketing Research
DEFINITION
Marketing research provides (1) information for management about the
company’s actual or potential markets and (2) information on the existing
or potential users of the goods or services marketed by the company
...
Marketing research provides answers to the following typical questions
put by manufacturers, distributors, wholesalers or retailers:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
How many people buy my product?
How much do they buy?
Who are my competitors?
How strong are they?
Are we/they gaining or losing?
What sort of people buy our/their products?
How responsive is my/their brand to promotion?
Has my product any particular strengths or weaknesses in different
regions or outlets or for different socio-economic groups?
This information is used to formulate plans and measure performance
...
ᔢ The nature, distribution and requirements of the industrial, commercial,
government or local government users of the goods, equipment or
services markets by the company (industrial market research)
...
ᔢ The market shares of major competitors
...
ᔢ The nature of economic and other environmental trends affecting the
market
...
ᔢ Product testing
...
ᔢ Investigation of alternative uses for existing products
...
Motivational research
ᔢ Attitudes and reactions to product attributes
...
Advertising research
ᔢ Media research
...
Marketing research techniques
The basic techniques used in marketing research are:
1
...
2
...
3
...
Marketing Research ᔡ 51
A marketing research study will normally contain two or more of these
elements
...
It will identify opportunities and gaps, reveal weaknesses and
provide a basis for effective segmentation and differentiation
...
FURTHER READING
Birn, R, The Effective Use of Market Research (4th edition), Kogan Page,
London 2004
...
Hague, P and Jackson, P, Do Your Own Market Research (3rd edition), Kogan
Page, London 1998
...
APPLICATIONS
According to Newson-Smith,1 research has three clear applications:
1
...
2
...
3
...
Background research
Desk research can provide the basic information about a market on which
further field studies or a product or market development plan can be
based
...
Desk research will
also provide the information necessary to decide on the size of the market,
rates of growth or decline, the types of product being supplied, who the
customers are and where they may be found
...
Desk analysis of, for example, the results of a retail audit (ie, analysis of
samples of retail outlets to measure the sales of different product brands)
or a product test (ie tests of consumer reactions to sample products) can
reveal much of what a marketing planner needs to know about the
consuming public’s reaction to a product
...
But desk research on its own can also be relevant in consumer marketing
where the market is diffuse and difficult to define and an unacceptable
level of sampling error may occur in the results obtained from consumer
surveys and test panels as in the food market
...
Input and output analysis can be used to set out purchases and sales
between industries so that management can more easily identify markets
to be attacked
...
BENEFITS
Desk research is:
1
...
an essential tool in industrial marketing, where good statistics are
usually available and the scope for field research is more limited; and
3
...
Desk Research ᔡ 55
REFERENCE
1
...
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14
Field Research
DEFINITION
Field research is the conducting of investigations by direct contact or
observation to collect fresh information about the attitudes and behaviour
of consumers and industrial buyers
...
the factors underlying choice and preference;
2
...
user and non-user profiles
...
It is to be distinguished from desk research, which simply
uses published or otherwise available information
...
2
...
4
...
6
...
Observation
...
Interviewing
...
Attitude scaling
...
It is used in consumer
market research because it is impracticable to get information from all
existing or potential customers, and even if it were, it would be too costly
...
But sampling investigations are subject to experimental error and the
outcome of a study has to be expressed in terms of probability and the
confidence with which its findings can be treated by management in
planning a launch or repositioning a product
...
Bias can also creep in if the sampling method does not allow each
member of the population an equal chance of contributing to the sample
...
The technique most commonly used to overcome
the costs of a very large random sample is quota sampling, in which interviewers are given a quota of informants in particular classes, such as socioeconomic status (a classification of heads of households into social grades
A, B, C, D and E), age or sex
...
Behaviour patterns can be established as a guide to the best way
to present or package a product
...
Interviewing
Interviewing is the key field-research technique because it establishes
direct contact with users or potential users
...
Unstructured or depth interviews are sometimes used to obtain impressions of feelings or attitudes
...
Research based on interviewing has to ensure by planning and control that
a representative sample of respondents is seen and that, where a structured
interview is used, the subject areas are covered comprehensively
...
They should not ‘lead’ respondents by, in effect, answering
themselves
...
Panels
Panels measure the consumer behaviour of a representative sample of
individuals or households over extended periods
...
the home audit – panel members allow an auditor into their homes to
check levels of household stocks in a product field; and
2
...
Attitude scaling
Besides measuring behaviour – what consumers actually do – market
research also attempts to assess attitudes to the product
...
To measure attitudes it is necessary to have a scale
...
Thurston’s comparative judgement technique
...
Respondents are asked to select the statement which most accurately
reflects their attitude
...
2
...
These present respondents with a series of statements and
ask them to indicate their degree of agreement/disagreement with each
...
3
...
A concept about a brand or product is
set out
...
Numerical values are then assigned to the
scale positions so that comparisons can be made between various
brands or between users and non-users of a brand
...
BENEFITS
The benefits of a properly conducted field survey are:
1
...
attitudes to new and existing products can be measured; and
3
...
61
15
Qualitative Research
DEFINITION
Qualitative research obtains information about attitudes by impressionistic means
...
identify relevant or ‘salient’ (ie significant) consumer behaviour
patterns, beliefs, opinions and attitudes;
2
...
obtain background information about consumer attitudes or behaviour
patterns;
4
...
conduct post-research investigations to amplify or explain points
emerging from a major desk or field study
...
The individual interview, which may take the form of a ‘depth’ or nondirective interview which is largely unstructured and attempts to get to
the heart of an individual’s motivation
...
2
...
The group leader
guides the discussion, encouraging members to express their views and
exchange them with one another
...
3
...
The interviewer presents
informants with the names of products in groups of three for them to
select the product that is different from the other two and to describe
how it is different
...
BENEFITS
Qualitative market research provides information on consumer tastes,
preference, attitudes and buying habits which, although subjective, can
yield significant insights which complement the more factual data
obtained from desk and field research
...
It is used for setting individual sales
staff targets at a tactical level, and makes a major contribution to the
corporate planning and budgeting system
...
SALES FORECASTING TECHNIQUES
The main techniques are summarized below:
ᔢ Derived demand includes lead/lag indicators in which an analysis is made
of trends or economic indicators that are known to be related to the data
being forecast
...
Consequently the indicator should predict the future trend
...
ᔢ Time series analysis is based on extrapolation (the process of projecting a
past trend or relationship into the future in the belief that history will
repeat itself), the components of which are trends, cycle, seasonality
and erratic events
...
This includes linear trends, exponential trends that increase by
the same percentage each year and ‘S’ shaped curves that illustrate how
64 ᔡ Marketing Management
ᔢ
ᔢ
ᔢ
ᔢ
sales build up slowly after a product launch, accelerate as the product
takes off and then ease off as maturity is achieved
...
Smoothing is used where sales fluctuate during the year and it may be
desirable to smooth out the peaks and troughs to produce a recognizable pattern for projection purposes
...
When the next quarter’s figures
are available they are added to the previous total and the sales for the
first quarter are deducted
...
The process continues until a trend is
established;
– exponential smoothing, which is a technique that takes into account
the greater significance of recent trends by progressively weighting
them more heavily and this produces an exponential curve
...
When a company has to take
account of such variations in its trading pattern when making sales
plans, it is useful to restore them by this technique
...
Statistical demand analysis treats sales as a dependent variable and it is a
function of a number of independent variables that can affect sales,
namely price, income, promotion and population
...
This technique takes
account of the various factors that are likely to affect sales, rather than
relying on relatively crude projections of past sales
...
They are used to explain how and why customers buy and gain understanding of the effects of different courses of action
...
Marketing models provide answers to what the
company needs to do to the product to improve sales, the features of
promotion that might affect customers and new brand issues
...
ᔢ Subjective methods of forecasting depend on judgement and intuition
using:
– subjective probability assessment that gets managers to rate the likelihood of something happening in percentage terms;
– the Delphi technique, whereby a panel of experts is assembled and
each makes an intuitive forecast
...
Subjective methods are not normally used exclusively
...
They can
each then serve as a check on the validity of the forecasts made by the
other method
...
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17
Marketing Planning
DEFINITION
Marketing planning decides on the basis of marketing analysis and
assessment in the context of the overall company plan:
1
...
2
...
3
...
THE MARKETING PLANNING PROCESS
Marketing planning involves the following:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
Diagnosis – where is the company now and why?
Prognosis – where is the company heading?
Objectives – where should the company be heading?
Strategy – what is the best way to get there?
Tactics – what specific actions should be undertaken, by whom and
when?
ᔢ Control – what measures should be watched to indicate whether the
company is succeeding?
68 ᔡ Marketing Management
The process of marketing planning is also described in a model called
APACS (Adaptive Planning and Control Sequence) developed by the
Marketing Science Institute which sets out the following stages:
Step 1
...
Step 2
...
Step 3
...
Step 4
...
Step 5
...
Step 6
...
Step 7
...
Step 8
...
The sequence of activities required by these processes is illustrated in
Figure 17
...
ANALYSIS
The analytical stage of marketing planning requires an appraisal of:
1
...
marketing threats and opportunities; and
3
...
The current situation
This is analysed under the following headings:
1
...
ᔢ The company’s overall objectives, explicit or implied
...
ᔢ The policies of that company, explicit or otherwise, with regard to
the use and development of these resources
...
2
...
ᔢ Current size of the market in units and sales revenue for the whole
market and each segment
...
1 The marketing planning process
70 ᔡ Marketing Management
ᔢ Sales trends over the past few years for the whole market and each
segment
...
3
...
4
...
ᔢ Description of the strategies adopted by major competitors in terms
of product range and quality, promotion, pricing and distribution
...
Distribution:
ᔢ Analysis of sales trends and developments in the major distribution
channels
...
As defined by Kotler:1
ᔢ A marketing threat is a challenge posed by an unfavourable trend or
specific event that would lead, in the absence of purposeful marketing
action, to product stagnation or demise
...
The assessment of marketing opportunities includes gap
analysis, ie the identification of gaps in the product range or segments
of the market not covered by the company or its competitors and which
can profitably be developed or penetrated by the company using its
existing or potential resources
...
2
...
No immediate action is needed
for one placed in the low/low cell
...
Future trends
The analysis of future trends takes the form of a summary of the results of
market and sales forecasts and market research activity as follows:
Marketing Planning ᔡ 71
Figure 17
...
Industry data and forecasts
...
Factors influencing purchasing/using decisions such as quality, price,
design, image, perceived market position, after-sales service
...
ᔢ Subjective forecasts of likely trends in the market giving most optimistic, pessimistic and best estimate values
...
objectives;
2
...
strategies
...
Market penetration – increase in sales to existing customers
...
Contribution or profit on sales for the period of the plan
...
It thus indicates the contribution made by the product to profit and to covering fixed costs
...
The headings to be covered are as follows:
ᔢ Market position
...
Is the company interested in achieving technological breakthroughs and introducing radically different products to
the market or is it content to maintain and develop the present product
range without making substantial changes?
ᔢ Product quality
...
What price levels should be adopted for each product?
ᔢ Promotional/advertising
...
To what extent is the company going to rely on improved
packaging to increase sales?
Marketing strategies
Marketing strategies are the broad approaches the company intends to
adopt in the longer term to achieve its marketing objectives in accordance
with its marketing policies
...
ᔢ Marketing mix – the blend of controllable marketing variables required
to produce the response wanted in the target market
...
ᔢ Marketing expenditure – how much will have to be spent to implement
the various marketing strategies
...
They specify
Marketing Planning ᔡ 73
not only what has to be done but also who does it and when it has to be
accomplished:
1
...
2
...
3
...
4
...
5
...
MARKETING BUDGET
The marketing budget sets out for the whole company and each product
group and product:
1
...
the marketing expenditure budgets for advertising promotion, research,
field sales, distribution and the costs of the marketing department itself
...
Product-mix analysis
Product-mix analysis aims to optimize profits by selling products in the
most profitable ratio to one another
...
Preliminary profit targets are set in line with corporate planning
objectives
...
Projections are made of sales revenue on the basis of the sales plans and
the pricing policies which it is believed will achieve the desired profit
target
...
Estimates are made of fixed and variable costs in relation to projected
activity levels
...
The projected contribution to profits and fixed costs (sales revenue
minus variable costs) is calculated
...
Estimated fixed costs are deducted from the contribution to show the
residual profit level
...
Adjustments are then made as required and as possible either:
ᔢ to sales plans, pricing policies or cost budgets to achieve the profit
target – these adjustments may increase marketing expenditure if it
is felt that the consequential increase in the ‘bottom-line’ profit figure
would provide an acceptable return on that expenditure; or
ᔢ to the profit target, on the basis of the assessment of what can realistically be achieved in terms of an increase in sales revenue or a
reduction in costs
...
Kotler, P, Marketing Management (12th edition), Prentice-Hall,
Englewood Cliffs, NJ 2005
...
Westwood, J, The Marketing Plan (3rd edition), Kogan Page, London 2002
...
In this chapter, product planning is examined from the
viewpoint of marketing
...
REASONS FOR PRODUCT PLANNING
ᔢ The best consumer marketers have long known that safety lies not in
products but in portfolios of products (Robert Heller)
...
What it offers for sale
includes not only the genetic product or service but also how it is made
available to the customer, in what form, when, under what conditions
and what terms of trade
...
The seller takes his or her cues
from the buyer in such a way that the product becomes a consequence
of the marketing effort, not vice versa (Theodore Levitt)
...
Products are planned and developed to serve markets
...
Even though a product
76 ᔡ Marketing Management
might, in its narrow sense, be indifferentiable, an individual supplier
may differentiate his or her product from competitive offerings through
service, product availability, and brand image, and differentiation in
one respect or another is the basis for developing a market franchise
(E Raymond Corey)
...
4
ᔢ A product is, to the potential buyer, a complex cluster of value satisfactions
...
Only the buyer or user can assign value, because
value can reside only in the benefits he or she wants or perceives
(Theodore Levitt)
...
2
...
4
...
the product line;
the product mix;
branding;
packaging;
new product development
...
Cars would be one product line in a vehicle manufacturing company
...
Second, product
line analysis considers the length of the line
...
Product line analysis will lead to decisions on the extent to which the
company wants to:
ᔢ extend the product line into the higher or lower end of the market; or
ᔢ concentrate in the higher, middle or lower end of the market
...
Product Planning ᔡ 77
PRODUCT-MIX ANALYSIS
The product mix is the set of all product lines and the numbers of models,
sizes and other significant product variations within each line that a
company offers for sale
...
The decisions
will be affected by market research on potential demand, gap analysis and
by obtaining answers to the basic corporate planning questions, namely:
1
...
What are the strengths and weaknesses of the company?
3
...
Decisions to remove non-profitable lines will be influenced by variety
reduction techniques, as described in Chapter 128
...
Brand
names may be given to individual products or to a complete product line
...
Branding differentiates the product, thus bringing it to the attention of
buyers
...
Branding also
helps to segment the market – a basic product can be differentiated into
several brands, each appealing to a different group of buyers
...
They
will be affected by the answers obtained to such questions as the following:
1
...
3
...
5
...
Is a brand name necessary?
How much quality should be built into the brand?
Should products be individually or family branded?
Should other products be given the same brand name?
To what extent can or should the market be segmented?
Should additional brands be developed in existing product categories
to exploit different market segments?
78 ᔡ Marketing Management
7
...
The packaging concept is what the package should basically be or do for a
product
...
But
packages also sell the product by conveying brand image – ie the benefits
promised by the brand to the consumer – and by facilitating the instant
recognition of the brand in shops and advertisements
...
identifying and evaluating new product opportunities and developing
them to meet market and consumer wants and needs; and
2
...
Identifying new product opportunities
The process of identifying new product opportunities starts by establishing search criteria
...
ᔢ Its experience in particular fields of development, marketing and
selling
...
Ideas for new products are generated from research and development
projects, market research activities and technological forecasting
...
Does it meet a well-defined consumer need?
2
...
Can it be differentiated adequately from alternative products in the
appropriate segment(s)?
4
...
Does it exploit the company’s existing skills and resources?
6
...
What is the likely return on that investment?
Concept development and testing
Following screening, new product ideas are developed into product
concepts which define the potential market for the product, the benefits
the product will provide to consumers and its positioning, ie how it stands
in relation to alternatives and how its distinctiveness can be established
and maintained in the minds of purchasers
...
Test marketing
New products can be tested by launching them on a limited scale in a
representative market
...
In a typical market test, the company selects a small number of representative towns in which the sales force will persuade shops to carry the
product and give it good shelf exposure
...
REFERENCES
1
...
2
...
80 ᔡ Marketing Management
3
...
4
...
5
...
81
19
Sales Planning
DEFINITION
Sales planning decides how sales targets are to be reached and sets standards for their achievement
...
THE SALES PLANNING PROCESS
Sales planning is related to the marketing plans and uses research and
control data on potential and actual sales
...
Set overall sales targets – for the year and for each sales period or
month
...
Decide on an acceptable level of selling costs in relation to sales,
prepare cost budgets and set an overall target for the ratio of selling
costs to sales
...
3
...
4
...
82 ᔡ Marketing Management
5
...
6
...
7
...
8
...
9
...
10
...
11
...
12
...
13
...
14
...
BENEFITS
Sales planning along the lines described above ensures that:
ᔢ the resources needed are deployed properly;
ᔢ the targets and standards required at all levels are set and communicated clearly;
ᔢ sales effort is directed where it will achieve the most profitable results;
ᔢ the return on sales effort and the costs thereof are maximized; and
ᔢ a sound basis is provided for the control of sales performance
...
It is commonly referred to as
e-commerce
...
1
...
The web can
supplement or complement other campaigns; it is unlikely to replace
them
...
It is particularly
appropriate, by association, for creating and monitoring the credibility
of high-tech companies and their products or services
...
1 Summary of the internet marketing process
ᔢ Increase sales – the web can provide extensive and vivid information
about a product
...
The site provides the basis for
‘one-to-one’ marketing and corporate promotional offers
...
Many of them will have bought
the product already and can be rewarded accordingly with special offers
...
A web catalogue is cheaper to update and distribute than a printed one
...
Web Marketing ᔡ 87
DEVELOPING A WEBSITE
The stages of developing a website are:
1
...
2
...
Users must be able
to register easily, to find what they want to know quickly, and to place
orders or ask for information without getting lost in a complex sequence
of actions
...
3
...
The patience of website
visitors is limited and if there is too much indigestible prose, they will
move on
...
Programme – the site needs to be programmed to enable a web browser
to use animation, video and, possibly, audio files
...
It is
important to minimize downloading time in order to be user-friendly,
however, and the simplest approach may sometimes be the best
...
5
...
6
...
Static pages (with no interactive elements) are cheaper
...
BENEFITS
The benefits of web marketing are clearly the ability to gain access to many
more customers, to enhance brand or company image and to generate
interest and sales
...
Davis, J, A Guide to Web Marketing, Kogan Page, London 2000
...
Relationship marketing is therefore primarily a concept which adds
customer service and quality to the traditional marketing mix of product,
price, promotion and place
...
1 He suggested that the relationship between a
seller and a buyer seldom ends when the sale is made: ‘In a great and
increasing proportion of transactions, the relationship actually intensifies
subsequent to the sale
...
’ According to Levitt the relationship between the buyer and the seller is ‘inextricable, inescapable and
profound’
...
ESSENCE OF RELATIONSHIP MARKETING
The essence of relationship marketing is contained within the concepts of:
ᔢ
ᔢ
ᔢ
ᔢ
the value chain;
the basic dimensions of quality and service support;
specific quality solutions; and
service support activities
...
Service and the value provided to the customer are integral and key parts
of this chain, leading to competitive advantage
...
This means doing it right, over a period of
time
...
ᔢ Assurance – knowledge and courtesy of staff and their ability to inspire
trust and confidence
...
ᔢ Tangibles – physical facilities, equipment and staff appearance
...
Service support
includes such activities as pre-sale information, objective advice, care and
attention during the sales negotiation, financing options, and after-sales
support in the form of warranties, accessories and repair services
...
This involves the following:
ᔢ Charting the service delivery system and setting standards for each part
of the system, especially the ‘encounter points’ – the critical events in
the system when the customer comes face to face with the service
process
...
ᔢ Setting service standards for all aspects of service delivery
...
ᔢ Developing programmes for contacting and maintaining good and
continuing relationships with customers with the aim of retaining their
loyalty
...
ᔢ Monitoring service standards and rewarding staff for exceeding service
levels while taking corrective action if service levels are persistently
substandard
...
BENEFITS
The benefits of relationship marketing are:
ᔢ focus on providing value to customers;
ᔢ emphasis on customer retention;
92 ᔡ Marketing Management
ᔢ the integrated approach to marketing, service and quality provides a
firmer basis for achieving sustainable competitive advantage; and
ᔢ the importance of quality and service support is made absolutely clear
to all staff
...
Levitt, T, The Marketing Imagination, Free Press, New York 1983
...
Porter, M E, Competitive Advantage, Free Press, New York 1984
...
Berry, L, Shostack, G and Upah, G, Emerging Perspectives in Services
Marketing, American Marketing Association, Chicago 1983
...
Christopher, M, Payne, A and Ballantyne, D, Relationship Marketing,
Butterworth-Heinemann, Oxford 1991
...
A database is a set of data entries which is held on a computer and
organized by a software package
...
OBJECTIVE
The objective of database marketing is to exploit information held about
customers in a way which maximizes the value of such information as a
means of targeting them in accordance with their needs and buying habits
...
Database techniques also offer a means of
defining and refining markets
...
DEVELOPING A DATABASE
The steps required to set up a database are to:
1
...
decide on the sources of that information; and
3
...
Information requirements
Information requirements will depend entirely on the type of business, its
marketing strategies, how it carries out marketing and selling activities
and the target population of existing customers or prospects (the
‘audience’ in mail-order operations)
...
ᔢ Demographic data – statistical information about population groups
covering such areas as numbers by age and marital status, type of
housing and socio-economic conditions such as numbers in certain
types of occupation, levels of car ownership, etc
...
The assumption is then made
that differences in the demographic make-up of groups will be reflected
in differences in purchasing behaviour
...
ᔢ Psychographic data – information about the personal characteristics of
customers covering such items as their household, their possessions,
their interests and their buying behaviour
...
Obviously, this is collected from records of sales transactions
...
It will be essential to provide precise postcodes (this can be
done through a specialized computer bureau)
...
This can be obtained from the census
...
This profile will not accurately describe every
household but will probably apply to a sufficiently large proportion of
them to justify targeting sales to all residents in accordance with the
overall profile
...
ᔢ Psychographic data
...
They obtain their information
through surveys which involve the completion of questionnaires by
people and their subsequent analysis
...
This software can be obtained from a software house
as a package, or it can be custom-built by a software consultancy
...
96 ᔡ Marketing Management
FURTHER READING
Fairlie, R, The Marketing Person’s Guide to Database Marketing, Exley
Publications, Watford 1990
...
THE CONTROL PROCESS
The basis of control is measurement, so that what has been achieved can be
compared with what should have been achieved
...
2
...
4
...
THE ELEMENTS OF MARKETING CONTROL
The headings under which marketing control is exercised are the same as
those used for setting targets and budgets in the marketing plan:
98 ᔡ Marketing Management
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
sales volume and revenue;
gross margin or contribution;
net profits;
market share;
marketing expense
...
The reasons for the variance are then established, which should
indicate the corrective action to be taken
...
These results are
compared with the forecast and the positive or negative variance
recorded
...
Information is recorded for comparative
purposes on the sales achieved in the corresponding period in the
previous year and for the corresponding year-to-date figure for the
previous year
...
1
...
1 Marketing control data
This month
Year-to-date
Actual
Sales
£000
Forecast
Previous
year
Actual
Forecast
Previous
year
2,856
2,888
2,710
18,414
17,310
16,500
Charting sales data
Actual sales are displayed and compared with the forecast by use of the Z
chart (see Figure 23
...
The name arises because the pattern on such a
graph forms a rough letter Z
...
2
...
4
...
Cumulative total actual sales for the year to date
...
The forecast cumulative sales
...
1 Z chart used for marketing control
Variance analysis
Variances are analysed to find out why they have happened
...
Variances can be caused by one or a
combination of any of the following three factors and should be assessed
accordingly:
1
...
2
...
3
...
Variance analysis may reveal inadequacies in performance, but it could
indicate unrealistic (ie over-optimistic or unduly pessimistic targets or
budgets)
...
100
Variances in contribution are attributable to differences between
forecast and actual sales or between budgeted and actual variable costs
...
Variances can be caused by differences between
actual and budgeted costs or by variations in the product mix
...
Marketing costs are analysed in the same way as sales and contribution
– the analysis of variances should not only establish why they have
happened but also what results have been obtained from any extra expenditure incurred, eg an estimate of the impact on sales of spending more on
promotion or advertising
...
This is the ‘bottom line’ from the marketing point of view
...
But the marketing function has a key responsibility for
achieving the net profit budget and must regard this as the ultimate
measure of its performance
...
Market saturation – the relationship between actual market volume of
sales and market potential
...
The degree of saturation achieved against
Marketing Control ᔡ 101
budget indicates the extent to which marketing opportunities have
been seized or are still available for further exploitation
...
Market penetration – the relationship between actual market share in
terms of sales and the actual market volume
...
BENEFITS
Monitoring control information is the best way to ensure that what was
intended has been done
...
In addition, this analysis highlights any
faults in the forecasting and budgeting process which can be corrected in
the future
...
THE PROCESS OF SALES CONTROL
Sales control is exercised by comparing the results achieved with the
targets, standards and budgets contained in the plan
...
This section concentrates on field sales control as the most important
element in most companies
...
1
...
1:
Figure 24
...
The number of calls made by representatives against targets
...
The quality of those calls against the quantitative targets for success and
sales per call and the qualitative standards for the effectiveness of the
sales representative during the calls
...
The allocation of sales effort by sales management to achieve economy
and effectiveness in the deployment of sales representatives
...
The quantitative information is obtained by returns and reports originally
from the individual sales representatives for their territories and analysed
by area and region
...
CONTROLLING SALES PERFORMANCE IN
THE FIELD
Sales performance in the field is controlled under three headings:
1
...
2
...
3
...
OVERALL CONTROL
The best overall measure of sales performance in the field is the contribution
...
106 ᔡ Marketing Management
BENEFITS
Managing a sales force consisting of independent-minded people scattered far and wide is never easy
...
Information not only on
sales but also on what the sales force is actually doing and how well they
are doing it is essential to maintain a sense of direction towards achieving
corporate sales targets
...
107
Part 2
Operational
Management
108
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109
25
Operations and Products
DEFINITION
Operations management is responsible for all the activities that are
directly concerned with making an organization’s products
...
GOODS AND SERVICES
Operations managers see every organization as making a product
...
From an operations viewpoint,
the intangible services given by an insurance company are their products,
in exactly the same way as washing machines are the products of other
companies
...
Ford is clearly a manufacturer of cars, but its products include warranties,
finance options and a range of other services; the BBC clearly provides a
service, but its products include books, videos and a range of other goods
...
1)
...
1 Spectrum of products from largely goods to largely services
OPERATIONS AND PRODUCTS
At the heart of every organization are the activities that make its products
...
To put it simply, the operations
describe what the organization does
...
A common view of operations is that they take a number of inputs, and
transform them into products (see Figure 25
...
The inputs include
raw materials, money, people, machines, time and other resources
...
The outputs are goods, services, waste material and so on
...
These operations
manufacture, serve, transport, sell and do everything needed to supply
INPUTS
INPUTS
People
People
Facilities
Facilities
Materials
Materials
Equipment
Equipment
Information
Information
OPERATIONS
OPERATIONS
OUTPUTS
OUTPUTS
Manufacture
Manufacture
Goods
Goods
Service
Service
Services
Services
Supply
Supply
Secondary
Secondary
outputs
outputs
Transport
Transport
Figure 25
...
Not surprisingly, the people who are responsible for these
operations are the operations managers
...
When taken together, all the operations that make a particular product
form its process
...
(See Figure 25
...
)
The aim of every organization is to make a product that satisfies
customer demand
...
The
features of a product depend on the process used to make it, so this
process must be appropriate, effective and efficient
...
Customers
to satisfy
create
Products
Demand
which
passes to
to make
Processes
Operations
who
use
Figure 25
...
The operations in British
Steel (or Corus), for example, do not seem to have much in common with
the operations of a local charity shop
...
Despite these apparent differences, most organizations actually face a
range of similar problems
...
Typical questions faced by operations managers include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
What products do we make?
What type of process do we use to make them?
How can we best organize our resources in the process?
How can we forecast demand and set production levels?
How do we guarantee high quality?
Where do we locate the operations?
How do we organize the flow of materials through the process?
Who do we employ and what skills do they need?
Who are the best suppliers for materials?
How do we organize distribution to customers?
The aim of operations managers is to find the best answers to these and a
range of related questions
...
They start by showing how the operations fit into the broader
business strategies
...
These concepts set the overall direction of operations and give
Operations and Products ᔡ 113
the context for other decisions
...
Operations managers look for the best way of organizing their resources
and making products
...
Ways of using operations management to gain a
competitive advantage are discussed in Chapter 27
...
Chapter 28 looks at
some aspects of product design and the following two chapters look in
more detail at product planning and new product development
...
This theme is introduced in Chapter 31, and extended with
descriptions of total quality management in Chapter 32 and quality control
in Chapter 33
...
This is not known with certainty in advance, but must be forecast
...
These forecast
demands can be used to find the best process
...
A key
question for a process concerns the best level of automation, and this is
discussed in Chapters 37 and 38
...
Every organization must measure its performance
...
There are many
alternatives to this, some of which are described in Chapters 40 and 41
...
The next chapters look at different aspects of planning
...
Chapter 44 shows how this is applied to capacity planning, and Chapters
45 and 46 look at tactical aggregate plans and master schedules
...
The next two chapters introduce alternative approaches to planning
...
This approach to ‘dependent
demand’ systems is expanded in Chapter 50
...
These special approaches are grouped
together in Chapter 52 under the topic of ‘project management’
...
The last group of chapters in this section discusses supply chain
management
...
Then Chapters 55 to 57 look at procurement, inventory control
and facility location
...
They show how the operations set about making the organization’s products – and hence satisfying
customers and achieving long-term objectives
...
Slack, N, Chambers, S, Harland, C, Harrison, A and Johnston, R, Operations
Management (2nd edition), Pitman Publishing, London 1998
...
115
26
Operations Strategy
DEFINITION
The operations strategy of an organization consists of all the long-term
decisions, policies and plans made for operations management
...
CONTEXT OF THE OPERATIONS STRATEGY
Senior managers make the long-term strategic decisions that set the
overall direction of an organization
...
116 ᔡ Operational Management
ROLE OF THE OPERATIONS STRATEGY
An operations strategy is one of the key functional strategies
...
The operations strategy gives the context for all other decisions in operations management
...
It is the link between the more
abstract corporate and business strategies and real products and
processes
...
If a company’s
strength is making high-quality products, while its competitors are aiming
for lower quality, it can get a clear advantage by making the highest
quality products
...
These comparisons are formalized in a SWOT
analysis – which lists the organization’s strengths, weaknesses, opportunities and threats:
ᔢ Strengths show what the organization does well – features on which it
should build
...
ᔢ Opportunities can help the organization – openings that it should seize
...
Strengths and weaknesses describe the organization’s internal features,
and typically include people, products, structure, finances, reputation,
processes, assets, innovation and knowledge
...
DESIGNING THE OPERATIONS STRATEGY
The operations strategy shows how an organization plans to build its
strengths into a distinctive competence that will give it a competitive
advantage
...
Operations Strategy ᔡ 117
The operations strategy is framed in general terms and describes the
features of products – processes rather than the details
...
This gives the
general concept, which leads to a series of related, more detailed decisions
...
Managers approach this in many different ways, usually
involving a mixture of analysis, reasoning, experience and intuition
...
Analyse the business strategy – and other strategies – from an operations viewpoint
...
2
...
3
...
4
...
This identifies the market, customers, competitors, their performance,
products, changes, and so on
...
Find the factors that will lead to success in this market, and the importance of each one
...
6
...
This includes factors such as capacity, quality, flexibility and
level of technology
...
Design the best organizational structure, controls and functions to
support the process
...
Define measures to compare actual performance with planned,
optimal and competitors’ performance
...
Implement the plans, setting the aims and conditions for other levels
of decisions
...
Monitor actual performance and continuously look for improvements
...
These policies concentrate on the type of customers to be
served, the type of products to be made, the types of processes to be used
and the associated organization of resources
...
Even with the best intentions
and communications, senior managers can become too remote from
operations: they see the financial ratios, but have little idea how the
operations are really done
...
Some common problems with strategies are:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
they are badly designed;
they are not implemented properly;
they are not related to actual operations;
they are not realistic;
they ignore key factors;
people only give the appearance of supporting the strategies;
enthusiasm for the strategies declines over time
...
At the end of this, managers have answered questions about all aspects of the operations
...
1 shows some examples
of these questions
...
1 suggests
...
FURTHER READING
Johnson, G and Scholes, K, Exploring Corporate Strategy (4th edition),
Prentice-Hall, London 1997
...
Operations Strategy ᔡ 119
Table 26
...
To be successful, an
organization has to develop its strengths into a distinctive competence
that gives it a sustainable competitive advantage
...
The operations strategy gives the
general concepts for these products and the processes used to make them
...
Unfortunately, when we begin to move beyond the general concepts, we
quickly meet problems
...
Customers would like to buy highquality products with lots of features at very low prices – but organizations
would like to make standard products, with few features and higher prices
...
Not only do customers and producers want different features in their
products but each customer frequently wants a different product
...
Again the operations managers have to find a compromise
between the wide range of products that customers would like to buy, and
the narrow range that the organization would like to produce
...
If there are many suppliers offering similar products, the
customers may have more power and their demands become more
important
...
An important point for operations is the way that customers approach
their purchases
...
The first stage finds a shortlist of products that have the qualifying
factors
...
The second stage looks at order-winning
factors
...
Operations managers have to make sure that their products have all the
important qualifying factors, and as many of the order-winning factors as
possible
...
Cost leaders make the same, or comparable, products more cheaply
...
Product differentiation makes products that customers cannot find
anywhere else
...
TOWARDS PRODUCT DESIGN
A traditional view of marketing says that an organization can compete by
concentrating on the ‘four Ps’:
ᔢ
ᔢ
ᔢ
ᔢ
Product – developing the right products that customers want
...
Price – setting a price that is acceptable to customers
...
A broader view says that an organization can compete by building on the
strengths of its operations
...
Some of
the most important of these, from an operations point of view, are listed
below:
ᔢ Cost
...
Such organizations typically aim at high sales, lowering unit costs by automation,
eliminating waste, reducing stocks, cutting overheads, and so on
...
Few customers are willing to accept poor quality, even at a low
price
...
ᔢ Timing
...
This might mean that products are
delivered at specified times, or with short development times for new
products
...
ᔢ Flexibility
...
There are two important aspects to flexibility:
product flexibility, which makes products that are customized to individual customer needs; and volume flexibility, which allows an organization to respond quickly to changing levels of demand
...
Some organizations, such as computer manufacturers or
mobile telephone operators, remain competitive by using the latest
available technology
...
There are many ways for operations managers to develop a competitive
advantage
...
FURTHER READING
Stacey, R D, Strategic Management and Organisational Dynamics (2nd
edition), Pitman, London 1996
...
124
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125
28
Product Design
DEFINITION
Product design describes the features of product
...
MATCHING PRODUCT DESIGN TO DEMAND
An operations strategy sets the general features of an organization’s
products and the processes used to make them
...
Many people think that designers are only interested in the
appearance of the finished product
...
Designers at McDonald’s
are not only interested in how its Big Mac looks, but also how it tastes,
how customers like it, how to cook it, the design of the restaurant and
kitchen, staff uniforms, where the materials come from, and all the other
parts of the product package
...
FEATURES OF THE DESIGN
There is such a wide range of products – and so many different factors to
consider – that it is almost impossible to describe specific features that
make a good design
...
Functional
Being functional means that the product can do the job for which it is
designed – it must be ‘of merchantable quality and fit for the purpose
intended’
...
This is the idea behind prototypes and test
marketing
...
This
essentially forms a table with the customer demands listed down one side,
the proposed design features listed across the top, and an indication of
how well the two are matched in the body
...
Easy to make
From an operations point of view, the best products are fast, cheap and
easy to make
...
SIMPLIFIED AND STANDARD PRODUCTS
Operations managers like to simplify and standardize product designs
...
Standardizing uses common parts and materials in a range of different
products
...
Standardization does not necessarily reduce the choice of products,
as the same parts can be used in a variety of ways
...
This makes sure that the design is as easy to make as possible, typically suggesting designs that are simple, have a small number of operations,
use as few parts as possible, use modular designs, have common parts
across the product range, use inexpensive materials, do not interfere with
other operations, use high-quality materials to reduce defects, and so on
...
This asks
whether customers see a product as giving good value – which means that
the amount they are asked to pay is low in relation to the benefits they get
...
128 ᔡ Operational Management
FURTHER READING
Baxter, M, Product Design, Chapman & Hall, London 1995
...
Hollins, B and Pugh, S, Successful Product Design, Butterworths, London
1990
...
The aim of product planning is to ensure that an organization
continues over the long term to supply products that customers want
...
A product that is very popular
this week might have no demand next week
...
1:
1
...
2
...
3
...
4
...
5
...
130 ᔡ Operational Management
Demand
Time
introduction
growth
maturity
decline
withdrawal
Figure 29
...
Product life cycles have five important consequences for operations
managers:
ᔢ Organizations emphasize different types of operations at each stage of
the life cycle
...
ᔢ Organizations with different expertise start (and later stop) making
products at different points in the life cycle
...
ᔢ Organizations need to continually develop new products to replace
older ones
...
EMPHASIS OF OPERATIONS DURING THE
LIFE CYCLE
The life cycle of every product has unique features, but we can describe a
general, if somewhat simplified, view of the operations
...
At the end of this, the product is launched and moves into the
introduction stage
...
The initial design of the
Product Planning ᔡ 131
product is adjusted as customers give their reaction, so the operations must
be flexible enough to deal with changes in both demand and specifications
...
The
product design becomes more stable, and operations managers look for
improvements in the process, typically changing to a more automated one
...
Units
are no longer made for specific orders, but are put into a stock of finished
goods, from which customer demands are met with short lead times
...
Eventually, the product reaches its mature stage, when demand stabilizes
...
Some early
competitors have stopped production, leaving the market to a few larger
companies, who are competing on price
...
Eventually demand will decline, and competitors will drop out of the
market
...
When this is
no longer worthwhile, they will design termination procedures to stop
production
...
2
...
2 Amount of innovation during a product life cycle
132 ᔡ Operational Management
COSTS, REVENUE AND PROFITS DURING
THE LIFE CYCLE
Before a new product is introduced, the organization spends money on
research, development, design, planning, testing, setting up new facilities
and so on
...
In the early stages of the life cycle the unit costs are high
...
At this stage the profit on
each unit may also be high, as customers are willing to pay a premium to
get a new or novel product
...
3
...
At this point the development costs are recovered and
the product starts to make an overall profit
...
Demand
Time
Costs
Time
Revenue
Time
Net profit
Time
Figure 29
...
By
this time competitors start to make similar products and demand slackens,
so both the unit price and revenue begin to fall
...
Sometimes, improved production methods,
experience and higher productivity can offset the decline, but profits will
inevitably fall
...
ENTRY AND EXIT STRATEGIES
Some companies spend a lot of money on research and development to
find new products
...
These companies look for the high
profits that come from new products, but they have to bear the high cost of
research and development
...
Most
organizations, however, do not start with basic research to develop
entirely new products; nor do they continue making a product through its
entire life
...
Then they try to find an
existing product which would fit into their own range, and which they
could modify to create their own ‘new’ product
...
The
time when an organization starts – and later stops – making a product
defines its entry and exit strategy
...
We can describe three common strategies as follows:
Research driven
ᔢ do basic research to give the ideas and technology for new developments, but they do not exploit them;
ᔢ work in the introduction stage and leave the market before the growth
stage – as they lack the resources and production skills to manage a
growing demand;
ᔢ are good at research, design and development;
ᔢ are innovative with constant changes in product;
ᔢ are characterized by high quality and high cost;
ᔢ are characterized by low sales volumes;
ᔢ are characterized by slow delivery
...
Cost reducers
ᔢ design very efficient operations, so they enter the market at the mature
stage and produce large quantities efficiently enough to compete with
organizations already in the market;
ᔢ exit when the product declines and the volume is too low to maintain
high production levels;
ᔢ are characterized by high-volume, low-cost production;
ᔢ are characterized by low innovation, concentrating on established
products;
ᔢ are characterized by low price and fast delivery;
ᔢ are often automated with production or assembly lines
...
Some
companies, for example, specialize in entering declining markets and
extending product lives
...
Organizations allow for these differences by
supplying a range of similar or related products
...
When they look for new
products, they want products that are similar to those they already make
but are different enough to create new demands
...
An obvious question is ‘how wide should the range of products be?’
Customers want a wide range of products, so they can choose one that
Product Planning ᔡ 135
gives a close fit to their individual needs – but producers want a narrow
range so they can benefit from:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
giving long production runs that reduce equipment set-up times;
using specialized equipment that has high productivity;
making production routine and well practised;
increasing experience and expertise with the product;
encouraging long-term improvements to the product;
making purchasing, inspections and handling routine;
reducing staff training time;
reducing stocks of parts and materials
...
If its range is too narrow, the organization can use
standard operations, but it loses customers to competitors who offer more
products, or different ones
...
However wide the range, organizations try to have products at different
stages in their life cycles
...
The overall production is smoothed as shown in Figure 29
...
Demand
Overall demand
D
B
C
A
E
Time
Figure 29
...
Kuczmarski, T D, Managing New Products (2nd edition), Prentice-Hall,
Englewood Cliffs, NJ 1992
...
Product development
includes all the work needed to ensure this supply of new products,
starting with the generation of ideas, and finishing with the introduction
of new products
...
The planning for this new product has
several stages, which start with the generation of ideas, and end when the
product is actually sold to customers
...
Stage 1: generation of ideas
Most organizations continuously search for new ideas they can exploit
...
New ideas are surprisingly easy to find – the difficulty is looking at these
ideas, choosing the best and turning them into viable products that
customers will buy
...
This screening can quickly reject products that:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
are impossible to produce, or are technically too difficult;
have been tried before and were unsuccessful;
duplicate an existing product;
need expertise or skills that the organization does not have;
do not fit into current operations;
would obviously not sell;
would obviously not make a profit;
are too risky
...
1)
...
This stage gives
a technical evaluation of ideas
...
General questions about the concept:
ᔢ
ᔢ
ᔢ
ᔢ
Can the product be made?
Is the idea based on sound principles?
Is it safe and legal?
Is it entirely new, or a variation on old ideas?
Developing New Products ᔡ 139
Commercial
success
Launch
Final product
development
Commercial
evaluation
Technical
evaluation
20%
Initial
screening
Proportion of ideas remaining
100%
Time
Figure 30
...
At this point, the initial designs for the process are
also considered
...
This stage removes
products that:
140 ᔡ Operational Management
ᔢ customers will not buy;
ᔢ are too similar to existing products;
ᔢ are so different from existing products that customers will not accept
them;
ᔢ are in a rapidly declining market;
ᔢ do not fit into existing strategies;
ᔢ will not make enough profit, or have margins that are too small;
ᔢ need too much capital, or have poor returns on investment;
ᔢ have too high production or operating costs
...
If this case is sound, the product moves forward to full
development
...
This is where all the lessons learnt from previous stages, together with the
results from customer surveys and any other relevant information, are
used in the final designs
...
This design
describes the overall package, including the design of any goods, the
services offered, materials used, quality measures, and everything else that
forms the final product package
...
Stage 6: launch of product
After the development, production starts and the organization offers its
new product to customers
...
Many products are not
successful and are quickly withdrawn
...
Even fewer become
successful products
...
If, for example, the results of the
commercial evaluation are unclear, the organization might adjust the
designs and initiate a new technical evaluation
...
Faster development can make an organization the first to market
a new product and so gain the price premium of new products, gain a
dominant position in the market, and set the standards for later
competitors
...
An obvious way of reducing the development time is to use concurrent
development
...
The initial screening of ideas, for example, need not wait until all
ideas have been generated; it can quickly remove obvious non-starters
while other ideas are still being generated
...
Companies using
concurrent development in different industries have reduced the time to
bring new products to market by up to 70 per cent
...
Urban, G and Hauser, J R, Design and Marketing of New Products (2nd
edition), Prentice-Hall, Englewood Cliffs, NJ 1993
...
142
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143
31
Quality Management
DEFINITION
Quality management is concerned with the plans, decisions, tests, design,
performance and all other aspects of a product’s quality
...
This is fairly clear,
but we hit a major obstacle when trying to define exactly what we mean
by ‘quality’
...
Sometimes
there are agreed measures for quality, such as the industry standards for
concrete, but these are very specific and cannot be used for other
products
...
This gives one view of quality, which is that
quality is the ability of a product to meet – and preferably exceed –
customer expectations
...
This still gives a rather vague idea of quality, especially as different
customers have different expectations
...
This list identifies two specific views of product quality: an internal view,
from the producer, who defines quality as the closeness of a product’s
performance to its designed specifications, and an external view, from the
customer, who defines quality by how well a product does the job it was
bought for
...
More recently, organizations have taken more notice of
customers’ views, and have recognized the obvious point that it is
customers who decide when a product meets their expectations
...
They want some balance of features that gives an acceptable
overall picture
...
This leads to another two aspects of quality: designed quality
– which sets the quality that a product is designed to have; and achieved
quality – which shows how closely a product comes to meeting the
designed quality
...
This has happened for four main reasons:
ᔢ improved processes can make products with guaranteed high quality;
ᔢ high quality gives a competitive advantage;
Quality Management ᔡ 145
ᔢ consumers have become accustomed to high-quality products and will
not accept anything less;
ᔢ high quality reduces costs
...
If
they make poor-quality products, customers will simply move to a
competitor who is better at meeting their expectations
...
Long-term survival, coming from satisfied customers, is the major
benefit of high quality
...
COSTS OF QUALITY
One interesting point from the list above is that higher quality reduces
costs
...
If you look at the wider costs,
however, you see that some actually go down with increasing quality
...
You
complain, and the manufacturer arranges for the machine to be repaired
...
At this point we should look at the costs of quality in a little more detail
...
Prevention costs are the costs incurred to prevent defects occurring
...
Prevention costs cover all
aspects of quality that are designed into a product
...
They
also include indirect costs related to the ease of production, type of
process, amount of automation, procurement needed, skills needed by
employees, and the amount of training they need
...
Appraisal cost is the cost of ensuring that the designed quality is actually
achieved
...
Related
costs include sampling, inspecting, testing and all the other elements of
quality control (which is discussed in Chapter 33)
...
Internal failure cost
...
This involves extra work and higher costs
...
The further a product goes through the process, the more money is
spent on it and the more expensive it will be to scrap or rework
...
Part of the internal failure costs come directly from the loss of material,
wasted labour effort, wasted machine time in making the defective item
and so on
...
External failure cost
...
If a
unit that goes through the entire process is delivered to a customer and is
then found to be defective, the producer must bring the defective unit
back from the customer and replace, rework or repair it as necessary
...
External failure faults are often the highest costs of quality management
and are the ones that should be avoided
...
MINIMIZING THE TOTAL COST OF QUALITY
The total cost of quality comes from adding these four separate components
...
1 Minimum costs come with perfect quality
per cent of sales – with the failure costs being highest
...
1
...
This is the idea of total quality management, which is described in
the next chapter
...
Kehoe, D F, The Fundamentals of Quality Management, Chapman & Hall,
London 1996
...
148
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149
32
Total Quality Management
DEFINITION
Total quality management (TQM) has the whole organization working
together to give products with guaranteed high quality
...
AIMING FOR PERFECT QUALITY
The last chapter showed how organizations could minimize their costs by
aiming for perfect quality or zero defects in their products
...
A better alternative is not to inspect units and discard defective ones but to make sure
that no defective units are made in the first place
...
The key idea behind TQM is that quality management is not a separate
function to be treated in isolation, but is an integral part of all operations
...
Suppose you go
to a tailor and order a suit
...
This means that everyone in the tailor’s shop – from the person who
designs the suit to the person who sells it, and from the person who owns
the organization to the person who keeps it clean – is directly involved in
the quality of their product
...
During the process, operations departments take responsibility for their
own quality
...
This is quality at source, with job enlargement for each
person who is now responsible for both their previous job and an inherent
quality management function
...
They find the cause of the fault and suggest ways of avoiding more faults
in the future
...
Traditionally people were paid to make high volumes – often using
‘piece work’ – with little regard for quality
...
These might be collected at quality circles, which are
informal groups of about 10 people who work on a process
...
Their aim is simply to discuss the operation and try to find improvements
...
Table 32
...
IMPLEMENTING TOTAL QUALITY
MANAGEMENT
Total quality management needs major changes within an organization
...
1 Different attitudes introduced by TQM
Criteria
Traditional attitude
New attitude with TQM
Importance:
Cost:
Responsibility:
Target:
Measured by:
Emphasis:
Attitude:
Defined by:
quality is a technical issue
high quality costs money
quality assurance department
meet specifications
average quality level
detecting defects
inspect quality
organization
quality is a strategic issue
high quality saves money
everyone in the organization
continuous improvement
zero defects
preventing defects
build quality
customers
changes and developing his ideas of TQM
...
Deming’s 14 principles
1
...
2
...
3
...
4
...
5
...
6
...
7
...
8
...
9
...
10
...
11
...
12
...
13
...
14
...
Deming’s 14 points suggest a new way of thinking in organizations
...
The process is really in two parts: the
system over which managers have control, and which contributes 85 per
cent of the variation in quality; and the workers who are under their own
control, and who contribute 15 per cent of the variation in quality
...
STEPS FOR IMPLEMENTATION
Now we have seen what is involved with TQM, we can describe the steps
that are needed for its implementation
...
Get top management commitment
...
Managers
have control of the organization, and they must realize that TQM is not
another fad that will disappear in a few months but is a way of thinking
that improves long-term performance
...
Find out what customers really want
...
This goes beyond simply asking for opinions, and gets customers
involved in the process, perhaps discussing designs in focus groups
...
Design products with quality in mind
...
4
...
The quality of the product
depends on the process used to make it, so this must work effectively
and efficiently to achieve perfect quality
...
Build teams of empowered employees
...
6
...
TQM looks for continuous improvement, with the
adjustments to products and processes having a cumulative effect over
time
...
Extend these ideas to suppliers and distributors
...
It can take years of continuous effort to implement TQM, so it is not
surprising that many organizations fail somewhere on this road
...
Perhaps suppliers cannot guarantee the
quality of their materials; or managers only gave TQM lip service without
becoming really involved; or administration got out of hand; or the
process could not reduce the variability enough; or TQM simply was not
implemented properly
...
Total Quality Management ᔡ 153
ISO 9000 STANDARDS
The International Standards Organization (ISO) has designed a family of
standards for quality management
...
There are actually five separate standards:
ᔢ ISO 9000, which defines quality and gives a series of quality standards
for which an organization might aim, with guidelines for their use;
ᔢ ISO 9001, which is used by organizations that design and make
products – it is the most comprehensive of the standards and deals with
the whole range of TQM, from initial product design and development,
through to standards for inspecting and testing final products;
ᔢ ISO 9002, which is used by organizations that make standard products
and has less involvement in the design – it concentrates on the actual
process, and how to document quality;
ᔢ ISO 9003, which deals with final product inspection and testing procedures; and
ᔢ ISO 9004, which is a guide to overall quality management and related
systems, and says how operations can develop and maintain quality
...
ISO 9001, 9002 and 9003 describe
what a quality management system must achieve to be certified
...
FURTHER READING
Bounds, G, Yorks, L, Adams, M and Ranney, G, Beyond Total Quality
Management, McGraw-Hill, New York 1994
...
Oakland, J S, Total Quality Management (2nd edition), Heinemann, London
1992
...
PRODUCT VARIABILITY
No matter how good the operations are, there will always be some variation in the units made
...
Provided these variations are small,
the performance of each unit remains within acceptable limits
...
The way to improve quality, therefore, is to reduce variability between
units, and get the performance of each as close to the target as possible
...
The further a unit is away from the target, the higher
is this cost
...
This is the purpose of quality control
...
It ensures that designed quality is actually
being achieved
...
Then the organization should find
the cause of the problem and correct it before any more defects are made
...
It is often difficult to find the real cause of a fault, but two simple diagrams
help with this
...
Suppose a
customer complains at a hamburger restaurant
...
Problems with
the raw materials may, in turn, be caused by suppliers, storage or costs
...
1
...
1 Part of a cause-and-effect diagram
Quality Control ᔡ 157
Pareto charts are based on the observation that 80 per cent of the
problems come from 20 per cent of the causes
...
Typically, a few causes will be
responsible for most of the problems
...
2)
...
The main effort in quality
control should be early in the process, with tests on materials when they
arrive from suppliers or before they leave the suppliers
...
If the main effort of inspection is started early
enough, there should be very few defects in the later stages, and the product
reaching the customer should be as nearly free from errors as possible
...
For raw materials:
ᔢ during suppliers’ operations;
ᔢ on arrival at the organization
...
2 Example of a Pareto chart
Food
cooking
Food
ingredients
Too limited
menu
Wait for a
table
Wine
Comfort of
chairs
Smokers too
close to nonsmokers
Slow service
0
Temperature
of restaurant
10
Mistakes on
the bill
Percentage of problems
60
158 ᔡ Operational Management
During the process:
ᔢ
ᔢ
ᔢ
ᔢ
at regular intervals during the process;
before high-cost operations;
before irreversible operations, like firing pottery;
before operations that might hide defects, like painting
...
It is, of course, possible to have too many inspections
...
SAMPLING
It is often impossible to test every unit as it moves through its process
...
Reasons for using samples rather than the whole output include:
ᔢ expense – it may be too expensive to test each unit;
ᔢ time needed – some tests are so long or complicated that they cannot be
fitted into normal operations;
ᔢ destructive testing – sometimes tests are destructive;
ᔢ reliability – no test is completely reliable, so testing all the units does not
necessarily give better results than a sample;
ᔢ feasibility – sometimes, as when testing new medicines, there is an
infinite number of tests that could be done
...
This gives a
general approach to sampling, with the following steps:
1
...
2
...
3
...
4
...
5
...
Quality Control ᔡ 159
6
...
7
...
The sample size and number which must be satisfactory are largely a
matter of policy – managers set the quality levels they want to reach and
standard sampling plans give the details of samples
...
Alternatively, the
organization can work to a higher standard than customers will accept, so
that if a ‘defect’ fails the organization’s criterion, it is still acceptable to
customers
...
The way to get more accurate samples is
to make them bigger – the larger the sample, the more reliable the results
...
ACCEPTANCE SAMPLING
There are two types of statistical quality control
...
It takes a sample of units from the batch
at the beginning or end of an operation, and tests to see whether the whole
batch should be accepted or rejected
...
It takes a sample
during the operations to see if the process is working within acceptable
limits or if it needs adjusting
...
3
...
There are two
main types of acceptance sampling
...
Then the performance of this
property in the batch is compared with the designed performance
...
A light bulb, for example,
either works or it does not; a box either contains 1 kg of soap powder or it
does not; a piece of furniture made with polished wood may look good to
an experienced inspector, or it may not
...
3 Types of statistical testing
PROCESS CONTROL
Process control emphasizes the prevention of defects – it investigates
whether the process is working as planned
...
It does this by taking samples over time to
see if there are any noticeable trends
...
Patterns can best be seen on a process control chart, which shows the
results from samples over time
...
Provided this does
not vary too far from a mean value, the process is working normally
...
This can be checked using two limits – an upper control limit and a lower
control limit
...
4)
...
Quality Control ᔡ 161
Proportion of defective units
Process out of control
Upper
control
limit
Process
in
control
Mean
Lower
control
limit
1
2
3
4
5
6
7 8 9 10 11 12 13 14
Sample number
Figure 33
...
Evans, J R and Lindsay, W M, The Management and Control of Quality (3rd
edition), West Publishing, St Paul, MN 1996
...
162
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163
34
Forecasting
DEFINITION
Managers have to plan all their operations some time in advance, and their
decisions take effect at some point in the future
...
Nobody knows exactly what will happen in
the future, so the best we can do is make forecasts
...
This chapter
examines forecasting from the operational perspective
...
APPROACH TO FORECASTING
All the planning and decisions of managers are based on forecasts of future
conditions
...
Forecasting is continuous and is never finished
...
Good forecasts should give an accurate view of some feature – typically
product demand – in the future
...
Unfortunately, there is no single ‘best’ method of forecasting, and we have
to use different approaches in different circumstances
...
DIFFERENT METHODS OF FORECASTING
One classification of forecasting methods considers the time in the future
covered by the forecasts
...
Mediumterm forecasts typically look ahead between three months and a year – the
time needed to replace an old product by a new one, or organize less
demanding resources
...
There is a clear link between the time covered by the forecast and the
levels of decision
...
Another classification of forecasting methods shows the difference
between qualitative and quantitative approaches (see Figure 34
...
If an organization is already making a product, it has records of past
demand and knows the factors that affect this
...
There are two ways of doing
this: projective methods, which look at the pattern of past demand and
extend this into the future, and causal methods, which analyse the effects
of outside influences and use these to forecast
...
Then the only alternative is a qualitative or judgemental forecasting method
...
1 Classification of forecasting methods
JUDGEMENTAL FORECASTING
Judgemental forecasting uses the opinions of experts in the field
...
Personal insight
...
This is fast, cheap and
convenient, but it relies entirely on one person’s judgement – as well as his
or her opinions, prejudices, ignorance and mood
...
Panel consensus or focus group
...
If there is no secrecy and the group talks freely and openly, a
genuine consensus can be found
...
Overall, panel consensus
is an improvement on personal insight, but you should be cautious about
the results from either method
...
Sometimes, even groups of experts do not have enough
knowledge to give a reasonable forecast and it is more useful to talk
directly to, say, potential customers
...
Historical analogy
...
A publisher, for
example, who is selling a new book could forecast demand for this book
from the actual demand for a similar book it published earlier
...
A number of experts are contacted by post and each is given
a questionnaire to complete
...
Each reply is
anonymous to avoid the influences of factors such as status
...
They may be convinced by the arguments in other
replies, and adjust their answers for a second round of opinions
...
By this time,
the range of opinions should be narrow enough to help with decisions
...
These time series often have an underlying
pattern, such as: 1) a constant series, where values stay roughly the same
over time; 2) a trend, which either rises or falls steadily; and 3) a seasonal
series, which has regular cycles
...
Unfortunately, there are almost always differences
between actual observations and the underlying pattern
...
2)
...
It is the noise that
makes forecasting difficult
...
Value
underlying pattern
plus random noise
Time
Figure 34
...
The sales of a product, for example, might depend on the price
being charged
...
The most widely used form of causal forecasting is linear regression,
which finds the line of best fit relating two variables
...
3 shows a
typical spreadsheet of results
...
9
88
...
1
72
...
3
56
...
6
40
...
8
24
...
0
Coefficient
Standard
Error
t Stat
95
...
8818
1
...
293345
55
...
05068E–12
–26
...
63179E–10
Intercept
X Variable 1
Summary output
Regression Statistics
Multiple R
0
...
9877
Adjusted R Square
0
...
0766
Observations
11
Intercept
X Variable 1
Coefficients
95
...
8818
P-value
Lower 95% Upper 95%
91
...
78951
–8
...
21822
100
Number of defects
90
80
70
60
Defects
50
Forecast
40
30
20
10
0
0
1
2
3
4
5
6
7
8
9
10
Number of inspections
Figure 34
...
PROJECTIVE FORECASTING
Projective forecasting examines historical values for demand and uses
them to forecast the future
...
This simply takes the average of past values as the
forecast for the future
...
ᔢ Moving averages
...
A moving average uses this reasoning to take
the average demand over the past few periods as a forecast, and ignores
any older data
...
Exponential smoothing is based on the idea that
as data become older they become less relevant and should be given less
weight
...
To be specific, a new forecast is calculated from:
New forecast = (␣ × latest demand) + [(1 – ␣) × last forecast]
where ␣ is a smoothing constant that takes a value of around 0
...
These three methods can give good results when demand is fairly stable,
but they need adjusting for more complicated patterns, such as seasonality
or trend
...
FURTHER READING
Jarrett, J, Business Forecasting Methods, Blackwell, Oxford 1991
...
169
35
Defining the Process
DEFINITION
The process consists of all the operations used to make a product
...
The structure of the process describes the relations between different operations
...
In
different circumstances, a process might be centred around:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
manufacturing – when changing a product’s physical form;
chemical processing – such as processing crude oil into chemicals;
information processing – with clerical or managerial processes;
supply – when changing a product’s ownership;
transport – when changing a product’s location;
warehousing – storing a product until it is needed;
other service – changing a product’s condition in some other way
...
As the design
of the process affects costs, quality, productivity, etc, it is important to find
the best match between the product and the process used to make it
...
PROCESS-CENTRED ORGANIZATIONS
Some organizations place so much emphasis on the process that they have
become process centred
...
So they should not concentrate on the short
term and current product designs, but on the longer term and the process
that can deliver a stream of products for the future
...
PROCESS STRUCTURE
The process is often seen as a ‘black box’ with inputs of materials and
outputs of products
...
These include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
the type of operations involved;
how the operations are organized;
details of tasks involved in the operations;
type of equipment and other resources used;
people working on the process, their skills and jobs;
material movement through the process
...
In its simplest form, a process might consist of a series of operations, sepa-
Defining the Process ᔡ 171
rated by stocks of work in progress, as shown in Figure 35
...
If the process
is a service, then the customer becomes involved earlier and we have the
system structure shown in Figure 35
...
WORK STATIONS
Operations along the process are divided into a series of stages, each of
which uses resources, such as the machines in a production line, to add
value to the product
...
Each work station might consist of a single
machine, but more often has a cluster of equipment and resources that
Suppliers
Stocks
Operations
Customers
Figure 35
...
2 Customers are more involved in service processes
172 ᔡ Operational Management
work together on one aspect of the product
...
The benefits of organizing the process in work stations include:
ᔢ
ᔢ
ᔢ
ᔢ
it simplifies the organization of operations;
it allows a smooth, balanced flow of products through a process;
it reduces stocks of work in progress;
it reduces handling of parts
...
Organizations prefer
to use more specialized equipment, which generally gives higher productivity (as discussed in Chapters 37 and 38), but they cannot justify this with
low production levels
...
These jobs are different, but have
some similar feature, which allows them to be combined for a specific
work station
...
Although these are different
products, they can be combined into a single batch for drilling the hole
...
FURTHER READING
Ramaswamy, R, Design and Management of Service Processes, Addison
Wesley Longman, Harlow 1996
...
173
36
Process Planning
DEFINITIONS
The process consists of all the operations needed to make a specific
product
...
TYPES OF PROCESS
Two key factors for the choice of process are the total number of units
made and the amount of variation in the final product
...
There are five basic types of process that are suited to different combinations of volume and variety
...
At the other extreme are projects
like those of satellite manufacturers, who rarely make the same product
twice
...
Although some of these terms seem to refer to manufacturing, they can be
used equally well for services
...
The product from each project is essentially unique, so
there is a lot of variety with little standardization
...
Organizations usually tender for work, so that details of future work are
174 ᔡ Operational Management
uncertain and there can be variability in overall demand
...
As a result, jobbing processes have relatively low
capital costs, but high unit costs
...
Batch processes make larger batches of similar products on the same
equipment
...
This type of process is used for medium
volumes of products, where there is less product variety and customizing
...
There is very little variety in the product, except
small changes to the basic model introduced in the finishing
...
There is, for example, no need to schedule individual pieces of
equipment, or check the progress of individual units through the process
...
Although capital costs
for specialized equipment can be high, mass processes give low unit costs
...
The
process is different from assembly lines as the product effectively emerges
as a continuous flow rather than discrete units
...
Figure 36
...
There is a diagonal across
the table, and any process not on this diagonal has problems
...
If a process works in area B,
making small numbers of the same product, it would be better to increase
the volume of a standard product, or allow more customization
...
Some other considerations include the following:
ᔢ overall demand;
ᔢ point in the product life cycle;
ᔢ variability in product range;
Process Planning ᔡ 175
Volume
Very low
None
Low
None – unit
costs are too
high
Medium
Continuous
B
Continuous
Mass
Little
Product
variation
Very high
Medium
Batch
A
High
Jobbing
Very high
Project
None – capital
costs are too
high
Figure 36
...
LEVELS OF TECHNOLOGY
One obvious feature of a process is the level of technology that it uses,
which can be described as manual, mechanized or automated
...
People have full control over operations that need their
constant attention
...
Their disadvantages are high unit cost, need
for a skilled workforce, variable quality and low output
...
A typical mechanized process has an operator
loading a piece of equipment, which can work without further intervention until the task is finished, when the operator unloads it
...
ᔢ Automated process
...
176 ᔡ Operational Management
The level of automation is clearly linked to the type of process, with higher
volumes of output using higher levels of automation
...
Higher levels of automation reduce the flexibility and variability in a
process
...
Perhaps the major
criticism of automated processes, however, is that they ignore the skills
that people can bring, including:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
giving a personal service;
drawing upon varied experiences;
intelligent use of all available information;
use of subjectivity and judgement;
ability to adapt to new and unusual circumstances;
generating entirely new solutions;
recognizing patterns;
using creativity;
flexibility
...
People and machines are better at different jobs and because automation is
better in some circumstances you should not assume that it is better for everything
...
FURTHER READING
Armistead, C and Roland, P, Managing Business Processes: BPR and beyond,
John Wiley, Chichester 1996
...
177
37
Automation in
Manufacturing
DEFINITION
Organizations can often improve their performance by using a more automated process
...
This chapter
describes some types of automation for manufacturing, and the next
chapter looks at the automation of services
...
These are examples of fixed or hard automation, where specialized
equipment is dedicated to making a single product
...
The result is an efficient process with little
flexibility, of the type that is suited to high-volume production
...
The aim is to
combine versatility with efficiency to give flexible or programmable
automation
...
These were originally
general-purpose machines that could do a series of tasks without any
intervention by an operator
...
Magnetic tapes replaced paper tapes for the control of NC machines,
and these, in turn, were replaced by microprocessors
...
These standard machine tools are the most widely used form of
automation in manufacturing
...
Operators do not do any of the actual work,
but they still have to load and unload the machine, check units, make
adjustments, change the programme, and so on
...
Computerized numerically
controlled machines were the first step in this direction, and the next step
came in the 1960s with industrial robots
...
They were first used for welding and paint spraying in
car assembly lines, but their costs fell and they have become common for a
variety of simple jobs
...
FLEXIBLE MANUFACTURING SYSTEMS
The next type of automated production is flexible manufacturing systems
(FMS)
...
This computer finds the best production
schedule, and coordinates operations to achieve this
...
Automatic loading
and unloading stations transfer the materials between the transport
system and manufacturing equipment
...
Once an FMS is programmed, the system can work with very little human
intervention, and has the following advantages:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
it allows fast, easy changes between different products;
low operating costs;
the computer takes over the difficult jobs of scheduling and routing;
utilization of equipment can be very high;
the computer can control inventories, reducing stocks of raw materials
and work in progress;
ᔢ the output has consistently high quality, without the variation found in
less automated processes
...
COMPUTER-AIDED DESIGN
As well as its direct use in production, automation can also be used in associated functions, such as product design
...
Design time is cut by having computer libraries
of designs rather than designing from scratch; similar designs are
recovered and modified as necessary
...
Organizations found that they were using computers to design products
(with CAD) and to control production (with CAM), so it made sense to join
these two parts into a single CAD/CAM system
...
This
lays the foundations for computer-integrated manufacturing
...
Many
separate systems support production, including product design, engineering, production planning, production control, materials handling,
inventory control, procurement, maintenance, logistics, accounting and all
the related management systems
...
Ultimately, a CIM could integrate all the systems of a factory and work
with virtually no human intervention
...
This would generate the
design for a product and have a completely automated process for making
and delivering it
...
Harrison, M, Advanced Manufacturing Technology Management, Pitman,
London 1990
...
In recent years many
services – particularly communications and information processing – have
undergone a major transformation as they moved from manual to automated processes
...
Banking, for example, has become more efficient and cheaper as its automated systems evolved
...
These inevitably have
high costs
...
The result is that
people receive services that are less personal but are a lot cheaper
...
182 ᔡ Operational Management
Unfortunately, services are so varied that it is difficult to describe
automation in the same general terms we used in the last chapter for
manufacturing
...
Clerical jobs in offices prepare, store, analyse, copy and
distribute documents and information
...
ᔢ Debit cards
...
Technology has opened many new ways of paying bills,
including Switch cards, telephone banking, electronic fund transfer,
internet services and so on
...
ᔢ Supermarkets
...
ᔢ Post Office
...
The need to send letters is declining with expanding
computer networks and various types of electronic mail
...
Automated warehouses have computers recording stock
movements, allocating locations and controlling all the physical
handling of goods
...
Airlines started using online reservation systems in
the 1960s
...
There are, of course, many other examples of services becoming more
automated
...
As the average productivity
of service industries is relatively low, this is an area with considerable
potential
...
Sometimes it can improve the performance of operations and at other times
it can allow new operations that were previously impossible
...
The first of these are concerned
with the way that information is moved around an organization:
Automation in Services ᔡ 183
ᔢ Distributed processing
...
This has benefits over centralized
data as it is maintained by those most closely involved, and can be
accessed quickly
...
This problem may be
overcome by communications that allow physically separate computers
to share data
...
A local area network (LAN) is a communications
system that connects a series of computers in a physical area – typically
within a building, site or organization
...
The
direct links between different parts of an organization allow, for
example, an inventory system to be linked to a procurement system, so
that removing an item from stores triggers a message to buy a
replacement
...
The benefits of LANs are so obvious that
organizations moved to the next stage and linked their computers to
systems in other organizations
...
Then
removing an item from stores sends a message to the supplier who
automatically delivers a replacement
...
ᔢ The Internet
...
Research departments in universities, for example, do not necessarily
have close links, but it is useful to see what problems each is working on
and to share results
...
ᔢ World wide web (WWW)
...
A hypertext markup language (HTML) allows any
organization to create pages on its website that can be read by any other
user
...
These developments have allowed information to flow more easily
through a process
...
Improved communications mean
that managers can access virtually limitless amounts of information
from anywhere in the world
...
A management
information system ensures a smooth flow of data into and within the
184 ᔡ Operational Management
organization
...
ᔢ Decision support system (DSS)
...
Rather than just
presenting information, a DSS gives more positive assistance in a
decision
...
ᔢ Expert systems
...
An expert system records the skills of
experts in a knowledge base, and when faced with a decision it uses an
‘inference engine’ to select and use these rules to duplicate the decisionmaking process of a human expert
...
This attempts to give computers the ability to
understand language, reason, make assumptions, learn and solve
problems
...
Information technology is changing many aspects of operations
...
Introducing new IT does not
automatically improve an organization’s performance or give it a
sustained competitive advantage; it does not necessarily give better
products or even a better process
...
FURTHER READING
Gunton, T, Inside Information Technology: A practical guide to management
issues, Prentice-Hall, Englewood Cliffs, NJ 1990
...
185
39
Facility Layout
DEFINITION
Facility layout is the physical arrangement of equipment, offices, rooms
and other resources within an organization
...
Layout planning aims to
organize the physical arrangement of facilities so that operations run as
efficiently as possible
...
Well-laid-out facilities are efficient and allow products to flow
easily and smoothly through the process: poorly laid-out facilities disrupt
operations and reduce efficiency
...
There are five general types of layout:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
process layout – which puts similar resources together;
product layout – which puts resources for a particular product together;
hybrid layout – which is some mixture of these two;
fixed-position layout – where everything is done in the same place;
a series of specialized layouts, such as retail shops, offices and warehouses
...
Typical objectives are to use a minimum amount of resources, or
186 ᔡ Operational Management
to achieve the maximum possible output
...
There can be many types of constraint on the layout, including the
planned capacity, total space available, building used, material handling
equipment, capital available, need for service areas, safety needs, and so
on
...
1 gives some guidelines about this
...
Offices use a process layout when they put all accountants in
one area, all purchasing people in another, all reference books in another,
and so on
...
Each product uses the facilities in a different sequence, as shown in Figure
39
...
Advantages of process layouts include:
ᔢ A variety of products can be made on the same facilities
...
ᔢ It is suitable for low volumes and variable demand
...
Disadvantages of process layouts include:
ᔢ Small batches give lower utilization of equipment and unit costs can be
high
...
Table 39
...
1 Process layout with similar operations grouped together and products
following different paths
ᔢ Scheduling work on equipment is complicated and must be done
continuously
...
ᔢ There is a lot of handling of products and materials
...
There is a
lot of standard software for this and many specialists who can offer
advice
...
Systematic layout planning allows
subjective views of how close areas should be to each other
...
Systematic layout planning describes such relationships in six
ways:
A
E
I
O
U
X
–
–
–
–
–
–
Absolutely essential that areas are close to each other
...
Important
...
Unimportant
...
188 ᔡ Operational Management
PRODUCT LAYOUTS
A product layout groups together all the facilities and equipment used to
make a particular product
...
2)
...
Advantages of product layouts include:
ᔢ
ᔢ
ᔢ
ᔢ
they can achieve a high rate of output;
high equipment use gives low unit costs;
materials handling is easy with low stocks of work in progress;
scheduling and controlling operations is easy
...
Line balancing
Product layouts essentially consist of a series of facilities through which
units of the product move
...
As we saw in
Chapter 35, the process is usually divided into a number of distinct work
stations, so the time spent in each must be about the same
...
With an unbalanced line, some work stations finish products
Operation 1
Operation 2
Operation 3
Operation 6
Operation 4
Operation 5
Figure 39
...
There is a straightforward procedure balancing product layouts, which
has three steps:
ᔢ Step 1
...
This is found by dividing the planned output by the
time available
...
ᔢ Step 2
...
This is found by dividing the total time
needed to make a unit by the cycle time
...
ᔢ Step 3
...
HYBRID LAYOUTS
Often the best layout for a process is a combination of product and process
layouts
...
Arrangements of this kind are called hybrid layouts
...
This is an arrangement
with a dominant process layout, but with some operations set aside in a
product layout
...
These work cells form islands of product layout in a sea of process layout
...
The idea of a permanent focused work
centre can be extended to focused factories, where the process is moved to
another building, which concentrates on developing a very efficient
process for making a single component
...
This usually happens when a product is too big or heavy
190 ᔡ Operational Management
to move around, like ships or construction sites
...
Fixed layouts have several disadvantages, including:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
all people, materials and components have to move to the site;
there is often limited space at the site;
there must be a reliable schedule of activities;
disruptions to this schedule might cause delays in completion;
external factors, such as weather conditions, may affect operations
...
One way of partially
avoiding these disadvantages is to do as much of the work as possible off
site
...
SPECIALIZED LAYOUT
Many operations need specialized layouts, with typical examples
including:
ᔢ warehouses – which store goods on their journey between suppliers
and customers;
ᔢ offices – which are organized around a flow of information;
ᔢ retail shops – which try to encourage customers to buy goods;
ᔢ schools – which have to consider the movement of large numbers of
pupils;
ᔢ shopping centres – which find the best arrangements for different kinds
of shops
...
Luggen, W, Flexible Manufacturing Cells and Systems, Prentice-Hall,
Englewood Cliffs, NJ 1991
...
They show whether the organization is achieving its
aims, or whether performance needs to be improved
...
There are many possible
measures of performance, including:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
flexibility;
quality;
profitability;
return on investment;
gross profit;
stock turnover;
conformance to standards;
number of customer complaints;
innovation;
sales per square metre;
throughput time;
amount of scrap;
percentage of lost orders;
lead time;
192 ᔡ Operational Management
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
return on value added;
number of customers;
ratio of sales to stock;
use of equipment;
number of returns;
staff morale;
absenteeism;
machine breakdowns;
production rate;
and a whole host of others
...
Unfortunately, the financial measures tend to
emphasize what has happened in the past, are slow to respond to changes,
and often do not record important aspects of operations
...
MEASURING THE OPERATIONS
From an operations point of view, a basic measure of performance is
capacity
...
There is a difference between: designed capacity, which is a
largely theoretical value that gives the maximum output in ideal circumstances, and effective capacity, which shows the output that can actually be
achieved over the long term, in normal circumstances
...
This leads to the related
measure of utilization, which shows the proportion of designed capacity
that is actually used
...
This measures the amount
of output that is achieved for each unit of resource used
...
Unfortunately, people often use these terms rather loosely and mistake
production (which is the total output from a process) with the productivity
Measuring Performance ᔡ 193
(which is the output achieved for each unit of a resource)
...
Another term that causes confusion is efficiency
...
This is often
confused with effectiveness, which measures how well an organization
sets and achieves its goals
...
ᔢ Effective capacity is the maximum amount that can realistically be made
in a given time, under normal conditions
...
ᔢ Production is the total amount of a product that is made
...
ᔢ Efficiency is the ratio of actual output to possible output
...
Example
A machine is designed to produce 100 units in a 10-hour shift
...
ᔢ Designed capacity is the maximum amount that can be produced in a
given time, which is 100 units a shift, or 10 units an hour
...
ᔢ Utilization is the proportion of designed capacity actually used, which is
70/100 or 70 per cent
...
ᔢ Productivity is the amount produced in relation to resources used, so a
reasonable measure is 70/8 = 8
...
ᔢ Efficiency is the ratio of actual output to possible output, which is
70/(8/10) or 87
...
PRODUCTIVITY
Productivity is the most widely used measure of operations, and most
managers assume that increasing productivity is always beneficial
...
Competitors are
always trying to gain an advantage by increasing their own productivity,
so an organization must match this improvement simply to stay in
business
...
There are really only four ways of improving productivity:
ᔢ improve effectiveness with better decisions;
ᔢ improve efficiency so that the existing resources are used better, giving
more outputs with the same inputs;
ᔢ improve the process in some other way – designing changes to the
process, perhaps increasing automation or putting more emphasis on
quality;
ᔢ improve morale – to give more cooperation and incentives
...
A hard-working person with a spade is far less
productive than a lazy person with a bulldozer
...
More importantly, productivity does not necessarily measure the production per
person
...
The input and output must be in consistent units and this normally means
that they are translated into units of currency
...
Another problem is finding and evaluating all the inputs and
outputs – including natural resources, waste, pollution and so on
...
Then typical measures of partial productivity are the amount produced per machine-hour, or the amount
produced per kilowatt-hour of electricity
...
Whichever measure of productivity is used, it should give a reliable view
of the performance of the organization
...
This seems obvious, but you can find many examples of organizations that ignore this simple advice
...
It would, for example, make no sense to aim for high
productivity if the quality of products becomes too low, or if the finished
products then sit in a warehouse because there is no demand for them
...
Then a reasonable
measure must:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
relate to the organization’s objectives;
focus on significant factors;
be measurable;
be reasonably objective;
be understood by people working on the operations;
be agreed by everyone concerned;
be linked to the reward and recognition system of employees;
use consistent units;
be difficult to manipulate
...
On the other
hand, an organization should not ignore important aspects of performance
such as staff morale because they are difficult to measure
...
Kaplan, R S, Measures for Performance Excellence, Harvard Business School
Press, Boston, MA 1990
...
It is
usually much better to use the measures in some form of comparison
...
COMPARING PERFORMANCE
The last chapter showed how measures of performance should give a
reasonable view of an organization’s operations
...
It is clear from this list that measures of performance are normally used for
some kind of comparison
...
Most measures are used to compare the organization’s actual
performance with some agreed standard measures
...
This is a target performance for which an organization would
ideally aim, such as zero defects
...
ᔢ Historical standards – which look at performance that has actually been
achieved in the past
...
ᔢ Competitors’ standards – which show the performance actually being
achieved by competitors
...
These comparisons can be done in many ways
...
Usually it is better to have a more formal procedure for
comparing performance, and the most popular method is benchmarking
...
There are several steps in benchmarking,
which are shown in Figure 41
...
These start when an organization recognizes the need to improve a process
...
To be blunt, organizations use benchmarking to find ideas and ways of
doing operations that they can copy or adapt
...
Sometimes it is difficult to find a direct competitor that can be used for
benchmarking, or to collect enough information about its operations
...
1 Procedure for benchmarking
Then organizations can use several variations on the basic theme
...
British Petroleum is not a direct competitor of Tate & Lyle, but they both
run fleets of tankers and might learn from each other’s transport operations
...
So a train operator might look at the operations of an
airline, or other companies that give high customer service, like supermarkets
...
200 ᔡ Operational Management
ANALYSING A PROCESS
Wherever an organization looks for its comparisons, it needs some way of
analysing a process – in other words, it needs a clear description of the
operations and the relationships between them
...
Process charts
There are several types of process chart but they all start by breaking down
the process into separate operations
...
A simple chart of this is given in Figure 41
...
This informal chart gives a general view of the process but it does not
give many details
...
2 Informal process chart for visit to doctor
Comparing Performance ᔡ 201
ᔢ storage – where products are put away until they are needed;
ᔢ delay – where products are held up;
ᔢ inspection – which tests the quality of the product
...
The first three
of these describe the current process, while the last three look for
improvements:
1
...
2
...
Find the time taken and distance moved in each step
...
Summarize the process by adding the number of each type of operation, the total time for the process, the rate at which each operation is
carried out, and any other relevant information
...
3
...
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
Fetch component
Put components on machine
Start machine
Fetch sub-assembly
Wait for machine to stop
Unload machine
Inspect result
Join sub-assembly
Move unit to machine
Load machine to start
Wait for machine to stop
Unload machine
Carry unit to inspection area
Inspect and test
Carry unit to finish area
Finish unit
Final inspection
Carry unit to store
Summary:
Delay
Storage
Time Distance
(mins) (metres) Comments
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
X
2
...
2
3
5
...
5
5
2
...
4
2
5
...
4
5
...
5
5
...
1
16
...
2
10
...
2
Figure 41
...
Critically analyse each operation
...
Based on this analysis, revise the process
...
6
...
The maximum output from the process is limited by the longest operation
...
3 finishing takes 5
...
5 = 10
...
In operations 5 and 11 the machine operator has to wait a total of 10
...
Better planning might reduce this
...
7 minutes
...
Multiple-activity charts
Process charts do not show what each participant in the process is doing at
any time
...
4
...
Multiple activity chart
Time
(mins)
Word
processor 1
Typist 2
Word
processor 2
Job 1
Typist 1
Job 2
Job 2
Printer
Photocopier
0
5
Job 1
10
15
20
Job 1
Job 1
25
30
35
Job 2
Job 3
Job 2
Job 3
40
45
Job 4
50
Job 4
Job 3
Job 3
55
60
65
70
75
Job 5
Job 4
Job 5
Job 6
Job 3
Job 4
Job 6
Job 6
Job 3
Job 6
Figure 41
...
Sink, D S, Productivity Management: Planning, evaluation, control and
improvement, John Wiley, New York 1985
...
Products change, as do
competitors, costs, markets, locations, customers, the economy, the
business environment, company objectives, technology, shareholders,
employees, and just about everything else
...
The way that operations change
has to be carefully managed
...
Some
signs that an organization is not managing change well include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
old products that are being overtaken by competitors;
low sales volume and falling market share;
problems with product quality and delivery dates;
large numbers of customer complaints;
reliance on a few customers, especially with long-term, fixed-price
contracts;
ᔢ an old-fashioned process;
ᔢ low employee morale and high staff turnover;
ᔢ poor industrial relations;
206 ᔡ Operational Management
ᔢ poor communications;
ᔢ too much inflexible top management;
ᔢ inward looking managers who are out of touch with operations or
customers;
ᔢ heavy debts
...
Change is essential for an
organization’s survival, however
...
This
constructive attitude involves:
ᔢ commitment to change, accepting that continual change is inevitable,
necessary and beneficial;
ᔢ an organizational culture and environment that welcomes change;
ᔢ an experimental approach, encouraging new ideas and practices;
ᔢ products and operations based on innovation and new ideas;
ᔢ keeping abreast of new developments and likely changes in the
industry;
ᔢ acceptance that not all new ideas will be successful, and willingness to
learn from failures;
ᔢ easy communications, so that everyone knows about the changes, why
they are needed, their effects, new practices, and so forth;
ᔢ reassurance, guidance and protection for people most affected by the
changes;
ᔢ managers who enjoy change
...
This
principle is used in TQM, which looks for continuous improvement
(described in Chapter 32)
...
Over time the accumulated effects of these small
changes can give dramatic improvements in performance
...
The management of small changes can be quite informal, with
someone working on a process finding a better way of doing things and
simply changing the operations
...
One
approach for this uses a plan-do-check-act cycle, which has a team of
people who:
Improving the Process ᔡ 207
ᔢ Plan: look at the current operations, collecting data and designing
improvements
...
ᔢ Check: see if the new operations actually bring the improvements that
were expected
...
As this is a cycle that aims to bring a continual stream of improvements, the
next stage is to go back to the start and plan the next changes
...
It might also move the process in the wrong direction, as an
attractive small change might block the way for much bigger gains in
another direction
...
If you have a fundamentally bad process, then making small adjustments will still leave you with a bad process
...
This would give a fundamental, sudden and dramatic change in operations,
typical of the breakthrough that comes when introducing new technology
(see Figure 42
...
The best known approach of this kind is business process
re-engineering (BPR)
...
Business process re-engineering focuses the organization on the whole
process of supplying products for customers
...
Some of its main principles are:
ᔢ organizations should concentrate on the whole process rather than on
the separate activities that make up the process;
ᔢ the process should be designed across functions and allow work to flow
naturally through the process;
ᔢ managers should strive for dramatic improvements in performance by
radically rethinking and redesigning the process;
ᔢ information technology is fundamental to re-engineering as it allows
radical new solutions to problems;
ᔢ work should be done where it makes most sense;
208 ᔡ Operational Management
Performance
Business process
re-engineering aims
for infrequent
dramatic
improvements in
performance
Time
Continuous
improvement
looks for small
frequent
improvement
Figure 42
...
Business process re-engineering is an approach to change rather than a
formal procedure, so we cannot say ‘this is how to re-engineer a process’
...
Some have reported spectacular successes, but around
three-quarters of organizations do not achieve the success they were
hoping for
...
The lack of success has been a consistent criticism of BPR, but there are
other basic criticisms, including:
Improving the Process ᔡ 209
ᔢ realistically, it is very difficult to get the dramatic improvements
promised by BPR;
ᔢ sudden changes to the process can be very disruptive and expensive;
ᔢ dramatic changes might use new technology with which the organization has no experience;
ᔢ a new process can take a long time to settle down before it starts
working properly;
ᔢ BPR is seen as the latest management fad and is not taken seriously;
ᔢ it always uses a radical approach, even when minor adjustments would
be best;
ᔢ BPR emphasizes staff reductions and becomes an excuse for getting rid
of workers;
ᔢ it can put short-term goals of costs reduction ahead of longer-term
interests;
ᔢ radical redesign and downsizing may lose essential experience from the
organization;
ᔢ re-engineered organizations can be vulnerable to changes in the
environment
...
A reasonable approach to this has the following steps:
1
...
2
...
3
...
4
...
5
...
6
...
7
...
8
...
9
...
10
...
11
...
12
...
13
...
210 ᔡ Operational Management
Accept that the new methods are only temporary, and continually look for
further improvements
...
Hammer, M, Beyond Reengineering, HarperCollins, New York 1996
...
Robbins, H and Finley, M, Why Change Doesn’t Work, Orion Business
Books, London 1997
...
It
designs timetables for all aspects of operations, showing exactly what must
be done at any time
...
CONTEXT OF PLANNING
The mission, corporate and business plans give the strategic direction of
the whole organization
...
The operations strategy includes all the long-term
decisions about products and processes, such as location, capacity, technology used, quality and so on
...
This gives a hierarchy of decisions, with operations managers making plans at all levels from the broad
strategic through to the detailed operational
...
These give the
starting points for the next stages of planning, which make sure that the
resources are available to make products to meet the forecast demand
...
Planning the resources starts with strategic capacity plans, which make
sure there is enough capacity to meet forecast demand
...
These production plans are expanded to give timetables for
employees, equipment, purchases and other resources
...
ᔢ Aggregate plans, which show the overall production for families of
products, typically by month at each location
...
ᔢ Short-term schedules, which show detailed timetables of production and
resources, typically by day
...
This compares the
resources available with the resources needed, develops plans to overcome
any differences between the two, chooses the best plan and implements it
...
It seems
quite straightforward, but taking these simple steps does not usually work
...
It is also difficult to
compare the alternatives as there is a range of competing objectives and
non-quantifiable factors
...
This designs a plan and sees how close it gets to achieving its
objectives; if it performs badly, the plan is modified to find improvements
...
ᔢ Step 2 – look at the process and any other relevant information to find
the resources available
...
Approach to Planning ᔡ 213
ᔢ Step 4 – suggest a plan for overcoming these mismatches
...
ᔢ Step 6 – if the plan is not good enough, see how it can be revised and go
back to Step 4
...
ᔢ Step 8 – control the plans, which means continually checking to make
sure that they are working properly
...
This iterative procedure accepts that it is usually impossible to find the
‘best’ solution
...
Planners inevitably look for a compromise that takes into account a large
number of factors, including:
ᔢ demand – forecast sales; sales already made; back orders; variation in
demand;
ᔢ operations – machine capacity and utilization; aim of stable production;
plans for new equipment; use of subcontractors; productivity targets;
ᔢ materials – availability of raw materials; inventory policies; current
inventory levels; constraints on storage;
ᔢ finance – costs; cash flows; financing arrangements; exchange rates;
general economic climate;
ᔢ human resources – workforce levels; levels of skills and productivity;
unemployment rates; hiring and training policies;
ᔢ marketing – reliability of forecasts; competition; plans for new products;
product substitution
...
Period covered by plans
The iterative procedure described in Steps 1 to 8 above gives plans for a
specific period
...
In other words, we have to design a series of plans, one for
every period, as suggested in Step 9
...
1 Continual updating of plans in cycles
the future – next month’s production plans can be found by adjusting
this month’s
...
In one cycle they
might finalize plans for the next period and make outline plans for the
following period and tentative plans for the period after that
...
1
illustrates this use of planning cycles
...
The second half of these plans is fairly tentative, but the first
half is more definite and forms the basis of the master schedules
...
Tomkins, J A and White, J A, Facility Planning, John Wiley, New York 1988
...
The aim of capacity planning is to make sure that
there is enough usable capacity to meet demand over the long, medium
and short term
...
In Chapter 40 we
said that the designed capacity is the maximum rate of output under ideal
conditions, whereas the effective capacity is the maximum output that can
realistically be expected under normal conditions
...
Most organizations also do not like to work flat out, as
equipment becomes less reliable, people feel overstretched and there is no
cushion to deal with sudden changes or unexpected events
...
MATCHING CAPACITY AND DEMAND
The aim of capacity planning is to make the usable capacity match the
demand for products
...
If capacity is
less than demand, the organization cannot meet all the demand and it
loses potential customers
...
To match capacity and demand we can use the general approach to
planning described in the last chapter
...
Discrete capacity
Demand comes in relatively small quantities and can take almost any
value, but capacity usually comes in large, discrete amounts
...
This gives problems with
matching discrete capacity to continuous demand
...
Capacity is increased at some point,
but the increase will come as a discrete step, giving three basic strategies
(illustrated in Figure 44
...
There is no way to avoid this problem, but managers need to find the
best alternative by balancing the costs and benefits
...
1(b), are:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
uneven or variable demand;
high profits, perhaps for a new product;
high cost of unmet demand, possibly with lost sales;
continuously changing product mix;
uncertainty in capacity;
variable efficiency;
capacity increases that are relatively small;
low cost of spare capacity, which might be used for other work
...
1(c), is the capital cost
...
1 Options for timing of capacity increases
Size of expansion
If an organization is expanding to meet growing demand, it might be
better to have one big expansion rather than several smaller ones, as
shown in Figure 44
...
The benefits of large increases include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
capacity stays ahead of demand for a long time;
sales are unlikely to be lost;
there might be economies of scale;
advantages might be gained over competitors;
there are less frequent disruptions
...
218 ᔡ Operational Management
(a) few large increases
Units
Time
(b) more smaller increases
Units
Time
Figure 44
...
Such decisions have long-term
consequences and mean that capacity planning is largely a strategic
function
...
Leasing extra space or working overtime might increase
capacity and these are tactical and operational decisions
...
Short-term adjustments to capacity
Short-term mismatches between supply and demand can be corrected in
two ways: adjust demand to match available capacity, or adjust capacity to
match demand
...
One result of this demand management is that business can be actively
discouraged at times of high demand
...
Professional institutions, for example, put up
barriers for entry; expensive cars have long delivery times; artists produce
limited editions of prints, perfumes charge very high prices
...
Ways of
adjusting capacity include:
ᔢ changing the total hours worked in any period, by changing the
number of shifts, amount of overtime, or holidays;
ᔢ employing part-time staff to cover peak demand;
ᔢ scheduling work patterns so the total workforce available at any time
varies in line with varying demand;
ᔢ using outside contractors, or renting extra space;
ᔢ adjusting the process, perhaps making larger batches to reducing setup times;
ᔢ adjusting equipment and processes to work faster or slower;
ᔢ rescheduling maintenance periods;
ᔢ making the customer do some work, like using automatic cashdispensing machines in banks or packing their own bags in supermarkets
...
CHANGING CAPACITY OVER TIME
Another problem with capacity planning is that the capacity of a process
changes over time
...
3 A typical learning curve
short-term variations due to operator illness, interruptions, breakdowns,
efficiency of equipment, and a wide range of other factors
...
So the capacity is not a fixed figure, but it depends on how well the
available resources are being used
...
We will look at
the reducing performance of equipment in Chapter 53, but mention the
effects of the learning curve here
...
This effect can
be seen in almost all operations, where efficiency increases with the
number of units produced, and the effective capacity rises
...
3
...
For example, the time taken for an operation
might reduce by 10 per cent every time the number of units doubles
...
Tomkins, J A and White, J A, Facility Planning, John Wiley, New York 1988
...
It expands the strategic plans to give tactical production plans
...
They only look at production of
families of products and are not concerned with individual products
...
The main inputs to aggregate plans are the forecast demand, capacity
and strategic production plans
...
The aggregate plans have to look at
all of these, and answer questions such as:
ᔢ Do we have enough resources to meet the forecast demand?
ᔢ Should we keep production at a constant level, or change it to meet
varying demand?
222 ᔡ Operational Management
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
Should we use stocks to meet changing demand?
Should we use subcontractors to cover for peak demands?
Should we change the size of the workforce with demand?
How can we change work patterns to meet changing demand?
Are shortages allowed, perhaps with late delivery?
Should we change prices to adjust the demand?
Can we smooth demand by any other means?
STABLE PRODUCTION
An important question for aggregate planning is how much variation
there should be in production levels – should production change with
demand or should it be more stable? There are obvious advantages in
having stable production, including:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
planning and scheduling resources is easier;
the flow of products is smoother;
there are fewer problems with product changes;
there is no need to ‘hire and fire’ employees;
employees have regular work patterns;
larger lot sizes reduce costs;
stocks can be reduced as there is less variation;
throughput can be faster;
experience with a product reduces problems
...
In practice there are three ways in which an organization can meet
uneven demand:
ᔢ Chase demand, where production exactly matches demand
...
ᔢ Produce at a constant production rate, where production is constant at the
average demand for the planning period
...
ᔢ Have a mixed policy, which is a combination of the first two policies
...
The
policy tries to compromise by having fairly stable production, but
reduces the inventory costs by allowing some changes
...
Aggregate Planning ᔡ 223
DESIGNING AGGREGATE PLANS
The aim of aggregate planning is to:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
design medium-term schedules for families of products;
meet forecast customer demand;
keep production relatively stable;
keep within the constraints of the capacity plan;
use available resources efficiently;
meet any other specific objectives and constraints
...
We now discuss the
most widely used
...
The easiest approach to planning is to ask an experienced planner to review the current plans and, in the light of that
planner’s knowledge and experience, design an updated version
...
Unfortunately, the results can also be of variable and uncertain quality,
they may take a long time to design, they rely solely on the skills and
knowledge of a planner, they can include bias, and so on
...
Some expert systems for
scheduling give very good results
...
Graphical methods
Planners often find it easier to visualize a plan from a graph
...
Then an aggregate plan is drawn as a line of cumulative supply
...
224 ᔡ Operational Management
Graphical approaches have the advantages that they are easy to use and
understand, but they are really only one step better than an intuitive
method
...
Spreadsheet calculations
Many planners prefer to look at numbers or tables, and an alternative
format for planning uses spreadsheets
...
Then the body of the matrix shows the
allocation of resources
...
Simulation
Simulation is a very flexible way of solving a wide range of problems
...
Organizations using simulation for aggregate planning have to start by
building a simulation model of the process
...
This can take some time, but the
results often give useful insights into the working of a process
...
A more formal mathematical approach could give better results
...
Unfortunately, these methods are too complicated
for large problems, or the effort involved is not worthwhile
...
FURTHER READING
Browne, J, Harhen, J and Shivnan, J, Production Management Systems (2nd
edition), Addison Wesley, Reading, MA 1996
...
Hess, R, Managerial Spreadsheet Modelling and Analysis, Irwin, Chicago 1997
...
It shows how the aggregate plan will be achieved as efficiently
as possible
...
Once
these plans are accepted, they can be expanded to give more details
...
These master schedules show
the number of individual products to be made in, typically, each week
...
The master schedule is clearly derived from the aggregate plan, so the
overall production levels are largely fixed
...
Then the production level comes from:
ᔢ production specified by the aggregate plan;
ᔢ adjustments because of more recent forecasts;
ᔢ actual customer orders for the period
...
Their main aims are to:
ᔢ identify all known demands for individual products – forecasts, actual
sales, internal transfers and so forth;
ᔢ design production plans to meet these demands;
ᔢ ensure that existing customer orders are met;
ᔢ meet the production targets specified in the aggregate plan;
ᔢ keep within all other constraints on the process;
ᔢ balance the needs of production, marketing, finance and other functions;
ᔢ communicate freely with all concerned functions;
ᔢ use stocks and other means to keep production relatively stable;
ᔢ use available resources efficiently;
ᔢ identify any problems and resolve them
...
There is a range of possible approaches, from intuitive
methods through to mathematical programming
...
This
inevitably makes the planning more complicated
...
They expand the
aggregate plan – probably with spreadsheets – and use their experience to
modify previous plans
...
This
iterative procedure can be continued up to some period, say three weeks,
before the master schedule is finalized and implemented
...
Later changes are only made in emergencies as they affect all the other
schedules
...
This is not the end of planning, however
...
This next stage of planning takes the tactical master schedule and uses it to
design short-term schedules
...
Designing a Master Schedule ᔡ 227
Aggregate
plan
Adjust or
revise
schedule
Actual
orders
Master
schedule
Examine
requirements and
consequences of
schedule
No
Material
use
acceptable
?
Detailed
material plan
Yes
No
Capacity and
other requirements
acceptable
?
Detailed
capacity and
resource plan
Yes
No
Costs
acceptable?
Yes
Accept
schedule
Finalize
and implement
schedules
Figure 46
...
Proud, J F, Master Scheduling, John Wiley, New York 1995
...
They show what
any part of the process is doing at any time
...
The organization now knows when each
product will be made, but it still has to organize the resources needed for
making them
...
These timetables are the result of short-term scheduling
...
They are needed for all resources, and
without them operations would be disorganized and chaotic
...
It is easiest to imagine this in terms of jobs waiting to use equipment
...
230 ᔡ Operational Management
Aims of short-term schedules
The aim of short-term scheduling is to achieve the master production
schedule, while giving low costs and high utilization of equipment
...
Schedules have to balance many different factors,
and typically have to:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
allocate jobs to equipment;
allocate staff, materials and other resources to the jobs;
set the sequence and timing of jobs on the equipment;
control the work, including checking progress and expediting late jobs;
revise schedules for late changes;
balance the needs of different operations and products
...
Scheduling is one of the most common
problems in any organization, and occurs in many different forms
...
The aim is to arrange the jobs so that the work is done as efficiently as possible – perhaps minimizing the waiting time, minimizing the
total processing time, keeping stocks low, reducing the maximum lateness,
achieving high utilization of equipment, or some other objective
...
Two basic
approaches to this are forward scheduling and backward scheduling
...
Then they can work through all operations needed for a job and find
the date when it will be finished
...
There may also be
advantages in giving customers their products before deadlines and
getting earlier payment
...
Schedulers have to work backwards
through the operations to find the date when the job must be started
...
Short-term Scheduling ᔡ 231
SCHEDULING RULES
It is very difficult to get optimal solutions to short-term scheduling
problems, largely because of the number of variables, including:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
patterns of job arrivals;
amount and type of equipment used;
number and skills of operators;
patterns of workflow through equipment;
priority rules for jobs;
disruptions caused by customer changes, breakdowns and so forth;
different criteria for evaluating schedules;
objectives of the schedulers
...
If an organization has a number of jobs
waiting to use a single machine, it might look at the following rules:
ᔢ First come, first served
...
The drawback here is that
urgent or important jobs may be delayed while less urgent or important
ones are being processed
...
ᔢ Most urgent job first
...
Emergency
departments in hospitals use this rule to treat their most urgent patients
first
...
ᔢ Shortest job first
...
This allows jobs that can be done
quickly to move on through the system, while longer jobs are left until
nearer the end
...
ᔢ Earliest due date first
...
Those that are expected first are then processed first
...
ᔢ Decreasing critical ratio
...
due date – today’s date
Critical ratio = ᎏᎏᎏ
time needed for the job
232 ᔡ Operational Management
If this ratio is low, the time to complete the job is short compared with
the time available, and the job becomes urgent
...
Other scheduling rules
These examples illustrate the type of scheduling rules that can be used
...
There is a huge variety
of simple scheduling rules, and more complicated ones to deal with
different circumstances
...
Typically these combine a hierarchy of rules,
together with more formal analyses and simulations
...
This concentrates on the capacity
of a process – particularly the bottlenecks that limit production
...
The theory of constraints looks
for ways of improving efficiency by systematically removing the current
bottleneck
...
Like many similar packages, OPT is a
proprietary product and the details of its operations are not published –
but it is based on a series of well-known principles:
ᔢ Balance the flow through the process rather than the capacity
...
ᔢ The utilization of an operation that is not a bottleneck is not set by its
own capacity, but by some other operation in the process
...
ᔢ An hour lost at a bottleneck cannot be recovered, and gives an hour lost
for the entire process
...
ᔢ Bottlenecks control both the throughput of the process and the stocks of
work in progress
...
ᔢ The size of the process batch should be variable and not fixed
...
ᔢ Lead times are set by the process and cannot be predetermined
...
Scheduling services
There is no fundamental difference between scheduling services and
scheduling in manufacturing
...
They often form
queues, which makes the time spent waiting for a service particularly
important
...
ᔢ As services cannot be held in stock, available capacity has to meet peak
demands
...
FURTHER READING
Baker, K R, Elements of Sequencing and Scheduling, Baker Press, Hanover,
NH 1995
...
Vollman, T E, Berry, W L and Whybark, D C, Manufacturing Planning and
Control Systems (3rd edition), Richard Irwin, Homewood, IL 1992
...
CONTROL OF SCHEDULES
Short-term schedules give detailed timetables that show what each job,
piece of equipment, person and every other resource should be doing at
any time
...
The schedules show what an organization
intends to do, but during the implementation there may be unforeseen
circumstances that prevent the plans actually happening:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
equipment may develop a fault or break down;
people may be ill and unavailable for work;
suppliers may not send necessary materials;
customers may send in new orders;
customers may change the specifications or cancel existing orders;
there may be other problems within the organization that disrupt the
process;
ᔢ the process may be disrupted by external factors that the organization
cannot control
...
There are two
main parts to a system
...
It checks details of jobs’ progress, and reports on times, efficiency, productivity, utilization and other measures
...
Then the control system adjusts the schedules, or takes
whatever action is necessary to allow revised plans
...
To be more specific, the control
system:
ᔢ ensures that jobs are scheduled according to plans;
ᔢ warns of problems with resources, delivery dates and so forth;
ᔢ makes sure that materials, equipment and operators are available for
each job;
ᔢ assigns jobs to specific orders and set delivery times;
ᔢ checks progress as jobs move through the process;
ᔢ makes small adjustments as necessary to plans;
ᔢ allows rescheduling if there is a major disruption to plans;
ᔢ gives information on current activities;
ᔢ gives feedback on performance
...
This shows the
schedules as an ordered list of the jobs to be done each day, their importance and how long each will take
...
Other inputs to the control system might include stock levels, bills of
materials (which list all the materials needed for a product), routes that
products move through equipment, and delivery dates for specific jobs
...
Some organizations link the control system to an input/output report,
which keeps a check on the units entering an operation and those leaving
...
Control and planning
In principle, planning is done before operations, and then control takes
over while the operations are actually being performed
...
Then the control system reports these, or it might take a
more active part in overcoming the problems
...
In such
cases, there is not really a clear separation between planning and control,
and the two functions tend to merge
...
Sink, D S, Productivity Management: Planning, evaluation, control and
improvement, John Wiley, New York 1985
...
It uses the bill of materials to show what
materials are needed for a master schedule, and then designs a timetable
for their arrival
...
In the same way, material requirements planning (MRP)
uses the master schedules to give a detailed timetable for the delivery of
materials
...
Conventional planning is based on forecasts of demand
...
Then the demands are independent of each
other and the demand for one product is not related to the demand for
240 ᔡ Operational Management
another
...
For example, when a manufacturer uses a
number of components to make a product, the demands for each
component are related, since they clearly depend on the demand for the
final product
...
Material requirements planning is based on dependent demand
...
THE MRP APPROACH
Material requirements planning needs a lot of information about products
and schedules, and it uses this in a large number of related calculations
...
Master schedules give the number of every product to be made in every
period
...
The
inventory records show which of these materials are already available and
which have to be bought or made
...
It shows not only the materials, parts and
components needed, but also the order in which they are used
...
1
...
Level 1 items are
used directly to make the level 0 item, level 2 items are used to make the
level 1 items, and so on
...
Every product has a bill of
materials that is prepared at the design stage
...
Suppose the master schedule shows 10 tables to be made in
Material Requirements Planning ᔡ 241
Table
Legs (4)
Top (1)
Hardware
Oak planks
(4)
Wood kit
Hardware
Pine blanks
(6)
Struts (8)
Wood kit
Figure 49
...
Then the company will need 10 tops and 40 legs ready for assembly
at the beginning of February
...
Not
all of these have to be ordered, as there may be some already in stock or due
to arrive shortly
...
Now the company has the quantities to order, and knows when these
orders should arrive
...
For this it needs to know the lead times, and then orders can be placed in
these lead times before the materials are actually needed
...
When all such factors are taken into account, the company can design a
detailed timetable for orders
...
2
...
These
typically include:
ᔢ timetable of operations for the supply of materials to achieve the master
schedule;
ᔢ list of internal orders for materials made within the organization;
242 ᔡ Operational Management
Master
production
schedule
Bill of materials
Gross
requirements
Current stocks
Inventory
records
Scheduled
receipts
Net
requirements
Materials to
order
Standard order
information
Time and
quantities to
order
Figure 49
...
BENEFITS AND PROBLEMS OF MRP
Material requirements planning reduces stock levels by relating the
supply of materials directly to demand
...
Problems with MRP
There are also some disadvantages with MRP, the most obvious being the
amounts of information and calculation that it needs
...
Many organizations simply do not have this
information, or they do not have it in enough detail, the right format, or
with enough accuracy
...
Another frequent problem is that MRP reduces flexibility in responding to
changes
...
Some disadvantages of MRP include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
it needs a lot of detailed and reliable information;
it involves a lot of data manipulation;
systems can be very complex;
reduced flexibility;
it assumes that lead times are constant and independent of the quantities ordered;
ᔢ in practice, materials are sometimes made in a different order to that
specified in the bill of materials;
ᔢ if MRP is used to schedule the production of parts, this may give poor
schedules;
244 ᔡ Operational Management
ᔢ material requirements planning may not recognize capacity and other
constraints;
ᔢ it can be expensive and time consuming to implement
...
Smolik, D P, Material Requirements of Manufacturing, Van Nostrand
Reinhold, New York 1983
...
245
50
Extensions to MRP
DEFINITION
There are many ways of extending the MRP approach
...
Once the dependent-demand MRP mechanism is established, it can be extended to include other resources – such as ‘closed-loop
MRP’, which gives feedback for capacity planning, ‘manufacturing
resource planning’, which extends the ideas to more resources, and ‘enterprise resource planning’, which eventually looks at controlling operations
throughout the whole organization
...
Services also need schedules for materials, and early work adopted MRP
to work in service organizations
...
Nonetheless, there are
many examples of services that have successfully used MRP
...
Then MRP can find the timetable for
materials needed, which are the teachers, classrooms, laboratories and so
forth
...
CLOSED-LOOP MRP
In its basic form, MRP designs a schedule for delivering materials for a single
period’s production
...
Each MRP run is self-contained and more or less isolated from the runs
for other periods
...
It makes obvious sense to extend MRP so that it checks the resulting
schedules to make sure that there are no problems
...
In other
words, there are links between the MRP system and other planning
systems
...
First, proposed plans that
would break capacity constraints are detected by closed-loop MRP and
early rescheduling is done to avoid the problem
...
Second, if operations are interrupted, the
master schedule can be revised quickly with inputs from the MRP system
...
It
explodes these and designs schedules for the supply of materials
...
This usually involves
some iteration, with repeated adjustments to plans and capacities until a
workable and acceptable solution is found
...
1
...
The most significant extension is manufacturing
resource planning, or MRP II, which extends the range of resources planned
using MRP
...
1 Capacity requirements planning
Basic MRP gives a timetable for ordering, purchasing and operations
needed to supply materials
...
But why not extend the MRP approach
to a range of other functions? Manufacturing resource planning shows
when parts have to be produced, so it can design schedules for the
machines that make the parts – and for the people who operate the
machines
...
248 ᔡ Operational Management
Continuing this line of reasoning, the approach could design schedules
for equipment, people working on the process, cash flows, and many
other resources
...
This is the aim of MRP II
...
Manufacturing resource planning II is an integrated system, with all
parts linked back to a production plan
...
Most organizations do not attempt to
develop full MRP II but use parts of the system – perhaps controlling
physical distribution through distribution resources planning
...
But it concentrates on the internal operations
...
In other words, organizations along the
supply chain cooperate, exchange information and integrate their
systems
...
This is the basis of enterprise resource planning (ERP)
...
It
extends the MRP systems to include a series of suppliers and customers
along the suppy chain
...
Enterprise resource planning relies on trust and a free flow of information between organizations
...
It is fair to say that ERP is currently still being
developed and is not widely used
...
Wallace, T, MRP II Making it Happen, Oliver Wight, Essex Junction, VT 1990
...
249
51
Just-in-Time Operations
DEFINITION
Just-in-time (JIT) operations try to eliminate all waste within an organization
...
They do this by scheduling all
operations to be done at just the time they are needed
...
It assumes that the main purpose of stock is to give a buffer
between operations, and allow for short-term mismatches between supply
and demand
...
Just-in-time gives a
more radical solution with the following argument
...
These stocks serve no useful purpose –
they only exist because poor coordination does not match the supply of
materials to the demand
...
This means that operations will continue to be poorly managed, with
problems hidden by the stocks
...
This will allow
them to eliminate stocks and have operations done just as they are needed
...
Just as the chassis moves
down the line to a work station, an engine arrives at the same point and is
fitted
...
As the car body arrives at another work
station, four doors also arrive and are added
...
EFFECTS OF JIT
JIT has much wider effects than simple stock control, and really involves a
change in the way an organization looks at its operations
...
It starts with the aim of organizing operations to occur at exactly
the right time, and becomes a way of eliminating all waste from an organization
...
Just-in-time assumes that stocks serve no useful purpose but
rather hide problems
...
ᔢ Quality
...
This reinforces the need for perfect quality, which
was discussed in Chapter 32
...
Just-in-time systems rely totally on their suppliers, and they
recognize that customers and suppliers are partners with a common
objective
...
ᔢ Employees
...
All employees
are treated fairly and equitably, with a stake in the success of the
company
...
Every time there are changes to a process, there are delays,
disruptions and costs
...
If we continue arguing in this way we can list the key elements in JIT operations, which include:
ᔢ a stable environment, making standard products with few variations;
ᔢ continuous production at fixed levels, probably with automated, highvolume operations;
Just-in-Time Operations ᔡ 251
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
a balanced process that uses resources fully;
reliable production equipment;
minimum stocks;
small batches of materials delivered with short lead times;
low set-up and delivery costs;
efficient materials handling;
long-term relationships with reliable suppliers;
consistently perfect quality of materials;
flexible workforce, which is treated and rewarded fairly;
ability to solve any problems;
an efficient method of control
...
Everything is changed, from the way that goods are ordered to the role of
people working on the shop floor
...
PUSH AND PULL SYSTEMS
Just-in-time might seem a good idea in principle but it needs some way of
controlling the operations
...
In a traditional process each operation has a
timetable of work that must be finished in a given time
...
This ignores what the next operations are actually doing –
they might be working on something completely different, or be waiting
for a different item to arrive
...
Just-in-time ‘pulls’ work through the process
...
The preceding
operation only passes materials forward when it gets this request
...
In practice, there must be some lead time between an operation
requesting material and having it arrive, so requests for materials are
passed backwards into this lead time before they are actually needed
...
252 ᔡ Operational Management
KANBANS
With JIT, messages are passed between operations using kanbans, which is
the Japanese for a card, or some form of visible record
...
All materials are stored and moved in standard containers
...
When an operation
needs more materials a kanban is attached to an empty container and this is
taken to the preceding operation
...
The empty container is a
signal for the preceding operation to start work on this material and it
produces just enough to refill the container
...
ᔢ Standard containers are used which hold a specific amount
...
ᔢ The size of each container is the smallest reasonable batch that can be
made and there are usually only one or two full containers at any point
...
This effectively
fixes the amount of work in progress
...
ᔢ Materials can only be moved in containers, and containers can only be
moved when they have a kanban attached
...
Although it is simple to administer, this system makes sure that stocks of
work in progress cannot accumulate
...
Unfortunately, some of these benefits can only be bought at a high price
...
A fast response to a demand may mean
that spare capacity is needed
...
Some specific problems listed by JIT users include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
high initial investment and cost of implementation;
long time needed to get improvements;
reliance on perfect quality of materials from suppliers;
problems with maintaining internal product quality;
inability of suppliers to adapt to JIT methods;
need for stable production;
difficulty making a range of different products;
reduces flexibility to deal with product changes;
difficulty of reducing set-up times;
lack of commitment within the organization;
lack of cooperation and trust between employees;
problems linking to existing information systems;
need to change layout of facilities;
increased stress in workforce;
inability of some people to accept devolved responsibilities
...
Hutchins, D, Just in Time, Gower Press, London 1989
...
254
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255
52
Project Management
DEFINITIONS
A project is a unique job that makes a one-off product
...
Project management deals with all aspects of planning, organizing,
staffing and controlling a project
...
Projects come at one
end of this spectrum, making individual units
...
Most organizations work with projects of some kind
...
In recent
256 ᔡ Operational Management
years many managers have realized that their work is not necessarily a
continuous process, but is more like a series of projects
...
Each project is essentially unique, so there is little relevant experience
...
They are often large, employing many people and
using many resources
...
PHASES OF A PROJECT
Because of the risks, and the size of many projects, a lot of effort is put into
project management
...
Major projects are usually divided into more parts, and a common
approach has the following six phases:
1
...
This describes in general terms the aims of the project and how
these will be achieved
...
2
...
If the concept seems reasonable, some details are added in
the definition
...
The definition
includes a scope that describes all the work to be done in a project
...
Planning
...
These plans
are based on a work-breakdown structure, which divides the whole
project into smaller manageable bits
...
Some aspects of
planning are discussed below
...
Execution
...
It implements the plans and does all the work described
...
Control
...
Projects have a lot of uncertainty, so plans might change quite frequently
during execution
...
Handover
...
The results are
handed over to the customers
...
Together, these form the
stakeholders, who include:
ᔢ owners – the customers for whom the project is done;
ᔢ sponsors or champions – who support the project and overcome problems
within the owners’ organization;
ᔢ project team – the people who do the actual work and execute the
project;
ᔢ project manager – who controls the project team and is responsible for the
work;
ᔢ contractors/subcontractors – outside organizations that are brought in to
do parts of the work;
ᔢ external parties – other people who may be affected by the project
...
Their job is to bring together all the resources and make sure the
project is a success
...
Projects usually have a matrix organization, where staff from different
functions are brought together into a team for a specific project
...
PROJECT PLANNING
The aim of project management is to complete the project successfully –
giving customers the product they want, keeping within the specified time
and within the budget
...
The first five of these are concerned with scheduling the project and are
done in the planning phase
...
PROJECT NETWORKS
A work-breakdown structure describes all the activities that are needed for
a project
...
Project network analysis is based on critical path methods (CPM), which
represent the activities of a project as a network
...
The nodes are called
events and a network consists of alternating activities and events, as illustrated in Figure 52
...
This kind of network is an ‘activity on arrow network’, but there is an
alternative format with ‘activity on node’
...
There is a wide range of software for drawing networks
...
1 A project network
D
13
P
12
Project Management ᔡ 259
activities
...
Software will then analyse
this table and draw a network in any desired format
...
These are typically shown as a
series of Gantt charts and bar charts
...
If any of these critical activities is delayed or extended,
the whole project is delayed
...
RESOURCE PLANNING
The initial timing of a project is found by CPM, which then finds the
resources needed to support the timetable
...
There are three main reasons for this:
ᔢ the initial schedule gives unacceptable use of resources, and the timings
are adjusted to increase utilization;
ᔢ the timing of the project is unacceptable – perhaps taking more time
than the organization has available;
ᔢ during execution an activity might take a different time from that originally planned
...
Another consideration is that the
duration of a project is set by the critical activities
...
The total cost of a project is made up of direct costs such as labour and
materials, indirect costs such as management and financing, and penalty
costs if the project is not finished by a specified date
...
260 ᔡ Operational Management
FURTHER READING
Lockyer, K G and Gordon, J, Project Management and Project Network
Techniques (6th edition), Pitman, London 1996
...
261
53
Maintenance and
Replacement
DEFINITION
The performance of most things deteriorates over time
...
Eventually, the cost of this maintenance rises to the point where it is better
to replace the equipment rather than continuing maintaining it
...
1
...
ᔢ As the teething problems decline, the equipment has a period of
stability, which lasts through its normal working life
...
Some aspects of this traditional view are becoming less acceptable, and
most organizations would not be happy with new equipment that did not
Probability of breakdown
262 ᔡ Operational Management
Time
Figure 53
...
At the other end of equipment life, however,
there is less that can be done to alleviate the effects of ageing
...
Sometimes this change is slow – like the fuel consumption of a car,
which rises over a period of years
...
The only way of reducing the effects of ageing is
to use planned or preventive maintenance
...
A car, for example, has a
regular service to replace filters, oil, plugs and other vulnerable parts
...
There are four
approaches to the replacement of these vulnerable parts:
ᔢ keep a check on parts, look for specific signs of wear, and replace them
when these signs first appear;
ᔢ replace parts after a specified period of working;
ᔢ replace parts when some measure of performance falls below an
acceptable level;
ᔢ replace parts when they actually fail
...
These
advantages include:
Maintenance and Replacement ᔡ 263
ᔢ improved overall performance of equipment;
ᔢ increased reliability and fewer disruptions;
ᔢ maintenance is done at convenient times such as evenings, weekends
or holidays;
ᔢ equipment has a longer working life;
ᔢ lower operating costs;
ᔢ higher resale value of equipment;
ᔢ safer operations
...
If the maintenance is done too frequently, the equipment will run efficiently but the maintenance costs will be too high
...
The best answer comes from an analysis of maintenance and expected
failure costs
...
2)
...
total cost
Total cost per unit time
expected cost
of failures
maintenance cost
Optimal
time
Time between maintenance periods
Figure 53
...
The basic
performance of equipment is largely set by its initial design, however
...
The reliability of a piece of equipment is the probability that it continues
to work normally throughout a specified period
...
95 that it will continue to
work normally during a performance
...
If a single component has a known reliability,
putting two identical components in parallel increases the overall reliability
...
Adding more components in parallel increases
reliability, as the equipment will only fail when all components fail
...
(See Figure 53
...
)
On the other hand, if components are added in series, the reliability of
the equipment is reduced
...
(See Figure 53
...
)
REPLACEMENT OF EQUIPMENT
Routine maintenance extends the working life of equipment, but there
comes a point when maintenance and repairs become too expensive and it
Figure 53
...
4 Components in series reduce reliability
is cheaper to buy replacements
...
In the first, equipment is replaced when its performance
falls so low that it is no longer acceptable – the output may be too low,
quality too poor, breakdowns too frequent, and so on
...
The second approach shows a better alternative,
which analyses costs and keeps the equipment working for the time that
minimizes total costs
...
One drawback with this planned replacement is that all equipment is
routinely replaced when it appears to be working well
...
The usual way of finding the best age for planned replacement is based
on minimal annual costs
...
Total operating costs = running + maintenance cost + cost of breakdown
+ capital costs
...
Then repeating
the calculation for different lengths of life gives a curve with a minimum,
which identifies the best age of replacement
...
FURTHER READING
Moubray, J, Reliability-centred Maintenance, Butterworth-Heinemann,
London 1991
...
266
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267
54
Supply-chain
Management
DEFINITION
The supply chain consists of all the organizations and operations along
which products move from the original suppliers of materials through to
the final customers
...
THE SUPPLY CHAIN
The final product of one organization is the raw material of another, so
materials are moved through a series of organizations and operations
between original suppliers and final customers
...
1 for the supply of paper
...
It
looks at three types of movement:
ᔢ Movement of raw materials from supplies into the organization – including
purchasing, inward transport, receiving, storage and retrieval of goods
...
ᔢ Movement of finished goods from the organization out to customers –
including packaging, storage and retrieval from warehouses, shipping
and distribution to customers
...
1 Example of a supply chain
Sometimes it is convenient to consider the broad range of logistics or SCM
in two parts
...
Physical distribution
management is responsible for the movement of finished goods out to
customers
...
Supply-chain Management ᔡ 269
AIMS OF SUPPLY-CHAIN MANAGEMENT
Coordinating all movement along the supply chain can be very complicated for even a simple product
...
This aim is summarized as supplying ‘the right
materials, to the right place, at the right time, from the right source, with
the right quality, at the right price’
...
IMPORTANCE OF SUPPLY-CHAIN
MANAGEMENT
All organizations rely on the movement of materials
...
270 ᔡ Operational Management
PLANNING FOR SCM
Generally, planning for the supply chain takes place after planning
production
...
Supply-chain management plans
can then be based on planned production
...
When details of these analyses are complete for every process, the organization can look at the implications in terms of:
ᔢ the amount of space needed to store the materials at points on its
journey into, through and out of the organization;
ᔢ best location and size of warehouses and depots;
ᔢ type and amount of equipment needed to handle and transport the
materials;
ᔢ systems and policies for controlling the stocks within warehouses;
ᔢ systems and policies for routing and transporting materials between
operations;
ᔢ numbers and skills of people needed to run the supply chain
...
2
...
Intermediaries give
a break between production and customers and have benefits that
include:
Supply-chain Management ᔡ 271
First level
suppliers
Second level Third level
suppliers
suppliers
First level
customers
Second level
customers
Third level
customers
Customer
Raw
materials
Materials
Retailer
Parts
Raw
materials
Operations
Materials
Wholesaler
Parts
Customer
Retailer
Customer
Retailer
Raw
materials
Customer
Customer
Figure 54
...
FURTHER READING
Coyle, J J, Bardi, E J and Langley, C J, The Management of Business Logistics
(7th edition), West Publishing, Minneapolis 1996
...
272
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273
55
Procurement
DEFINITION
Procurement buys the materials needed by an organization
...
AIMS OF PROCUREMENT
Many organizations use the terms ‘purchasing’ and ‘procurement’ to
mean the same thing
...
The purpose
of procurement is to make sure that materials needed to support operations arrive from suppliers at the time they are needed
...
PURCHASE CYCLE
We can look in more detail at the work done in procurement by considering a typical purchase cycle
...
Then procurement:
ᔢ
ᔢ
ᔢ
ᔢ
receives and analyses the purchase request;
verifies and checks its details;
checks current stocks, alternative products and so forth;
makes a shortlist of possible suppliers, from regular suppliers and/or
those who are known to be reliable;
ᔢ sends a request for quotations to this shortlist
...
Then procurement:
ᔢ clears up any points with potential suppliers;
ᔢ chooses the best supplier, based on their product, delivery, price and so
forth;
ᔢ discusses and finalizes details with the supplier;
ᔢ issues a purchase order
...
Procurement ᔡ 275
Then procurement:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
does any follow-up to make sure the materials are delivered;
expedites late deliveries;
receives, inspects and accepts the items;
updates inventory records, notifies the purchasing department;
approves the supplier’s invoice for payment
...
The whole supply-chain management is important for a successful organization, and this is particularly true of procurement
...
All materials are purchased somewhere
and mistakes in procurement can lead to poor quality, interrupted operations, late deliveries, wrong quantities, high costs and poor customer
service
...
With a profit margin of 10 per cent, a 1 per cent
reduction in the cost of purchased goods can increase profits by 6 per cent
...
It used
to be little more than a clerical job, buying materials as they were
requested
...
There are several reasons for this change
...
In fact, TQM specifically advises
against giving business on the basis of cost alone
...
Organizations thought that this gave them good prices because
suppliers would compete fiercely to get business
...
This creates a
relationship with suppliers, who are prepared to pay attention to orders,
guarantee performance and become involved in improvements to product
design
...
In effect, value analysis finds substitute materials that are
lower in price but equally as good as the original
...
Many organizations now organize their sales around the internet, or with linked systems
in the supply chain giving ‘lean operations’
...
FURTHER READING
Bailey, P, Farmer, D, Jessop, D and Jones, D, Purchasing Principles (7th
edition), Pitman, London 1994
...
277
56
Inventory Control
DEFINITION
Stocks are supplies of goods and materials that are held by an organization
...
An inventory is actually a
list of items held in stock, but this is often used in the same general sense as
‘stock’
...
The main reason for doing this
is to give a buffer between variable and uncertain supply and demand
...
Other
reasons for holding stocks include:
ᔢ to act as a buffer between different operations;
ᔢ to allow for demands that are larger than expected, or at unexpected
times;
ᔢ to allow for deliveries that are delayed or too small;
ᔢ to take advantage of price discounts on large orders;
ᔢ to buy items when the price is low and expected to rise;
ᔢ to buy items that are going out of production or are difficult to find;
ᔢ to make full loads and reduce transport costs;
ᔢ to give cover for emergencies
...
ᔢ Work-in-progress – materials that have started but not yet finished their
journey through the process
...
ᔢ Spare parts – for machinery, equipment and so forth
...
COSTS OF CARRYING STOCK
The traditional approach to stock control uses an independent demand
system (see Chapter 49) with forecasts giving the expected demand for an
item
...
These costs come from four main sources:
ᔢ Unit cost – the cost of acquiring one unit of the item
...
If a company
makes the item itself, it may be difficult to give a reliable production cost
or set a transfer price
...
It might
include the cost of drawing up an order, correspondence and telephone
costs, receiving, checking, supervision, use of equipment and followup
...
ᔢ Holding cost – the cost of holding one unit of an item in stock for a unit
period of time
...
Other holding costs are due to
storage space, loss, handling, administration and insurance
...
ᔢ Shortage cost – the cost that occurs when an item is needed but it cannot
be supplied from stock
...
Shortages of raw materials for a production
process can cause disruption and force rescheduling of production,
retiming of maintenance periods and laying-off of employees
...
Inventory Control ᔡ 279
APPROACHES TO INVENTORY CONTROL
An important point about inventory costs is that some rise with the
amount of stock held, and others fall
...
Inventory control
must balance these competing costs and suggest policies that give the
lowest overall costs
...
ᔢ When should an order be placed? This depends on the inventory
control system used, type of demand (high or low, steady or erratic,
known exactly or estimated), value of the item, lead time between
placing an order and receiving it into stock, supplier reliability, and a
number of other factors
...
If small, frequent orders are placed, the average
stock level is low but the costs of placing and administering orders is
high
...
One
approach finds an economic order quantity (EOQ), which is the order
size that minimizes the overall costs for a simple inventory system
...
The answer to this comes from the
reorder level
...
1
...
To get a
delivery just as stock is running out, we have to place an order this lead
time earlier
...
With constant demand, an order is placed when the stock level falls
to:
lead time
Reorder level = ᎏᎏ
demand
280 ᔡ Operational Management
Economic
order
quantity
Stock level
EOQ
Reorder
level
L
Place Order
order arrives
L
Place Order
order arrives
Time
Figure 56
...
In
practice, demand can vary widely and have a lot of uncertainty
...
Although shortage costs are difficult to find, they are usually a lot
higher than holding costs, so organizations are willing to hold additional
stocks, above their expected needs, to add a margin of safety
...
The safety stock
has no effect on the reorder quantity, but the reorder level now becomes:
Reorder level = lead time demand + safety stock
The larger the safety stock, the greater the cushion against unexpectedly
high demand, and the greater the customer service
...
This service level will typically be
around 95 per cent, which means that 95 per cent of orders are met from
stock – and 5 per cent of orders cannot be met from stock
...
PERIODIC REVIEW SYSTEM
The EOQ uses a fixed-order quantity, but there is an alternative periodic
review system that orders varying amounts at regular intervals
...
The operating cost of this system is generally lower
and it is better suited to high, regular demand of low-value items
...
2
...
The system works by looking at the amount of
stock on hand at the end of a period and ordering the amount that brings
this up to the target stock level
...
At the other
end of the scale are very expensive items that need special care above the
routine calculations
...
This is based on
a Pareto analysis or the ‘rule of 80/20’, which suggests that 20 per cent of
inventory items need 80 per cent of the attention, while the remaining 80 per
cent of items need only 20 per cent of the attention
...
2 Comparison of fixed-order quantity and fixed-order time systems
282 ᔡ Operational Management
ᔢ A items as expensive and needing special care;
ᔢ B items as ordinary ones needing standard care;
ᔢ C items as cheap and needing little care
...
The computer system might make some suggestions for A items,
but managers make final decisions after reviewing all the circumstances
...
FURTHER READING
Tersine, R J, Principles of Inventory and Materials Management (3rd edition),
Elsevier, New York 1987
...
283
57
Facility Location
DEFINITION
Facility location finds the best possible geographical location for an organization’s operations
...
These include:
ᔢ
ᔢ
ᔢ
ᔢ
the end of a lease on their existing premises;
desire to expand into new geographical areas;
changes in the location of customers or suppliers;
significant changes in operations – such as an electricity company
changing from coal generators to gas;
ᔢ upgrading of facilities – perhaps introducing new technology;
ᔢ changes to the logistics system – such as changing from rail transport to
road;
ᔢ changes in the transport network – such as a new bridge or the Channel
Tunnel
...
Location decisions are also very complicated, and need to take into account a lot of
284 ᔡ Operational Management
factors, including operating costs, wage rates, taxes, international
exchange rates, competition, current locations, exchange regulations,
availability of grants, reliability of supplies, and a whole range of other
factors
...
Alternatives to locating new facilities
New facilities are inevitably expensive and many organizations prefer to
look for alternatives
...
ᔢ Exporting – the company makes the product in its existing facilities and
sells it to a distributor operating in the new market
...
ᔢ Local assembly/finishing – the company makes most of the product in its
existing facilities, but opens limited facilities in the new market to finish
or assemble the final product
...
The choice between these depends on many factors, such as the capital
available, the risk that the organization will accept, its target return on
investment, existing operations, the timescale, local knowledge, transport
costs, tariffs, trade restrictions and available workers
...
These must be balanced against the
more complex and uncertain operations
...
These start with a wide view, looking at the attractions of different countries or geographical regions
...
At the top of this hierarchy, an organization may take a decision about
the country of operation
...
Low
wage rates in developing countries have encouraged manufacturers to
open factories in the Far East, South America and Eastern Europe
...
Low wage rates do not automatically mean low costs
...
Perhaps more importantly, manufacturing processes have changed so that
labour costs often form a very small part of overall costs
...
Some of these are commercial, but experience suggests three other
factors are important:
ᔢ Culture
...
ᔢ Organization
...
ᔢ Operations
...
COSTING ALTERNATIVE LOCATIONS
Once a decision has been made about the country or geographical region,
more detailed decisions are needed about areas, towns, cities and individual
sites
...
The feasible
set approach looks at a small number of feasible sites and finds which of these
is the best
...
The feasible set approach is generally easier, and more realistic
...
In
principle it is possible to do a full costing, but there are only a certain
number of costs that will vary between locations – such as the transport
costs and certain operating costs
...
On the other
hand, sites near to customers will have low costs for outward transport,
286 ᔡ Operational Management
but high costs for inward transport
...
We can combine these costs – together with any other relevant ones –
and get a direct comparison of sites
...
Even reliable costs are likely to
change and the analysis will become outdated
...
The weaknesses of costing models include:
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
it is difficult to get accurate forecasts of costs;
data depends on accounting conventions;
costs vary over time and the analyses become dated;
customer locations and exact demands may not be known in advance;
suppliers may move to new locations;
there are many factors that cannot be costed
...
SCORING MODELS
Many important factors in location decisions are intangible
...
For the country and region
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
ᔢ
availability and quality of workforce;
climate;
local and national government policies;
availability of development grants;
attractiveness of locations;
quality of life – including health, education, welfare and culture;
reliability of local suppliers;
infrastructure – particularly transport and communications;
economic stability
...
With location decisions there are some distinct differences between manufacturers and services
...
They will typically look for a site where costs are low, there is a skilled workforce and
suppliers are nearby
...
They cannot keep stocks of their services, so they need small
local facilities that meet demand as soon as it arises
...
When an organization has listed the most important factors for its location
decision, it must find some way of comparing the alternative sites
...
GEOMETRIC MODELS
Geometric models use an infinite set approach to see where the best
location would be in principle
...
A common
approach finds the centre of gravity of demand
...
But
they can be used as a starting point to look for actual sites
...
FURTHER READING
Johnson, J C and Wood, D F, Contemporary Logistics, Macmillan, New York
1990
...
289
Part 3
Financial Management
290
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291
58
Financial Management:
An Overview
DEFINITION
Financial management is concerned with all aspects of how a business deals
with its financial resources in order to maximize profit over the long term
...
ᔢ Financial accounting, which clarifies, records and interprets in monetary
terms transactions and events of a financial nature
...
The
accounts prepared by the firm will be audited to ensure that they
present a ‘true and fair view’ of its financial performance and position
...
292 ᔡ Financial Management
ᔢ Financial analysis, which analyses the performance of the business in
terms of variance analysis, cost–volume–profit analysis, sales mix
analysis, risk analysis, cost–benefit analysis and cost-effectiveness
analysis
...
Management accounting provides the data
for financial analysis and for capital appraisal and budgeting
...
The capital appraisal techniques comprise accounting rate of
return, payback and discounted cash flow
...
293
59
Financial Planning
DEFINITION
Financial planning is the process of predicting the performance of a
business to give an overall measure of how well it is doing, and to provide
the basis for decision making about future requirements for finance and
the rates of growth and profitability required to meet the expectations of
shareholders and the City
...
ᔢ Cash-flow forecasting – predicting the flows of cash into and out of the
business and net cash balances in the bank
...
ᔢ Long-range budgeting – preparing long-range capital and financial
budgets indicating what funds will be required in the future
...
294 ᔡ Financial Management
ᔢ Profit and dividend planning – planning to achieve a rate of profit and
dividend payment to achieve earnings per share figures and price/
earning ratios which will satisfy the City and existing investors
...
295
60
Financial Accounting
DEFINITION
Financial accounting records the revenue received and the expenditure
incurred by a company so that its overall performance over a period of
time and its financial position at a point in time can be ascertained
...
PURPOSE
The purposes of financial accounting are to meet:
1
...
the internal requirements of the management of the company who
require information, not only for control purposes but also as a guide to
decision making
...
The balance sheet, which is a statement on the last day of the accounting
period of the company’s assets and liabilities and the share capital and
reserves or shareholders’ investment in the company
...
The manufacturing and trading accounts, which, for a period of accounts,
show the cost of goods manufactured, the cost of goods sold, sales
revenue and gross profit (the difference between the sales revenue and
the cost of goods sold)
...
The profit-and-loss account, which takes the gross profit from the trading
account and deducts marketing, distribution and administrative costs
and expenditure on research and development to determine the
company’s trading or operating profit, for the period
...
(See Chapter 62
...
The profit-and-loss appropriation account, which indicates the profit
available for appropriation to shareholders in the form of dividends, for
transfer to reserves and for carrying forward to the next account
...
5
...
It describes the sources from which
additional cash (funds) were derived and the application to which this
cash was put
...
The statement of total recognized gains and losses, which is produced if there
are any gains or losses other than the profit or loss for the year shown in
the profit-and-loss account
...
The statement’s long name
has resulted in accountants abbreviating it (albeit normally in an
unwritten fashion) to ‘strgl’, which is pronounced ‘struggle’
...
Manufacturing and trading accounts are frequently produced only for the
management of the company
...
Some companies produce financial
statements specifically for their employees; these often include summarized information in pictorial form and may include a value-added statement
to show how much wealth the company has created
...
Financial Accounting ᔡ 297
RELATIONSHIP BETWEEN THE BALANCE
SHEET AND THE PROFIT-AND-LOSS
ACCOUNT
The balance sheet and the profit-and-loss account are the two key financial
statements
...
1
...
1
...
Money is used as the common
denominator and accounting therefore only deals with those facts that can
be represented in monetary terms
...
The business as a separate unit
Each business is a separate entity for accounting purposes and accounts
are kept for each entity
...
Financial reports are meant to show how effectively this stewardship has
been undertaken
...
1 Relationship between balance sheet and profit-and-loss account
298 ᔡ Financial Management
3
...
The claims of the owners are represented by issued share capital
and retained profits
...
All the assets of the business are claimed by someone, either owners or
creditors
...
An increase in the owners’ claims must
always be accompanied by an equivalent increase in assets or a reduction
in liabilities
...
The going concern
In accounting, the business is viewed as a going concern, one that is not
going to be sold or liquidated in the near future
...
Therefore regular accounting reports do not usually attempt to
measure what the business is currently worth to its owners at market rates,
ie it is not normally the practice to value capital assets at their net realizable
value (the price that could be obtained if the goods were sold on the open
market less the cost of selling them)
...
There are two capital maintenance concepts:
financial capital maintenance (maintain original cash investment) and
physical capital maintenance (maintain physical operating capability) – see
Chapter 66
...
5
...
The balance sheet does not therefore show the current value of the
Financial Accounting ᔡ 299
business
...
Systems of current cost accounting have been developed to adjust
accounts for the effects of inflation and these are described in Chapter 66
...
This applies, for example,
to the knowledge, skills and expertise of its staff
...
6
...
This process gradually removes the cost of the asset
from the balance sheet by showing it as a cost of the operation in the
profitit-and-loss account
...
Note that the depreciation process as such does not provide a separate
fund to replace the asset at the end of its useful life
...
How these retained funds are used – for
expansion, acquisitions, replacements or research and development – is a
matter for the financial and capital budgeting processes of the company
and its system of cash or funds flow management
...
7
...
The impact of events on
assets and equities is recognized in the time periods when services are
rendered or utilized instead of when cash is paid or received
...
These revenues and costs are
entered into profit-and-loss account in the period to which they relate
...
Adjustments are made in the form of:
ᔢ accruals – expenses arising from services that have been provided in the
current accounting period, the benefit from which has been used in
300 ᔡ Financial Management
earning the current period’s revenue, but which will not be paid for
until the following period; and
ᔢ prepayments – recorded expenses which refer to a period beyond that for
which the final accounts are being presented
...
8
...
9
...
Revenues and profits are never anticipated and are only included in
financial statements when they are realized, but provision is made for all
known liabilities
...
Decisions have to be
made at the end of each period on the basis of an assessment of future
events
...
This means deciding on the extent to which
the expenditure should appear in the profit-and-loss account of the
current year as distinct from appearing in the balance sheet as a resource at
the end of the year
...
To assist in making consistent and acceptable (from
an accounting point of view) judgements, accounting bases and policies
are developed
...
These bases are produced in
Financial Accounting ᔡ 301
the form of accounting standards issued by accounting professional
bodies
...
Statements
issued by the predecessor body to the ASB were known as Statements of
Standard Accounting Practice (SSAPs)
...
Accounting standards have covered areas such as cash-flow statements (FRS 1), related party disclosures (FRS 8) and goodwill and intangible assets (FRS 10)
...
In the United States, the Financial Accounting Standards Board (FASB –
pronounced ‘fasbee’) is the issuing body
...
Accounting policies
Accounting policies are the specific accounting bases judged by the
business to be the most appropriate to its circumstances and therefore
adopted in the preparation of its accounts
...
FURTHER READING
Davies, M, Paterson, R and Wilson, A (eds), UK GAAP (6th edition),
Butterworths, London 1999
...
302
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303
61
Balance Sheet Analysis
DEFINITION
Balance sheet analysis assesses the financial strengths and weaknesses of
the company primarily from the point of view of the shareholders and
potential investors, but also as part of management’s task to exercise
proper stewardship over the funds invested in the company and the assets
in its care
...
assets = what the business owns;
2
...
capital = the owners’ interest in the business
...
MAKE-UP OF THE BALANCE SHEET
The balance sheet contains four major sections:
1
...
ᔢ Short-term or current assets which change rapidly as the company
carries on its business: stocks of raw materials; work-in-progress;
stocks of finished goods; debtors; bank balances and cash
...
In this
cycle, cash flows out of the business up to the point where the
customer, or debtor, takes delivery of the finished goods
...
2
...
These will be shown under the
heading of creditors in the balance sheet and will include tax, bank
overdraft and dividend payments due to shareholders
...
Net current assets or working capital, which is current assets less current
liabilities
...
4
...
ANALYSIS
Balance sheet analysis concentrates on two areas: liquidity and capital
structure
...
Balance Sheet Analysis ᔡ 305
Liquidity analysis
Liquidity analysis aims to establish that the company has sufficient cash
resources to meet its short-term obligations
...
The working capital ratio (current ratio)
...
However, too high a ratio
(say more than 2) might be due to cash or stock levels being greater than
is strictly necessary and might therefore be indicative of the bad
management of working capital requirements
...
2
...
The working capital ratio includes stock as
a major item and this may not be convertible very readily into cash if the
need arises to pay creditors at short notice
...
The quick ratio is calculated as:
Current assets minus stocks
ᎏᎏᎏᎏ
Current liabilities
Again, there are no rigid rules on what this ratio should be
...
The company would fail
the ‘acid test’ of being able to pay its short-term obligations and would
therefore be in danger of becoming insolvent
...
Capital structure analysis
Capital structure analysis examines the overall means by which a
company finances its operations
...
These two sources of finance are referred to as equity
and debt respectively, and the relationship between the two indicates the
gearing or leverage of the company
...
The problem which can arise from
high gearing is that providers of loan capital have priority for payment
over shareholders, and in hard times the latter might suffer
...
The gearing position of a company can be assessed by the
use of the following balance sheet ratios:
1
...
This is the classic gearing ratio and is calculated as:
Long-term loans plus preference shares
× 100
Ordinary shareholders’ funds
2
...
This ratio calculates the amount
of debt finance as a proportion of total long-term finance as follows:
Long-term loans plus preference shares
ᎏᎏᎏᎏᎏ × 100
Long-term loans plus preference shares plus
ordinary shareholders’ funds
The implications of this ratio are similar to those of the long-term debt to
equity ratio
...
There is no such thing as an optimum ratio
...
But a company with a low level of business risk with stable
operating profits may be able to withstand higher gearing than a
company whose operating profits fluctuate widely
...
Total debt to total assets ratio
...
It is calculated as:
Long-term loans plus short-term loans
ᎏᎏᎏᎏᎏ × 100
Total assets
The total debt to total assets ratio recognizes the fact that short-term
bank loans and overdrafts are often almost automatically renewable
Balance Sheet Analysis ᔡ 307
and are therefore effectively a source of long-term finance
...
FURTHER READING
Pendlebury, M and Groves, R, Company Accounts (3rd edition), Unwin
Hyman, London 1994
...
Profit (or loss) can be defined as revenue or income minus expenses
...
PURPOSE
Profit serves three purposes, as defined by Peter Drucker:1
1
...
2
...
3
...
Profitability is the primary aim and best measure of efficiency in competitive business, and profitability analysis aims to provide the data on which
action can be taken to improve the company’s business performance
...
Gross profit – the difference between sales revenue and the cost of goods
sold
...
2
...
3
...
4
...
PRESENTATION OF PROFITS
Profit information is derived from the trading account and the profit-andloss account
...
This is shown in Table 62
...
Table 62
...
2
...
)
MEASUREMENT OF PROFITABILITY
Profitability is a measure of the return in the shape of profits that shareholders obtain for their investment in the company
...
Profitability Analysis ᔡ 311
Table 62
...
Return on equity
This ratio shows the profitability of the company in terms of the capital
provided by the owners of the company, ie the shareholders
...
This is regarded by
many analysts as the basic profitability ratio
...
Return on capital employed
The return on capital employed ratio aims to provide information on the
performance of a company by concentrating on the efficiency with which
the capital is employed
...
Interest charges to loan creditors are not deducted
because, assuming the capital employed represents the total assets of the
company, it will be partially financed by creditors, and the profit figure
should therefore be the amount before any interest payments to those
creditors are made
...
Capital employed is usually taken as either the total assets of the
company, ie fixed assets plus current assets, or the net total assets, ie fixed
assets plus current assets minus current liabilities
...
The argument for using net
total assets is that these are the resources which are most under the control
of the company and any distortions caused by variations in working
capital policy will be minimized
...
Return on total assets
Trading profit before interest and taxation
ᎏᎏᎏᎏᎏ × 100
Average total assets for the period
2
...
Earnings per share
Earnings per share are calculated as:
Profit after interest, taxation and preference dividends
ᎏᎏᎏᎏᎏᎏᎏ
The number of ordinary shares issued by the company
This is widely used as a variation on the return on equity indicator of profitability
...
Similarly, comparisons over a
period of time within a company will be affected if any bonus share issues
have taken place
...
Price–earnings (P/E) ratio
This ratio is calculated as follows:
Market price of ordinary shares
ᎏᎏᎏᎏ
Earnings per share
It reflects the expectations of the market concerning the future earnings of
the company (market price), and the earnings available for each ordinary
share, based on the results of the most recent accounting period
...
00 ÷ 0
...
This means that, if £5 is paid for a
share, then the shares are selling at 10 times earnings, ie 10 years of current
earnings at 50p have been bought
...
5
...
It shows how well the
company is doing in maximizing sales and minimizing costs
...
The profit figure used is generally, but not always, the
trading profit before interest and taxation, as is the case in the formulae for
return on capital employed
...
Asset turnover ratio
Although a much-used ratio, the return on sales may be misleading
because it fails to take account of the assets available to achieve the profit
margin
...
It measures the performance
of the company in generating sales from the assets at its disposal
...
Drucker, P, The Practice of Management, Heinemann, London 1955
...
315
63
Value-added Statement
DEFINITION
A value-added statement sets out the details of the value added to the cost
of raw materials and bought-out parts by the process of production and
distribution
...
FORMAT
The format recommended in the discussion paper, The Corporate Report
(1975), issued by the predecessor body of the Accounting Standards Board,
is as follows:
Value added
1
...
2
...
3
...
Distribution as follows
4
...
6
...
To employees (wages, salaries and other employment costs)
...
To providers of capital (interest on loans, dividends)
...
316 ᔡ Financial Management
CONTENT
The content of the value-added statement comprises the following
...
The turnover figure that appears in the profit and loss account
...
The cost of bought-in items, which will include raw materials, boughtin parts, heating and lighting, printing, and professional and specialist
services
...
3
...
Distribution of value added
4
...
5
...
6
...
7
...
Some people argue that depreciation should not be
included in this category, but should be treated as a deduction from
gross value added at the head of the statement
...
But it does rearrange this information in order to
highlight the fact that a company is operated for the benefit of a number of
different interests – employees, shareholders, lenders and government –
who each have certain rights which have to be satisfied to the best of the
company management’s abilities
...
But the statements also draw the attention of employees and
Value-added Statement ᔡ 317
others to the fact that the results obtained additionally depend on the
contribution of shareholders and lenders, who provide capital and have to
be rewarded for the risk they take
...
318
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319
64
Cash Management
DEFINITION
Cash management forecasts cash flows (inflows or outflows of cash) as
part of the working capital cycle, prepares cash and financial budgets and
fund-flow statements, and manages the cash or funds flowing through the
company
...
In other words, the purpose of cash or funds management is to ensure
that the company has the cash and working capital for its expanding or
fluctuating needs without either tying up funds which could be more profitably invested or used elsewhere, or relying too heavily on bank overdrafts or other short-term loans
...
This takes
place when a rapidly expanding company achieves increased profits but
has a deteriorating cash position because the profits generated by sales are
not translated into cash flows
...
Sales
result in the first place in the creation of debts with a time lag before they
are paid
...
The extent to which a company can and should rely on overdrafts to
finance a deficit is limited
...
THE WORKING CAPITAL CYCLE
The working capital cycles for a manufacturing and a retailing company
are illustrated in Figures 64
...
2 respectively
...
COMPONENTS OF CASH MANAGEMENT
Cash management starts with the construction of operating and capital
expenditure cash budgets
...
1 Working capital cycle – manufacturing company
Cash Management ᔡ 321
Figure 64
...
As an ancillary to this budget
a funds-flow statement shows the source and application of all the funds
used by the company
...
THE OPERATING CASH BUDGET
The operating cash budget deals with budgeted receipts (forecast cash
inflows) and budgeted payments (forecast cash outflows)
...
The operating cash budget is based on forecasts of cash inflows and
outflows for each accounting cycle of the year and is set out as shown in
Table 64
...
If the first budget run reveals any cash-flow problems, steps can
be taken to see if any adjustments can be made to outflows (delays in paying
creditors) or inflows (calling in debts more vigorously)
...
322 ᔡ Financial Management
Table 64
...
13
Total
Budgeted receipts
Cash sales
Receipts from debtors
Budgeted payments
Materials
Cash purchases
Payments to creditors
Factory payroll
Other production outlays
(excluding depreciation)
Selling outlays
Administrative outlays
Total payments
Operating cash surplus
or (deficit)
CAPITAL EXPENDITURE CASH BUDGET
The capital expenditure cash budget plans cash outlays on capital
expenditure projects
...
Capital expenditures can often be rephased
to avoid embarrassment
...
The intention of this depreciation charge is to spread the cost of
the fixed assets to the particular periods or products that benefit from their
use, so that the capital of the company remains intact
...
FINANCE BUDGET
The finance budget is prepared from the information supplied by the
operating cash and capital expenditure budgets together with further
information on inflows or receipts (investment income) and outflows or
payments (taxation, dividends and interest payments)
...
If cash
deficits cannot be smoothed out, the analysis will show when there will
be a need to raise finance
...
A finance budget is set out along the lines shown in Table 64
...
Table 64
...
It provides information that can
help in assessing liquidity, solvency and financial adaptability
...
3)
...
The statement
324 ᔡ Financial Management
shows the increase or decrease in cash arising analysed into the following
categories: net cash inflow from operating activities, returns on investments and servicing of finance, taxation, capital expenditure, equity dividends paid, management of liquid resources, and financing
...
For
example, Table 64
...
Adjustments are made for non-cash aspects of that profit for
depreciation and increases in amounts still tied up in balance sheet assets,
such as debtors
...
For example, the financing cash movement
may result from the issue of ordinary share capital (with associated
expenses paid) less the repayment of a debenture loan
...
3 Example of a cash-flow statement
£000
Net cash inflow from operating activities
Returns on investments and servicing of finance
Taxation
Capital expenditure
Equity dividends paid
Management of liquid resources
Financing
Increase in cash
3,463
1,501
(1,433)
(725)
2,806
(1,200)
1,606
72
1,454
Table 64
...
It is about managing
money in the broader sense of the systems concept of funds
...
Funds flow management therefore ensures that:
1
...
steps are taken to ensure that, as far as possible, inflows and outflows
are balanced to enable an appropriate degree of liquidity to be maintained, thus avoiding excessive deficits that cannot be financed by
normal means;
3
...
the cost of financing short-term deficits is minimized by such means as
negotiating beneficial overdraft facilities or, within reason, delaying
payments to creditors;
5
...
surplus cash resources are invested profitably, both in the shorter and
in the longer term; and
7
...
BENEFITS
Cash management is a systematic process of ensuring that problems of
liquidity are minimized and that funds are managed effectively
...
Steps can
then be taken to modify trading plans to keep them in line with cash
resources or, preferably, in an expanding business, to raise the additional
capital required before a crisis hits the company
...
This consumption arises from wearing
out, using up or otherwise reducing the useful economic life of an asset
...
An asset may become
obsolete through either changes in technology or demand for the goods or
services it produces
...
The purpose of depreciation is
to remove gradually the cost of the asset from the accounting records by
showing it as an operational cost
...
Note that the depreciation process does not provide a separate fund to
replace the asset at the end of its useful life
...
If liquid funds are
required for replacements, a separate provision must be made for them by
means of a corresponding investment in a cashable security
...
In practice, in many
industries, simple ‘rules of thumb’ are applied when deciding useful
economic lives
...
Where an asset has been revalued, the current period’s depreciation
charge is based on the revalued amount
...
Straight-line method
...
Thus a £10,000
asset with a life of five years will be depreciated at the rate of £2,000 a
year
...
Reducing-balance method
...
If 25 per
cent were used as the rate for an asset worth £10,000, the depreciation
figures would be: year 1 − £2,500; year 2 − £1,875; year 3 − £1,406, etc
...
As a result, profits may be overstated
...
66
Inflation Accounting
DEFINITION
Inflation accounting is the technique used to adjust financial accounts to
allow for the effect of inflation
...
REASONS FOR INFLATION ACCOUNTING
Financial accounts are the basis on which the success of a business is
measured and on which investors can find out whether or not their
investment is safe and will produce a reasonable return for them
...
But if this value is expressed in terms of historical
costs, without allowing for the impact of inflation, it could be illusory
...
These issues are considered in
more detail below
...
the level of dividends declared by the directors;
2
...
the willingness of a potential creditor to lend to the company;
4
...
the agreement of shareholders to the re-election of directors;
6
...
the attitude of employees and trade unions to the company; and
8
...
The concept of income and the
maintenance of capital
Income is increase in wealth, ie capital, and invested capital is traditionally
regarded as a financial rather than a physical concept
...
Financial resources (capital) are invested with the expectation of the
return of that capital as well as an additional amount representing the
return on that capital
...
There are two concepts of capital maintenance:
1
...
Physical capital maintenance, in which costs and expenses are measured
as the amount required to preserve the capacity of the company to
maintain previous levels of output of goods or services
...
In
times of inflation, they can produce misleadingly high levels of profit
when current revenues are matched against costs incurred in previous
years, and these costs are expressed in historic pounds
...
TECHNIQUES
The two techniques used in inflation accounting are:
1
...
current cost accounting (CCA)
...
This approach is linked to financial capital maintenance in that it meets the needs of proprietors or businessmen and
women who seek to preserve the value of their investment and look at
accounts to assess its growth
...
The problem with the CPP system is the use of an overall index to
deflate the accounts when, in practice, the replacement costs of some
assets may have changed at a rate which is quite different from the
movement in the index of retail prices
...
Historic cost figures are
adjusted individually for the changes in prices which are specific to the
physical resources (stock, plant or equipment)
...
Current costs in CCA are usually replacement costs and are therefore
based on the assumption that the business will continue in its present form
as a ‘going concern’
...
This can be done if the net realizable value (NRV) concept is used, ie
the amount of money for which an asset can be exchanged in the marketplace (selling price less selling cost)
...
332 ᔡ Financial Management
The current cost method separates income from continuing operations
from income arising from holding gains
...
Holding gains are defined as
increases in the replacement costs of the assets held during the current
period
...
The point being made is that
for a going concern, no income can result unless the physical capital
devoted to operations during the current period can be replaced
...
CCA may be used both to establish pricing policies and because it provides
a more reliable measure of the return on capital employed, which can be
used to assess the comparative performance of different divisions within a
company
...
It might be revealed,
for example, that after a period of high inflation a company may have
much less to distribute to its shareholders on a current cost basis than if
historical costs had been used
...
It directs attention to real
increases or decreases in income by removing the effect of inflation and
concentrates the minds of businessmen and women on the need for
physical capital maintenance so that the capacity of the business to
continue is preserved
...
333
67
Raising Finance
DEFINITION
Raising finance requires initial decisions on the capital structure of the
company
...
Further decisions are
then made on the most appropriate method of satisfying either shortterm requirements to finance current trading, or medium- and longerterm needs to provide funds for growth, capital investments and
acquisitions
...
This proportion of fixed interest capital to equity or ordinary shares is
known as gearing or leverage
...
Some analysts assert that the
value of the company cannot depend on the manipulation or distortion of
financial policy with regard to the proportion of debt finance, but rather
depends upon the investment performance and risk characteristics of the
particular enterprise
...
If preference for debt finance results in a
high proportion of fixed-interest capital, the company is said to be highly
geared
...
Advantages of high gearing or leverage
A preference for debt finance and therefore high gearing may be justified
for one or more of the following reasons:
1
...
2
...
3
...
4
...
5
...
Interest payment is a tax-deductible
expense
...
This may result in an
increase in the equity capitalization rate needed to compensate shareholders for the additional financial risks they must now carry
...
Many companies take a cautious view of gearing and, while they
recognize its advantages, prudently require five times cover and use this
as a guide to the maximum amount of fixed-interest debt they can incur
...
short-term borrowing;
2
...
longer-term debt capital;
Raising Finance ᔡ 335
4
...
equity capital; and
6
...
Short-term borrowing
Short-term (less than one year) funds to finance current trading can be
obtained by means of the following:
1
...
2
...
An
overdraft or, in the United States, a line of credit facility, is relatively
cheap and can be used flexibly
...
3
...
An acceptance credit
allows the borrower to draw his or her bill directly on the bank and this
bill can be rediscounted or sold in the market, thereby generating
immediate cash
...
4
...
Limited facilities exist in the
UK for intercompany loans, when companies bypass the banking
system by placing deposits directly with one another or through a
broker
...
5
...
6
...
A factor purchases his or her client’s book debts and, on an
agreed maturity date, pays to the client the full value of the approved
debt purchased less the agreed service fee of between 1 and 3 per cent of
turnover
...
Thus factoring provides a credit facility
and can reduce debts
...
The
main sources are as follows:
1
...
Term loans are usually made to purchase a fixed
asset and banks prefer them to be self-amortizing
...
2
...
Interest
rates are high
...
Leasing – a method of financing the use of equipment as distinct from
financing ultimate ownership
...
Contract hire applies
to the provision of motor vehicles
...
Leasing at one time
offered significant tax advantages in the UK but this is no longer the
case, except for companies which may be unable to make full use of
their capital allowances to reduce their tax liabilities
...
Loan capital – long-term bank loans, mortgages, loan stocks and debentures which constitute a fixed-term debt and usually carry a fixed rate of
interest
...
Both adequate asset and earnings cover will be
expected if a Stock Exchange listing for the debt is sought, and
constraints may be placed on the borrower on the use of assets arising
under the terms of the security
...
2
...
They provide a greater rate of return
for shareholders than fixed-interest stocks, although with less security
...
The disadvantage of this form of finance is that the borrower is
committing him- or herself to a long-term fixed-rate debt, probably at
historically high rates of interest
...
Raising Finance ᔡ 337
Convertibles
Convertible loans are issues of debt stock, carrying a rate of interest and
specified maturity date and giving the holder the right to convert into
issues of equity at stated prices
...
Although convertible into equity at a
later date, convertible stock affords for the present a given volume of
cheaper, fixed-rate loans
...
Equity capital
Equity capital normally represents the largest proportion of capital
employed by a company
...
By internal finance supplied from retained earnings
...
2
...
3
...
Venture capital
Venture capital can be raised from or through merchant banks or agencies
...
Venture
capital investment almost always includes an equity shareholding of
between 5 and 40 per cent, and very often the holding company requires a
seat on the board of the client company
...
The advantage of using venture capital is that smaller companies can
gain access to long-term finance without recourse to a public share issue or
without saddling themselves with heavy, fixed-interest payments
...
338 ᔡ Financial Management
CHOICE OF METHODS
The following factors have to be taken into account in choosing a method
of raising finance:
1
...
3
...
5
...
7
...
the term over which it is required;
the level of gearing or leverage existing in the company and the policy
on the limits to which gearing can be increased;
the cost of the finance in terms of interest rates;
the degree to which the company wishes to tie itself down with fixed
commitments or, put another way, the extent to which it needs to vary
its requirements for finance in the short or medium term;
the relative tax advantages of different forms of borrowing;
the size and reputation of the company (when raising equity finance);
the costs of raising finance, eg the cost of a new issue of securities;
the readiness of the company to accept a degree of involvement in its
affairs by providers of venture capital or, in some cases, institutional
shareholders
...
Creative accounting operates within the letter both of the law and of
accounting standards but is clearly against the spirit of both
...
Some of the main areas in which creative accounting can take place are
described below
...
The amount at which they are shown in the
balance sheets will not necessarily represent their value
...
If the company wants to maintain its fixed assets in the
340 ᔡ Financial Management
balance sheet at the highest level it can, then the useful economic life will
be as long as possible
...
As
Jameson suggests, ‘the useful life decision is taken by determining first,
what answer is required and second, by assessing what useful life will give
that answer’
...
Changing from one method to another can make a significant
impact on profits
...
3 to 16
...
CURRENT ASSETS
Legal manipulation when accounting for current assets can take place in
the areas of stocks and work-in-progress, debtors and cash
...
However, this year’s closing stock is next year’s opening stock, so a high
figure at the end of one year will reduce next year’s profits
...
Massaging stock figures can be achieved by varying methods of
accounting for stock
...
Indirect labour costs and certain overheads
can be included or excluded from the stock valuation
...
Alternatively, stocks could be run down to
reduce current profit levels
...
Creative Accounting ᔡ 341
Debtors
The debtors figure in the current assets can be manipulated by adjusting
the provision for bad debts
...
If there has been overprovision for bad debts, profits can be increased in later years by reducing
the provision
...
Cash
Cash holding can be manipulated by varying the timing of payments and
receipts
...
Profits can also be boosted in one year by
delaying payment until after the year end
...
LIABILITIES
Judgement can be exercised on the recognition of liabilities in the balance
sheet and there is scope for creativity in moving liabilities off the balance
sheet
...
There is also
scope for adjusting the level and timing of accruals (expenses arising from
services provided in the current accounting period, the benefit from which
has been used in earning the current period’s revenue, but which will not
be paid for until the following period)
...
Where loans are of an indeterminate duration it may be possible
to ‘roll them over’ into the future, especially where the debts exist between
companies in the same group
...
Financial reporting standards issued by
the UK Accounting Standards Board during the 1990s have had the effect
of reducing the scope for off-balance sheet schemes
...
The quasi-subsidiary is a company effectively owned by another but with ownership structured so that it falls
outside the company law requirement for its balance sheet to be consolidated with that of its owner (parent company)
...
INCOME
The basis of company accounting is not cash but the accrual system
...
Its revenue is the value of
the goods and services that it has delivered to customers during the year
...
Accountants have, however, to make assumptions about accruals
...
This is especially the case when long-term
contracts are involved, and the creative accountant may be able to provide
for the sales revenue to increase at a desirable rate (neither too fast nor too
slow)
...
This propensity of creative accountants to smooth out profit figures has
been encouraged by the City’s enthusiasm for steady increases in turnover
and profitability without any sudden fluctuations
...
To maximize
profits and produce favourable price–earnings (P/E) ratios, creative
accountants may wish to massage expenses by deferring costs into the
future
...
Another popular method of deferring costs into the future is to capitalize them, ie to include them on the balance sheet as fixed assets
...
Creative Accounting ᔡ 343
In some cases accountants might want to accelerate the charging of
expenses to smooth profits
...
If the provision is too large it can be released in future
periods to boost profits
...
The practice of making large provisions when taking over another
company (known as ‘big bath’ provisions) became so prevalent that in
1998 the UK Accounting Standards Board issued FRS 12 ‘Provisions,
contingent liabilities and contingent assets’ to restrict the making of provisions to very specific circumstances
...
CONCLUSION
The existence of creative accounting in the above fields and others such as
pre-acquisition write-downs, disposals, brand accounting, pension fund
accounting and currency mismatching has been demonstrated clearly by
Terry Smith
...
There is often room for judgement, and although auditors are there to
ensure that a ‘true and fair view’ is expressed by the accounts, they are not
always in a position to challenge the judgements and assumptions made
by company accountants
...
FRS 5 ‘Reporting the
substance of transactions’ did much to curb the use of artificial structures
and transactions
...
In addition, the
enforcement of accounting standards became a reality in the 1990s with
the formation of the Financial Reporting Council and its enforcement
body the Financial Reporting Review Panel
...
FURTHER READING
The original version of this chapter drew heavily on Michael Jameson’s A
Practical Guide to Creative Accounting (Kogan Page, London 1988)
...
This book became famous for its ‘blob guide’, which
scored companies by the number of creative accounting practices used
...
It does not
set out to be a creative accounting guide, although it does offer some
strategies for taking on the Financial Reporting Review Panel
...
345
69
Management Accounting
DEFINITION
Management accounting provides information to management on present
and projected costs and on the profitability of individual projects,
products, activities or departments as a guide to decision making and
financial planning
...
ᔢ Cost analysis – the classification and analysis of costs to aid business
planning and control
...
ᔢ Marginal costing – the segregation of fixed and variable or marginal costs
and the apportionment of those marginal costs to products or
processes
...
ᔢ Variance analysis – the identification and analysis of differences between
actual and standard costs, or between actual and budgeted overheads,
sales and profits, with a view to providing guidance on any corrective
action required
...
ᔢ Profit–volume charts, which specifically reveal the impact of changes in
volume on net income
...
It also shows the net
profit or loss that is likely to arise from different levels of activity
...
ᔢ Financial budgeting, which deals with the creation of budgets (statements in quantitative and financial terms of the planned allocation and
use of the company’s resources)
...
ᔢ Flexible budgets, which take account of a range of possible volumes or
activity levels
...
ᔢ Budgetary control, which compares actual costs, revenues and
performance with the fixed or ‘flexed’ budget so that, if necessary,
corrective action can be taken or revisions made to the budget
...
ᔢ Responsibility accounting, which defines responsibility centres and holds
the managers of those areas responsible for the costs and revenues
assigned to them
...
The main capital appraisal techniques comprise
accounting rate of return, payback and discounted cash flow
...
USES
Objective
The main objective of management accounting is to provide management
information which will help managers to optimize their decisions with a
view to improving present performance and providing for longer-term
profitable growth
...
Management Accounting ᔡ 347
Principles
In carrying out this task, management accountants are governed by two
key principles:
1
...
Either of:
ᔢ what has been achieved with what should have been achieved – this
is a feedback process designed to point the way to corrective action
and improved performance, not simply a stick with which to beat
managers; or
ᔢ alternative courses of action with a view to deciding which, on
balance, is the best in terms of cost/benefit, cost-effectiveness or
return on investment – this is an evaluative process
...
Relevance
...
When managers make decisions they are
choosing between alternatives in order to predict which one has the
best future
...
Any item is irrelevant if it will remain the same regardless
of the alternative selected
...
Long-range planning
...
Budgetary and financial control
...
Profitability measurement and analysis and profit improvement
planning
...
Cost reduction
...
Investment appraisal and portfolio management
...
Pricing
...
Make or buy
...
Product development and product mix
...
Capacity planning
...
Distribution planning
...
By understanding what is available in the way of
348 ᔡ Financial Management
these techniques and how they can be used, management is placed in the
best position to make good decisions and to prepare realistic plans for the
future
...
Mott, G, Management Accounting for Decision Makers (2nd edition), Pitman,
London 1991
...
OBJECTIVES
1
...
To provide guidance on pricing decisions and to ensure that
prices at least cover the costs of developing, manufacturing and selling
the products of the company and the costs of administering and
financing the firm
...
Control
...
Operational control systems provide feedback to
production and department managers on the resources consumed
(labour, materials, energy, overheads) during an operating period
...
Profit management
...
4
...
To ensure that inventory is valued correctly and
thus provide a basis for the realistic measurement of profit
...
350 ᔡ Financial Management
5
...
To provide information which
will help in decision making concerned with strategic planning,
product planning and the appraisal of capital investment projects
...
Cost classification
...
Costing
...
Cost analysis
...
Costing
determines product costs by allocating prime costs and overheads to
products and provides the basis for analysis, decision making and control
...
Direct costs are divided into:
ᔢ direct materials, which form part of the finished product and can be
directly associated with it;
ᔢ direct labour, the labour which contributes to the conversion of the direct
material or components into the finished product;
ᔢ direct expenses, those costs other than material or labour which can be
charged direct to the product (eg the cost of processing the product by a
subcontractor)
...
Indirect manufacturing costs cannot readily be identified with the product
or ultimate cost unit
...
The total of indirect material and labour costs plus indirect expenses is
known as the factory overhead
...
Other indirect
expenses or overheads which are incurred on activities or to pay for facilities
or services other than those connected with production include:
ᔢ
ᔢ
ᔢ
ᔢ
marketing and selling costs;
distribution costs – warehousing, depots or transportation;
research and development costs; and
administration expenses – the costs of administrative departments such
as finance, personnel and the corporate office, plus any corporate costs
such as rent, rates and insurance that cannot be charged directly to
manufacturing
...
1
...
Variable, where the cost varies directly or proportionately to the level of
activity
...
In this case the
variable cost per unit is constant, irrespective of changes in the level of
activity
...
Non-variable or fixed, where the total cost remains unchanged over a
period of time regardless of changes in the levels of activity
...
1 The make-up of total costs
= TOTAL
COST
352 ᔡ Financial Management
depreciation of fixed assets
...
3
...
4
...
Graphical representations of fixed
and variable costs are shown in Figures 70
...
3 respectively
...
In addition, departmental overheads are allocated in accordance with one of the following measures of activity:
1
...
3
...
Direct labour costs
...
Machine hours
...
Figure 70
...
Classification of costs by location
Costs may be classified according to function, department, location or designated cost centre
...
In a fully
absorbed costing system, other costs which cannot be attributed directly will
be apportioned to departments on some arbitrary basis, eg building occupation costs might be apportioned on the basis of floor area
...
Cost of
rent and
rates
Material
and labour
costs
Output
Figure 70
...
3 Variable costs
Cost Accounting ᔡ 353
Figure 70
...
But when carrying out cost–volume–profit (CVP) analysis
(see Chapter 76), or preparing break-even charts, it may be necessary to
make assumptions as to whether costs are truly variable or whether they
should be regarded as fixed for the purpose of the calculation
...
A fixed cost is fixed only in relation to a given period
of time – the budget period – and a given, though wide, range of activity
called the relevant range
...
This is
illustrated in Figure 70
...
Figure 70
...
In addition, overheads are allocated in one of the
ways described below
...
Costing techniques also, and importantly, provide information for control
and decision making
...
Cost measurement
Cost measurement involves measuring the direct costs of materials and
labour plus the indirect costs (overheads) originating in the factory
(factory overheads) and elsewhere in the company (distribution,
marketing, advertising, servicing, research and development, purchasing,
information systems and administration)
...
It involves some method of allocating overheads to products on the grounds that all company resources
support production and sales – even corporate expenses should be allocated to product costs
...
Absorption costing
The most widely used method of overhead recovery is called absorption
costing and involves allocating all fixed and variable costs to cost units
...
This can result in a situation where a
very small change in the number of direct labour hours worked can have
Cost Accounting ᔡ 355
an unrealistic and dramatic effect on the costs allocated to products
...
Absorption
costing is described more fully in Chapter 71
...
This is founded on the
assumption that activities cause costs and a link is made between activities
and products by assigning costs of activities to products on the basis of an
individual product’s demand for each activity
...
Marginal costing
Marginal or direct costing (see Chapter 73) segregates fixed costs and
apportions the marginal or variable costs to products
...
Standard costing
Standard costing (see Chapter 74) is the preparation of predetermined or
standard costs and their comparison with actual costs to identify variances
...
It is used
mainly in mass or large-batch production factories
...
2
...
4
...
The distinction between product costs and period costs
...
The need for relevance
...
Opportunity costs
...
These product or inventory costs
become expenses in the form of cost of goods sold only when the
inventory is sold
...
The distinction between product and period costs when analysing gross
margin and operating profit is illustrated in Figure 70
...
Total and marginal costs
If some costs are variable while others are fixed, the total cost per unit of
output is representative of only one level of activity
...
Marginal costing recognizes the variability of cost items and differentiates throughout the costing system between the variable or marginal
costs and the fixed or period costs
...
The difference between the marginal cost of
the product and the selling price is the marginal income or contribution
...
It has to provide information that will lead
to the best decisions concerning future courses of action when alternatives
are available
...
In cost analysis terms, relevance is
therefore about the expected future costs of alternatives and is not simply
about historical or past data which may have no bearing on the decision
...
6 Product and period costs
Operating
profit
Cost Accounting ᔡ 357
Differential costing
Differential costing is used in decision making, which is essentially a
process of choosing between competing alternatives, each with its own
combination of income and costs
...
Differential costing is concerned with the effects on costs and revenue of
a certain course of action
...
Economists use the term incremental costs for the
same concept and define them as the additional costs of a change in the
level or nature of an activity
...
In other
words, it eliminates residual costs (usually historical or sunk costs) and
concentrates on the costs that will be incurred as a result of company decisions, ie future costs
...
Opportunity costs
Opportunity costs represent income forgone by rejecting alternatives
...
Opportunity
costs are, however, very relevant when examining alternative proposals or
projects
...
BENEFITS
The provision of comprehensive but relevant cost data is an essential
component in successful management
...
This analysis then provides the basis for output
and pricing decisions
...
358
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359
71
Absorption Costing
DEFINITION
Absorption or full costing is the practice of assigning all costs, both fixed
and variable, to operations or products
...
In a full historical cost system,
however, all administration and sales expenses are also absorbed into
production costs
...
Prime costs – direct material and direct labour
...
Production overheads – indirect materials and wage costs arising in such
areas as stores, packing, maintenance, the salaries of factory managers
and supervisors, and the costs of power, heating and lighting, and
depreciation
...
The selling value of the goods produced minus the full cost of
production is the factory profit
...
Overhead absorption or recovery is achieved by one
or a combination of overhead rates, for example, labour hour rate, machine
hour rate, direct material costs percentage
...
The methods used to allocate or assign overheads to production are as
follows:
1
...
Such costs may be
direct to the cost centre but indirect to the production process
...
2
...
Some aspect of
size in the department or production volumes is usually the base,
although there is no one generally accepted approach to apportioning
overhead costs
...
FULL ABSORPTION
For pricing and inventory valuation purposes it is necessary to know the
full cost of producing a cost unit
...
These overheads are distributed to the cost unit by apportionment and
absorption, using one or more of the bases mentioned earlier, eg direct
labour hour rate or machine hour rate
...
This process is sometimes referred to as the global recovery method
...
Nothing seems to be hidden away
...
Absorption costing is also recognized by the International Accounting Standards Body as the appropriate
method of valuing stocks and work-in-progress
...
The fixed costs are apportioned on the basis of assumptions about the
level of output and are, in fact, representative of only one level of
activity
...
Overheads are then either under- or over-absorbed and the total
cost per unit will have been under- or over-stated
...
For
example, if fixed costs remain unchanged, reduction in output levels
will mean they have to be apportioned over a smaller number of units
...
But
management may still expect the higher budgeted profit fixed for a
larger output figure to apply at the lower level
...
The concept of operating leverage is relevant to this problem
...
The higher
this is, the more sensitive overhead recovery is to volume forecasting
errors
...
There is no satisfactory method of allocating indirect fixed expenses to
the final product
...
However, the technique of activity-based costing aims to
overcome this problem (see Chapter 72)
...
Absorption costing does not provide adequate guidance on the relationships between cost, volume and profit or on the pricing decisions
362 ᔡ Financial Management
which are dependent on these relationships
...
4
...
There is no reference to possible changes in
price if the product is to be produced in the future
...
The difficulty of
changing prices is particularly relevant in the case of materials whose
prices vary considerably over short periods of time
...
The more
refined departmental overhead recovery method is used by many larger
firms with diversified products and production systems
...
These operational cost centres then charge out their overheads but only to
those cost units passing through that cost centre
...
This aims to provide
better management accounting information for product costing, decision
support and cost control purposes
...
In addition, some companies use marginal costing, as described in
Chapter 73, to help them make decisions which allow for volume and price
changes
...
363
72
Activity-based Costing
DEFINITION
Activity-based costing (ABC) systems are based on the belief that activities
cause costs and that a link should therefore be made between activities
and products by assigning costs of activities to products based on an individual product’s demand for each activity
...
1,2 They argued that
managers in companies selling multiple products are making important
decisions about pricing, product mix and process technology based on
distorted cost information
...
This was
especially the case in the typical situation where a company was making a
limited range of products and the costs of direct labour and materials, the
most important production factors, could be traced easily to individual
products
...
Direct labour now represents a relatively small proportion of
corporate costs, while expenses covering factory support operations,
marketing, distribution and engineering have exploded
...
Costs are therefore allocated to products in ways which are
not connected to actions taken within a cost centre
...
According to Kaplan and Cooper,
however, this still does not guarantee that the allocation of overheads will
not distort product costs, and cost centre managers may not get the control
information they need
...
Profits are frequently understated on highvolume products and overstated on speciality items
...
Operating costs are reported too late and are too aggregated to
benefit production cost centre managers
...
However, information costs are no longer a barrier
...
Automatic bar-code
reading of parts combined with local area networks permit continual
tracking of parts and operatives
...
A further reason for the reliance on traditional methods is that they were
originally designed for inventory valuation, which, in accordance with
financial accounting principles, requires manufacturers to allocate
periodic production costs to all items produced
...
But as Kaplan argues, cost system designers have failed to recognize that
their systems need to address three different functions:
ᔢ inventory valuation for financial and tax statements, allocating period
production costs between goods sold and goods in stock;
ᔢ operational control, providing feedback to production and department
managers on the resources consumed (labour, materials, energy and
other services) during an operating period;
ᔢ individual product cost measurement
...
The traditional method of allocation is appropriate for
Activity-based Costing ᔡ 365
inventory valuation but is inadequate as a means of providing data for
operational control and product pricing
...
THE PHILOSOPHY OF ACTIVITY-BASED
COSTING
The assumption underpinning activity-based costing (ABC) is that
virtually all of a company’s activities exist to support the production and
delivery of goods and services
...
And because nearly all factory and corporate support costs
are separable, they can be split apart and traced to individual products or
product families
...
The reporting of the costs consumed by the significant activities of a
business, and their cost drivers, provides the basis for understanding what
causes overhead costs and directs attention to where steps can be taken to
improve profitability
...
Thus activity-based costing provides better, more accurate, information
for decision making on prices and product mix, and for the control of
manufacturing operations
...
Identify the main activities performed in the organization, such as
manufacturing and assembly, as well as support activities, including
purchasing, packing and dispatching
...
Identify the factors which influence the cost of each activity – the cost
drivers
...
Collect accurate data on direct labour and material costs and on the
costs of each of these factors
...
Establish the demands made by particular products on activities, using
the cost drivers as a measure of demand
...
Trace the cost of activities to products according to a product’s demand
for each activity
...
This process cannot be done with surgical precision, but, as Kaplan and
Cooper say:
It is better to be basically correct with activity-based costs, say within
5 or 10 per cent of the actual demands a product makes on organizational resources, than to be precisely wrong (perhaps by as much as
200 per cent) using outdated allocation techniques
...
But many of the benefits of ABC can still be obtained by implementing a partial system which focuses only on the most important
activities
...
Traditional methods can be used for that, leaving ABC to support strategic
decision making, profitability analysis and the control of manufacturing
costs
...
While
it provides a more accurate basis for calculating product costs, perhaps its
greatest benefit is that it is a mechanism for managing costs
...
Activity-based Costing ᔡ 367
In particular, the benefits of ABC are that:
ᔢ the cost-driver rates established by the system can be used to measure
activity performance and efficiency and provide a more suitable basis
for budgeting;
ᔢ accurate feedback can be provided to cost centre managers on their
performance based on their consumption of resources during a period
rather than the allocations of costs over which they have no control; and
ᔢ the provision of accurate information on product costs enables better
decisions to be made on pricing, marketing, product design and
product mix
...
Kaplan, R, ‘One cost system isn’t enough’, Harvard Business Review,
January–February 1988, pp
...
2
...
96–103
...
368
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369
73
Marginal Costing
DEFINITION
Marginal or direct costing divides costs into fixed and variable costs
...
Marginal costing first segregates fixed costs and then
apportions the marginal costs to products or processes
...
Where it
is incorporated into the system of recording and collecting costs, stocks are
valued at variable costs, while fixed costs are not charged to production
but are instead written off to the profit-and-loss account in the year in
which they are incurred
...
BACKGROUND TO MARGINAL COSTING
The background to the marginal costing concept is the marginal theory in
economics which refers to the ambition of the entrepreneur to expand his
or her business at the point where the additional cost of producing one
more unit equals the additional revenue from selling it
...
As more units are
produced which need to be sold, prices will have to be reduced to ensure
their disposal
...
No further
profits will therefore be made and it will no longer be in the interests of the
company to continue to expand production
...
MAKE-UP
Marginal cost
Marginal cost comprises material, labour and expenses, plus variable
works, administration and selling expenses
...
This
indicates the amount which sales of the product contribute to the fixed
expenses of the enterprise and to profit, thus highlighting the fact that
until those fixed expenses have been covered, no profit has been made
...
1
...
Cost–volume–profit analysis
...
It demonstrates the relationships between cost
and volume and, therefore, the effect on profit of a change in volume
...
2
...
Marginal costing highlights the
significance of fixed costs on profits
...
1 Comparison of full and marginal costing
Full
cost
p
p
Sales price
Direct material costs
Direct labour costs
Direct expenses
Prime cost
Works expenses
Fixed
Variable
Administration expenses
Fixed
Variable
Cost of production
Selling expenses
Fixed
Variable
Total of above costs
and expenses
Net profit
Marginal
cost
p
p
50
50
5
3
2
10
8
4
5
3
2
10
12
22
4
6
6
28
10
6
16
6
44
20
6
Margin or total contribution
Contribution to fixed costs
Contribution to profit
p
30
24
6
highly competitive situation, it may well be wise to take an order which
covers marginal costs and makes some contribution towards fixed costs,
rather than lose the order and the contribution by insisting upon a price
above full cost
...
Contribution analysis
...
These
statements may be further refined by deducting any discretionary or
separable period costs (ie costs such as annual tooling and product
advertising) which should be avoided if the product line were dropped
...
Sales mix decisions
...
5
...
The problems of volume
variance in a standard absorption costing system are overcome
...
In businesses with
large variations in stock levels and a high ratio of fixed costs this
approach can lead to serious distortions in the profit figures
...
Profit planning and control are
therefore made more difficult
...
Consequently, the relationship between sales volume and contribution
is much easier to explain and understand
...
Make-or-buy decisions
...
But it
is also helpful to know through marginal costing what contribution to
fixed costs will result from a ‘make’ decision
...
Limiting factor decisions
...
The order to be
accepted is the one that marginal costing shows will make the highest
contribution per unit of the limiting factor
...
8
...
The marginal cost approach to pricing decisions recognizes that decision making is about choosing between competing alternatives, each with its own combination of income and costs
...
The marginal approach answers the question ‘What will
happen to profits if the selling prices of particular products are raised or
lowered?’ With marginal pricing, the company seeks to fix its prices so
as to maximize its total contribution to fixed costs and profit
...
ADVANTAGES AND DISADVANTAGES
Advantages
Marginal costing systems are simple to operate and do not involve the
problems of overhead apportionments
...
Marginal costing emphasizes the contribution made
by sales to fixed cost recovery and profit and clarifies decision making in
many key areas of management accounting where volume and product
mix and pricing considerations are important
...
But in the long run it is important to have an understanding of the
full cost of a product to the company, since the company must make sufficient contribution from all products to cover fixed costs and provide an
adequate return on capital employed
...
But it is important to know what the implications of such decisions are on fixed-cost recovery at the time they are
made
...
CONCLUSION
Marginal costing is an essential tool for cost–volume–profit analysis and
planning
...
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375
74
Standard Costing
DEFINITION
Standard costing is the preparation of predetermined or standard costs,
their comparison with actual costs to identify variances, and the analysis of
variances to determine causes and to decide on any corrective actions
required
...
Standards are developed by analysis for each of the cost
components in a product
...
USE
Standard costs are used to measure performance
...
In theory, standard costs are the real costs of the product and can
properly be used as a means of charging production and, therefore, for
valuing work-in-progress and finished stocks
...
376 ᔡ Financial Management
METHOD
Basic approach
Standards are set after a careful analysis of the job, the methods which are
used and the efficiency of performance
...
Before setting direct labour or direct material standards,
however, it is necessary to decide on the type of standards to be used
...
ideal or perfection standards, which are expressions of the absolute
minimum costs possible under the best conceivable conditions, using
existing specifications and equipment; and
2
...
Currently attainable standards are most commonly used because:
ᔢ they do not demotivate employees by setting almost unachievable
goals, as ideal standards do; and
ᔢ they provide a more realistic basis for cash budgeting, inventory valuation and departmental budgets
...
Standard time
...
Work study is used to determine the standard work
output for an average worker working at an average pace
...
In departments with a number of products all units of hours are
expressed in terms of the standard input of hours allowed for their
production
...
2
...
Standard Costing ᔡ 377
The unit labour cost is calculated by multiplying the standard time per unit
by the standard hourly pay rate
...
establishing the price per unit of each material or ingredient used in
manufacturing the product;
2
...
multiplying price per unit by standard usage to obtain the standard
material cost per unit
...
To this are added the variable expenses or
overheads which are recovered on a basis such as so much per labour
hour
...
If fixed costs are added, the total cost per unit is obtained as
set out in the example of a standard cost profile in Table 74
...
This profile
includes variable and fixed overheads for which standards are also
required
...
1 Standard cost profile
Per unit
£
Direct materials
Direct labour
Variable expenses
6
...
00
...
70
...
00
1
...
00
OVERHEADS
Overhead standards are set on the basis of an estimate of the activity levels
in the coming period
...
Overheads are applied as a standard
rate per unit of output on the basis of direct labour or machine hours or
direct material
...
Variances for labour or material are either price (wages or ingredients)
or quantity (standard hours or material usage)
...
Variance analysis is treated in more detail in Chapter 75
...
The information provided by a standard cost system is used to promote cost control
and improve managerial efficiency
...
The reasons for variances are then established to provide guidance for any
corrective action required
...
1
...
1 Classification of variances
380 ᔡ Financial Management
OPERATING PROFIT VARIANCE
Operating profit is revenue less current expenses
...
SALES VARIANCE
Sales variance is the difference between the budgeted value of sales and
the actual value of sales achieved in a given period
...
The latter is
subdivided into sales quantity variance and sales mix variance
...
In other words, it
is the difference between the actual price at which the product was sold
and the standard or budgeted price
...
It can be subdivided into two types of variance:
1
...
Under
absorption costing, these variances are valued at the standard unit
profit, and under marginal costing they are valued at the standard unit
contribution
...
Sales mix variance – that portion of the sales volume variance which is
due to differences between the actual and the standard or forecast
composition of the sales mix, ie the proportions of each type of product
sold
...
Labour rate variance – the difference between the actual and budget/
standard hourly rate of pay applied to the actual hours paid
...
2
...
This variance can be
subdivided into:
ᔢ labour productivity variance – the variance caused by the standard
mix of labour producing more or less than expected;
ᔢ labour mix variance – the variance caused by differences between the
proportions of the different grades of labour actually used and the
budgeted or standard proportions; and
ᔢ labour idle time variance – the difference between budgeted hours
paid and actual hours worked; this difference is idle time, which will
have been budgeted at zero, so that any idle time causes an adverse
variance
...
Materials price variance – the difference in unit prices between standard/
budget and actual applied to the actual quantity of materials used
...
Materials usage variance – the materials quantity variance; the variance
arising from using more or fewer units of material input than budgeted/
standard to produce the actual quantity of units
...
382 ᔡ Financial Management
Interrelationships
The interrelationships between price (or rate) and quantity (efficiency or
usage) variance is illustrated in Figure 75
...
In this example, the rectangle
represents standard costs and its sides represent standard price and
standard quantity
...
The upper right-hand area
is treated as a price variance so that the analysis of the quantity variance
can concentrate on the factors other than price which produced it
...
Volume – the overhead quantity variances arising from the volume
against which overheads are recovered being different from standard/
budget
...
Expenditure – the overhead price variances arising because of a
difference between standard/budget overhead expenditure in the
month and actual expenditure applied to the actual recovery volume
...
Efficiency – that part of the volume variance arising from labour productivity variances when overheads are recovered against labour hours
...
It uses the management by exception principle which means that problems are brought into prominence so that
action can be taken where it is most needed, and efforts are made directly
where they can produce the best results
...
2 Interrelationship between variances
383
76
Cost–Volume–Profit
Analysis
DEFINITION
Cost–volume–profit (CVP) analysis studies the relationships between
expenses (costs), revenue (sales) and net income (net profit)
...
USES
CVP analysis is used to study the effects of changes in volume on variable
costs, and the relationship between profit and volume (the profit–volume
or P/V ratio)
...
CONCEPTS AND TECHNIQUES
CVP analysis combines the following management accounting concepts
and techniques:
384 ᔡ Financial Management
1
...
3
...
5
...
the variable and fixed elements of cost;
profit–volume (P/V) ratio analysis;
differential costing;
break-even analysis;
margin of safety ratio; and
sales mix analysis
...
Variable costs vary directly with the level of business activity and are
constant per unit of production
...
Fixed costs remain constant over a particular period of time, whatever
the level of business activity, within a given, though wide, range known
as the relevant range
...
It shows the rate at which
profit increases or decreases with an increase or decrease in volume
...
In CVP analysis it is used to assess
the impact of alternative decisions about activity volumes on fixed or
variable costs and on contribution or profit
...
Break-even analysis
Break-even analysis shows the point at which sales revenue is just sufficient to cover total costs, ie the number of units which must be sold before
the company begins to earn a profit
...
The margin of safety ratio, therefore, indicates the extent to which sales volume could decrease before profits would
disappear, other things being equal
...
Cost–Volume–Profit Analysis ᔡ 385
Sales mix analysis
Sales mix analysis establishes the effects of changes in the sales mix on
cost–volume–profit relationships
...
METHOD
CVP analysis combines the concepts and techniques listed above by
initially:
1
...
calculating the relationship between sales volume and revenue by
reference to actual or assumed unit prices;
3
...
using differential costing and sensitivity analysis to assess the impact of
alternative decisions on activity levels on costs and profits;
5
...
deducing from the break-even analysis the margin of safety ratio to
indicate the levels of profit as different volumes of sales above the
break-even point; and
7
...
The outcomes of each of the above analyses are then linked to answer such
questions as follows:
ᔢ What sales revenue must be achieved to recover fixed costs?
ᔢ By what percentage can current sales drop before the margin of safety is
exhausted and the break-even point is reached?
ᔢ How will profits be affected by different levels of sales?
ᔢ What level of sales revenue must be achieved to reach profit targets?
ᔢ What are the implications of increases or decreases in costs per unit or
fixed costs on profits?
ᔢ What is the optimum mix of products from the point of view of
profitability?
ᔢ What effect will price changes have on profits (on the basis of assumptions about the impact of such changes on demand and therefore
revenue)?
386 ᔡ Financial Management
BENEFIT
The benefit of CVP analysis is that it highlights the key factors that affect
profits and enables the company to understand the implications of
changes in sales volume, costs or prices
...
387
77
Profit–Volume Charts
DEFINITION
Profit–volume (P/V) charts show the impact of changes in volume on net
income
...
1
...
The vertical axis represents total profit (net income) or loss
...
The horizontal axis represents volume in units
...
Unrecovered fixed costs are shown as losses below the horizontal axis,
and at zero volume the net loss equals total fixed costs, of £25,000 in this
example
...
The profit line slopes upwards from the intercept with the vertical axis
at a loss of £25,000
...
The profit line intercepts the horizontal volume axis at the break-even
point of 50,000 units
...
6
...
In this example, every 10,000
units sold above the break-even point adds £5,000 to profits
...
The P/V ratio represents the slope of the profit line on the profit–
volume chart
...
1 Profit–volume chart
sales – variable costs (total contribution)
P/V = ᎏᎏᎏᎏᎏ
sales
The P/V chart differs from the break-even chart in the following respects:
1
...
2
...
USES
The P/V chart provides indicative answers to the following questions:
1
...
If the unit variable costs can be reduced, what additional profits can be
expected at any given volume of sales?
3
...
To improve profits the best
approach is to increase sales rather than simply cut costs
...
One way of increasing sales is to reduce prices
...
If the demand for the product is inelastic, volume will not respond to
changes in price and the only result will be lower profits
...
Even if greater quantities can be sold at a lower price, any advantage
gained will be lost if competitors retaliate by lowering their prices as
well
...
While sales volume may increase with reductions in price, it may not
increase sufficiently to overcome the handicap of selling at a lower
price
...
The third limitation can be dealt with by use of the P/V chart
...
The profit line, in either case, will rise at
a slower rate on the P/V chart
...
BENEFITS
The great advantage of the P/V chart is that profits or losses at any level of
activity can be read directly off the vertical scale
...
It does not, however, reveal how costs may vary following a change in
activity as does the break-even chart
...
It indicates the break-even point, the
point where sales revenue equals total cost (the sum of fixed and variable
costs) and there is neither profit nor loss
...
THE BREAK-EVEN CHART
Break-even analysis is carried out by means of a break-even chart, which is
illustrated in Figure 78
...
variable costs in relation to sales units or output added to fixed costs to
produce total costs;
2
...
the break-even point, where the sales revenue line crosses the total cost
line;
4
...
the margin of safety in sales units or cash, ie, the extent to which sales
volume or revenue exceeds the break-even point; and
6
...
The aim of management will be to achieve as large an
angle of incidence as possible, since this gives a correspondingly high
rate of profit once the break-even point has been passed
...
1 A break-even chart
An alternative method of drawing a break-even chart is shown in Figure
78
...
This clearly indicates the contribution to fixed costs and profits
achieved above the break-even point
...
These can limit
their usefulness
...
the variable costs associated with producing the various levels of output
are constant and can be represented by a straight line
...
the fixed costs remain constant over the range of output;
3
...
production and sales are equal and there are no significant changes in
inventory levels; and
5
...
Break-even Analysis ᔡ 393
£000
Margin of safety (cash)
Profit
90
Profits
wedge
80
Contribution
Costs and revenues
100
Profit
Sa
les
70
60
Break-even point
£50,000
Fixed
costs
Angle of
incidence
50
Margin of safety (units)
40
a
Tot
sts
l co
Losses
wedge
30
20
iab
Var
Loss
s
ost
le c
Variable
costs
10
10
20
30
40
50
60
70
80
90
Sales
100
Figure 78
...
BENEFITS
In spite of the limitations mentioned above, break-even analysis still
provides the following benefits:
1
...
2
...
3
...
4
...
394
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395
79
Sales Mix Analysis
DEFINITION
The sales mix is the combination of quantities of a variety of company
products that comprise total sales
...
METHOD
When comparing the relative profitability of different products the contribution concept is used (contribution is sales revenue minus variable costs)
...
It is carried out by
multiplying the units to be produced of the product by the contribution
per unit
...
5
2
...
5
7,500
10,000
12,500
Contribution or marginal costing is used because it would be misleading to
make comparisons on the basis of profits calculated after all costs, fixed
396 ᔡ Financial Management
and variable, have been fully absorbed
...
The true impact of
any changes in output can only be compared between products if this
comparison is made by reference to the marginal impact of additional sales
on revenues and costs
...
The unit contribution margin for product A is £1 and for product B £2
...
Fixed costs are £100,000
...
The break-even point, Fixed costs/Contribution margin, is therefore
100,000 units if only B is sold
...
If the planned mix is three units of A for each unit of B, the contribution
margin for this package of products will be (3 × £1) + (1 × £2) = £5
...
The average contribution margin per unit of product would be £5
divided by four units in each package = £1
...
6
...
25 = 80,000 units (consisting of 60,000 units of A and 20,000 of B)
...
1
...
The slope of the broken line shows the average contribution
...
However, if the mix changes
and the sales of B are higher than expected, net income increases
...
When the sales mix
changes, the break-even point and the expected profits at various levels of
sales are altered
...
A limiting factor is a factor in the activities of an undertaking which at a
point in time over a period of time will limit the volume of output
...
The limiting factor concept deals with a single constraint
...
Sales Mix Analysis ᔡ 397
+100
+80
+60
Combined contribution
of A and B
(slope of £1
...
1 Sales mix shown on a P/V chart
If there are more constraints, linear programming techniques may have to be
used
...
These decisions are made on the basis of
comparisons between the contribution to profit and fixed cost made by
different combinations of products, especially when limited factors apply
...
Budgets are usually prepared annually, but may be
updated during the year
...
For this, the basic
budgeting techniques are no different, but a less detailed approach may be
adopted to keep the amount of budgeting work at realistic levels
...
to show the financial implications of plans;
2
...
to provide a means of measuring, monitoring and controlling results
against the plans
...
1
...
1 The budgeting process
Financial Budgeting ᔡ 401
1
...
The annual
budget can be regarded as the first year of the long-range financial
plan
...
2
...
The sales forecast will have been made with the help of market
research and will take into account both likely demand and any
limiting factors or constraints in such areas as production capacity
...
3
...
The budget will set out sales targets in total
and for each product line
...
Sales
will be analysed by area or unit
...
The production budget, which defines what needs to be produced and at
what cost
...
Bottlenecks and other limiting factors are isolated
and decisions taken about their treatment
...
The budgeted costs of buying materials, finished
parts and tooling are also set out
...
5
...
They will
be based on forecast and budgeted activity levels
...
In addition:
ᔢ
ᔢ
ᔢ
the selling costs budget will include the costs of running the
marketing function and the field sales force, plus the costs of
distribution, advertising, promotions, market research and
customer servicing;
the production cost budget will cover the expenses incurred in operating the production departments and in maintaining plant and
machinery, and the depreciation to be charged for that plant and
machinery;
the administration budget will cover the costs of all central services
provided by finance, personnel, management services, legal,
402 ᔡ Financial Management
6
...
8
...
10
...
Any
other expenses such as insurance, depreciations and outside
professional services which cannot be charged directly to other
departments will be included in this budget, which will be divided
into sections for each service department or area; and
ᔢ the research and development budget will cover all the research and
development expenses of the company, including the operation
of research establishments, the costs of buying external research
and the costs of any materials used
...
From these will be devised overhead budgets
for each department against which they will control expenditure,
and these will be added to form the corporate overhead or master
budget
...
This will be
analysed into gross revenue, bad debts and the net revenue (gross
revenue less bad debts) that will flow into the cash budget
...
The capital expenditure budget, which will be derived from the corporate
plan and forecasts and will cover all capital investments or equipment
needed in the budget year
...
The cash or finance budget, which translates the operating budgets for
each function and department which have been prepared as revenues
and expenses into cash inflows and outflows
...
It
is necessary to plan and budget for the inflow and outflow of cash
from all other sources so that a funds-flow budget can be prepared
and cash flows controlled against that budget
...
Besides setting out the sales,
production, capital and cash budgets, the master budget will include a
balance sheet, a profit-and-loss account and a cash-flow statement
...
Financial Budgeting ᔡ 403
FINANCIAL BUDGETING PROCEDURE
The procedure for preparing financial budgets consists of the following
steps:
1
...
These will include sales and output targets
and the activity levels for which budgets have to cater
...
Finally, the assumptions to be used in budgeting are given
...
2
...
Changes to
previous budgets which are not in line with changes in activity levels or
assumptions on inflation and cost or price increases have to be justified
...
3
...
This is reviewed by top management, who may
require changes at departmental level to bring it into line with corporate
objectives for profitability and growth
...
The master budget is finally approved by top management and budget
packs are issued to each departmental or budget centre manager for
planning and control purposes
...
It is certainly the only
basis upon which control can be exercised, as described in Chapter 83
...
It is sometimes referred to as a multi-volume budget
...
‘Flexing’ a budget takes
place when the original budget is deliberately amended to take account of
changed activity levels
...
This means that both fixed and variable costs
are assumed to remain constant at any level of activity
...
1
...
It is therefore
necessary to ‘flex’ budgets to reflect different levels of output – assumed or
actual
...
For
example, in an assembly shop, activity levels, if a standard costing system
406 ᔡ Financial Management
Figure 81
...
Thus, the targeted standard hours would be shown as the 100 per cent
activity level
...
1
...
1 Weekly flexible budget for assembly shop
Performance
Standard hours produced
Activity (%)
Costs
Directly allocable
Direct materials
Direct labour
Indirect labour
Tools and consumables
Power
Repair materials and labour
Depreciation of plant
Apportioned
Associated labour costs
Rent and rates
Factory administration and services
Total costs
(V = Variable, F = Fixed, SF = Semi-fixed)
2,850
95
Budget
3,000
100
3,150
105
£
£
£
V
V
F
V
V
V
F
3,700
11,400
2,750
50
20
150
60
4,000
12,000
2,750
55
30
160
60
4,300
12,600
2,750
60
30
170
60
SF
F
F
290
200
4,500
300
200
4,500
310
200
4,500
23,120
24,055
24,980
Flexible Budgets ᔡ 407
Budgets based on fixed output levels can be ‘flexed’ during the year on the
basis of revised activity forecasts
...
The result of the reforecast is a completely recast
master budget, incorporating a revised balance sheet and profit-and-loss
account
...
The budget with which the actuals are compared, however, is
the adjusted budget based on achieved activity levels
...
Table
81
...
is an example of a departmental operating statement which shows
the original budget for a performance of 3,000 standard hours compared
with the adjusted budget for a performance of 3,150 standard hours, an
activity ratio of 105 per cent
...
Table 81
...
If such allowances are not made, a
completely unrealistic picture of variances is built up and control cannot
be overcome
...
Appropriate funding levels, from zero to a significant increase, will be
determined by the priorities established by top management and the
overall availability of funds
...
This practice begins with the past level of
expenditures as a base and concentrates on projected increases or
decreases from that base
...
The minds of
managers concentrate only on justifying increases rather than on challenging the need for any function or activity in its present form
...
This would be unrealistic
...
The approach recognizes that, ultimately, the
production of a budget is a matter of assessing priorities against margin
410 ᔡ Financial Management
and profit targets, in the light of an analysis of the costs and benefits of
alternative approaches
...
For each
activity the basic elements or decision units are defined and each unit is
analysed to establish:
1
...
3
...
5
...
its objectives;
the activities carried out;
the present costs of these activities;
the benefits resulting from each activity;
the standards and other performance measures that exist;
alternative ways of achieving objectives, and the priorities between
them; and
7
...
BENEFITS
Zero-base budgeting is no panacea and it has often failed because
companies have introduced over-elaborate procedures which have sunk
almost without trace in a sea of paperwork
...
The most elaborate control
system in the world is useless if it relates to an unsound base
...
They should not be used in a threatening way
...
411
83
Budgetary Control
DEFINITION
Budgetary control compares actual costs, revenues and performances with
the budget so that, if necessary, corrective action can be taken or revisions
made
...
2
...
4
...
plan what needs to be achieved;
measure regularly what has been achieved;
compare actual achievements with the plan;
take action to correct deviations from the plan; and
feed back results to amend the plan as required
...
A budget for each cost centre which sets out under each cost heading (to
which a cost code will have been attached) the budgeted expenditure
against whatever activity levels have been built into the budget
...
A system of measurement or recording which allocates all expenditures
to the current cost code and cost centre and records the activity levels
achieved
...
A system for comparison or reporting which sets out actuals against
budgets and indicates the positive and negative variances that have
occurred
...
4
...
This
requires reports to higher management on what is being done to deal
with variances
...
A procedure for feeding back changes in activity or performance levels or
revised forecasts so that the budget guidelines can be amended and
budgets updated
...
1
...
It will not work effectively, however,
unless:
1
...
the budget is realistic – the targets are not so high as to be unattainable
or so low as to be meaningless;
3
...
1 The process of budgetary control
Action
Budgetary Control ᔡ 413
4
...
steps are taken by higher management to ensure that variances are
analysed and reported on and that corrective action is planned, implemented and successful
...
But these volumes
change, and many assumptions about the incidence of variable costs and
the amount and allocation of overheads or expenses included in the
original budget will no longer be valid
...
This was described in Chapter 81
...
Overheads, for the purpose of
overhead accounting, are costs that are not specific to a particular activity
...
PRINCIPLES OF OVERHEAD ACCOUNTING
The following principles apply to overhead accounting:
1
...
Overheads should only be analysed for specified accounting units and
over a defined period of time
...
No overhead analysis can be relevant by itself for all decisions and
control purposes
...
416 ᔡ Financial Management
4
...
Historical costs provide a
base for projections into the future but are not relevant in themselves
...
An overhead cost is only
controllable if the manager concerned can influence the level of cost
incurred
...
Overhead costs are therefore
classified in a way which is consistent with that structure
...
A proper system of overhead accounting avoids arbitrary allocation of overheads
...
Significant variances in this overall figure should
prompt investigations at each level of responsibility so that reasons can be
established and corrective action taken
...
This problem typically arises because
the overheads are not classified accurately and responsibility for their
control is diffuse
...
FURTHER READING
Drury, C, Management and Cost Accounting (3rd edition), Van Nostrand
Reinhold, London 1992
...
The managers of each of these centres are held responsible
for the costs and revenues assigned to them
...
Cost centres, where only costs are reported formally
...
Typically, cost centres are departments, but a department
may contain several cost centres
...
Profit centres, where costs and revenues are reported formally
...
3
...
Their success is measured not only by
their income but also by relating that income to their invested capital
...
BASE
Responsibility accounting is based on four principles
...
Objectives
The overall objectives of the business are divided and subdivided into the
objectives of each of its constituent parts, expressed as profit, contribution
or cost
...
1
...
Controllable costs
Responsibility accounting excludes or segregates costs which are not
controlled directly by the manager
...
COMPANY
Return on
shareholders'
investment
DIVISION A
DIVISION B
DIVISION C
Operating profit
Operating profit
Operating profit
PRODUCTION
ADMINISTRATION
Controllable costs
SALES
Overall
contribution
PRODUCT LINE A
PRODUCT LINE B
PRODUCT LINE C
Contribution
Contribution
Contribution
Controllable costs
Figure 85
...
Explanation
The results achieved in a profit centre are not all directly controllable by
the profit centre manager
...
But responsibility accounting requires managers to explain
why the actual results obtained differ from those in the forecast or budget
...
Only by seeking and offering
such explanations will they be able to adopt a proactive rather than a
reactive stance to the management of change
...
4
...
This is the principle of management by exception, whereby the
attention of managers is focused on exceptions to the norm so that they do
not waste time on those parts of the reports that reflect smoothly running
phases of operations
...
1
...
The organization is divided and subdivided into responsibility centres – for
return on investment, profit, contribution, revenue or controllable costs
...
Managers are identified who will be accountable for the results
achieved in each responsibility centre
...
Objectives, standards, targets and budgets are agreed for the organization as a whole and for each responsibility centre
...
An information system is set up which reports actuals against standards, targets or budgets and highlights variances
...
1 Responsibility accounting for controllable costs
Cost centre
Budget (£000)
Variances (£000)
(favourable/
unfavourable)
This period Year to date
This period Year to date
Level 1
...
Production Director
Plant A
Plant B
Plant C
100
70
80
280
200
220
(10)
–
(10)
(30)
10
(20)
Total
250
700
(20)
(40)
50
30
20
140
80
60
(4)
(4)
(2)
(15)
(10)
(5)
100
280
(10)
(30)
Level 4
...
Plant A Manager
Department A
Department B
Department C
Total
5
...
BENEFITS
Responsibility accounting first facilitates the delegation of decision taking
...
Second, exception reporting, which is built into any fully developed
responsibility accounting system, enables managers to concentrate on the
key issues which need their attention
...
421
86
Capital Budgeting
DEFINITION
Capital budgeting is the process of selecting and planning capital investments based on an analysis of the cash flows associated with the investments and appraisals of the benefits that are likely to arise from them
...
Capital budgeting and
investment appraisal procedures frequently require choices to be made
from several options
...
1
...
The detailed factors to be evaluated in making investment decisions are:
1
...
3
...
the initial cost of the project;
the phasing of expenditure over the project;
the estimated life of the investment; and
the amount and timing of the resulting income
...
1 Capital investment cash flows
The outflow of funds needed to acquire a capital asset is called ‘the
investment’
...
The returns on a project are represented by the
excess of added revenue over added costs (other than depreciation, since
in capital investment decisions depreciation over the life of the investment
is represented by the investment)
...
Projects which earn a rate of return less
than could be earned by other means (less than the opportunity cost of
capital) should be rejected, and those that yield a superior rate of return
should be accepted
...
A favourable decision is indicated if returns less investment is
positive
...
Some adjustment for this time difference is
desirable for two reasons:
Capital Budgeting ᔡ 423
1
...
2
...
Because of the importance of this principle, the most favoured approach to
investment appraisal as part of the capital budgeting procedure is
discounting
...
The effect of
discounting is to express the two streams of investment and returns in
present value equivalents
...
INVESTMENT APPRAISAL TECHNIQUES
The four main techniques for appraising investment proposals are as
follows:
1
...
2
...
3
...
4
...
Although the discounted cash flow and the net present value methods
are in many ways the most appropriate techniques because they involve
discounting cash flows to present values, this does not mean that the
payback or accounting rate of return method cannot or should not be
used to provide a quick and simple, although somewhat crude, view on
how long it will take the company to get its money back (payback), or
how the average rate of return compares with other rates that could be
earned
...
424 ᔡ Financial Management
CAPITAL BUDGETING PROGRAMME
A capital budgeting programme consists of the following stages:
1
...
To provide for profitable growth,
management generates a constant flow of investment opportunities for
appraisal
...
The identification of relevant alternatives
...
3
...
The emphasis is on relevant cost information,
ie future incremented cash flows, not traditional historical cost accumulations
...
4
...
Again these are forecast in the form of cash
flows over a period of time
...
Risk analysis techniques such as the calculation of expected values,
utility theory, mean variance analysis, game theory, Monte Carlo simulations and decision trees are all used for this purpose
...
The screening and ranking of projects
...
The payback period
and the accounting rate of return from different projects may also be
considered
...
This policy will be influenced by the target rates of return
on shareholders’ capital or on capital employed, and by the cost of
obtaining capital
...
Capital expenditure control
...
Project
control information is needed as part of the system of project
management
...
7
...
Information is generated which compares net cash
flows with budget and enables corrective action to be taken when
required
...
projects are properly evaluated in terms of the cash outflows and
inflows involved and the payback, rate of return and net present value
of the investment;
2
...
procedures are set up for the controlling expenditure within agreed
budgets for the lifetime of the project and for comparing returns with
forecasts so that corrective action can be taken when necessary
...
426
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427
87
Payback Method of
Capital Appraisal
DEFINITION
The payback period method of capital appraisal forecasts when a project
or capital investment will reach its break-even point, ie the length of time
which will elapse before the cash inflow from the project equals the total
initial cash outflow
...
The time taken to recoup is called the payback period, and it
should be as short as possible
...
CALCULATING PAYBACK
Payback is calculated by:
1
...
estimating the cash inflows for year 1 (if any), then year 2, year 3 and so
on until the total of inflows equals or slightly exceeds the outlay and
428 ᔡ Financial Management
any further deductions would be negative
...
if, having deducted the inflows, there is a residue left which is less than
the next year’s inflow, that inflow figure is divided into the residue
...
This process is called interpolation
...
It is also an easy method of assessing the relative merits of
different investments
...
For
example, it may be decided that no investment should be considered if the
payback period is longer than three years
...
The payback method also ignores the timing of cash flows
...
It is also known as
the unadjusted rate of return
...
Tabulate the capital outlays for each year of the project
...
Divide the total capital outlay by the number of years over which the
project runs to obtain the average annual capital outlay
...
Tabulate the net inflows for each year
...
Total the net inflows and divide that total by the number of years of
project life in order to obtain the average annual return
...
Divide the average annual return by the annual average capital outlay
and multiply the result by 100 to obtain the percentage average annual
rate of return
...
It is thus a simple measure of
profitability, producing a figure which is easily compared with the return
from alternative projects, the return that can be obtained from alternative
investments (eg bank deposits), or the dividend yield expected from an
ordinary public company share
...
The discounted cash-flow method is designed to
overcome this defect
...
It focuses on cash inflows and
outflows rather than on net income as computed in the accrual accounting
sense
...
BASIS OF THE TECHNIQUE
The DCF technique recognizes that £1,000 receivable in one year’s time is
worth less than £1,000 receivable now
...
The
£870 could be invested at 15 per cent, which would represent a total of
£1,000 in one year’s time
...
This process of expressing future inflows in present values is known as
discounting and it is, in effect, compound interest in reverse
...
The return from a project is
calculated before any depreciation charges are deducted
...
This will incorporate all taxation allowances on the capital
432 ᔡ Financial Management
equipment, as this is a tax saving which increases the actual cash inflow of
the project
...
The present value is
compared with the initial cost and the actual rate of return is the discount
rate required to equalize the present value with the original cost
...
Alternative investments can be evaluated by comparing their
respective rates of return
...
Calculation of present value
...
Calculation and use of net present value
...
Calculation and use of internal rate of return
...
This is the current
discounted value of the cash flow expected in a future year
...
Alternatively, present value tables can be used which are set out as in
Table 89
...
Table 89
...
9259
0
...
7938
Discount rate
9%
0
...
8417
0
...
9091
0
...
7513
Discounted Cash Flow ᔡ 433
Using this table, the present value of £50,000 received in year 2 and
discounted at 10 per cent is 50,000 × 0
...
Net present value
The net present value (NPV) technique assumes some minimum desired
rate of return (discount factor), adds the present values for each year of the
project of all the cash inflows, and deducts from this figure the sum of all
the present values of the cash outflows for each year of the project
...
An
example of this calculation is given in Table 89
...
If, having worked out the NPV, the result is positive, the project is
desirable, and vice versa
...
Table 89
...
9091
0
...
7513
0
...
6209
£000
(54
...
32)
22
...
15
43
...
28
Internal rate of return
The internal rate of return (IRR) is the discount rate that makes the NPV of
a project equal to zero
...
The IRR indicates
the maximum cost of capital a project may incur without making a loss, ie
without its NPV becoming negative
...
The IRR can be found by trial and error
...
2 a
discount factor of 10 per cent gave a positive NPV of 4
...
If the discount
factor were 14 per cent, the NPV would be minus 4
...
A discount factor of 12
per cent gives minus 0
...
98 per cent)
...
The IRR in
the above example is just under 12 per cent of the capital invested during
each year
...
The IRR is used to ensure that the project will at least achieve the target
rate of return set by the company, which will be related to the cost of
capital
...
BENEFITS
The discounted cash-flow technique, including the use of NPVs and the
IRR, is the only capital appraisal method which indicates the value of a
project after accounting for the opportunity cost of money
...
It has to be remembered, however,
that the DCF is based on two fundamental assumptions: first, that the
predicted cash flows will occur in the amounts and at the times specified;
second, that the original amount of the investment can be looked upon as
being either borrowed or loaned at some special rate of return
...
But these
also have assumptions about future inflows built into them
...
To minimize the problems of uncertainty, risk analysis techniques can be used
...
FURTHER READING
Mott, G, Investment Appraisal, Pitman, London 1993
...
Outcomes are generally
expressed as net present values (NPVs), following discounted cash-flow
calculations of the probabilities of variations occurring to the basic data
built into the forecast, such as demand, costs, inflation and cash flows
...
Errors occur
because:
1
...
costs and therefore cash outflows are time based, but unforeseen
circumstances can change them; and
3
...
436 ᔡ Financial Management
TECHNIQUES
The most commonly used techniques in risk analysis are:
1
...
expected value
...
It is similar to sensitivity analysis in that, unlike other risk
analysis techniques, it does not incorporate probability assessments of
variations into the basic factors
...
These provide an overall feel for what might
happen to the project upon which management can base its decisions
...
Expected value
The expected value is a forecast based on the weighted average of all the
reasonably probable levels that sales might achieve
...
In risk
analysis, expected values are also called certainty equivalents
...
1
...
1 Expected value calculation
Forecast demand
in units
Cash flow
£
Probability
%
Expected value
£
2,000
3,000
4,000
5,000
20,000
30,000
40,000
50,000
20
40
30
10
100
4,000
12,000
12,000
5,000
33,000
Risk Analysis ᔡ 437
BENEFITS
Risk analysis ensures that the factors influencing the likely outcomes of
investments are identified and that the probabilities of their occurrence are
fully explored
...
FURTHER READING
Mott, G, Investment Appraisal, Pitman, London 1993
...
establishing priorities and strategies for major public sector developments or operational programmes;
2
...
planning the work to be done to achieve the expected outputs; and
4
...
In programme budgeting, a programme is an activity or sequence of activities which needs to be carried out to achieve a desired output over a set
period of time and within a predetermined budget
...
CONCEPT OF PROGRAMME BUDGETING
The concept of programme budgeting was developed in the United States in
the 1960s
...
It became
fashionable in the UK at the time of the Fulton Report on the Civil Service,
* Referred to in the United States as program budgeting
...
Possibly
because it was oversold as a panacea at the time, programme budgeting as
such is not heard about much today
...
The need
The belief that programme budgeting was necessary arose because of the
indissoluble connection between budgeting and the formulation and
conduct of national policy
...
Planning, programming and budgeting
constitute the processes by which it was thought that objectives and
resources, and the interrelationships between them, could be taken into
account to achieve a comprehensive and coherent programme of action
for a government as a whole
...
The task of
helping to make the necessary compromises among various objectives is a
function of planning, programming and budgeting
...
A government, like a private business, can determine its policies most
effectively if it chooses rationally among alternative courses of action, with
as full knowledge as possible of the implications of those alternatives
...
The importance of management
accounting
The significance attached to the role of management accounting in the
planning and control processes of the government was emphasized in a
UK government White Paper reprinted in 1983 on Efficiency and
Effectiveness in the Civil Service
...
The emphasis in
Programme Budgeting ᔡ 441
management accounting is not only to assess cash expenditure on an input
basis, as in the British government vote system, but also, and more importantly, to allocate such costs to outputs or objectives so that they can
provide a proper basis for monitoring performance against plans
...
Hence the use of cost–benefit techniques to
measure inputs and outputs in these more subjective areas
...
Appraisal and comparison of various government activities in terms of
their contribution to national objectives
...
Determination of how given objectives can be attained with minimum
expenditure and resources
...
Projection of government activities over an adequate time horizon
...
Comparison of the relative contribution of private and public activities
to national objectives
...
Revision of objectives, programmes and budgets in the light of experience and changing circumstances
...
1
...
2
...
4
...
6
...
In addition, the analytical process of establishing objectives and drawing
up alternative programmes can be assisted by building a hierarchical
programme structure to illustrate how departmental or functional
442 ᔡ Financial Management
MAKE STRATEGIC
CHOICE
Establish
long-range goals
Develop strategy
Establish interim
objectives
FORMULATE
ALTERNATIVE
PROGRAMMES
Develop interim
plans
Conduct cost–benefit
analysis
EVALUATE
ALTERNATIVES
PROGRAMME
ANALYSIS
AND
REVIEW
Relate to resources
available
Establish operational
targets
ALLOCATE
RESOURCES
Develop operational
plans
EXECUTE PLANS
Achieve targets within
planned times and
budgets
REPLAN
Control and
feedback
Figure 91
...
This is shown in Figure 91
...
DEVELOPMENTS IN PROGRAMME
BUDGETING
Although little reference is now made, in the UK at least, to the original
notion of programme budgeting, the basic concepts are retained in one
form or another, although the emphasis may have changed
...
2 Possible educational objectives for an education authority
Provide
extra
teachers
Improve accommodation
and facilities
SUPPORT
SERVICES
ADMINISTRATION
AND
INSPECTION
Improve teaching
methods
SCHOOL
HEALTH
SERVICE
TEACHER
TRAINING
Improve
overall
standards
SCHOOL
TRANSPORT
SCHOOL
MEALS
Adjust number of
places to cover
population changes
FURTHER
EDUCATION
SPECIAL
EDUCATION
Reduce pupil–teacher ratio
(from A to B by 20xx)
Improve standards
of schools in
priority areas
SECONDARY
EDUCATION
Provide
extra
accommodation
Operate and maintain
existing primary
schools
PRIMARY
EDUCATION
443
444 ᔡ Financial Management
In the United States, rational policy analysis has become a major feature
of the administration, using ‘hard edge’ quantitative techniques in a logicof-choice approach to decision making, drawn from economics, statistical
decision theory and operation research
...
In the UK, the emphasis on output budgeting coupled with increasing
attention to management accounting techniques has focused attention on
the assessment of the cost-effectiveness of present and future activities in
order to ensure the efficient use of available resources and, in particular:
1
...
to ensure that decisions are taken with full knowledge of all relevant
financial information
...
What is interesting
to management in the private sector, however, is that although programme
budgeting has been developed and adapted for use in public administration,
the way it brings together its planning, evaluation and control techniques
into a coherent package has much of interest to those involved in corporate
planning and financial control in industry or commerce
...
445
92
Cost–Benefit Analysis
DEFINITION
Cost–benefit analysis conducts a monetary assessment of the total costs
and revenues or benefits of a project, paying particular attention to the
social costs and benefits which do not normally feature in conventional
costing exercises
...
The aim is then
to see a strategy which achieves the maximum benefit for the minimum
cost
...
BACKGROUND
In business, the usual method for testing the ‘soundness’ of proposed
activities is investment appraisal, which requires a calculation of the value
of the resources to be employed in them (the costs) and a comparison with
the value of the goods or services to be produced (the benefits)
...
Because money in the hand is worth more than money in
prospect, discounted cash-flow (DCF) techniques are often used to discount
expected future cash flows at arbitrary chosen rates to arrive at a present
value
...
In contrast, in the public sector many services are provided, such as
roads and schools, without direct prices being charged for them
...
And there
may be social costs involved which are difficult (in some cases, perhaps,
impossible) to measure
...
To obtain a full
picture of the likely costs and benefits of projects in the public sector, it
may be necessary to try to assess these social costs and benefits
...
METHOD
A cost–benefit analysis is conducted in the following stages:
1
...
2
...
Social benefits and costs will be included in this list
...
The list of benefits and costs, direct or indirect, is reduced to monetary
values in order to arrive at an estimate of the current net benefit of the
project (if any)
...
The fact that the term
sometimes used for these values is ‘shadow price’ is revealing
...
But how is the effect of noise on
local residents to be measured? One way is to ask individuals how
much they would pay to have a quieter house
...
This will not, of course, give a
precise answer
...
But
the advocates of attaching values to social benefits and costs will say
that at least, if consistent methods are used, a basis is provided for
comparing the total costs and benefits of alternative projects, which is
the main object of cost–benefits analysis
...
The stream of net benefits is predicted for each year of the project
...
This stream will be expressed as a
Cost–Benefit Analysis ᔡ 447
positive or negative cash flow depending on whether benefits exceed
costs or costs exceed benefits
...
The stream of annual net benefits is compared with the capital cost of
the project, and this can be expressed as a percentage rate of return on
the investment
...
Investment costs are then deducted and the projects appraised in the
light of the resulting net present values
...
ᔢ The implicit rate of return on capital employed yielded by each
project may be found by mathematical methods
...
ᔢ The present values of the benefit stream can be expressed as
‘benefit–cost’ ratios with the denominator representing total costs
...
6
...
Crudely, if costs exceed benefits, ie the
benefit–cost ratio is less than 1, the project should not be considered
...
BENEFITS
Cost–benefit analysis can be used simply to ensure that value for money is
obtained from a project which requires the investment of funds
...
Cost–benefit studies attempt to allow for social costs and benefits
...
The difficulty is, of course, placing realistic values on
such things as good health, quiet houses or protection from a potential
enemy
...
But at least cost–benefit
analysis concentrates attention on basic issues
...
448 ᔡ Financial Management
FURTHER READING
Jones, R and Pendlebury, M, Public Sector Accounting (4th edition), Pitman,
London 1996
...
AIMS
The aims of cost-effectiveness analysis are to:
1
...
ensure that the course of action selected will provide good value for
money – better than any other course of action; and
3
...
METHOD
Cost-effectiveness analysis is carried out in the following stages:
1
...
At this stage, preliminary
information will be obtained about how to measure the extent to which
450 ᔡ Financial Management
2
...
4
...
6
...
objectives are achieved
...
Identify alternatives – the means by which the objectives will be attained
...
Because the choice of an alternative implies that certain specific
resources can no longer be used for other purposes, the true measure of
their cost is the opportunities they preclude
...
The means of representation may vary from a set of mathematical equations to a purely verbal description of the situation, in
which judgement alone is used to predict the consequences of various
choices
...
Select criteria – the rules or standards by which to rank the alternatives,
selected in order of desirability; the most promising is chosen
...
Conduct analysis – the consequences of choosing an alternative as indicated by means of the model
...
The criteria can then be used to arrange the alternatives in
order of preference
...
The review will then determine any changes
needed to improve cost-effectiveness
...
FURTHER READING
Jones, R and Pendlebury, M, Public Sector Accounting (4th edition), Pitman,
London 1996
...
The aim is to provide information on how well
the human capital of an organization is managed as a guide to future
action
...
THE NEED FOR HUMAN CAPITAL
MEASUREMENT
There is an overwhelming case for evolving methods of valuing human
capital and as an aid to decision making
...
The issue is to develop a framework within which reliable information can
be collected and analysed such as added value per employee, productivity
and measures of employee behaviour (attrition and absenteeism rates, the
454 ᔡ Human Resource Management
frequency/severity rate of accidents, and cost savings resulting from
suggestion schemes)
...
ᔢ People in organizations add value and there is a case for assessing this
value to provide a basis for HR planning and for monitoring the effectiveness and impact of HR policies and practices
...
ᔢ Measurements can be used to monitor progress in achieving strategic
HR goals and generally to evaluate the effectiveness of HR practices
...
APPROACHES TO MEASUREMENT
The main approaches to measurement are described below
...
These are:
Practice
total rewards and accountability
collegial, flexible workforce
recruiting and retention excellence
communication integrity
Impact on market value %
16
...
0
7
...
1
The organizational performance model –
Mercer HR Consulting
The Organizational Performance Model developed by Mercer HR
Consulting as explained by Nalbantian et al2 is based on the following
elements: people, work processes, management structure, information
Human Capital Measurement ᔡ 455
and knowledge, decision making and rewards
...
If these elements have been developed piecemeal, as often happens, the
potential for misalignment is strong and it is likely that human capital is
not being optimized to create opportunities for substantial improvement
in returns
...
The statistical tool ‘Internal Labour
Market Analysis’ used by Mercer draws on the running record of
employee and labour market data to analyse the actual experience of
employees rather than stated HR programmes and policies
...
The human capital monitor – Andrew Mayo
Andrew Mayo3 has developed the ‘human capital monitor’ to identify the
human value of the enterprise or ‘human asset worth’ which is equal to
‘employment cost × individual asset multiplier’
...
The absolute figure is not important
...
Mayo advises against using too many measures
and, instead, concentrate on a few organization-wide measures that are
critical in creating shareholder value or achieving current and future organizational goals
...
ᔢ People development and performance data – learning and development
programmes, performance management/potential assessments, skills
and qualifications
...
ᔢ Performance data – financial, operational and customer
...
quality of corporate strategy;
2
...
management credibility;
4
...
research leadership;
6
...
market share;
8
...
alignment of compensation with shareholders’ interests;
10
...
APPROACHES TO HUMAN CAPITAL
MEASUREMENT
The points that should be borne in mind when measuring human capital
are:
ᔢ Identify sources of value including the competencies and abilities that
drive business performance
...
ᔢ Remember that human capital measurement is concerned with the
impact of people management practices on performance so that steps
can be taken to do better
...
It needs to be value
focused rather than activity based
...
ᔢ Keep measurements simple – concentrate on key areas of outcomes and
behaviour
...
ᔢ Analyse and evaluate trends rather than simply record actuals –
compare the present position with base line data
...
ᔢ Remember that measurement is a means to an end not an end in itself
...
Human Capital Measurement ᔡ 457
REFERENCES
1 Watson Wyatt Human Capital Index, Watson Wyatt, London 2002
...
3 Mayo, A, The Human Value of the Enterprise: Valuing people as assets, Nicholas
Brealey, London 2001
...
THE PROCESS OF HUMAN RESOURCE
PLANNING
While human resource planning is primarily concerned with ensuring that
the company gets the quantity and quality of people it needs, it is also
linked with productivity planning to ensure that the best use is made of
the company’s human resources
...
Demand forecasting – estimating future needs by reference to corporate
and functional plans and forecasts of future activity levels
...
Supply forecasting – estimating the supply of employees by reference to
analyses of current resources and future availability, after allowing for
wastage
...
Determining human resource requirements – analysing the demand and
supply forecasts to identify future deficits or surpluses
...
Productivity and cost analysis – analysing productivity, capacity,
utilization and costs in order to identify the need for improvements in
productivity or reductions in cost
...
Action planning – preparing plans to deal with forecast deficits or
surpluses of personnel; to improve utilization and productivity or to
reduce costs
...
Human resource budgeting and control – setting human resource budgets
and standards and monitoring the implementation of the plans against
them
...
1
...
The basis of the forecast is the annual
budget and longer-term corporate plan, translated into activity levels for
each function and department
...
1 The process of human resource planning
Human Resource Planning ᔡ 461
1
...
work study;
3
...
Ratio-trend analysis
Ratio-trend analysis is carried out by studying past ratios between, say, the
number of direct and indirect workers in a manufacturing plant, and forecasting future ratios, having made some allowance for changes in organization or methods
...
Work study
Work study techniques can be used when it is possible to apply work
measurement to calculate how long operations should take and the
amount of labour required
...
The budgets of productive hours are then
compiled by the use of standard hours for direct labour, if standard labour
times have been established by work measurement
...
This is divided by
the number of operators required
...
The following is a highly
simplified example of this procedure:
1
...
3
...
Planned output for year: 20,000 units
...
Planned hours for year: 100,000 hours
...
5
...
Work study techniques for direct workers can be combined with ratiotrend analysis to calculate the number of indirect workers needed
...
Econometric models
To build an econometric model for human resource planning purposes it is
necessary to analyse past statistical data and to describe the relationship
462 ᔡ Human Resource Management
between a number of variables in a mathematical formula
...
The
formula could then be applied to forecasts of movements in these variables
to produce a human resource forecast
...
Supply forecasting measures the quantity of people that is likely to be available from
within and outside the organization, having allowed for absenteeism,
internal movements and promotions, wastage and changes in hours and
other conditions of work
...
2
...
4
...
existing human resources;
potential losses to existing resources through labour wastage;
potential changes to existing resources through internal promotions;
effect of changing conditions of work and absenteeism; and
sources of supply from within the company
...
They
provide the basis for action plans dealing with recruitment, management,
training, retraining, career progression, redundancy (if necessary) and the
improvement of productivity
...
The result of role analysis is a role
profile that defines the outcomes role holders are expected to deliver in
terms of key result areas or accountabilities
...
Role profiles can be individual or generic
(covering a number of similar roles)
...
ᔢ Organization – to whom the role holder reports and who reports to the
role holder
...
464 ᔡ Human Resource Management
ᔢ Competency requirements – the specific technical competencies attached to
the role; what the role holder is expected to know and to be able to do
...
METHODOLOGY
The essence of role analysis is the application of systematic methods to the
collection of information required to produce a role profile under the
headings set out above
...
Obtain documents such as the organization structure, existing job
descriptions (treat these with caution, they are likely to be out of date),
and procedure or training manuals which give information about the
job
...
Ask managers for fundamental information concerning the overall
purpose of the role, the key result areas and the technical competencies
required
...
Ask the role holders similar questions about their roles
...
Interviews
To obtain the full flavour of a role, it is best to interview role holders and
check the findings with their managers or team leaders
...
It is helpful to use a check list when
conducting the interview
...
The basic questions to be answered are:
1
...
3
...
5
...
7
...
What is the title of your role?
To whom are you responsible?
Who is responsible to you? (An organization chart is helpful
...
What are the results you are expected to achieve in each of those key
activities?
What are you expected to know to be able to carry out your role?
What skills should you have to carry out your role?
Role Analysis ᔡ 465
The answers to these questions may need to be sorted out – they can often
result in a mass of jumbled information which has to be analysed so that
the various activities can be distinguished and refined to seven or eight
key areas
...
It is
therefore the most common approach
...
This speeds up the interviewing process or even replaces the
interview altogether, although this means that much of the ‘flavour’ of
the job – ie what it is really like – may be lost
...
They are helpful
when a large number of roles have to be covered
...
The simpler the questionnaire the better
...
The advantage of questionnaires is that they can produce information
quickly and cheaply for a large number of jobs, but a substantial sample is
needed and the construction of a questionnaire is a skilled job which
should only be carried out on the basis of some preliminary fieldwork
...
The accuracy of the results also depends on the willingness
and ability of job holders to complete questionnaires
...
Observation
Observation means studying role holders at work, noting what they do,
how they do it and how much time it takes
...
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467
97
Selection Testing
DEFINITION
Selection testing consists of the application of standard procedures to
subjects which enables their responses to be quantified
...
The tests used for
selection are intelligence tests, aptitude and attainment tests, and personality tests
...
it is a sensitive measuring instrument which discriminates well between
subjects;
2
...
it is reliable in the sense that it always measures the same thing – a test
aimed at measuring a particular characteristic, such as intelligence,
should measure the same characteristic when applied to different
people at the same or a different time, or to the same person at different
times; and
4
...
INTELLIGENCE TESTS
Intelligence tests are the oldest and most frequently used psychological
tests
...
An IQ is the ratio of the mental age
as measured by a Binet-type test to the actual (chronological) age
...
It is assumed that intelligence is distributed normally throughout the
population, ie, the frequency distribution of intelligence corresponds to
the normal curve shown in Figure 97
...
The most important characteristic
of the normal curve is that it is symmetrical – there are an equal number
of cases on either side of the mean, the central axis
...
APTITUDE AND ATTAINMENT TESTS
Aptitude tests are designed to predict the potential an individual has to
perform a job or specific tasks within a job
...
They may
come in the form of well-validated single tests, or as a battery of tests such
as those developed some years ago by the British National Institute of
Industrial Psychology for selecting apprentices
...
1 An IQ normal curve
Selection Testing ᔡ 469
All aptitude tests should be properly validated
...
A standard test or a test battery is then obtained from a test
agency
...
The test is then given to employees already working on the job and the
results compared with a criterion, usually supervisors’ ratings
...
To validate the test further, a follow-up study of the
job performance of the applicants selected by the test is usually carried
out
...
A typing test is the most typical
example
...
PERSONALITY TESTS
Personality tests attempt to assess the type of personality possessed by the
applicant in terms of personality traits (styles of behaviour such as aggressiveness or persistence) or personality types (salient features which characterize the individual such as extroversion or introversion)
...
For selection purposes they
are almost meaningless if they have not been validated by a thorough
correlation of test results with subsequent behaviour
...
BENEFITS
Selection testing provides an objective means of measuring abilities or
characteristics
...
In these circumstances it is economic to
develop and administer the tests and a sufficient number of cases can be
built up for the essential validation exercise
...
470 ᔡ Human Resource Management
FURTHER READING
Toplis, J, Dulewicz, V and Fletcher, C, Psychological Testing: A Practical
Guide, Institute of Personnel Management, London 1987
...
establish the rank order of jobs within an organization, measure the
difference in value between them and group them into an appropriate
grade in a job grade structure;
2
...
provide a continuing basis for assessing the value of jobs which is easy to
understand, administer and control and is accepted by the staff as fair
...
Job analysis
...
2
...
Following job analysis, whole jobs are compared
with one another to determine their relative importance and their place
in a hierarchy
...
)
3
...
Separately defined characteristics or factors which are
assumed to be common to all jobs are analysed and compared
...
472 ᔡ Human Resource Management
TYPES OF JOB EVALUATION
Job evaluation schemes are usually grouped into two basic types:
1
...
The main nonanalytical schemes are job ranking and job classification
...
Analytical, based on factor comparisons
...
Job ranking
The simplest form of job evaluation is job ranking
...
The rank
order is established by considering the worth of each job to the organization
...
Job classification
Job classification is based on an initial definition of the number and characteristics of the grades into which the jobs will be placed
...
Jobs are allotted to grades by comparing the whole-job description
with the grade definition
...
The factors
selected are those considered to be most relevant in assessing the comparative value of jobs
...
Each factor is given a range of points so that a maximum number of points
is available
...
In each factor, the total
range of points is divided into degrees according to the level at which the
factor is present in the jobs
...
Jobs are evaluated by studying job descriptions containing analyses of
the degree to which the factor is present in the job and comparing them
with the factor level definition
...
This score can
then be related to the scores of other jobs to indicate the rank order
...
1
...
1 An example of points rating
Factor
Job A
Level
Resources
Decisions
Complexity
Knowledge and skills
4
4
5
3
Job B
Points
20
60
25
15
Level
5
4
3
3
120
Points
25
60
15
15
115
JOB EVALUATION PROGRAMME
A job evaluation programme consists of the eight stages shown in Figure
98
...
Stage 2 is the planning stage when the programme is drawn up; the staff
affected are informed; arrangements are made as required for setting up
working parties; and the representative sample of benchmark jobs to be
analysed is selected
...
Stage 4 is the internal evaluation stage when the jobs are ranked by means
of the chosen evaluation scheme and graded, usually on a provisional
basis pending the collection of market rate data, except where a job classification scheme is used to slot jobs into an existing job grade structure
...
Stage 6 is the stage in which the salary structure is designed
...
Choose
scheme
2
...
Analyse
jobs
4
...
External
evaluation
6
...
Grade
jobs
8
...
1 Job evaluation programme
Stage 7 is the grading stage in which the jobs are slotted into the salary
structure
...
BENEFITS
If job evaluation is based on proper job analysis and a systematic approach
is used to make comparisons, it will provide a consistent and agreed
framework within which defensible differentials can be maintained
...
However elaborate the analysis or compli-
Job Evaluation ᔡ 475
cated the scheme, judgement is still required to rank or grade jobs or to
allocate points to them
...
Job evaluation can be described as, in effect, a process of
systematic subjectivity
...
476
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477
99
Salary Surveys
DEFINITION
Salary surveys obtain information on the rates of pay in comparable
companies for similar jobs
...
METHOD
Salary surveys obtain and analyse information from the sources described
below:
1
...
An indication of
dispersion is usually given in the form of the upper-quartile salary (the
point above which 25 per cent of jobs are paid) and the lower quartile
(the point below which 25 per cent of the jobs are paid)
...
It is not possible to ensure a representative sample in all regions,
industrial sectors or job types and it is essential that the survey user is
aware of the areas where data are thin and can accordingly treat them
with caution
...
478 ᔡ Human Resource Management
2
...
3
...
Surveys are either conducted by a single company
approaching others on a reciprocal basis, or they are carried out by a
group of independent companies acting as a ‘salary survey club’
...
1
...
The aim is to
extract a derived market rate based on effective estimates of the reliability
of the data, and to strike a reasonable balance between the competing
merits of the different sources used
...
Once all the available data have been
collected and presented in the most accessible manner possible (ie job by
job for all the areas the structure is to cover), a proposed scale midpoint has
to be established for each level based on the place in the market the
company wishes to occupy, ie its ‘market posture’
...
1 Salary survey data presented graphically
Salary Surveys ᔡ 479
salary data but on indications of movements in earnings and the cost of
living, which are likely to affect the whole structure
...
480
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481
100
Grade and Pay Structures
DEFINITIONS
Grade structures
A grade structure consists of a sequence or hierarchy of grades, bands or
levels into which groups of jobs which are broadly comparable in size are
placed
...
Alternatively the structure
may be divided into a number of career or job families consisting of groups
of jobs where the essential nature and purpose of the work are similar but
the work is carried out at different levels
...
Pay structure
A pay structure defines the different levels of pay for jobs or groups of jobs
by reference to their relative internal value as determined by job evaluation, to external relativities as established by market rate surveys and,
sometimes, to negotiated rates for jobs
...
482 ᔡ Human Resource Management
TYPES OF GRADE AND PAY STRUCTURE
Narrow-graded structure
Narrow-graded structures consist of a sequence of job grades into which
jobs of broadly equivalent value are placed
...
Grades may be defined by a bracket of job evaluation points so that
any job for which the job evaluation score falls within the points bracket
for a grade would be allocated to that grade
...
Broad-graded structures
Broad-graded structures have six to nine grades rather than the 10 or more
grades contained in narrow-graded structures
...
Broad-banded structures
Broad-banded structures compress multi-graded structures into four or
five ‘bands’ each with, typically, a range of pay from 70 per cent to 100 per
cent of the minimum
...
Pay can be managed
more flexibly than in a conventional graded structure and more attention
is paid to market rate relativities
...
Career family structures
Career families consist of jobs in a function or occupation such as
marketing, operations, finance, IT, HR, administration or support services
which are related through the activities carried out and the basic
knowledge and skills required, but in which the levels of responsibility,
knowledge, skill or competence needed differ
...
They therefore define career paths – what people have to know and
be able to do to advance their career within a family and to develop career
opportunities in other families
...
1 Design of a new grade and pay structure
Conduct analysis
of market rates
484 ᔡ Human Resource Management
Table 100
...
Some families may have
more levels than others
...
The
main difference between job family and career family structures is that
each job family has in effect its own pay structure which takes account of
different levels of market rates between families (this is sometimes called
‘market grouping’)
...
FURTHER READING
e-research, Survey of grade and pay structures, e-reward, Stockport 2004
...
486
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487
101
Salary Control Systems
DEFINITION
Salary control systems ensure that the salary policies of the company are
implemented and that salary costs are kept within budget
...
TECHNIQUES
There are four techniques for monitoring salary costs and checking on the
stability and effectiveness of the salary system:
488 ᔡ Human Resource Management
1
...
3
...
salary budget;
attrition measurement;
compa-ratio;
salary audit
...
It is therefore based on human resource plans, present salary levels and
forecasts of additional costs arising from general or individual salary
reviews
...
1
...
1 Salary cost return
Category
of staff
Budget
for year
No
Cost
Budget
for period
No
Cost
Period
actual
No
Cost
Year
to date
No
Cost
Grades 3–2
Grades 7–4
Grades 12–8
Total
SALARY ATTRITION
Salary attrition takes place when entrants join on lower salaries than those
leaving so that salary costs over a period are likely to go down, given a
normal flow of starters and leavers and subject to the effect of general and
individual salary increases
...
It has been claimed that fixed incremental systems can be
entirely self-financing
...
But some amount of attrition of merit-increased costs is normal and
should be measured in order to assess actual costs and to forecast future
expenditure
...
Salary Control Systems ᔡ 489
COMPA-RATIO
A compa-ratio (short for comparative ratio) provides a measurement of
how far average salaries in a range differ from the target salary, defined as
the salary which should be earned by a fully competent individual in a job
...
If, typically, the target is the midpoint of the salary
range for a grade, the compa-ratio can be calculated as follows:
Average of all salaries in grade × 100
ᎏᎏᎏᎏᎏ
Midpoint of range
If the distribution of salaries is on target (ie the average salary is equal to
the midpoint), the compa-ratio will be 100
...
Conversely, if the ratio is below 100, the causes would probably be that
salaries are too low or that a large number of entrants on lower salaries
have affected the relationships
...
SALARY AUDIT
The salary system needs to be audited to check that:
1
...
the salary structure is not being eroded by grade drift (unjustifiable
upgradings) or because salaries for new starters or promoted staff are
fixed at too high a level;
3
...
salary progression policies are being implemented properly
...
Monitoring external relativities
Market rate surveys are conducted or analysed regularly and comparisons
made with salaries paid within the company to assess whether salaries are
490 ᔡ Human Resource Management
generally keeping pace with the market or whether any particular groups
of staff are out of line
...
1):
1
...
the salary policy line (the line joining together the target salaries for
each grade – usually the midpoint salary); and
3
...
Monitoring internal relativities
Internal relativities are monitored by carrying out periodical studies of the
differentials that exist vertically within departments or between categories
of staff
...
There is nothing sacrosanct about
the pattern of differentials
...
But it is desirable to
know what is happening so that action can be taken, if required and if
feasible, to restore the proper relationships
...
1 Analysis of salary structure policy and practice in relation to market rates
Salary Control Systems ᔡ 491
It may also be interesting to analyse key ratios, for instance between the
salary of the chief executive and the average earnings without overtime of
semi-skilled employees
...
Monitoring procedures
The following procedures are monitored to ensure that they are operating
in accordance with the company’s salary policies:
1
...
The audit should ensure that general increases are
not above the rate of inflation or the general level of market rate
increases, and that the amount they cost is what the company can
afford to pay
...
Individual salary reviews
...
3
...
The audit checks that regradings are justified by job evaluation and that the new salaries resulting from regradings or promotions
are in line with responsibility levels as indicated by the salary structure
...
4
...
The audit checks that salaries for new staff are in
line with policies on where jobs fit into the salary structure and how
much can be paid above the minimum to attract candidates
...
492
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493
102
Contingent Pay
DEFINITION
Contingent pay is the term used to describe schemes for providing
financial rewards that are related to individual performance, competence,
contribution or skill
...
Scope is provided for consolidated pay
progression within pay brackets attached to grades in a grade and pay
structure (see Chapter 99)
...
(See also Chapter 103
...
It is a method of paying people for the ability to perform now
and in the future
...
It focuses on what people in
organizations are there to do, that is, to contribute by their skill and efforts
to the achievement of the purpose of their organization or team
...
Rewards are related to the employee’s ability to apply a wider range or a
higher level of skills to different jobs or tasks
...
Analyse culture, strategy and existing processes including the grade
and pay structure, performance management and methods of
progressing pay or awarding cash bonuses
...
Set out aims which demonstrate how contingent pay will help to
achieve the organization’s strategic goals
...
Communicate aims to line managers staff and involve them in the
development of the scheme
...
Determine how the scheme will operate covering:
– the use of performance and competence measures;
– the performance management processes required;
– the scope for awarding cash bonuses as well as base pay increases;
– the approach to making decisions on awards;
– the amount of money that will be available for contribution pay, and
how that money should be distributed;
– the guidelines and procedures needed to govern contribution pay
reviews and ensure that they are carried out fairly and consistently
and within available budgets;
– the basis upon which the effectiveness of contingent pay will be
evaluated
...
Develop competence framework and role profiles
...
Develop or improve performance management processes covering the
Contingent Pay ᔡ 495
Table 102
...
7
...
8
...
9
...
10
...
FURTHER READING
Armstrong, M and Murlis, H, Reward Management (5th edition), Kogan Page,
London 2004
...
497
103
Performance-related Pay
DEFINITION
Performance-related pay (PRP) links reward or salary progression to some
form of performance rating
...
TYPES OF PERFORMANCE-RELATED PAY
SCHEMES
The main types of individual PRP schemes are variable salary progression,
variable increments and achievement bonuses
...
1
...
1 Variable salary progression
Some organizations simplify the system by having only three ratings
which indicate whether an individual should have an above-average,
average or below-average increase
...
There is much to be said
for this approach in that it does not label people and avoids asking
managers to make fine discriminations in what is essentially a subjective
process
...
The achievement of high
ratings can also provide for job-holders to be awarded extra increments on
top of their scale
...
They are sometimes the only variable element in pay, but
they can be used to recognize exceptional performance or as a means of
rewarding people who have reached the top of their salary scale when
they perform particularly well
...
Performance-related Pay ᔡ 499
CRITERIA FOR EFFECTIVENESS
Performance-related pay is more likely to work as a motivator if:
ᔢ it is appropriate to the type of work carried out and the people
employed on it and fits the culture of the organization;
ᔢ the reward is clearly and closely linked to the effort of the individual or
team;
ᔢ the reward follows as closely as possible the accomplishment which
generated it;
ᔢ employees are in a position to influence their performance by changing
their behaviour;
ᔢ they are clear about the targets and standards of performance required;
ᔢ they can track their performance against these targets and standards;
ᔢ fair and consistent means are available for measuring performance;
ᔢ the reward is clearly and closely linked and proportionate to the effort
of the individual or team;
ᔢ employees expect that effective performance (or specified behaviour)
will certainly lead to worthwhile rewards;
ᔢ the performance-related pay scheme operates by means of a defined
and easily understood formula;
ᔢ provisions are made in the scheme for amending the formula in specified circumstances;
ᔢ constraints are built into the scheme which ensure that employees cannot
receive inflated rewards which are not related to their own performance;
ᔢ the scheme is properly designed, installed and maintained; and
ᔢ employees covered by the scheme are involved in its development and
operation
...
These benefits are, however, dependent on the scheme meeting the
exacting criteria set out above
...
501
104
Payment by Results
DEFINITION
Payment by results systems relate the pay or part of the pay received by
individual workers or groups of workers to the number of items produced
or the time taken to do a certain amount of work
...
2
...
4
...
straight piecework;
differential piecework systems;
measured day work;
group incentive schemes;
factory-wide incentive schemes
...
This means
payment of a uniform price per unit of production and it is most appropriate where production is repetitive in character and can easily be divided
into similar units
...
In the case of money piecework,
the employee is paid a flat money price for each piece or operation
completed
...
502 ᔡ Human Resource Management
Workers are paid at their basic piecework rate for the time allowed, but if
they complete the job in less time, they gain the advantage of the time
saved, as they are still paid for the original time allowed
...
Piece rates may be determined by work study using the technique
known as effort rating to determine standard times for jobs
...
This often involves prolonged haggles with operators
...
The most familiar applications of this approach have been the
premium bonus systems such as the Halsey/Weir or Rowan schemes
...
Unlike straight
piecework, the wages cost per unit of production falls as output increases,
but the hourly rate of workers’ earnings still increases, although not in
proportion to the increased output
...
MEASURED DAY WORK
In measured day work the pay of the employee is fixed on the understanding that he or she will maintain a specific level of performance, but
the pay does not fluctuate in the short term with his or her performance
...
Fundamental to measured
day work is the concept of an incentive level of performance, and this
distinguishes it clearly from time rate systems
...
Payments by
results, on the other hand, allows employees discretion as to their effort
level but relates their pay directly to the output they have achieved
...
GROUP INCENTIVE SCHEMES
Group or area incentive schemes provide for the payment of a bonus
either equally or proportionately to individuals within a group or area
...
FACTORY-WIDE INCENTIVE SCHEMES
Factory-wide incentive or gainsharing schemes provide a bonus for all
factory workers which is related to an overall measure of performance
...
The basic
type of scheme links the bonus to output or added value (the value added
to the cost of raw materials and bought-in parts by the process of
production)
...
In their simplest form these schemes provide for a direct link between
the bonus and output or added value
...
BENEFITS
The benefits claimed for payment-by-results schemes are that people who
work primarily for money will work harder if they are paid more
...
But even if it is accepted, as it is by most people, that money is a prime
motivator, incentive schemes can only work if the following conditions are
fulfilled:
1
...
2
...
3
...
4
...
504 ᔡ Human Resource Management
From management’s point of view, the increases in effort arising from a
well-run scheme based on proper work measurement can be considerable
in the right circumstances (ie when the conditions listed above can be
met)
...
505
105
Systematic Training
DEFINITION
Systematic training is specifically designed to meet defined needs which
will be satisfied by improving and developing the knowledge, skills and
attitudes required by individuals to perform adequately a given task or
job
...
The identification and analysis of training needs
...
2
...
Training must aim to achieve measurable
goals expressed in terms of the improvements or changes expected in
corporate, functional, departmental or individual performance
...
The preparation of training plans
...
The overall scheme should further
provide for the development of training programmes and facilities, the
selection and use of appropriate training methods, the selection and
training of trainers, and the implementation of training plans, including
the maintenance of training records
...
The measurement and analysis of results
...
5
...
So that training
plans, programmes and techniques can be improved
...
1
...
These definitions indicate what training is but not how it can be
effective
...
The benefits that result from this approach are:
Figure 105
...
learning time is shortened and the costs of training and the losses
resulting from too lengthy a learning curve are reduced (the learning
curve is the time taken to reach an acceptable level of performance);
2
...
commitment to the job and identification with the company are
increased; and
4
...
FURTHER READING
Kenney, J and Reid, M, Training Interventions, Institute of Personnel
Management, London 1988
...
AIMS
The analysis of training needs aims to define the gap between what is
happening and what should happen
...
1)
...
1 The training gap
510 ᔡ Human Resource Management
ᔢ what people know and can do and what they should know and do; and
ᔢ what people actually do and what they should do
...
2
...
The
company human resource plan will also indicate the numbers and types of
people required in the future
...
Job analysis can be used to determine the
knowledge and skills required in specific jobs and this information can be
supplemented by analysing the results obtained from the assessment of
individual needs
...
BENEFITS
Training programmes are too often shots in the dark
...
The only way to ensure relevance is to carry out a systematic training
needs analysis exercise as an essential starting point in developing a
training programme
...
2 Training needs – areas and methods
511
107
Skills Analysis
DEFINITION
Skills analysis identifies what the worker needs to know and be able to do
to perform a job satisfactorily at experienced worker standard
...
This is used as the basis for the instruction given to trainees and for the
design of the overall training programme
...
It then sets
out the characteristics that the worker should have in order to perform
these tasks successfully
...
Knowledge – what the worker needs to know
...
2
...
Skills are built
512 ᔡ Human Resource Management
gradually by repeated training or other experience
...
3
...
TECHNIQUES
Skills analysis starts with job analysis, as described in Chapter 104
...
The specific techniques used in skills analysis are:
1
...
3
...
job breakdown;
manual skills analysis;
task analysis;
faults analysis
...
Method
A job breakdown analysis is recorded in a standard format of three
columns:
1
...
The different steps in the job are described – most
semi-skilled jobs can easily be broken down into their constituent
parts
...
The instruction column
...
This, in effect, describes what has to be learned by the
trainee
...
The key points column
...
Skills Analysis ᔡ 513
MANUAL SKILLS ANALYSIS
Definition
Manual skills analysis is a technique developed by W D Seymour from
work study
...
It is used to analyse short-cycle, repetitive
operations such as assembly tasks and other similar factory work
...
The analysis concentrates on the tricky parts of the job which, while
presenting no difficulty to the experienced operative, have to be analysed
in depth before they can be taught to trainees
...
Explanatory comments are added when necessary
...
It can be used for all types of jobs but is specifically relevant for clerical
tasks
...
The results of
the analysis are usually recorded in a standard format of four columns as
follows:
1
...
2
...
514 ᔡ Human Resource Management
3
...
4
...
FAULTS ANALYSIS
Definition
Faults analysis is the process of analysing the typical faults which occur
when performing a task, especially the more costly faults
...
Method
A study is made of the job and, by questioning workers and supervisors,
the most commonly occurring faults are identified
...
BENEFITS
Skills analysis is an essential element in systematic training
...
Skills analysis enables instruction to be based on the progressive part
method in which the trainee is taught and practises each part until it can
be done at target speed and at an acceptable level of quality
...
Then a third part is added
and so on, until the complete job has been learned
...
515
108
Training Techniques
DEFINITION
A training technique is a specific and systematic approach to imparting
knowledge or developing skills
...
ACTION LEARNING
Action learning, as developed by Professor Revans, is a method of helping
managers to develop their talents by exposing them to real problems
...
It accords with
the belief that managers learn best by doing rather than being taught
...
It recognizes
that the most perplexing task managers face is how to achieve change – how
to persuade their colleagues and others to commit themselves to a different
way of operating
...
The concept of action learning is based on five assumptions:
1
...
516 ᔡ Human Resource Management
2
...
However, it is possible to reduce the external
threat so that it no longer acts as a total barrier to learning about oneself
...
People only learn when they do something, and they learn more the
more responsible they feel the task to be
...
Learning is deepest when it involves the whole person – mind, values,
body, emotions
...
The learner knows better than anyone else what he or she has learned
...
COMPUTER-BASED TRAINING
Computers can be used for training in the following ways:
1
...
For
example, technicians can be trained in troubleshooting and repairing
electronic circuitry by looking at circuit diagrams displayed on the
screen and using a light pen to measure voltages at different points in
the circuit
...
2
...
3
...
4
...
5
...
The technique of adaptive
testing uses a program containing a large number of items designed to
test a trainee’s comprehension of certain principles
...
His or her
responses to a limited number of questions will show whether or not he
or she has grasped the appropriate concepts to satisfy given training
objectives
...
JOB INSTRUCTION
Job instruction techniques are based on skills analysis
...
Preparation
...
Training Techniques ᔡ 517
2
...
This consists of a combination of telling and showing
(demonstration)
...
Practice
...
The aims are to reach the target level of
performance for each element of the total task and to achieve the
smooth combination of these elements into a whole job pattern
...
Follow-up
...
518
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519
109
Total Loss Control
DEFINITION
Total loss control is a comprehensive programme of activities designed to
prevent personal injury and accidents and to minimize losses to a business
arising from damage or pollution
...
However,
although the technique as a whole is referred to as total loss control, it is
divided into two main areas: accident control and loss control
...
ACCIDENT CONTROL
An accident is an unintentional or unplanned happening that may or may
not result in property damage, personal injury, a work stoppage or interference, or a combination of those circumstances
...
Only in this way
can preventive measures be taken to avoid a recurrence
...
An accident control programme consists of the following steps:
1
...
Regular surveys of all work areas are made using checklists to
identify potential causes of injury or loss
...
Spot checks
...
3
...
These are set up to report on and analyse injuries (firstaid posts) or damage (maintenance units)
...
4
...
Strict rules are published and enforced on reporting
incidents
...
’
5
...
This is carried out initially by the foreman or supervisor
following a standardized procedure
...
6
...
The designated accident control officer recommends
remedial action to prevent potential accidents or to eliminate a hazard
...
Proactive advice
...
8
...
Foremen, supervisors and workpeople need specific
induction and continuous training in safety practices and methods of
preventing accidents
...
Education
...
10
...
The designated accident control officer continually follows
up to ensure that remedial action has been taken and that training and
education are effective
...
locate and define errors involving incomplete decision making, faulty
judgement, bad management or individual behaviour leading to incidents which result in loss of any kind to the business; and
2
...
Total Loss Control ᔡ 521
Methods
Loss control follows broadly the same procedures as accident control
except that it covers a wider variety of potential problem areas, ie not only
potential damage but any losses, direct or indirect, arising from accidental
damage or the standard processing methods used in the company
...
It
will also consider the losses that might arise from interruptions to
production in order to assess priorities in high potential-loss areas for
remedial work
...
2
...
4
...
implementation of these methods within the organization
...
The overriding benefit of a system of total loss control is
that it can produce significant reductions in losses and accidents if it is
introduced and maintained as a comprehensive programme with full
backing from the top and properly trained and qualified accident or loss
prevention officers
...
522
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Part 5
Management Science
524
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525
110
Operational Research
DEFINITION
Operational research (OR) has been defined by the Operational Research
Society of the United Kingdom as follows:
Operational research is the application of the methods of science to
complex problems arising in the direction and management of large
systems of men, machines, materials, and money in industry,
business, government, and defence
...
The purpose is to help management determine its policy
and actions scientifically
...
Decision theory
In one sense, all operational research is about decisions
...
The techniques available are:
1
...
means-end analysis to clarify a chain of objectives and identify a series
of decision points;
3
...
decision trees to assist in making decisions in uncertainty when there is
a series of either/or choices;
5
...
subjective probability techniques which aim to systemize the process of
making intuitive decisions or decisions based largely on personal experience; and
7
...
Modelling
Modelling is a representation of a real situation
...
Simulation
Simulation is the construction of mathematical models to represent reallife processes or situations as they develop over a period of time
...
One of the most commonly
used simulation techniques is the Monte Carlo method, which builds into
the system the chance elements that will affect outcomes
...
Operational Research ᔡ 527
Linear programming
Linear programming uses a mathematical approach to solving problems
where there are many intersecting variables and only limited resources are
available
...
Queuing theory
Queuing theory uses mathematical techniques to describe the features of
queues of people, materials, work-in-progress, etc in order to find the best
way to plan the sequence of events so that bottlenecks can be avoided (see
Chapter 115)
...
Decisions can then be made on
how to concentrate on the A items where the best results will be obtained
in relation to the effort expanded
...
Sensitivity analysis
Sensitivity analysis is a technique, also used frequently in management
accounting, to predict the impact on results (eg profits or contribution) of
varying the levels of the parameters which affect those results (see
Chapter 116)
...
Statistical techniques
Operational research, in its use of mathematics to assist in describing the
circumstances in which decisions are made, deploys statistical techniques
extensively
...
So are the
analysis of distributions of data and the study of the interrelationships or
correlations between interacting variables
...
ᔢ Distribution planning, using statistical analysis, linear programming,
simulations or algorithms to solve, with the aid of computers, standard
transportation problems of how to achieve the best and cheapest distribution pattern
...
ᔢ Forecasting, where models are developed to predict likely changes in
demand or the impact of alternative marketing approaches, including
new product development and changes in the marketing mix
...
ᔢ Long-range financial planning, where models are used to predict profit,
contribution and sales turnover figures
...
ᔢ Profit planning, where sensitivity analysis is used to predict the outcome
of alternative assumptions about demand, prices and costs
...
ᔢ Queuing problems, where queuing theory is used to plan sequences of
events in order to optimize service levels to customers and to minimize
bottlenecks
...
Operational Research ᔡ 529
OPERATIONAL RESEARCH METHOD
OR is based on a sequence of three key tasks:
1
...
2
...
This frequently requires a degree
of optimization, ie obtaining the best answer in the circumstances by
balancing the parameters and variables
...
Present proposals for action and assist in implementing decisions
...
Its ability to deal in a quantitative manner with conditions of uncertainty, bearing in mind Bertrand Russell’s dictum that ‘we are not able
to predict the future with complete certainty but equally we are not
entirely uncertain about the future’
...
Its use of objective methods to sort out in complex situations what information is relevant and what information from past experience has a
causal relationship with the situation being examined
...
Its capacity to illustrate the likely outcomes of alternative courses of
action based upon the information analysed (ie answering ‘what if’
questions)
...
The assistance it gives to managers in understanding the many interrelated factors affecting their decision
...
Its provision of various logical approaches to decision making in
complex situations
...
Its ability to handle masses of data with the help of the computer
...
Littlechild, S C (ed), Operational Research for Managers, Philip Allan,
Deddington 1977
...
Decision
theory analyses types of decisions, sets out ground rules for making decisions and develops decision making methods using various kinds of
models or procedures
...
Features
contained in any of these categories may be present in a single decision
...
532 ᔡ Management Science
Structure
Decisions may be either:
ᔢ structured and unambiguous in that they are well defined, the options
are clear and explicit, and evaluation criteria exist; or
ᔢ unstructured and ambiguous in that the circumstances in which the
decisions are being made are unclear, the reasons for making the decisions are ill-defined, the options available are not apparent, and criteria
for judging the outcome of the decisions are not readily available
...
These may be internal, arising from such factors as
complex technology or processes, a multiproduct production line or a
complicated distribution network
...
Degree of dependence and influence
Decisions may be more or less dependent on other decisions – past,
current or future
...
The extent to which they are dependent or
exert influence has to be taken into account and may increase the
complexity of the decision making process
...
Alternatively, they may be made in conditions of uncertainty, either
because the facts are not known or because the outcomes may be affected
by the unforeseeable results of human behaviour
...
(‘Stochastic’
simply means, as defined by the Oxford English Dictionary, ‘pertaining to
conjecture’, in other words, guesswork
...
opportunity decisions made voluntarily to exploit a chance to develop a
new product or enter a new market;
2
...
crisis decisions – major problems imposed on management often from
outside the company
...
DECISION RULES
The four basic decision rules are as follows:
1
...
Choose the option which yields the best possible outcome
(the maximax rule)
...
Pessimistic
...
3
...
What opportunity is forgone when one course of action
is chosen rather than another? This is sometimes called the regret rule
and has been formulated as ‘If we decide on one particular option, then,
with hindsight, how much would we regret not having chosen what
turns out to be the best option for a particular set of circumstances?’1
4
...
Choose the option in accordance with an estimate of the
likelihood of a particular situation occurring
...
These are considered below
...
Means–ends analysis
Means–ends analysis as described by Cooke and Slack1 is a method of clarifying a chain of objectives and thus identifying a series of decision points
...
In other words, one person’s means is another
person’s end
...
1
...
The form in which a decision matrix is constructed is shown in
Figure 111
...
Decision trees
Decisions are often made in conditions where there are a number of alternative courses of action and when the outcomes of these actions are
uncertain
...
Decision trees are a means of setting out problems of this kind, which
are characterized by the interaction between uncertainty and a series of
‘either/or’ decisions
...
Thus the
Decision Theory ᔡ 535
Figure 111
...
From Making Management Decisions, S Cooke and
N Slack, Prentice-Hall International, London 1984
consequences of future decisions can be traced back to assess their
influence on the present decision
...
list decisions and uncertainties in chronological order;
2
...
3 (an example is shown in Figure 111
...
assign costs, benefits or probabilities to appropriate branches; and
4
...
Figure 111
...
3 Decision tree structure
pm
Pilot productio
dev
elo
n
ssf
ul
oduction
Full-scale pr
Sh
cce
elv
ep
Su
roj
ect
(6
No competition
Competitor
introduces
similar product
mo
nth
s)
De
vel
o
wo
rk
Competitor
introduces
similar product
pm
pm
ent
ent
fai
l
s
De
vel
o
No competition
Competitor
introduces
similar product
Ab
and
on
No similar product
introduced
pro
jec
t
Competitor
active
Competitors not active
= Decision node
= Choice node
Figure 111
...
From International Dictionary of Management,
fourth edition, H Johannsen and G T Page, Kogan Page, London 1990
Decision Theory ᔡ 537
Algorithms
Algorithms contain a logical sequence of deductions for problem solving
...
Illustrations of an instructional and an analytical
type of algorithm are given in Figures 111
...
6 respectively
...
The subjective
perception of the likelihood of an event occurring and the allocation to it of
a probability figure (eg there is a 70 per cent chance that x will happen) is
known as subjective probability, and is an expression of the degree of
belief in an event happening
...
People tend to overestimate the occurrence of events with low probability and underestimate the occurrence of events with high probability
...
People tend to adopt the gambler’s fallacy of predicting that an event
that has not occurred for a while is more likely to occur in the near
future
...
People tend to overestimate the true probability of events that are
favourable to them and underestimate those that are unfavourable
...
Bayesian analysis
Bayesian statistical analysis aims to translate subjective forecasts into
mathematical probability curves in situations where there are no normal
538 ᔡ Management Science
Figure 111
...
From International Dictionary of
Management, H Johannsen and G T Page, Kogan Page, London 1986
Figure 111
...
From International Dictionary of
Management, fourth edition, H Johannsen and G T Page, Kogan Page, London 1990
Decision Theory ᔡ 539
statistical probabilities because alternatives are unknown or have not been
tried before
...
They enable revisions to be made to
probabilities after further information becomes available
...
However,
although Bayesian statistics can lead to spurious accuracy, like any manipulation of subjective probabilities, they do provide a useful logical
structure in making probability revisions as more is learned about the
assumptions built into the decision
...
The analytical approach ensures that the danger
of superficial judgements is minimized and that the alternatives available
are properly evaluated
...
Cooke, S and Slack, N, Making Management Decisions, Prentice-Hall,
London 1984
...
Lindsay, P, and Norman, D, Human Information Processing, Academic
Press, London 1977
...
It depicts interrelationships
between the relevant factors in that situation and, by structuring and
formalizing any information about those factors, presents reality in a
simplified form
...
increase the decision maker’s understanding of the situation in which a
decision has to be made and the possible outcomes of that decision;
2
...
evaluate alternative courses of action
...
concrete or abstract – scales exist which define the degree of correspondence with reality that a model possesses, ranging from a replication of
542 ᔡ Management Science
the original process to a completely synthetic extraction of essential
elements of the original situation;
2
...
deterministic or stochastic – deterministic models use single estimates to
represent the value of each variable, while stochastic models show
ranges of values for variables in the form of probability distributions;
and
4
...
THE PROCESS OF MODELLING
The steps followed in developing a model are as follows:
1
...
Consider whether the purpose of the model is to:
ᔢ provide optimal solutions to the problem (linear programming and
decision trees come into this category); or
ᔢ provide satisfactory or workable solutions to the problem (corporate
models, queuing theory, stock control simulations and heuristic
models do this – a heuristic model adopts short cuts in the reasoning
and uses rules of thumb or a form of trial and error in its search for a
satisfactory solution)
...
Describe in general terms the situation that the model is meant to
represent and the factors or variables that impinge on that situation
...
A typical situation will be a
long-range profit forecast, and the factors will be the production,
marketing and financial resources of the company and the broad
strategies developed for their future
...
Classify the variables, which may be exogenous or endogenous
...
They can be either controllable or uncontrollable
...
5
...
The rate of interest, for example, may be taken as a
constant
...
Analyse the interactions to determine the influence of one factor on
another and therefore the cause-and-effect relationship
...
An example of a causeeffect model is shown in Figure 112
...
7
...
Computers are
used when the model becomes too complex to be used manually
...
Order
frequency
Organizing
cost of
ordering
Order
quantity
Total
ordering
cost
Cost of
capital
Average
stock
level
Reorder
level
Maximum
stock
level
Cash in
stock
Cost of
storage
Demand
rate
Supply
lead
time
Probability
of stockout
Figure 112
...
From Making Management
Decisions, S Cooke and N Slack, Prentice-Hall International, London 1984
544 ᔡ Management Science
SELECTING A MODELLING SYSTEM
When selecting a modelling system the following factors are considered:
1
...
Is the language and command structure easily understood by a nonspecialized user?
3
...
What are the processing costs?
5
...
APPLICATIONS
Typical modelling applications include:
ᔢ budgetary planning models which forecast out-turns, help to allocate
resources, determine the optimal product mix and indicate the sensitivity of the budget to changes in key variables during the planning
period, eg the impact of varying rates of inflation, or changes in
working capital and cash flow;
ᔢ transport and distribution models aimed at increasing the profitability
of fleet operations and the scope for economics by better routeing and
scheduling techniques;
ᔢ production planning models to allocate production to departments and
production lines in a way which will maximize throughput, reduce
delays and minimize manufacturing, distribution and inventory
holding costs; and
ᔢ resource allocation models to plan future machine loading and workforce requirements;
ᔢ inventory models to optimize stock holding and define minimum
safety stock and reorder stock levels
...
Clarification of all the issues, factors and variables surrounding a
decision
...
The improvement of decision making by providing information on
alternatives and outcomes
...
The scope to ask ‘what if’ questions and therefore to evaluate different
opportunities
...
Bringing data and decision rules into the open so that assumptions can
be questioned
...
Shortening planning cycles by removing much of the manual calculation
...
Improving the accuracy of forecasts by using the power of the
computer
...
Cooke, S and Slack, N, Making Management Decisions, Prentice-Hall,
London 1984
...
546
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547
113
Simulation
DEFINITION
Simulation is the construction of mathematical models to represent the
operation of real-life processes or situations
...
Ackott and Sasieni1 have defined the distinction between modelling and
simulation as follows: ‘Models represent reality, simulation imitates it
...
’
The distinction between simulation and queuing theory is defined at the
end of Chapter 115
...
It usually relies on a statement of procedure which underlies
the logical relationship between variables
...
The
model is then used to execute the procedure described in the flow chart,
and thus the behaviour of the system which is being modelled is simulated
...
548 ᔡ Management Science
Because in the real situation events are often triggered off by random or
chance influences, simulation sometimes uses techniques such as the socalled Monte Carlo method to represent this random process
...
stochastic digital simulation, usually called the Monte Carlo method,
because early applications used roulette wheels to simulate the chance
events inherent in this approach;
2
...
deterministic simulation – a method used to test a series of decision
rules whose effects cannot be found out easily; single estimates
represent the value of each variable in the decision
...
An
example of such a flow chart is shown in Figure 113
...
The Monte Carlo
technique is used when the flow of inputs into the system has random
characteristics, although the random nature of these inputs may follow
some form of pattern
...
For example:
ᔢ in a stock control system like the one illustrated in Figure 113
...
Previous
records are examined to show the frequency distributions of these
inputs
...
It will be possible to establish
from records the average inter-arrival time and also the distribution of
times
...
These
random arrivals within the overall pattern can be simulated by using
random numbers
...
1 Flow chart describing the procedural logic involved in simulating stock
behaviour
...
The characteristics of such a series are that over a large set the
digits 0 to 9 should occur with equal frequency
...
Random numbers are
allocated in proportion to the frequency in the distribution as established
by records of past experience
...
In the examples given above these events would be
either daily deliveries and lead times or the inter-arrival time of ships
...
It simulates the interactions between the flows of information,
money, orders, personnel and capital equipment in a company, an
industry or a national economy
...
A
decision is made which leads to action, but there is a time-lag or delay
between the decision to act and the act itself
...
The results are then fed back to the decision
maker as information on which to base a further decision, and so on
...
The system will have properties which are quite
distinct from the elements which compose it
...
In essence, systems dynamics is a method of simulating certain kinds of
total complex situations such as a complete production distribution
system
...
Deterministic simulation
Deterministic simulation is used to clarify the decisions required in situations such as the accurate calculation of the resources needed to achieve a
given throughput time and output with a known level of input
...
Deterministic simulation excludes the uncertainty present in everyday life
for the sake of convenience, clarity or tractability
...
A flow chart showing the main stages of the programme drawn up
is shown in a simplified version in Figure 113
...
Figure 113
...
From A Guide to Operational Research, W E
Duckworth, A E Gear and A G Lockett, Chapman & Hall, London 1977
552 ᔡ Management Science
A computer working according to predetermined decision rules, such as
the priorities for allocating people and jobs to machines, simulated alternative loadings and the effect on queues, and throughput time
...
BENEFITS
Simulation enables the likely effects of many decisions in complex situations to be estimated so that harmful consequences can be avoided and
more beneficial methods introduced
...
Ackott, R L and Sasieni, M W, Fundamentals of Operational Research,
Wiley, New York 1986
...
Forrester, J, Industrial Dynamics, Wiley, New York 1961
...
Pidd, M, ‘Computer simulation models,’ in Operational Research for
Managers, Littlechild, S G (ed), Philip Allan, Deddington 1977
...
Duckworth, W E, Gear, A E and Lockett, A G, A Guide to Operational
Research, Chapman & Hall, London 1977
...
It is a decision
model under conditions of certainty where constraints affect the allocation
of resources among competing uses
...
THE BASIC TECHNIQUE
The aim of linear programming is to find the specific combination of variables that satisfies all constraints and achieves the objectives sought
...
A linear
equation is simply x + 3 = 9
...
Linear
programming:
ᔢ constructs a set of simultaneous linear equations, which represent the
model of the problem and which include many variables; and
ᔢ solves the equations with the help of a digital computer
...
The computer does the rest
...
THE LINEAR PROGRAMMING METHOD
The linear programming approach can be divided into four steps:
1
...
This is usually to
maximize profit or minimize cost
...
Determine the basic relationships (particularly the constraints)
...
3
...
If the simplex method is used (the most
common approach), a step-by-step process is followed
...
4
...
The simplex method goes on substituting
feasible solutions until further improvement is impossible, given the
constraints
...
APPLICATIONS
Linear programming can be used to provide solutions to problems such as
the following:
1
...
The solution to a production planning problem may
contain decisions on the production levels at each plant, the machine
capacity required, stock levels, raw material inputs and transportation
resources
...
Product mix decisions where the objective is to determine the combination of products which maximizes the total contribution towards
fixed costs and profit
...
The constraints will include
production capacity and the level of demand expected for each product
at different prices
...
This is not simply a matter of comparing
margins per unit of product and assuming that the production of the
product with the greatest margin per unit should be maximized
...
3
...
4
...
5
...
BENEFITS
Linear programming can help to produce optimal decisions where there
are a number of predictable variables and constraints
...
Linear programming is a good technique for combining materials, labour
and facilities to best advantage when all the relationships are linear, where
outcomes are known with certainty and where many combinations are
possible
...
USES
Queuing theory deals with problems such as congestion in telephone
systems, airports and harbours, machines out of action waiting for repair or
materials (machine interference problems) and the design of production
schedules
...
The arrival of items or customers
...
Such arrival patterns are described by means of probability
distributions
...
558 ᔡ Management Science
2
...
Items or customers may be dealt with strictly in turn and
service may be on a first-in first-out (FIFO) basis, a last-in first-out (LIFO)
basis, or on a random basis
...
Constraints in the system may limit queue size
...
Service mechanism
...
Speed of operation may vary
or be constant
...
Optimization means minimizing delays, and therefore queues, while
still operating at an acceptable level of costs
...
SOLVING QUEUING PROBLEMS
The basic information required to solve a queuing problem is traffic
intensity
...
Traffic intensity is denoted by the Greek symbol
...
Thus a frequency distribution is built up and calculations are
made of the mean or average arrival rate and the variance or standard
deviation of that rate
...
Queuing problems arise when jobs or customers arrive at random so
that the probability of an arrival in a particular interval of time depends on
the length of the interval and not on the time of day or the number of
previous arrivals
...
This describes the occurrence of isolated
events in a continuum
...
(For a full description of this graph
paper, refer to M J Moroney, Facts from Figures, Penguin, pp
...
2)
In a Poisson probability distribution, the number of items or users is
very large and the chance of any one item occurring or any request origi-
Queuing Theory ᔡ 559
nating from a particular individual is small
...
An example of Poisson distribution is that of telephone subscribers using
long-distance lines
...
Yet there are a large number of subscribers to any exchange, so the
average number of long distance calls over the same short period may be
considerable
...
A property of this function is that the probability of arrivals
happening at a particular time is not related to the time already elapsed
since the previous arrival
...
This was a reasonable assumption, since there
was a large number of customers acting independently of each other,
as long as the grade of service achieved was good enough to ensure
few repeated calls
...
Figure 115
...
The histogram was drawn from
data on call durations taken at an off-peak time
...
At peak times the exponential fit is not so good, but there
is still a long tail to the distribution and the average call duration is
not significantly different
...
Grades
of service (ie the proportion of calls which are lost) and waiting time (ie the
length of time callers are kept waiting) were then assessed
...
The costs of providing service and of queuing can then be added to
produce the total cost, which can be recalculated for various values of the
average service time so that a decision can be made on the optimum
service arrangements
...
2
...
1 Histogram showing number of calls of a given length at half-minute
intervals
...
322 minutes
...
There is a limit, however, to the extent to which queuing theory can deal
with highly complex problems in dynamic situations with many variables
...
Littlechild has explained succinctly that:1
The difference between simulation and queuing theory is that the
former involves the repeated trial of a particular system, under
different patterns of customer arrivals or service performance, until
Queuing Theory ᔡ 561
Figure 115
...
Queuing theory gives an explicit picture, generally in the form of a
mathematical function or graph, relating behaviour to certain system
parameters
...
Simulation allows
one to test out ideas for different system designs but does not, of
itself, lead to a ‘best’ design
...
REFERENCES
1
...
2
...
562
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563
116
Sensitivity Analysis
DEFINITION
Sensitivity analysis is the study of the key assumptions or calculations on
which a management decision is based in order to predict alternative
outcomes of that decision if different assumptions are adopted
...
METHOD
1
...
For example, when estimating the
likely profitability of a project the factors may be market growth rate,
market share, selling price, and the costs of direct labour and direct
materials
...
Attach the most likely values to each of these parameters, and from
these predict the most likely level of profits
...
Calculate the effect of varying the values of all or a selected few of these
parameters
...
Different incidences of variation between the values may be calculated if appropriate
...
List the outcomes of the alternative assumptions and make a subjective
assessment of their likelihood
...
Draw conclusions on any actions required which would make the
achievement of the better outcomes more likely
...
1
...
Table 116
...
This process may involve challenging the original assumptions and could
result in a rethink about the project
...
In
presenting a range of possible outcomes, sensitivity analysis facilitates the
development of alternative or contingency plans if the basic assumptions
have to be changed
...
In the words of Stafford Beer:1 ‘Cybernetic
systems are complex, interacting, probabilistic networks
...
’
BASIC PRINCIPLES
Cybernetics involves three control principles: the most basic are erroractuated feedback and homeostasis; the third is that of the Black Box
...
Feedback systems may only
operate effectively if overcorrection is avoided by making the correction
somewhat less than the error
...
The homeostatic mechanism is one that itself responds to the
error-actuated feedback instead of relying on an outside agent
...
In macro terms, the economic system of a
country is a Black Box
...
But it
may not matter too much
...
If this is achieved satisfactorily, it may be a futile exercise to try to
find out precisely what is going on
...
APPLICATIONS
Cybernetics can be applied to the design of manufacturing processes
...
Some
of these can automatically initiate corrections on the principle of homeostasis
...
Cybernetics applied to management ensures that feedback on
performance is available so that corrections can be made
...
The Black Box principle can be used to control systems that are highly
complex
...
The
operations in the tool room were so complex that three or four clerks
would be required to record all the necessary information
...
Without worrying too much about what
precisely was happening inside the tool room, it was possible to schedule
Cybernetics ᔡ 567
work to it on the basis of an output of 40 jobs and keep production flowing
smoothly and economically
...
Beer, S, Cybernetics and Management, EUP, London 1959
...
Duckworth, W E, Gear, A E and Lockett, A G, A Guide to Operational
Research, Chapman & Hall, London 1977
...
It
achieves this aim by analysing the component parts of a project and
assessing the sequential relationships between each event
...
BASIC TECHNIQUE
Networks are built up from the following basic elements:
1
...
2
...
3
...
The basic sequence shown in a network is illustrated in Figure 118
...
572 ᔡ Planning and Resource Allocation
1
2
Figure 118
...
No dangling activities
...
They must not be allowed to appear in isolation, as in Figure 118
...
1
2
4
3
Figure 118
...
Either it is not a real part of the project or it must
be linked directly to 4 with an activity which does not consume time or
resources
...
3
...
3 A dummy activity introduced to avoid a dangling activity
2
...
This is illustrated in Figure
118
...
There are three routes from 1 to 6
...
The
second also lies directly from 1 through events 4 and 5
...
The broken line from 4 to
3 is the third route, a dummy activity for which no time or resources are
Network Analysis ᔡ 573
Figure 118
...
3
...
5, because this leads to confusion
...
6
...
5 Incorrectly drawn parallel activities
Figure 118
...
Closed loops are not allowed
...
A situation like the one shown in Figure 118
...
574 ᔡ Planning and Resource Allocation
Figure 118
...
Preceding and succeeding activities
...
This is illustrated in Figure 118
...
If the start of 3 to 5 depends on the completion of 2 to 3 and not
1 to 3 as well, then an additional event (6) and a dummy activity (3 to 6)
are needed, as shown in Figure 118
...
Figure 118
...
9 Use of a dummy activity to clarify the sequence of events between preceding
and succeeding activities
Network Analysis ᔡ 575
THE COMPLETE NETWORK
An example of a complete network is shown in Figure 118
...
This
network follows the convention of treating time as increasing from left to
right
...
Figure 118
...
ᔢ Activities 2 to 6, 3 to 5, 4 to 7 cannot start until, respectively, activities 1 to
2, 1 to 3 and 1 to 4 have been completed
...
ᔢ Activities 6 to 9 and 7 to 8 cannot start until, respectively, activities 2 to 6
and 4 to 7 have been completed
...
TECHNIQUES
When the network has been drawn, it is used as the basis for timing the
duration of each activity in order to determine the duration of the whole
project
...
The main network analysis techniques are:
576 ᔡ Planning and Resource Allocation
1
...
3
...
critical path method;
programme, evaluation and review technique (PERT);
activity-on-node or precedence networks;
resource allocation
...
It starts with a time analysis of the duration of each activity
...
This process is illustrated in Figure
118
...
1:5
4:8
3
2
6
2
1
0:0
3:5
1
3
3
4:7
1
8:8
5
8
1
3
4
2
9
1
4:4
4
10:10
7:7
3
7
Figure 118
...
The estimated time for each activity is entered against the activity
arrow
...
11 activity 1 to 2 takes one week and
activity 3 to 8 takes three weeks
...
The earliest completion times for each activity are obtained by taking
each path and adding the times of all the activities that form that path
from left to right along the network
...
4
...
6
...
For example, the earliest time to reach
event 6 is the time for activity 1 to 2 (one week) plus the time for activity
2 to 6 (three weeks), making four weeks in all
...
For example, event 8 can be reached via
activities 1 to 3, 3 to 5 and 5 to 8 making a total of five weeks
...
But the longest path is formed by activities 1 to 4, 4 to 7 and 7 to
8, and following this route will delay the earliest possible completion
time to eight weeks, which is the figure entered above the node for
event 8
...
In the example, this is 10 weeks, which is the sum of the
times for activities 1 to 4, 4 to 7, 7 to 8 and 8 to 9, ie 4 + 3 + 1 + 2 = 10
...
In the example, the
activities listed in step 3 (1 to 4, 4 to 7, 7 to 8 and 8 to 9) are the critical
activities and the critical path they form is denoted by a double bar on
the network
...
The latest time of the end event is
equal to the critical time for the project, in this example 10 weeks
...
This is entered as the right-hand figure
above the node alongside the figure for the earliest completion time
...
The first, via
event 5 takes two weeks which, if this were the only route, would result
in the latest start time for event 3 being six weeks, ie 8 – 2
...
The ‘float’ time, which is the extra time that can be taken over an activity
without delaying the start of another activity, is calculated by deducting
at each event the earliest start time from the latest start time
...
11, there is four weeks’ float available to
complete activity 1 to 2 (5 – 1)
...
Uses
The critical path method is used to determine:
578 ᔡ Planning and Resource Allocation
ᔢ The latest start times for each activity
...
The total float
will be the maximum increase in activity duration which can occur
without increasing the project duration
...
ᔢ The critical activities along the critical path where there is no float and
where any delay in carrying them out will delay the project
...
Pert
The programme evaluation and review technique (PERT) considers
activity durations in the network as uncertain
...
PERT is frequently used in construction projects where jobs may be
delayed by unfavourable weather, etc
...
Activity-on-node
Activity-on-node or precedence networks provide an alternative notation
to the arrow diagram
...
Its format is shown in Figure 118
...
When two or more arrows terminate at an activity, all must be followed
before the activity can begin
...
No dummy activities are required in precedence networks, but it is not
so easy to draw them against a timescale
...
Network Analysis ᔡ 579
Figure 118
...
The number of people
needed for each activity is sometimes entered on the network alongside
the time estimate
...
This visual picture forms the basis for any
rescheduling of the programme which is needed, if possible within the
critical time, to maintain a steady level of resource usage and to contain
resource requirements within presented limits
...
Bar charts can
be used successfully to show the starting and finishing times of different
activities but they do not reveal dependencies and they cannot highlight
the critical activities or the leeways allowed in completing non-critical
activities (float) as the critical path or PERT can
...
Lockyer, K G, Critical Path Analysis, Pitman, London 1991
...
METHOD
The five stages required in the line of balance technique are:
1
...
3
...
5
...
These stages are illustrated in the simplified example that follows
...
OPERATION PROGRAMME
The operation programme shows the ‘lead time’ of each operation, ie the
length of time prior to the completion of the final operation by which
582 ᔡ Planning and Resource Allocation
intermediate operations must be completed
...
1 illustrates an
operation programme chart
...
The programme shows that purchased
part A must be combined with item B in operation 4 three days before
completion
...
The
longest lead time is 10 days, which is when the purchased part for item B
must be available
...
1 Operation programme
STAGE 2
...
1
...
1 Completion schedule
Week no
0
1
2
3
4
5
Completed items
0
5
10
10
10
15
Cumulative items
0
5
15
25
35
50
Line of Balance ᔡ 583
The completion schedule can be shown graphically, as in Figure 119
...
50
40
Schedule
Actual
30
Cumulative
completions
20
10
0
1
2
3
4
5
Week number
Figure 119
...
CONSTRUCT LINE OF BALANCE
Progress review week (No
...
It
can be prepared analytically or graphically, as illustrated in Figure 119
...
50
40
30
Cumulative
completions
20
B
50
A
F
Cumulative completions
40
30
E
Op
...
2
10
20
H
10
D
G
C
Op
...
3 Construction of a line of balance
5
584 ᔡ Planning and Resource Allocation
The steps required to construct the line of balance graphically are as
follows:
1
...
3)
...
Draw a vertical line on the completion schedule at the week in which
the review is to take place (B)
...
Show by means of a vertical bar on the line of balance schedule (the
right-hand graph) how many items have been completed for delivery
(operation 5) by the review week (week 2)
...
4
...
This will be the total of not only the requirements for the completed item by the two-week review date but also the
number to be completed in the lead time for that operation
...
3 this is line D, which adds the lead time of
10 days for operation 1 to the two-week review period;
(b) extending a vertical line from that point to cut the completion
schedule line, thus showing how many items of this operation
should be completed (E);
(c) extending a horizontal line from this point towards the line of
balance schedule to the point above the appropriate operation
number (F);
(d) drawing a vertical bar from the operation number on the line of
balance schedule to the line drawn at step 4(c) (G); and
(e) joining the tops of the bars for each operation drawn up at step 4(d)
to produce the line of balance (H)
...
PROGRAMME PROGRESS CHART
The programme progress chart for a review week (week 2 in this example)
is illustrated in Figure 119
...
This graphs the numbers of items produced at
each item against the line of balance, thereby indicating clearly any shortfalls or overproduction
...
4 Programme progress chart
STAGE 5
...
This
example reveals that while the delivery of the item is on schedule, there is
a shortfall on the conversion operation, number 4
...
Steps will have to be taken to
increase output at the conversion stage and to expedite delivery of the
bought-in part
...
In complex operations, the line of balance calculations can be performed
by a computer, which will also generate control reports
...
It prevents any
feeling of false security which might be engendered if the delivery of an
item is on schedule but unappreciated shortfalls at early stages are building
up trouble
...
586 ᔡ Planning and Resource Allocation
FURTHER READING
Wild, R, Production and Operations Management, Holt, Rinehart & Winston,
Eastbourne 1984, pp
...
587
Part 7
Efficiency and
Effectiveness
588
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589
120
Balanced Scorecard
DEFINITION
The balanced scorecard was defined by Kaplan and Norton, who introduced the concept as follows:
The Balanced Scorecard (BSC) translates an organization’s mission and
strategy into a comprehensive set of performance measures that
provides the framework for a strategic measurement and management
system
...
AIM
As described by Kaplan and Norton, the balanced scorecard enables
companies to track short-term financial results while simultaneously
monitoring their progress in building the capabilities and acquiring the
intangible assets that generate growth for future financial performance
...
This replaces the focus on financial
indicators alone, which could lead to short-term decisions, overinvestment in easily valued assets through mergers and acquisitions with
readily measurable returns, and underinvestment in intangible assets,
such as produce and process innovation, employee skills and motivation
or customer satisfaction, whose short-term returns are difficult to measure
...
It can
and should be used as a fundamental approach to managing a business by
ensuring that strategic goals in key performance areas are defined and
communicated to all employees
...
METHODOLOGY
The steps required to introduce and operate a balanced scorecard approach
are listed below
...
The elements usually include
financial, process and customer factors
...
In the retail network of Halifax plc the four areas are:
ᔢ
ᔢ
ᔢ
ᔢ
how people are managed;
how internal processes are managed;
levels of customer service;
business performance (sales)
...
Identify performance drivers
The second step is to identify the performance drivers for each of the categories – for example, repeating and expanding sales from existing
customers, the internal processes at which the company must excel, the
needs and wants of customers and the particular people skills the organization needs now and in the future
...
For example, high levels of customer service
in defined areas will lead to better financial performance; customer service
levels can be improved by attention to processes such as on-time delivery,
and customer care will be enhanced if the right people are selected and
given the training to develop the necessary skills
...
In some areas such as finance and customer service it
may be quite easy to determine quantitative measures such as sales or
levels of service as assessed by surveys, questionnaires and mystery
shopping
...
Communicate
This fourth step is to communicate to all employees what the balanced
scorecard is, why it is important, how it will work, the part they will be
expected to play and how they and the organization will benefit from it
...
This means developing
policies, procedures and processes that ensure that it is applied at all levels
in the organization – strategically at the top, tactically in the middle – and
as a matter of continuing importance so far as working practices are
concerned to all employees
...
At an individual level, performance management
processes may be based on the four elements of the scorecard
...
Train
The sixth step is to provide training for everyone in the organization on
the operation of the balanced scorecard and on what, on their different
levels, they are expected to do about managing and implementing the
process
...
A review can
then take place to decide on where improvements or amendments need to
be made and how they will take place
...
REFERENCE
Kaplan, R S and Norton, D P, ‘The balanced scorecard – measures that
drive performance’, Harvard Business Review, January–February 1992, pp
71–79
...
AIM
The aim of benchmarking is to improve the performance of the organization by incorporating appropriate best practice into existing procedures
and practices, and by identifying areas where performance is inadequate
compared with other organizations so that corrective action can be taken
...
When comparing policies, practices and procedures it is essential to
establish the extent to which they can be transferred in their present or a
modified form
...
Something that works well in one organization may
not work well in another because of differences in such areas as organizational culture and structure, management style, technology and customer
base
...
Even if the best ingredients are taken from a number of different
sources, the real skill lies in knowing how to mix the ingredients properly
...
BENEFITS
Benchmarking ensures that organizations are aware of best practice elsewhere and/or know how well they are doing in comparison with other
similar firms
...
595
122
Business Process
Re-engineering
Business process re-engineering is concerned with the systematic
analysis and redesign of business processes in order to achieve significant improvement in performance in terms of quality, service, speed
and cost
...
It can involve
fundamental rethinking, radical streamlining or the total redesign of a
process from its beginning within the organization to its end with the
customer
...
Typical
processes are fulfilling a customer order, issuing a new insurance policy,
developing a new product and setting up a new retail outlet
...
AIMS
The overall aims of business process re-engineering is to streamline and
link together business processes so that business performance is improved
...
METHODOLOGY
The steps required in a business process re-engineering exercise are to:
1
...
3
...
5
...
7
...
9
...
Select the process to be re-engineered
...
Select and brief the process re-engineering team
...
The analysis may use the ‘what–how–when–where–why?’
Diagnose problems and issues, again in conjunction with staff
...
Redesign the process, setting out the sequence involved, the activities carried out and the roles of those involved in introducing and
managing the new process
...
It is essential at this stage to identify any problems that
might arise for the people concerned because their roles will change
or because new skills will be required
...
Plan the actions required to implement the new process, recognizing
that this is a change management issue and that steps must be taken to
communicate to and involve the staff affected and to provide help and
training
...
Monitor the implementation and amend or improve arrangements as
required
...
It can, however, be difficult to manage
Business Process Re-engineering ᔡ 597
effectively and it will fail if it does not take account of the people implications, including the opinions and feelings of those concerned
...
Hammer, P and Champy, J, Re-engineering the Corporation, Harper
Business, Oxford 1993
...
The
object is to reveal factors and trends affecting performance so that action
can be taken
...
2
...
4
...
6
...
8
...
PROFITABILITY
The profitability ratios are as follows:
600 ᔡ Efficiency and Effectiveness
1
...
Return on capital employed
Trading or operating profit
Total assets (fixed assets and current assets)
or
Trading or operating profit
Net total assets (fixed and current assets − current liabilities)
3
...
Price/earnings (P/E) ratio
Market price of ordinary shares
Earnings per share
5
...
PERFORMANCE
The main performance ratios are as follows:
1
...
Asset turnover ratio
Total sales
ᎏᎏ
Assets
These two ratios are discussed in Chapter 62
...
Sales
ᎏᎏ which is subdivided into:
Fixed assets
(a)
(b)
Sales
ᎏᎏᎏ
Plant and machinery
(c)
2
...
Production cost of sales
ᎏᎏᎏ
Sales
× 100 which is subdivided into:
602 ᔡ Efficiency and Effectiveness
(a)
Cost of materials
ᎏᎏᎏ
Sales value of production
× 100
(b)
Works labour cost
ᎏᎏᎏ
Sales value of production
× 100
(c)
Other production costs
ᎏᎏᎏ
Sales value of production
× 100
2
...
Administration costs
ᎏᎏᎏ
Sales
4
...
The formula is:
Production costs
ᎏᎏ
Output in units
The relationships between the profitability, performance and cost ratios
referred to above are shown in Figure 123
...
LIQUIDITY
The two main liquidity ratios, which establish that the company has sufficient cash resources to meet its obligations, are as follows:
1
...
The quick ratio (acid-test ratio)
Current assets minus stocks
ᎏᎏᎏᎏ
Current liabilities
Ratio Analysis ᔡ 603
Figure 123
...
Long-term debt to equity ratio (the gearing ratio)
Long-term loans plus preference shares
ᎏᎏᎏᎏᎏ × 100
Ordinary shareholders’ funds
2
...
Total debt to total assets ratio
Long-term loans plus short-term loans
ᎏᎏᎏᎏᎏ
Total assets
The liquidity and capital structure ratios referred to above are examined in
more detail in Chapter 61
...
The main risk ratios are as follows:
1
...
Interest cover ratios focus attention on the relationship
between interest payment liabilities and the profits or cash flow
available for making these payments, thus providing an alternative way
of analysing gearing
...
Interest cover ratios exist in two forms:
(a)
Profit before interest and tax
ᎏᎏᎏᎏ
Gross interest payable
(b)
Cash-flow operations before interest and tax
ᎏᎏᎏᎏᎏ
Gross interest payable
Profit provides the overall measure of ability to pay, but as interest has to
be paid out of cash, the cash-flow ratio is perhaps more significant
...
It depends
on the circumstances of the company, although any company would be in
a really bad way if it could not cover interest by profits or even cash
...
For
profits, a two times cover is fairly satisfactory in stable conditions
...
2
...
The dividend cover ratio examines the amount by which
profits could fall before leading to a reduction in the current level of
dividends
...
Ratio Analysis ᔡ 605
EFFICIENCY
Debtors
The three main debtor ratios are as follows:
1
...
The formula is:
Sales
ᎏᎏ
Debtors
The higher the ratio the better
...
Average collection period, which measures how long it takes to collect
amounts from debtors
...
If it is longer than those terms, then this indicates some
inefficiency in the procedures for collecting debts
...
Bad debt, which measures the proportion of bad debts to sales:
Bad debts
ᎏᎏ
Sales
This ratio indicates the efficiency of the credit control procedures of the
company
...
Mail-order
companies have to accept a fairly high level of bad debts, while retailing
organizations should maintain very low levels or, if they do not allow
credit accounts, none at all
...
Creditors
The measurement of the creditor turnover period shows the average time
taken to pay for goods and services purchased by the company
...
But there will be a point beyond which
delays in payment will damage relationships with suppliers which, if they
are operating in a seller’s market, may harm the company
...
Inventory
A considerable amount of a company’s capital may be tied up in the
financing of raw materials, work-in-progress and finished goods
...
The two stock turnover ratios are:
1
...
Stock turnover period
Sales
ᎏᎏ × 365
Cost of sales
The higher the stock turnover rate or the lower the stock turnover period
the better, although the ratios will vary between companies
...
The level of inventory in a company may be assessed by the use of the
inventory ratio, which measures how much has been tied up in inventory
...
The main ratios are as follows:
1
...
Sales per employee
Sales
ᎏᎏᎏ
Number of employees
Ratio Analysis ᔡ 607
3
...
Added value per employee
Added value (sales revenue minus cost of sales)
ᎏᎏᎏᎏᎏᎏ
Number of employees
USE OF RATIOS
Ratios by themselves mean nothing
...
Caution has to be exercised in using ratios
...
Ratios are calculated from financial statements which are affected by
the financial bases and policies adopted on such matters as depreciation
and the valuation of stocks
...
Financial statements do not represent a complete picture of the
business, but merely a collection of facts which can be expressed in
monetary terms
...
3
...
For example, the return on
capital employed can be improved by reducing assets rather than
increasing profits
...
A ratio is a comparison of two figures, a numerator and a denominator
...
5
...
1 demonstrates, are interconnected
...
The effective use of ratios therefore
depends on being aware of all these limitations and ensuring that,
following comparative analysis, they are used as a trigger point for
investigation and corrective action rather than being treated as meaningful in themselves
...
FURTHER READING
Pendlebury, M and Groves, R, Company Accounts (2nd edition), Unwin
Hyman, London 1990
...
Productivity is the relationship between the input and output of a good
or service
...
MEASURING PRODUCTIVITY
Productivity is not simply performance and not simply the economic use
of resources, but a combination of both
...
input variables – payroll costs, the associated costs of employment, the
number of people employed and the number of hours worked or time
taken; and
2
...
610 ᔡ Efficiency and Effectiveness
A wide variety of productivity ratios can be derived from these input and
output variables and these can be analysed and added to under the
following headings:
1
...
Cost ratios
(a)
Wages cost
ᎏᎏ
Units produced
(b)
Sales turnover
ᎏᎏᎏ
Payroll/employment costs
(c)
Added value
ᎏᎏᎏ
Payroll/employment costs
(d)
Actual labour cost per standard hour
ᎏᎏᎏᎏᎏ
Target cost per standard hour
(e)
Standard hours produced
ᎏᎏᎏ
Labour costs
3
...
There are very few occasions, however, when the
basic index of:
Productivity Planning ᔡ 611
Results
ᎏᎏ
Resources
ie
Sales
ᎏᎏ
Employees
will not prove to be the most useful of all
...
It considers, first of all, actual performance compared with
company standards and trends and what other organizations achieve
...
Inefficient methods or systems of work
...
Insufficient mechanization or inadequate plant and machinery
...
Poorly motivated employees
...
Too many restrictive practices
...
Excessive waste
...
Work simplification
...
2
...
Introducing new tools or equipment to speed up
processing
...
Automation
...
4
...
Providing more efficient services; improving the
availability of materials, manufactured parts, small tools; improving
the working environment through better layouts and ergonomic
studies
...
The more effective use of human resources
...
612 ᔡ Efficiency and Effectiveness
6
...
7
...
Negotiating with unions to get their agreement
to changes in working practices which will improve productivity as a
quid pro quo for a pay increase
...
They have to be
worked for
...
613
125
Method Study
DEFINITION
Method study is the systematic recording and critical examination of
existing and proposed ways of doing work as a means of developing and
applying easier and more effective methods and reducing costs
...
TECHNIQUES
Flow processing
The sequence of activities carried out by individuals can be recorded by
flow process charts
...
1) are prepared as follows:
1
...
Each activity is described in terms of one of the
ASME symbols
...
2
...
The main sequence is shown on
the right-hand side
...
1 Life policy – underwriting flow chart
Method Study ᔡ 615
represented on the left as a vertical sequence of activities joined to the
main stream by a horizontal line at the appropriate place
...
Reference numbers
...
Numbering starts at the head of the main sequence, continues to the
entry of a subsidiary activity, then to the top of the subsidiary, and back
to the main sequence to the foot of the chart
...
Repeats and changes
...
5
...
Data are included on the chart to identify the method or
the job, when the process starts and finishes and who did the charting
...
Individual work analysis
An individual’s work can be analysed by the use of therblig charts (see
Figure 125
...
Each therblig is identified by a symbol, a name, a definition,
an abbreviation and a colour for charting purposes
...
Therblig charts are only
used when highly detailed studies are required
...
The documents are identified in boxes at the beginning
of each sequence and their distribution is shown in the same way as alternative routes in process charting (see Figure 125
...
Recording group activities
Group activities can be recorded by multiple activity charts which show the
activities of each member of a group linked to a timescale (see Figure 125
...
Recording movements
The main techniques for recording movements round a workshop, office,
room or site are as follows:
1
...
String diagrams give a
vivid picture of how movements take place and can quickly reveal
unnecessary, unnecessarily long or duplicated movements
...
2 Therblig symbols
Method Study ᔡ 617
Time
A
B
C
Activity
1
2
3
4
Figure 125
...
Flow diagrams, which are a representation of a flow chart on a plan so
that the physical movements are traced by a line between the different
activities
...
From this analysis two fundamental questions are posed:
1
...
Are there any better ways of doing it?
The questioning approach is set out in more detail in Figure 125
...
BENEFITS
The main benefits resulting from method study are:
1
...
facilities improvement – providing more efficient transportation and
procurement services, speeding up the flow of paperwork and materials, speeding up processing activities;
3
...
better planning and scheduling of work
...
4 Questioning approach
619
126
Work Measurement
DEFINITION
Work measurement is the application of techniques designed to establish
the work content of a specified task and the time for a qualified worker to
carry out that job at a defined level of performance
...
USES
The uses of work measurement are to:
1
...
2
...
Actuals can
be compared with targets to indicate where corrective action may be
required
...
Assist in budget preparation
...
4
...
By objectively providing an indication
of ‘should take’ time, work measurement gives management the ability
620 ᔡ Efficiency and Effectiveness
to compare the amount of time actually spent with the amount of time
that should have been spent
...
When the reverse applies, the current level can be increased
...
Determine future workforce needs
...
TECHNIQUES
Time study
Time study employs stopwatches to determine the standard time for
completing a job
...
This stage permits the critical appraisal of the method of
performing the job and then the improvement of the method wherever
possible
...
Finally, a rating adjustment is made to take account of the speed and
effectiveness of the operator, and a relaxation allowance is calculated to
provide for the effect of fatigue over a longer period
...
The end result is the time for the task defined in standard minutes,
which is the time the experienced worker of average ability should take to
do the task while taking the normal amount of rest from fatigue and for
personal needs
...
On the British Standards Institute scale this is
called a 100 rating (ie 60/60 × 100) and is referred to as standard
performance
...
Synthesis
Synthesis is used by work study departments, which over the years have
built up a library of ‘synthetics’, ie standard times for doing common tasks
which can be applied to any of these tasks as they exist in a job
...
Work Measurement ᔡ 621
Predetermined motion time systems
(PMTS)
Predetermined motion time systems (PMTS) are libraries of standard
synthetics which are based on the concept that human work of a physical
kind consists of combinations of basic motions of the hands, arms, trunk,
legs, head and eyes
...
Standard times for a task can then be calculated by adding up the PMTS
times for each motion, and these standards can be used for planning and
control purposes in exactly the same way as those resulting from time
studies
...
Analytical estimating
Analytical estimating builds up standard times partly from synthetics and
partly on values estimated by experienced workers who have been trained
in rating
...
DEFINING WORK STANDARDS
Work measurement produces standard times for each job expressed in
standard minutes
...
If there is no incentive scheme,
a standard of 83 is expected from experienced and reasonably wellmotivated workers
...
The number of standard minutes of work produced is
calculated by multiplying the number of units produced by the standard
minute value per unit
...
The
formula is therefore:
622 ᔡ Efficiency and Effectiveness
Number of units produced × standard minute values per unit
ᎏᎏᎏᎏᎏᎏᎏ × 100
Time taken to produce the units in minutes
Thus, if the number of standard minutes per unit is 15 and in 360 minutes
an operator produces 20 units, his or her individual performance will be:
20 units × 15 standard minutes per unit
ᎏᎏᎏᎏᎏ × 100 = 83
360 minutes on measured work
Overall performance
Individual performance measures the rate of working while actually doing
the job
...
It is
measured by the following formula:
Number of standard minutes of work produced
ᎏᎏᎏᎏᎏᎏ × 100
Total attendance time in minutes
Overall performance is usually about 10 units below individual operator
performance
...
USING WORK STANDARDS
Workforce budgeting
Workforce budgets can be built up from the overall performance figures as
follows:
ᔢ Calculate number of standard minutes to be produced by multiplying
output required (say 430 units a day) by standard minutes per unit (say
15) = 6,450
...
Standard minutes of work produced (6,450)
ᎏᎏᎏᎏᎏ × 100 = 80
Attendance minutes (8,100)
ᔢ Divide attendance minutes by minutes attended per person per day
(say 450) to give number of staff: 8100/450 = 18
...
The actual cost per
standard hour will be the gross wages divided by the number of standard
hours worked
...
In addition to comparing actuals with planned performance, this control
information can be used to compare trends between different periods of
time
...
BENEFITS
Work measurement provides an analytical basis for incentive schemes, for
budgeting and controlling workforce costs and for increasing productivity
by providing standards against which performance can be planned, monitored and improved
...
Currie, R M, Work Study, Pitman, London 1977
...
Value can be classified as either use value (the ability of the item to
achieve its function) or esteem value (the status or regard associated with
ownership)
...
The objective of value analysis is to improve the value–cost relationship,
which means a product which provides the necessary function with the
essential qualities at minimum cost
...
Select the products to be analysed
...
Criteria for choice include:
ᔢ
ᔢ
ᔢ
ᔢ
a multiplicity of parts;
a large usage;
a small difference between use value and cost value;
a long-designed product
...
Define the function of the product
...
3
...
The more there are, the greater the
chance of cost reduction
...
Extract existing costs
...
5
...
These will include changes in design, specification
or manufacturing methods which will reduce costs without affecting
the function of the product
...
The aim of this key stage is to identify the scope to:
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
eliminate or simplify parts or operations;
substitute alternative materials;
use standard parts;
eliminate unnecessary design features;
substitute low-cost manufacturing processes;
change design to facilitate manufacture;
buy rather than make, if this is cheaper; and
relax manufacturing tolerances
...
Evaluate alternatives
...
Recommendations for implementation are then made
...
It
ensures that every feature, tolerance, hole, degree of finish, piece of
material or part of the service is vetted to ensure that none of these is
adding to the total cost without serving a necessary purpose
...
AIMS
The overall aims of variety reduction are to increase efficiency and reduce
costs
...
simplifies – reduces unnecessary variety;
2
...
specializes – concentrates effort on undertakings where special expertise
or resources are available
...
Product analysis
...
Following Pareto’s law, it
628 ᔡ Efficiency and Effectiveness
might well be the case that 20 per cent of the products account for 80 per
cent of the turnover or total contribution
...
2
...
The relative performance of the items generating less
income are scrutinized to check recent trends in turnover
...
Action plan
...
4
...
The final decision on whether or not to phase out a
product for which the action plan has not improved its performance
will be affected by two considerations
...
The second will be
the economies that would result from discontinuing the product
...
Component variety reduction
Component variety reduction examines every component in the final
production to find out if there is any scope for standardization, amalgamation or eliminating unnecessary items
...
Rather than making the component, it
might be more economical to buy it from an outside supplier
...
Production runs will be longer and ancillary time for setting up and
breaking down will be reduced
...
Inventory levels will be reduced
...
Planning and production control will be simplified
...
Potential savings will be achieved in plant and equipment requirements
...
Activity can be concentrated more in development and design,
marketing and sales, and after-sales service
Title: Management Techniques
Description: All you need to be successful in business management.
Description: All you need to be successful in business management.