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How does a business create goods
and services to sell?
Learning Objectives:
After reading this module and completing the associated exercises, you will be able to:
LO1:
Differentiate between operations and production.
LO2: Describe the purpose of production schedules.
LO3: Discuss the importance of inventory control.
LO4: Describe an economy of scale.
LO5: Discuss the five components of supply chain management.
LO6: Discuss why it is important to manage quality.
LO7: Describe how to measure productivity.
LO8: Define the accounting equation.
LO9: Discuss the typical types of managerial accounting reports.
LO10: Describe how to calculate contribution margins and why these are valuable.
Key Terms To Look For:
Accounting equation
Benchmarking
Carrying cost
Contribution margin analysis
Economies of scale
Fixed costs
Inventory control
Master production schedule
Materials requirement planning
Productivity
Supply chain management
Total Quality Management
Variable costs
Work-in-process inventory
56 | Module 3
Production Basics
The story so far…
We know that a business exists to make a
profit by offering goods and services that
satisfy customer needs in a marketplace. We
know that there are many types of markets –
physical and virtual – and we have analyzed
the market for electronic sensors in our Foundation Business Simulation. We have discovered how to define customer needs and how
important it is to promote our products and
to make them accessible to customers.
Now let’s talk about production: creating
something to sell at a cost and level of quality
that allows the company to satisfy customer
needs and make a profit.
Production is a process that uses resources
– such as cash, labor, and raw materials – to
create a value proposition that is attractive to
a particular market.
If “profit” is the answer to “why does a business exist?” and “marketing” holds the answers to “who does the business sell to?”
then “production” is the answer to the “how,
what, and when” questions about business.
In Foundation, your Production Department decides
how many products your company will produce
(depending on demand and your assessment of
how attractive your products are to the market),
whether to add or reduce production capacity in
line with your production schedule, and the level
of automation on your production lines. Production
decisions come with a high price tag because you
are dealing with sophisticated machinery and
robotics. Weighing the options and the tradeoffs in
the context of the overall business is critical.
Let’s begin with an overview of production
management.
A production process can be defined as:
any activity that increases the similarity between the pattern of demand for goods and
the quantity, form, and distribution of these
goods to the marketplace.
Inputs to outputs
Production is the act of making products that
will be traded or sold commercially based on
decisions about what goods to produce, how
to produce them, the costs to produce them,
and how to optimize the mix of resource
inputs used in their production. Production
information is combined with market information such as demand to determine the
quantity of products to produce and sell at
an optimal price point.
A business needs a production process
whether it provides products or services.
The production process involves planning,
procuring goods or expertise to produce the
product or service, plus assigning and organizing tasks to get the products or services
to the market. It is important to differentiate
“production” from “operations” in the business context.
Operations describe the full range of
management activities that enable a
company to be profitable and sustainable.
Production involves the actual process
of creating goods and services.
Production can take the form of mass production, where a large number of standard
products are created in a traditional assem-
Production | 57
bly line process; it can be a very specialized
process with individual or small quantities of
a good being created; or it might involve running the logistics necessary to deliver a service efficiently. Inputs, therefore, can be raw
materials like steel and chemicals; human in-
puts like specialized computer programmers,
designers, or engineers; and money from a
few thousand dollars to start a home-crafts
business to millions of dollars for sophisticated manufacturing equipment. The concepts
are the same whatever the business may be.
Core Functions in Production Management
Production management seeks to develop an
efficient, relatively low-cost, and high-quality
production process for creating specific products and services. Good production management is important if business goals, for both
manufacturing and service-oriented companies, are to be met. The profit and value of
each company is determined, to some extent, by its production management process.
The primary resources that firms use for the
production process include:
Human Resources: employees and
their skills as applied to the production
process
Raw Materials: the cost of all the goods
needed to create the products or services
Capacity: the annual production capabilities of the facilities, technology, machinery, and equipment
Each of these resources costs money. Employees need to be paid, materials have to
be purchased, plus there are buildings, production facilities, and computer systems that
require time and money to be maintained for
ongoing production. The objective of production management is to use these resources in
the most efficient manner possible. This will
enable the organization to take advantage of
higher production levels by producing more
units at a lower cost per unit.
Whatever the business is selling, its production process is the conversion of inputs
(such as skills and raw materials) into outputs
(goods or services) as efficiently as possible.
The process can include sourcing, manufacturing, storing, shipping, packaging, and
more. Because it is based on a flow concept
(the steps have to flow in a logical order to
get the product or service ready for sale) production is measured as a “rate of output per
period of time.”
In any manufacturing environment – and
your Foundation Business Simulation is in the
manufacturing business – it is the Production
Manager who has responsibility for scheduling the production sequence, type of product
to be produced, and the volume of production. The three elements of management we
discussed in Module 1 – planning, organizing, and controlling – are clearly necessary
for production management. Following are
some key concepts you will need to understand, along with some of the functions performed in the production department.
58 | Module 3
Scheduling Production
A master production schedule determines
when the products will be produced and in
what quantities. Dates must be met, specified quantities must be produced on time,
and costs controlled to ensure this process
goes smoothly and meets commitments.
One tool to help with this process is a PERT
chart. PERT stands for “Program Evaluation
and Review Technique.” This is a graphical
representation that tracks production events
and their time frames from start to finish. A
PERT chart maps out the production process,
which can help to identify problems before
the process even begins.
Is the BlackBerry season over?
Inventory management is critical to prevent stockouts and have smooth
flow of product from your company to your customers. Production, however,
is based on sales forecasts – and if the forecasts are not met?
RIM, maker of the BlackBerry, learned the answer to that question the hard way. In its disastrous second
quarter results for 2013, the company announced a write-down of $934 million for unsold phones and cut
4,500 jobs, or about a third of its workforce. Sales for the period were about $1.6 billion, compared with the
$3.03 billion analysts had expected.
As early as May 2012, business news site Bloomberg reported: “stockpiles of BlackBerry smartphones and
PlayBook tablets have swollen by two-thirds in the past year because of slumping sales”. Bloomberg data
suggested the value of RIM’s “in-house supplies” grew 18 percent in the first quarter of 2012 “a faster rate than
at any other company in the industry.”
In 2009, Fortune magazine named BlackBerry as the fastest growing company in the world. It held a 43%
market share of the personal smartphone market at its peak in 2010. The competition from smartphones
running Google’s Android operating system and the Apple iPhone moved fast into BlackBerry’s market.
Management underestimated the impact of its competitors and over-estimated the popularity of its new
product offerings. The BlackBerry Z10 phone, released in January 2013 to compete with the iPhone, did not
excite buyers as expected. The result was close to a billion dollars in unsold BlackBerries left on the shelf.
Production | 59
Inventory Control
As goods are produced, they also need to be
managed. Inventory control is the process of
efficiently managing inventory. It is important to have enough products to sell, but not
to have too many products unnecessarily sitting in the warehouse tying up cash. An efficient inventory control system minimizes the
costs associated with inventory.
Companies must also manage inventory
while it is in the process of being built. This
is described as work-in-process inventory,
or products that are only partially completed but have required an investment of some
type of resource. Products cannot be sold
until they are complete, and monitoring the
status of products still involved in production
is important.
Another cost directly associated with inventory is carrying cost. Carrying cost is the cost
of maintaining completed products. Inventory ties up space, cash, and human resources.
A popular method for reducing carrying costs
Step fixed costs in Foundation.
In Foundation, you will encounter what is called step
fixed costs, which is a business expense that is more
or less constant over a low level shift in activity
but changes incrementally when activity in the
business shifts substantially. An example of a step
fixed cost in your Foundation business is the need
to buy new production machinery (e.g. capacity)
to “step up” production to another level. Another
example is investment in achieving a higher level
of automation. Step fixed costs can be offset as
production continues to expand, however, there
are challenges assessing the impact on operating
costs through the process of increasing activity
levels in the business, and also the relationship with
economies of scale. We will demonstrate how to
calculate these impacts in the Module 3 Exercises.
is the just-in-time (JIT) inventory system. This
system is based on having just enough products on hand to satisfy consumer demand.
Product should always be available, but not
an overstock of what is needed for the near
future.
The JIT system is often associated with a
materials requirement planning system that
ensures materials are available when needed. A materials requirement planning system
or MRP helps determine when the materials
to produce the product are needed to meet
production deadlines. As a firm develops a
forecast of the demand for its products, it
determines the time at which the materials
need to arrive at the production site to meet
the anticipated market demand.
Economies of Scale
An economy of scale occurs when the cost
of each good produced decreases as the
volume produced increases. This reduction
in cost per unit occurs because the initial investment of capital is shared with an increasing number of units of output. Variable costs
Everyday life – economies of
scale
You are setting up a small business in your local
area and need a business card. The cost to print
50 business cards is $25, which is 50 cents per
card. However, if you were to place an order for
500 business cards, the total cost is $50, reducing
the cost to 10 cents per card. The more business
cards printed in each print “run,” the lower the
cost per individual business card. The cost for the
printing company is in setting the job up; the small
additional cost in ink and paper to run a larger print
run is marginal, so the cost per unit comes down.
60 | Module 3
(those that change with the number of goods
produced) and fixed costs (costs that do not
change regardless of volume) are monitored
throughout this process. As output increases, fixed costs remain the same, and variable
costs on a per-unit basis decline.
Economies of scale are particularly critical in
industries with high fixed costs such as manufacturing. With an initial fixed investment
in machinery, one worker, or unit of production, begins to work on the machine to produce a certain number of goods. If a second
worker is added to the production line, he or
she is able to produce an additional number
of goods without significantly adding to the
factory’s cost of operation. If the number of
goods produced grows significantly faster
than the plant’s cost of operation, the cost of
producing each additional unit is less than the
unit before, and an economy of scale occurs.
This is one important reason why businesses
always want to grow: Growth means you can
reap the efficiency rewards offered by economies of scale.
Can Tesla achieve economies of scale and keep its promise?
Electric vehicles were first popular in the late 19th and early 20th centuries – before Ford
Motor Company developed the production technologies to mass produce gasoline-fueled cars
with internal combustion engines. For the next century and more, gas-powered cars ruled the
highways with high-volume manufacturing providing the economies of scale to make them
affordable. In the late 20th century, high oil prices, environmental concerns, and advances in
battery technology brought electric cars back into the mainstream.
Most traditional car companies, including Ford, GM, BMW, Toyota, Honda, and Nissan, have released
electric or electric/gasoline hybrid cars. By 2013, however, it was an automotive start-up, Tesla Motors from
California, not only winning all the awards but also proving it had a profitable model for electric cars that
might challenge the traditional car companies. Tesla opened a “new” market segment: luxury electric cars,
with a longer battery life and range of up to 300 miles (480 kilometers), designed for discerning motorists
and sold not through dealerships but their own, branded stores. It wasn’t offering the battery version of a gaspowered car with fewer extras, but a new sought-after trend in upscale motoring.
When Tesla made its first profit in 2013, CEO Elon Musk said his company’s goal had always been to
mass-produce fully electric cars at a price affordable to the average consumer, and would do it “within five
years.” The current Tesla business model, however, makes the company a specialty car manufacturer (with the
starting price on its Model S around $80,000), not a mass-market auto producer.
In Tesla’s favor is the fact that as battery range increases, battery cost is likely to decrease; parts vendors –
as they see the volumes increase on Tesla vehicles – are revamping their production and reducing the cost of
parts; the company says it is steadily cutting the number of worker hours necessary to build each car; plus it is
looking to buy additional production capacity.
The major car makers, however, are not sitting by while Tesla muscles into their space – they share all
those advantages and have experience in mass manufacturing as well. Perhaps Tesla’s biggest advantage is
the extremely strong support it enjoys from its investors. In mid-2013, the Motley Fool site reported Tesla’s
market capitalization was almost $12 billion. “That’s about a fifth of BMW’s, and BMW sold 1,845,186 vehicles
last year. Tesla expects to sell 21,000 in 2013, and BMW will probably sell around 2 million.”
Forbes calls Tesla’s share price “a cult-like valuation”, and critics suggest that without generous U.S.
Government loans and subsidies the company will not survive. Tesla’s performance in the next few years will
prove whether the beliefs of the Tesla faithful are well founded, or whether the challenge of economies of
scale for mass market vehicles was too tough for the new market entrant.
Production | 61
Supply chain management
The collection of partners – manufacturer,
wholesaler, distributor, retailer, on-line sales
site – is referred to as the “supply chain.” Efforts to improve the relationship between a
company and its suppliers are referred to as
supply chain management (SCM). The objective of SCM is to manage the connections
between different businesses in the supply
chain in order to enhance efficiencies and reduce costs.
Supply chain management involves these
five basic components:
Plan: The strategic plan to manage all of
the resources needed to meet customer
demand for your product or service
Source: The selection of the supplies
that will deliver goods and services (e.g.,
suppliers that can offer parts faster and/
or cheaper)
Make: The manufacturing step involving
scheduling, testing, packaging, and preparing for delivery
Deliver: The logistics and timing of getting products and/or services through
the relevant channels to the customer
Return: The “soft” link in the chain that
supports customers who are returning
products or have had problems with
their product/service experience
Quality Control and Total Quality Management
Quality is the degree to which a product or
service meets the company’s internal or external standards and satisfies customer expectations. Quality control is the process of
testing to ensure the product or service meets
the organization’s standards before it is sold.
Techniques to monitor quality may include
sampling, monitoring customer/user complaints, and planning to correct deficiencies.
National or international authorities often set
standards in business. The International Organization for Standardization (ISO), founded in 1947 and made up of representatives
from many national standards organizations,
sets international quality standards. The ISO
9000 family of standards was designed to
help organizations ensure they can meet the
needs of customers and other stakeholders.
The ISO 9000 standards are focused on a
company’s quality management systems.
Certification requires a company to meet all
of the requirements and pass a series of audits from independent certifiers. The benefits of compliance include internal management efficiencies – quantified by substantial
research – and access to new business from
companies that will work only with ISO-certified suppliers.
Companies are often required to adhere to
standards set by national agencies or industry associations. In the United States, for example, standards agencies include the Food
and Drug Administration (FDA) and the Consumer Products Safety Council (CPSC). The
standards imposed by these entities affect
design, performance, durability, safety, and
many other attributes relating to performance and function. Quality is also used as a
competitive advantage to provide “perceived
excellence” compared with other choices in
the market.
62 | Module 3
Whispers from the supply chain suggest a bullwhip
Apple Inc. is well known for extreme secrecy – particularly around new product offerings
– but the company’s silence creates an information vacuum that rumors race to fill. And Apple
rumors are extremely popular on news websites, blogs, and in the general consumer and tech
media.
A major source of information is Apple’s supply chain – the many manufacturers that feed
product components into the devices the world loves to buy.
A month after Apple released its new high-e …
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