The blue dotted line in Figure 6.8 shows this effect. The two other blue lines show similar curves for a 600-unit plant and a 1,000-unit plant. Figure 6.8 also shows that a similar rela- tionship occurs between the average-cost curves for plants of increasing size. As the nominal capacity of the plants increases, the lowest-cost points at first reduce. There are two main rea- sons for this:
● The fixed costs of an operation do not increase proportionately as its capacity increases.
An 800-unit plant has less than twice the fixed costs of a 400-unit plant.
● The capital costs of building the plant do not increase proportionately to its capacity. An 800-unit plant costs less to build than twice the cost of a 400-unit plant.
These two factors, taken together, are often referred to as economies of scale. However, above a certain size, the lowest-cost point may increase. In Figure 6.8 this happens with plants above 800 units capacity. This occurs because of what are called the diseconomies of scale, two of which are particularly important. First, transportation costs can be high for large operations. For example, if a manufacturer supplies its global market from one major plant in Denmark, materials may have to be brought in to, and shipped from, several countries.
Second, complexity costs increase as size increases. The communications and coordination effort necessary to manage an operation tends to increase faster than capacity. Although not seen as a direct cost, it can nevertheless be very significant.
Scale of capacity and the demand–capacity balance
Large units of capacity also have some disadvantages when the capacity of the operation is being changed to match changing demand. For example, suppose that the air-conditioning unit manufacturer forecasts demand increase over the next three years, as shown in Figure 6.9, to level off at around 2,400 units a week. If the company seeks to satisfy all demand by build- ing three plants, each of 800 units capacity, the company will have substantial amounts of over-capacity for much of the period when demand is increasing. Over-capacity means low capacity utilization, which in turn means higher unit costs. If the company builds smaller plants, say 400-unit plants, there will still be over-capacity but to a lesser extent, which means higher capacity utilization and possibly lower costs.
Figure 6.9 The scale of capacity increments affects the utilization of capacity Economies of scale
Diseconomies of scale
Balancing capacity
As we discussed in Chapter 1, all operations are made up of separate processes, each of which will itself have its own capacity. So, for example, the 800-unit air-conditioning plant may not only assemble the products but may also manufacture the parts from which they are made, pack, store and load them in a warehouse and distribute them to customers. If demand is 800 units per week, not only must the assembly process have a capacity sufficient for this output, but the parts manufacturing processes, warehouse and distribution fleet of trucks must also have sufficient capacity. For the network to operate efficiently, all its stages must have the same capacity. If not, the capacity of the network as a whole will be limited to the capacity of its slowest link.
The timing of capacity change
Changing the capacity of an operation is not just a matter of deciding on the best size of a capacity increment. The operation also needs to decide when to bring ‘on-stream’ new capacity. For example, Figure 6.10 shows the forecast demand for the new air-conditioning unit. The company has decided to build 400-unit-per-week plants in order to meet the growth in demand for its new product. In deciding whenthe new plants are to be introduced the company must choose a position somewhere between two extreme strategies:
● capacity leadsdemand – timing the introduction of capacity in such a way that there is always sufficient capacity to meet forecast demand;
● capacity lagsdemand – timing the introduction of capacity so that demand is always equal to or greater than capacity.
Figure 6.10(a) shows these two extreme strategies, although in practice the company is likely to choose a position somewhere between the two. Each strategy has its own advantages and disadvantages. These are shown in Table 6.4. The actual approach taken by any com- pany will depend on how it views these advantages and disadvantages. For example, if the company’s access to funds for capital expenditure is limited, it is likely to find the delayed capital expenditure requirement of the capacity-lagging strategy relatively attractive.
Figure 6.10 (a) Capacity-leading and capacity-lagging strategies, (b) Smoothing with inventories means using the excess capacity in one period to produce inventory that supplies the under-capacity period
Capacity leading
Capacity lagging
‘Smoothing’ with inventory
The strategy on the continuum between pure leading and pure lagging strategies can be implemented so that no inventories are accumulated. All demand in one period is satisfied (or not) by the activity of the operation in the same period. Indeed, for customer-processing operations there is no alternative to this. A hotel cannot satisfy demand in one year by using rooms which were vacant the previous year. For some materials- and information- processing operations, however, the output from the operation which is not required in one period can be stored for use in the next period. The economies of using inventories are fully explored in Chapter 12. Here we confine ourselves to noting that inventories can be used to obtain the advantages of both capacity leading and capacity lagging. Figure 6.10(b) shows how this can be done. Capacity is introduced such that demand can always be met by a combination of production and inventories, and capacity is, with the occasional exception, fully utilized. This may seem like an ideal state. Demand is always met and so revenue is maximized. Capacity is usually fully utilized and so costs are minimized. There is a price to pay, however, and that is the cost of carrying the inventories. Not only will these have to be funded but the risks of obsolescence and deterioration of stock are introduced.
Table 6.5 summarizes the advantages and disadvantages of the ‘smoothing-with-inventory’
strategy.
Table 6.4 The arguments for and against pure leading and pure lagging strategies of capacity timing
Advantages
Capacity-leading strategies
Always sufficient capacity to meet demand, therefore revenue is maximized and customers satisfied
Most of the time there is a ‘capacity cushion’
which can absorb extra demand if forecasts are pessimistic
Any critical start-up problems with new plants are less likely to affect supply to customers Capacity-lagging strategies
Always sufficient demand to keep the plants working at full capacity, therefore unit costs are minimized
Over-capacity problems are minimized if forecasts are optimistic
Capital spending on the plants is delayed
Disadvantages
Utilization of the plants is always relatively low, therefore costs will be high
Risks of even greater (or even permanent) over-capacity if demand does not reach forecast levels
Capital spending on plant early
Insufficient capacity to meet demand fully, therefore reduced revenue and dissatisfied customers
No ability to exploit short-term increases in demand
Under-supply position even worse if there are start-up problems with the new plants
Table 6.5 The advantages and disadvantages of a smoothing-with-inventory strategy
Advantages
All demand is satisfied, therefore customers are satisfied and revenue is maximized
Utilization of capacity is high and therefore costs are low
Very short-term surges in demand can be met from inventories
Disadvantages
The cost of inventories in terms of working capital requirements can be high. This is especially serious at a time when the company requires funds for its capital expansion Risks of product deterioration and obsolescence
Break-even analysis of capacity expansion
An alternative view of capacity expansion can be gained by examining the cost implications of adding increments of capacity on a break-even basis. Figure 6.11 shows how increasing capacity can move an operation from profitability to loss. Each additional unit of capacity results in a fixed-cost break that is a further lump of expenditure which will have to be incurred before any further activity can be undertaken in the operation. The operation is unlikely to be profitable at very low levels of output. Eventually, assuming that prices are greater than marginal costs, revenue will exceed total costs. However, the level of profitability at the point where the output level is equal to the capacity of the operation may not be sufficient to absorb all the extra fixed costs of a further increment in capacity. This could make the operation unprofitable in some stages of its expansion.
A business process outsourcing (BPO) company is considering building some process- ing centres in India. The company has a standard call centre design that it has found to be the most efficient around the world. Demand forecasts indicate that there is already demand from potential clients to fully utilize one process centre that would generate $10 million of business per quarter (3-month period). The forecasts also indicate that by quarter 6 there will be sufficient demand to fully utilize one further pro- cessing centre. The costs of running a single centre are estimated to be $5 million per quarter and the lead time between ordering a centre and it being fully operational is two quarters. The capital costs of building a centre is $10 million, $5 million of which is payable before the end of the first quarter after ordering, and $5 million payable before the end of the second quarter after ordering. How much funding will the com- pany have to secure on a quarter-by-quarter basis if it decides to build one processing centre as soon as possible and a second processing centre to be operational by the beginning of quarter 6?
Analysis
The funding required for a capacity expansion such as this can be derived by calculat- ing the amount of cash coming in to the operation each time period, then subtracting the operating and capital costs for the project each time period. The cumulative cash flow indicates the funding required for the project. In Table 6.6 these calculations are performed for eight quarters. For the first two quarters there is a net cash outflow because capital costs are incurred by no revenue is being earned. After that, revenue is being earned but in quarters four and five this is partly offset by further capital costs for the second processing centre. However, from quarter six onwards the additional revenue from the second processing centre brings the cash flow positive again. The maximum funding required occurs in quarter two and is $10 million.
Table 6.6 The cumulative cash flow indicating the funding required for the project
Quarters
1 2 3 4 5 6 7 7
Sales revenue ($ millions) 0 0 10 10 10 20 20 20
Operating costs ($ millions) 0 0 −5 −5 −5 −10 −10 −10
Capital costs ($ millions) −5 −5 −0 −5 −5 0 0 0
Required cumulative funding ($ millions) −5 −10 −5 −5 −5 +5 +15 +25
Worked example
Fixed-cost breaks are important in determining break-even points
Figure 6.11 Repeated incurring of fixed costs can raise total costs above revenue
A specialist graphics company is investing in a new machine which enables it to make high-quality prints for its clients. Demand for these prints is forecast to be around 100,000 units in year 1 and 220,000 units in year 2. The maximum capacity of each machine the company will buy to process these prints is 100,000 units per year. They have a fixed cost of a200,000 per year and a variable cost of processing of a1 per unit.
The company believe they will be able to charge a4 per unit for producing the prints.
Question
What profit are they likely to make in the first and second years?
Year 1 demand =100,000 units; therefore company will need one machine Cost of manufacturing =fixed cost for one machine +variable cost ×100,000
=a200,000 +(a1 ×100,000)
=a300,000 Revenue =demand ×price
=100,000 ×a4
=a400,000
Therefore profit =a400,000 −a300,000
=a100,000
Year 2 demand =220,000; therefore company will need three machines Cost of manufacturing =fixed cost for three machines +variable cost ×220,000
=(3 ×a200,000) +(a1 ×220,000)
=a820,000 Revenue =demand ×price
=220,000 ×a4
=a880,000
Therefore profit =a880,000 – a820,000
=a60,000
Note: the profit in the second year will be lower because of the extra fixed costs associ- ated with the investment in the two extra machines.
Worked example
Summary answers to key questions
Check and improve your understanding of this chapter using self assessment questions and a personalised study plan, audio and video downloads, and an eBook – all at www.myomlab.com.
➤ Why should an organization take a total supply network perspective?
■ The main advantage is that it helps any operation to understand how it can compete effectively within the network. This is because a supply network approach requires operations managers to think about their suppliers and their customers as operations. It can also help to identify particularly significant links within the network and hence identify long-term strategic changes which will affect the operation.
➤ What is involved in configuring a supply network?
■ There are two main issues involved in configuring the supply network. The first concerns the overall shape of the supply network. The second concerns the nature and extent of outsourcing or vertical integration.
■ Changing the shape of the supply network may involve reducing the number of suppliers to the operation so as to develop closer relationships, any bypassing or disintermediating operations in the network.
■ Outsourcing or vertical integration concerns the nature of the ownership of the operations within a supply network. The direction of vertical integration refers to whether an organization wants to own operations on its supply side or demand side (backwards or forwards integration). The extent of vertical integration relates to whether an organization wants to own a wide span of the stage in the supply network. The balance of vertical integration refers to whether operations can trade with only their vertically integrated partners or with any other organizations.
➤ Where should an operation be located?
■ The stimuli which act on an organization during the location decision can be divided into supply-side and demand-side influences. Supply-side influences are the factors such as labour, land and utility costs which change as location changes. Demand-side influences include such things as the image of the location, its convenience for customers and the suitability of the site itself.
➤ How much capacity should an operation plan to have?
■ The amount of capacity an organization will have depends on its view of current and future demand. It is when its view of future demand is different from current demand that this issue becomes important.
■ When an organization has to cope with changing demand, a number of capacity decisions need to be taken. These include choosing the optimum capacity for each site, balancing the various capacity levels of the operation in the network, and timing the changes in the capacity of each part of the network.
■ Important influences on these decisions include the concepts of economy and diseconomy of scale, supply flexibility if demand is different from that forecast, and the profitability and cash-flow implications of capacity timing changes.
In August 2006, the company behind Disneyland Resort Paris reported a 13 per cent rise in revenues, saying that it was making encouraging progress with new rides aimed at getting more visitors. ‘I am pleased with year-to-date revenues and especially with third quarter’s, as well as with the success of the opening of Buzz Lightyear Laser Blast, the first step of our multi-year investment program. These results reflect the group’s strategy of increasing growth through innovative marketing and sales efforts as well as a multi-year investment program. This performance is encour- aging as we enter into the important summer months’, said Chairman and Chief Executive Karl L. Holz. Yet it hadn’t always been like that. The 14-year history of Disneyland Paris had more ups and downs than any of its rollercoasters. From 12 April 1992 when EuroDisney opened, through to this more optimistic report, the resort had been subject simultane- ously to both wildly optimistic forecasts and widespread criticism and ridicule. An essay on one critical Internet site (called ‘An Ugly American in Paris’) summarized the whole venture in this way. ‘When Disney decided to expand its hugely successful theme park operations to Europe, it brought American management styles, American cultural tastes, American labor practices, and American marketing pizzazz to Europe. Then, when the French stayed away in droves, it accused them of cultural snobbery.’
The ‘magic’ of Disney
Since its founding in 1923, The Walt Disney Company had striven to remain faithful in its commitment to ‘Producing unparalleled entertainment experiences based on its rich legacy of quality creative content and exceptional story- telling’. In the Parks and Resorts division, according to the company’s description, customers could experience the
‘Magic of Disney’s beloved characters’. It was founded in 1952, when Walt Disney formed what is now known as
‘Walt Disney Imagineering’ to build Disneyland in Anaheim, California. By 2006, Walt Disney Parks and Resorts oper- ated or licensed 11 theme parks at five Disney destinations around the world. They were: Disneyland Resort, California, Walt Disney World Resort, Florida, Tokyo Disney Resort, Disneyland Resort Paris, and their latest park, Hong Kong Disneyland. In addition, the division operated 35 resort hotels, two luxury cruise ships and a wide variety of other entertainment offerings. But perhaps none of its ventures had proved to be as challenging as its Paris Resort.
Service delivery at Disney resorts and parks
The core values of the Disney company and, arguably, the reason for its success, originated in the views and personality of Walt Disney, the company’s founder. He had
Case study
Disneyland Resort Paris (abridged)
10what some called an obsessive focus on creating images, products and experiences for customers that epitomized fun, imagination and service. Through the ‘magic’ of legendary fairytale and story characters, customers could escape the cares of the real world. Different areas of each Disney Park are themed, often around various ‘lands’
such as Frontierland, and Fantasyland. Each land con- tains attractions and rides, most of which are designed to be acceptable to a wide range of ages. Very few rides are ‘scary’ when compared to many other entertainment parks. The architectural styles, décor, food, souvenirs and cast costumes were all designed to reflect the theme of the ‘land’, as were the films and shows. And although there were some regional differences, all the theme parks followed the same basic set-up. The terminology used by the company reinforced its philosophy of consistent enter- tainment. Employees, even those working ‘backstage’, were called ‘cast members’. They did not wear uniforms but
‘costumes’, and rather than being given a job they were
‘cast in a role’. All park visitors were called ‘guests’.
Disney employees were generally relatively young, often of school or college age. Most were paid hourly on tasks that could be repetitive even though they usually involved constant contact with customers. Yet, employees were still expected to maintain a high level of courtesy and work performance. All cast members were expected to conform to strict dress and grooming standards. Applicants to become cast members were screened for qualities such as how well they responded to questions, how well they listened to their peers, how they smiled and used body language, and whether they had an ‘appropriate attitude’.
Disney parks had gained a reputation for their obsession with delivering a high level of service and experience through attention to operations detail. All parks employed queue management techniques such as providing information and entertainment for visitors, who were also seen as
Source: Corbis/Jacques Langevin