Operations Management: Getting Acquainted Sridhar Tayur The OM core, a required class (by definition) for all MBA students regardless of their career aspirations, caters to a heterogeneous group, and so is designed to satisfy (a) those who want to focus on Operations by being a launching point to other electives in the OM track, and (b) others, by ensuring that they have the appropriate kaleidescopic view of Operations, in the contexts of an individual firm, a supply chain of many interacting firms, and the economy as a whole. Recall that the goal of the Operations Management track is to provide you (the MBA students) with an ability to (1) apply analytical techniques and models to assess, improve and optimize various aspects of real world operations in an environment of increasing complexity and uncertainty, and (2) make thoughtful and timely decisions, and implement appropriate actions, in your organizations as managers and executives, in such a dynamic environment. This will help you be professionally successful in a globally competitive marketplace of knowledge workers. Let us first discuss the following ten topics - just a conversation and some thinking and some drawing and some “Googling� (and some math) -- to set the stage for the rest of the course, and to help you all get oriented to what Operations Management is about. Some of the topics will be covered in this core, and many others in the electives.
1. Process Mapping
A process, or operation, converts (or transforms) a set of inputs to a set of outputs. A firm (or an organization) creates value for its customers by providing a product or service by performing a series of operations. It pays its employees and its suppliers for materials, utilities, capital (including cash financed through debt or equity for working capital) and labor. Profits, the difference between revenues from customers and payments to employees and suppliers is given to the shareholders (investors) of the firm or reinvested for future profits. The investors are looking for a good return on their investment, and so in a competitive environment, the firm has to cross a certain hurdle rate of return, over a certain time horizon, depending on the riskiness of the venture, and also deliver the profits in a somewhat predictable, growing way. The goal of operations management is to manage these operations in the most effective manner, supporting the firm's strategy: be responsive, be cost-effective, manage risk, be competitive and provide a quality product and/or service in a timely and consistent manner.
To help achieve this goal, it is sometimes helpful to visualize these processes, as an interconnected set of operations, with inputs, outputs and dependencies. This drawing is process mapping. A box is used to represent an operation, triangles to represent inventory points of inputs and outputs, and arrows indicate the flow (and dependencies) of activities or materials.
Exercise: let us draw a process map for purchasing (and receiving) 2 items--a book and a DVD -- from Amazon.com, showing (a) your operations; (b) Amazon's operations and (c) UPS/Fedex/USPS operations. What are the other entities that we have not considered? 2. Little's Law Three key performance metrics of any operation are throughput, flow time and inventory. They are related: inventory=throughput*flow time. If there are 200 MBA students who graduate every year (throughput), and it takes two years to graduate (flow time), then there are 400 students in the program (inventory). Less obvious is the effect of this law in presence of uncertainty in a manufacturing or service center. While the law holds for averages, assuming that service rate is larger than the arrival rate, the inventory and flow times can fluctuate. The amount of fluctuation and the amount on average (both inventory and flow time) depend on both the excess capacity-- the gap between arrival rate and service rate -- and the co-efficient of variation (due to arrival or service or
both) in the system. Now this fluctuation and average can both get quite large if the excess capacity is low and the variation is high. This automatically forces the firm to cut the arrival rate it can serve competitively, or equivalently some fraction of customers will self select out, thus reducing the actual system throughput. Thus reduction of variation can improve effective throughput although the service rate remains the same, in the real world. This is central to designing (and operating) service operations such as call centers, hospital operating rooms, imaging/diagnostic centers and even repair/maintenance shops. Exercise: What is the loss in effective demand if the average flow time through a call center cannot be more than 15 minutes, and both the unconstrained arrival and service processes are exponentially distributed random variables, with means 4/hr and 6/hr respectively? 3. Bullwhip effect: inventories, information, incentives, multi-agent decentralized systems; impact of marketing and promotions When you buy cereal (made by Kellogg's) or peanut butter (made by ConAgra Foods) or ketchup (made by Heinz) or cleaning solution (made by Clorox) at your grocery retail store (say at Giant Eagle in Pittsburgh or at a Target anywhere in the US), there is a replenishment action that is created. (This is the same with products from Estee Lauder.) The shelf is restocked from inventory in the
DC (distribution center) of the retailer (if it is there; otherwise, there is a 'short'). This then triggers replenishment to the retailer's DC from the manufacturer's DC,that in turn triggers production at a factory, which triggers replenishment of its raw materials from its supplier, and so on. This is the multi-enterprise, multi-stage supply chain, made up of hundred of operations and processes, spanning procurement, production, logistics, warehousing and store operations. Exercise: Draw the supply chain diagram for Blackberry phone. Who makes Blackberry? (Hint: Not RIM). RIM designs and markets the Blackberry, but the manufacturing is outsourced. Due to the decentralized nature of this supply chain, each of the organizations within and across firms act in their best selfinterest, with different incentives and objectives, and so ordering/producing/moving products in different batch sizes at different frequencies. Small fluctuations at a retailer demand can therefore cascade up the supply chain with severe amplifications. This is called the bullwhip effect. Exercise: List the issues in the interaction between Cisco and its supplier Celestica. What about between Celestica and its suppliers? (Puzzle: Interestingly, recently we have found situations where the reverse bullwhip is occurring! A decrease in demand variation at a retailer actually amplifies her order
variance to a supplier: can you figure out why this may be happening?) Companies routinely run promotions and marketing campaigns to spur demand, and these have a sizable effect on operations, both in terms of upfront co-ordination and planning, but also in execution since these campaigns typically create a lot of variability in the demand signal. Exercise: What does Lady Gaga have to do with manufacturing planning and global inventories? A goal of operations management is to try to dampen these amplifications through better information sharing and co-ordination across silos within a firm and across enterprises, through information technology as well as by setting incentives appropriately. We also see the crucial role of incentives and information in service operations, for example, in healthcare operations, where physician's motivations for ordering diagnostic tests are significantly distorted as compared to socially efficient equilibrium, even when he is not getting paid for the extra tests! 4. Lean techniques, JIT, Six-Sigma, Toyota Production System, Push vs. Pull, push-pull boundary, MRP vs. Kanban, Efficiency vs. Responsiveness, pro-active vs. reactive, sense and respond; Operational risk management
To really tighten the execution of these
hundreds or thousands of operations, whether they are in manufacturing, services or logistics, several methods have been developed over the years that focus on waste elimination, reduction of variability, improved quality control, increased flexibility and so on. These methods are labeled lean techniques (executed through six-sigma projects) supporting the goal of just-in-time production and delivery. Toyota, until recently, had been viewed as a gold standard in having successfully implemented these methods. Exercise: What lean techniques are applicable at UPMC? Push means producing to a forecast; pull means responding to actual demand. For efficiency reasons, whether in manufacturing to achieve a high utilization or minimize lots time in changeovers, planners like to have a predictable rhythm based on a deterministic forecast. However, demands from customers are variable, and inventory planners in charge of service levels prefer that system have flexibility in response. The middle ground is a hybrid push-pull system where the uncertainty is buffered by a combination of safety stock and safety (reactive) capacity, or expedited logistics, and efficiency is achieved by having planned production (and logistics) frequency and lot sizes. A virtual line that separates the mostly push part of a supply chain from a largely pull part is called the push-pull boundary. MRP stands for materials requirements planning, and is essentially an arithmetic
and accounting system that converts forecast end item demand into needed subassemblies, and eventually into components (that may be procured from a supplier) by netting against available inventory, using the bill-of-materials (BOM) to get the right multiples and appropriately off-setting these requirements by lead times. This is a push system. Kanban, Japanese for card, is a visually simple system for production and transport authorization, based on the demand signal. This is a pull system. In many facilities, both MRP and kanbans are used, for weekly planning and real time operations, respectively. In the late 1980s and early 1990s, it was fashionable to know a variety of Japanese terms, such as Jidoka (immediate stoppage), perhaps using an Andon cord, Poka-Yoke (fool-proofing), kaizen (continuous improvement) and others. In fact, quality improvement was considered a national priority for manufacturing competitiveness against the Japanese on-slaught and the (allegedly) prestigious Malcolm Baldridge award was created. Exercise: Name 3 winners of the Baldridge award in the last 10 years. There will always be a need to balance the drive for efficiency with the need for flexibility, to be responsive to new information, whether in the design of a supply chain or in the planning of manufacturing and logistics, especially in a volatile economy with uncertainty in both supply and demand, and in exchange rates, where customers want predictable service at
low cost (but are themselves not prepared to be entirely predictable!). Exercise: How does Zara manage to be so profitable, yet have such a rapid cycle of changes in its large product variety? (They pioneered "fast fashion".)
requirements, and in some industries such as Pharmaceuticals, Food and Financial Services, these are regulated by the appropriate Federal oversight organizations. Exercise: List some operational risk elements at State Street and BNY Mellon.
Another goal of operations management is to develop multi-period contracts that allow all sides to achieve a balance, and help the efficacy of operations of all the entities involved.
5. ROIC, SVA, Inventory Turns, Executive compensation, Why inventories exist, Who owns it? Strategic scarcity.
Exercise: How does a contract between Cisco and Celestica look like? Who is bearing the "inventory liability"?
ROIC stands for return on invested capital, and is the ratio of profits to capital used (to generate this profit).
Pro-active measures include anticipating fluctuations and designing the system to be able to adjust itself. Reactive measures, constrained by choices made by pro-active design, allow the firm effectively once new information, resolving some uncertainty, has been revealed. A key focus of operations management has been to build systems that are agile, which has two components: 'sense' any change of new information quickly, and then have the ability to 'respond' appropriately. The importance of enterprise information technology that spans the globe cannot be underemphasized.
SVA stands for share holder value added, and is computed as the difference between profit and cost of assets used, and this cost of assets equals (weighted average cost of capital)*inventory.
Exercise: List the "Enterprise IT" requirement ("the stack") for supply chain and manufacturing operations at Celestica.
Note that executive compensation at many firms significantly depends on meeting or exceeding targets of some of these metrics.
The role of processes and technology are also critical in terms of managing operational risk, and meeting compliance
Inventories (or stocks) exist for several reasons and in many forms. Safety stock exists to buffer against uncertainty, in
Inventory turns measures how rapidly material is flowing through the system and is the ratio of annual revenue to average inventory in the system. Note that ROIC = inventory turns * gross margin, as gross margin is the ratio of profit to revenue.
supply or manufacturing or demand. Prebuild stock exists because of seasonal demands that need to be satisfied with capacity that is not that seasonal. Cycle stock exists because of efficiencies in transport or production by moving or making in certain block sizes. Pipeline, or in-transit, stock exists due to lead times between locations. Merchandizing (also called marketing/show-room) stock exists to drive demand. Strategic (or hurricane) stock exists to cover catastrophic events such as earthquakes. Hedge stock exists to optimize a firm's financial position due to fluctuating costs of commodities. Deal (or forward buying) stock exists to take advantage of discounts that may be valid only for a limited time window. Exercise: How much inventory of Heinz ketchup should Giant Eagle keep at its stores? What about at the DCs? Exercise: How much cash should a (depository) bank have at any time? Exercise: How much blood is needed in the Blood Bank? Exercise: How many bullets does the Joint Munitions Command (JMC) have at any time? Who makes them? Have you heard of the "Jessica Lynch" effect? Exercise: How much flu vaccine inventory is needed? In each of the above cases list what happens if there is (a) too much inventory versus (b) too little inventory.
The inventories can be in raw material form, work-in-process form, semi-finished (or ready for postponement, thus creating a 'risk pooling' effect across demands, usually negatively correlated, of all finished products that it supports) form or in the (final, for this firm) finished goods form. Note that in a B2B setting, one firm's finished good form can be a raw material form of the customer firm. Inventories in transit and sometimes inventories at a supplier or customer location can be owned by different parties, based on contract structure and agreements (such as vendor managed inventory, VMI or consignment stock). There are times when inventory shortage (limited supply) drives increased demand; this is when firms can create strategic scarcity. Exercise: List 3 products/firms where strategic scarcity works in their favor. 6. Quality: on-line, off-line and robust design; Strategic choice; Warranty and directed parts; product recalls
On-line quality control refers to the ability to, in real time, monitor an operation to ensure that is performing as per its specifications. Control charts, such as X-bar and R charts, are commonly used. Off-line quality control involves periodic, perhaps also at random, sampling of a batch
of produced goods, or taking surveys of customers after a product or service has been provided. By tracking the defects (or customer satisfaction ratings), one can decide if some intervention is required. Robust design, of an operation or a product, aims to make the operation or product consistent, in view of the fact there is always going to be uncertainty in raw materials, labor or customer use. A method that is used in manufacturing process design is the Taguchi method: design of experiments and fractional-factorial DOE are used for robust design of products. Quality is a strategic choice, as the firm is not only optimizing up-front winning in the marketplace, in a cost-effective manner, but is also ensuring that sufficient profits can be created by providing upgrades, after-market parts and service, and that the (durable) products wear out so that newer products can be sold. Of particular profitability can be the warranty programs, and analysis of failure (and assignment of blame) is sometimes further confounded by the existence of 'directed' parts. Exercise: Why are there so many recalls (eggs, Tylenol, Toyota, BMW, child seats....) these days? What is the role of the FDA and other safety governance/consumer protection organizations? How to distinguish between accidental contamination, negligence, design flaw and counterfeits? 7. Product variety: cost of complexity vs. market share
A central tension between the manufacturing/service providing operations/cost side of a firm and its sales/revenue generating operations is deciding how much product variety is optimal for the entire firm. The sales organization would prefer as many options (in service offerings, product configurations, availability windows, pricing etc) as possible to generate demand and capture market share from the competitors. The operations folks would prefer a small set of tasks or products as they can provide a higher quality, lower cost and more consistent (and faster) service or product to the market. Since that is usually not possible, strategies such as delayed differentiation (postponement) and use of common components and platforms exist (which unfortunately reduces end product differentiation and so affects pricing and positioning), as well as creating logical product bundles from which the customers can select (rather than unconstrained a la carte). Exercise: What choices are not possible in buying a BMW? Product line rationalization is an important operations management issue that goes into the heart of a firm's competitive strategy. 8. Contemporary topics These include sustainability (“green�), risk management, corporate social responsibility (CSR), dealing with dark side of globalization (counterfeits; illegal labor, including child trafficking), preparing for and exploiting the impact of new
technologies (such as role of genetically modified food, improved medical techniques), and how to best exploit mobile technology and social networks. Exercise: How is Gap ensuring that there are no sweatshops in their supply chain? What are some of their projects in CSR?
9. Disaster relief and humanitarian logistics Questions include (a) how to pre-position food and essential needs, including logistics capacity, around the world? (b) Can disasters be anticipated? (c) How to most effectively respond to a disaster (earthquake, tsunami, political unrest, chemical leak, terrorist attack)? Exercise: How is the US protecting the milk supply chain from a bio-terrorism attack? 10. How we study the various (complex) issues that arise in operations management Modeling choices: deterministic vs. stochastic, discrete time vs. continuous time, stationary vs. non-stationary, single period vs. multi-period (finite) vs. infinite horizon, single stage vs. multi-stage, capacitated vs. uncapacitated, full information vs. partial information, symmetric information vs. asymmetric information, centralized vs. decentralized. In decentralized, multi-period stochastic models, it is also important to know when information is revealed, what it is, and who knows it first in addition to its reliability. Goals of the models and analysis: (a)
qualitative insights and directional information, potentially counter-intuitive to conventional wisdom; or (b) decision support for actually making strategic choices, driving tactical decisions or automating operational execution. Analytical methods used to solve these models: inventory models, queuing models, Mixed Integer Linear programming, Dynamic Programming, Game Theory, simulation and non-linear programming. Exercise: What is the Black-Scholes model? How is it related to the Feynman-Kac formula? Why do quantum physics and General Theory of Relativity not work well together? Why is my PhD student running the “Automated Algorithmic Proprietary Trading” Group at Credit Suisse? As MBAs, you are the future leaders in our economy. So, remember the old saying: Analysis but no action = day dreaming Action but no analysis = nightmare So, here is my equation for you: Analysis + Action = Accomplishment. Now, we are ready to go to Chapter 1 of the course. One key is: Lean Operations + Private Equity = Sustainability + Prosperity.
Gentlemen and Ladies, as they say in NASCAR, “Start your engines!”. PS: Ethics and morals matter, and so please do not cheat on your home works and exams, and generally, in your career and personal life.