OPSM 901: Operations Management

1. Koç University Graduate School of Business EMBA Program OPSM 901: Operations Management Session 2: Measuring Process Flows Little’s Law Zeynep Aksin zaksin@ku.edu.tr

2. Recall from last class • Strategic position: what product attributes? • Operational effectiveness: how well the process performs • Process competencies: cost, time, variety, quality • Need internal measures that are leading indicators of financial performance • Zara and article on textile industry: importance of time based competition

3. Three Internal Process Measures • We examine processes from the perspective of flow • To study process flows, we first answer three important questions: • On average, how many flow units pass through the process per unit time? • On average, how much time does a typical flow unit spend within process boundaries? • On average, how many flow units are within process boundaries at any point in time?

4. Process Measures • On average, how many flow units pass through the process per unit time? THROUGHPUT RATE (TH)

5. 1 2 3 4 Terminology Throughput Rate (R or TH) The average output of a production process per unit time. At the firm level, it is defined as the production per unit time that is sold.

6. Process Measures • On average, how much time does a typical flow unit spend within process boundaries? FLOW TIME (FT)

7. Terminology Flow Time (T or CT) The flow time (also called variously throughput time, cycle time) of a given routing is the average time from release of a job at the beginning of the routing until it reaches an inventory point at the end of the routing. Flow time 1 2 3 4

8. 1 2 3 4 Terminology System Cycle Time The average interdeparture time between two jobs leaving a routing System cycle time

9. Process Measures • On average, how many flow units are within process boundaries at any point in time? INVENTORY (I)

10. 1 2 3 4 Terminology Work in Process (I or WIP) The average inventory between the start and end point of a product is called work in process (WIP) WIP (9 for this realization)

11. Relating operational measures (flow time T, throughput TH & inventory I) with Little’s Law • Inventory = Throughput x Flow Time I = TH x T • Turnover = Throughput / Inventory = 1/ T Flow rate/Throughput R [units/hr] Inventory I [units] ... ... ... ... ... Flow Time T[hrs]

12. Inventory I [units] ... ... ... ... ... Time=0 Throughput Rate [units/hr] Flow Time T[hrs] Inventory I [units] ... Time=t ... ... ... ... Throughput Rate [units/hr] Flow Time T[hrs] Inventory I [units] ... ... ... ... ... Time=FT Throughput Rate [units/hr] Flow Time T[hrs] Understanding Little’s Law: Consider a first come first served Queue

13. An Intuitive Argument for Little's Law • Consider a process with the FCFS queue discipline • An order departs the process: At this moment there are I (Inventory) orders within the process • The orders that are in the process now are the ones that came after our departing order had arrived, in other words, they arrived during the waiting period of the departing order • Since order arrival rate is equal to the throughput rate, we have the following relationship: Inventory = Throughput Rate x Flow Time

14. Once again... Inventory = Throughput x Flow Time

15. Little’s Law basics • Little’s Law is for a system in steady state: input rate = output rate • Applies to most systems, even those with variability • Uses average values

16. Process Flow Examples Material Flow: A fast-food restaurant processes an average of 5,000 lb. of hamburgers per week. The typical inventory of raw meat is 2,500 lb. What is the average hamburger’s flow time and the restaurant’s turnover? Customer Flow: The above fast-food restaurant processes on average 1,500 customers per day (15 hours). On average there are 75 customers in the restaurant (waiting to place the order, waiting for the order to arrive, eating etc.). How long does an average customer spend at the restaurant and what is the average customer turnover? Job Flow: A branch office of an insurance company processes 10,000 claims per year. The average processing time is 3 weeks. Assuming 50 weeks in a year, what is the average number of claims “in process”.

17. Process Flow Examples Cash Flow: A major manufacturer sells $300 million worth of cellular equipment per year. The average accounts receivable in the cellular group is $45 million. What is the average billing to collection process flow time? Question: A general manager at at a pharmaceutical company states that her inventory turns three times a year. She also states that everything that the company buys gets processed and leaves the docks within six weeks. Are these statements consistent?

18. Example: Auto-Moto Financial Services • Auto-Moto provides loans to qualified customers. • The company receives about 1000 loan applications per 30-day working month… • …and makes accept/reject decisions based on an extensive review of each application

19. Auto-Moto: Current Process • Currently, Auto-Moto processes each application individually. • On average, 20% of all applications received approval. • An internal audit showed that, on average, Auto-Moto had about 500 applications in process at various stages of the approval procedure, but on which no decisions had yet been made. • In response to customer complaints about the time taken to process each application, Auto-Moto called in OPSM Consulting Inc.

20. Auto-Moto: Assessment • OPSM Consulting found that although most applications could be processed rather quickly, some took a disproportionate amount of time because of insufficient and/or unclear documentation. • They suggested the following Process II

21. Auto-Moto: Process II • Because, the percentage of approved applications is fairly low, an Initial Review Team should be set up to pre-process all applications according to strict but fairly mechanical guidelines. • Each application would fall into one of three categories: type A (looks excellent), type B (needs more detailed evaluation), and type C (reject summarily). Type A and B applications would be forwarded to different specialist subgroups • Each subgroup would then evaluate the applications in its domain and make accept/reject decisions

22. Auto-Moto: Process II implementation • Process II was implemented on an experimental basis. • The company found that, on average, 25% of all applications were of type A, 25% were of B, and 50% were of C. • Typically, about 70% of type A and 10% of B were approved on review. • Internal audit checks showed that, on average, 200 applications were with the Initial Review Team undergoing preprocessing. Only 25 were with the Subgroup A Team undergoing the next stage of processing and approximately 150 were with the Subgroup B Team

23. Auto-Moto would like to determine if the implemented changes have improved service performance.

24. Current System 20% accept 200/month 1000/month review 500 80% reject 800/month T=?

25. Proposed System Subgroup A review 70% 200 /month accept 30% 25 25% 10% Subgroup B review 25% 1000 /month initial review 90% 800 /month 50% 150 reject 200 C

26. Proposed System Subgroup A review 70% 200 /month accept I=25 30% 25% 10% Subgroup B review 25% R=1000 /month initial review 90% 800 /month 50% I=150 reject I=200 C

27. New process • Flow units: • Initial review: • Team A: • Team B: • Type A: • Type B: • Type C: • Average:

28. New process: different flow unit definition • Flow units: approved/rejected applications • Approved: • Tapproved= • Rejected: • Treject=

29. Analyzing Financial Flows through Financial Statements • MBPF manufactures prefabricated garages • MBPF operations called for the purchase of both sheet metal (raw materials) and prefabricated bases (purchased parts). • Garages were made in the fabrication area from sheet metal and then assembled with prefabricated bases in the assembly area. • Completed garages were stored in the finished goods warehouse until they were shipped to customers • Analyze the firm’s income statement, balance sheet, and cost of goods sold statement to determine in which department process improvements have the greatest impact on working capital

30. Definition: working capital • Working capital requirements include the value of inventories in the process and the value of any accounts receivable. Any reduction in working capital reduces the firm’s interest expense and makes extra cash available for other investments.

31. Consolidated Statements of Income and Retained Earnings • NET SALES 250.0 • COSTS AND EXPENSES • Cost of goods sold 175.8 • Selling, general and administrative expenses 47.2 • Interest expense 4.0 • Depreciation 5.6 • Other (income) expenses 2.1 • TOTAL COSTS AND EXPENSES 234.7 • INCOME BEFORE INCOME TAXES 15.3 • PROVISION FOR INCOME TAXES 7.0 • NET INCOME 8.3 • RETAINED EARNINGS, BEG. OF YEAR 31.0 • LESS CASH DIVVIDENDS DECLARED 2.1 • RETAINED EARNINGS AT THE END OF YEAR 37.2 • NET INCOME PER COMMON SHARE 0.83 • DIVIDENDS PER COMMON SHARE 0.21

32. Consolidated Balance Sheet of Dec. 31, x Current Assets Cash 2.1 Short-term investments at cost 3.0 Receivables, less allowances of $0.7 mil 27.9 Inventories 50.6 Other current assets 4.1 TOTAL CURRENT ASSETS 87.7 Property, Plant, and Equipment (at cost) Land 2.1 Buildings 15.3 Machinery and equipment 50.1 Construction in progress 6.7 Subtotal 74.2 Less accumulated depreciation 25.0 NET PROPERTY, PLANT, AND EQUIPMENT 49.2 Investments 4.1 Prepaid expenses and other deferred charges 1.9 Other assets 4.0 TOTAL ASSETS 146.9 Selected current liabilities (Payables) 11.9

33. Inventories and Cost of Goods Details Cost of Goods Sold • Raw Materials 50.1 • Fabrications (Labor and Overhead) 60.2 • Purchased Parts (Labor and Overhead) 40.2 • Assembly (Labor and Overhead) 25.3 • TOTAL 175.8 Inventory • Raw Materials (roof) 6.5 • Fabrications WIP (roof) 15.1 • Purchased Parts (base) 8.6 • Assembly WIP 10.6 • Finished goods 9.8 • TOTAL 50.6

34. Questions • How long does it take for a cost dollar to yield revenue? • How long does it take on average between the time at which a dollar enters the accounts receivable department and the time at which it is received as payment from the customer? • In which department does a reduction of flow time have the greatest impact on working capital?

35. How long does it take for a cost dollar to yield revenue? L&OH fab $60.2/yr $25.3/yr L&OH ass RM $50.1/yr COGS $50.6 $175.8/yr Parts $40.2/yr

36. Process Flows: Accounts receivable • How long does it take on average between the time at which a dollar enters the accounts receivable department and the time at which it is received as payment from the customer? • Flow unit: • R= • I= • T=I/R=

37. In which department does a reduction of flow time have the greatest impact on working capital? $60.2/yr $25.3/yr Raw materials Fabrication $50.1/yr $6.5 $15.1 $110.3/yr Assembly Finished goods $175.8/yr Purchased Parts $10.6 $9.8 $40.2/yr $8.6 $40.2/yr

38. Detailed Financial Flow Analysis $60.2/yr $25.3/yr Raw materials Fabrication $50.1/yr $6.5 $15.1 $110.3/yr Assembly Finished goods $175.8/yr Purchased Parts $10.6 $9.8 $40.2/yr $8.6 $40.2/yr Flow unit: cost dollars T=I/R=50.6/175.8=0.288 years=14.97 weeks

39. Flow Times through MBPF

40. Inventory Value Representation TH (mil/week) 5.0 3.38 Accounts Receivable 2.12 Fabrication Assembly Finished goods 0.96 Raw materials 0.77 Purchased Parts 11.12 6.75 7.12 3.14 2.90 5.80 T (week)

41. Example: Emergency Room Flow units?

42. On average how long does a patient spend in the ER? • Two types of flow units: • Potential admits • Simple prescriptions • Potential admits flow time= • Simple prescriptions flow time= • Average • T =.

43. On average how many patients are being examined by doctors? • Potential admits: • R =, • T = • I = RT = • Simple prescription: • R =, • T = • I = RT =

44. On average how many patients are there in the ER?

45. For next time • Read the Kristen’s Cookie case (3 pages) • Will have Quiz 1 • Closed books and notes • Problems similar to what we have seen in class • Study: business model; product attributes-process capabilities; product-process matrix; process flows; Little’s Law