PRODUCTION AND OPERATIONS MANAGEMENT

By
NSENGIYUMVA BALINDA Steven
MBA [Finance]; M.A [Economics]
E-mail:stevenbalinda@gmail.com
Tel:0788884994

Table of Contents
CHAPTER I: CONCEPTS OF PRODUCTION AND OPERATIONSMANAGEMENT ................... 4
1.1. Introduction ............................................................................................................................ 4
1.2. Historical Background ............................................................................................................ 4
1.3. Concept of Production ............................................................................................................ 5

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 1.4. Production System ................................................................................................................. 5
1.5. Classification of Production System ...................................................................................... 6
1.5.1. Job-Shop Production........................................................................................................... 6
1.5.2. Batch Production ................................................................................................................ 7
1.5.3. Mass Production ................................................................................................................. 8
1.5.4. Continuous Production ....................................................................................................... 8
1.6. Concept of Production Management ...................................................................................... 9
1.6.1. Objectives of Production Management ................................................................................. 12
1.7. Operations Systems .............................................................................................................. 13
1.7.1. Framework of Operations Management ........................................................................... 13
1.8. Strategic Roles of Operations .............................................................................................. 13
1.9. The Trend: Manufacturing and Non-Manufacturing System .............................................. 14
1.10. Scope of Production and Operations Management .......................................................... 15
CHAPTER II: OPERATIONS DECISION-MAKING ...................................................................... 16
1.1. Introduction .......................................................................................................................... 16
2.2. Characteristics of decisions ..................................................................................................... 16
2.3.1. Defining the problem............................................................................................................. 17
2.3.2. List possible future events ..................................................................................................... 17
2.3.3. Generating alternatives ......................................................................................................... 17
2.3.4. Express the payoff through Model ........................................................................................ 17
2.3.5. Evaluating the alternatives .................................................................................................... 17
2.4. Decision environment .............................................................................................................. 17
2.4.1. Decision making under Ignorance ........................................................................................ 19
2.4.2. Decision making under Uncertainty ..................................................................................... 19
2.4.3. Decision under risk ............................................................................................................... 23
2.5. Break-Even-Analysis as an economic model of certainty decision making ........................ 25
CHAPTER III: CORPORATE CAPACITY ANALYSIS ................................................................ 33
3.1. Introduction .......................................................................................................................... 33
3.2. Manufacturing and service systems ..................................................................................... 33
3.3. Design and system capacity ................................................................................................. 33
3.4. Capacity planning ................................................................................................................ 35
3.5. Process of capacity planning................................................................................................ 35

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 3.6. Importance of capacity decisions ......................................................................................... 37
CHAPTER IV: FACILITY LOCATION AND LAYOUT ................................................................ 39
4.1. Introduction .......................................................................................................................... 53
4.2. Location Choice for the First Time or New Organizations ................................................. 53
4.3. Location Choice for Existing Organization .............................................................................. 54
4.3. Global Location ................................................................................................................... 55
4.3.1. Reasons for a global/foreign location .......................................................................... 55
4.3.2. Factors influencing facility plant location/facility location .............................................. 56
4.4. Location theories ................................................................................................................... 61
4.5. Location Models .................................................................................................................. 62
4.6. Plant layout .......................................................................................................................... 65
4.6.1. Objectives of Plant Layout ............................................................................................... 65
4.6.2. Principles of Plant Layout .............................................................................................. 66
4.7. Classification of layouts ........................................................................................................ 66
CHAPTER 5: LINEAR PROGRAMING AND DEMAND FORECASTING.................................. 69
5.1 Introduction to Linear Programming ........................................................................................ 69
5.2. The Fundamental Assumptions of Linear Programming ......................................................... 71
5.3. Graphic Method for LP ............................................................................................................ 72
5.4. Demand forecasting ................................................................................................................. 76
5.4.1. Introduction ........................................................................................................................... 76
5.6. Forecasting Methods ................................................................................................................ 77
Correlation ...................................................................................................................................... 84
CHAP 6: STORAGE AND INVENTORY MANAGEMENT .......................................................... 85
6.1. Storage Management ........................................................................................................... 85
6.2. Inventory control .................................................................................................................. 86
6.3. Inventory control Model ...................................................................................................... 90

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CHAPTER I: CONCEPTS OF PRODUCTION AND OPERATIONSMANAGEMENT

1.1. Introduction

Production refers to convert inputs (resources) into outputs oriented to the markets
Operations refers to methodology or technology used in the conversion process. It may either
be manual, mechanical, semi-automated or fully automated operations. It is up to the firm to
decide on the applicable technology, depending on the investment level.
The concept of management has been initiated by Henry Fayol, it consists in process of
planning, organizing resources, coordinating and controlling the available resources or
products in the purpose of attaining the organizational goal.
The set of interrelated management activities, which are involved in manufacturing certain
products, is called as production management. If the same concept is extended to services
management, then the corresponding set of management activities is called as operations
management.

1.2.Historical Background

Step Period Author Scope

The beginning of the development of
Benvenuto production transformation theory was in
Cellini– the Guildhalls by Mastercrafters. These
Beginning 1545
goldsmith and artisans studied the transformation of
sculptor materials using new tools and techniques.
Step 1: specialization of work activities
1776 Adam Smith
Interchangeable
Parts (IP) and inventor of IP and facilitator of batch
Division of Labor 1780 Eli Whitney production
Frederick father of scientific management Scientific
Step 2 1900 Management (SM)
W.Taylor
sequenced assembly and the serialized
Step 3 1912 Henry Ford flow shop Sequenced Assembly (SA)
originator of statistical quality control
Statistical Quality Control (SQC) 1940’s–
Step 4 1930 Walter Shewhart 1960: Batch Production and Sequenced
Assembly Systems Predominate

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 Japanese manufacturing systems are
1970’s– emulated for low cost and high quality
Step 5 obtained with focus on statistical quality
1990’s
control (SQC) and other quality methods
Lean Production Systems (LPS)
Growth of computer technology from the
1990– 1950’s spurs Flexible Production Systems
Step 6
2000’s (FPS) new technology
The next steps are new energy sources,
huge battery capacities, and Mass
Step 7 2000’s– Customization (MC) and eventually
interplanetary travel Global Competition
(GC)

1.3.Concept of Production

Production function is ‘the part of an organization, which is concerned with the

transformation of a range of inputs into the required outputs (products) having the requisite
quality level’.

Production is defined as ‘the step-by-step conversion of one form of material into another
form through chemical or mechanical process to create or enhance the utility of the product
to the user’.
Thus production is a value addition process. At each stage of processing, there will be value
addition.

Edwood Buffa defines production as ‘a process by which goods and services are created’.
Some examples of production are: manufacturing custom-made products like, boilers with
a specific capacity, constructing flats, some structural fabrication works for selected
customers, etc., and manufacturing standardized products like, car, bus, motor cycle, radio,
television, etc.

1.4.Production System

The production system is ‘that part of an organization, which produces products of an

organization. It is that activity whereby resources, flowing within a defined system, are
combined and transformed in a controlled manner to add value in accordance with the
policies communicated by management’. A simplified production system is shown below:

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 Fig.1.1 Schematic production system

The production system has the following characteristics:

1. Production is an organized activity, so every production system has an
objective.
2. The system transforms the various inputs to useful outputs.
3. It does not operate in isolation from the other organization system.
4. There exists a feedback about the activities, which is essential to control and improve
system performance.

1.5.Classification of Production System

Production systems can be classified as Job-shop, Batch, Mass and Continuous production systems.

Fig. 1.2 Classifications of production systems

1.5.1. Job-Shop Production

Job-shop production is characterized by manufacturing one or few quantity of products

designed and produced as per the specification of customers within prefixed time and cost.
The distinguishing feature of this is low volume and high variety of products. A job-shop
comprises of general-purpose machines arranged into different departments. Each job
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 demands unique technological requirements, demands processing on machines in a
certain sequence.

Characteristics Advantages Limitations

High variety of products and low Because of general purpose Higher cost due to
volume. machines and facilities variety frequent set up
Use of general purpose machines of products can be produced. changes
and facilities.
Operators will become more Higher level of
Highly skilled skilled and competent, as inventory at all
operators who can each job gives them learning
levels and hence
Opportunities.
take up each job as a higher inventory
challenge because of
Full potential of operators can cost
uniqueness. be utilized.
Production
Large inventory of Opportunity exists for Creative planning is
materials, tools, parts. methods and innovative ideas complicated

Detailed planning is Larger space

essential for sequencing requirements.
the requirements of each
product, capacities for
each work Centre and
order priorities.

1.5.2. Batch Production

American Production and Inventory Control Society (APICS) defines Batch Production as
a form of manufacturing in which the job pass through the functional departments in lots
or batches and each lot may have a different routing. It is characterized by the manufacture
of limited number of products produced at regular intervals and stocked awaiting sales.

Characteristics Advantages Limitations

Shorter production Better utilization of Material handling is
runs. plant and machinery complex because of
irregular and longer
Plant and machinery Promotes functional flows.
are flexible specialization.
Plant and machinery Production planning
set up is used for the Cost per unit is lower and control is
production of item in as compared to job complex
a batch and change of order production
set up is required for Lower investment in Work in process
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 processing the next plant and machinery inventory is higher
batch compared to
Flexibility to continuous
Manufacturing lead- accommodate and production.
time and cost are process number of Higher set up costs
lower as compared to products. due to frequent
job order production changes in set up
Job satisfaction
exists for operators

1.5.3. Mass Production

Manufacture of discrete parts or assemblies using a continuous process are called Mass
Production. This production system is justified by very large volume of production. The
machines are arranged in a line or product layout. Product and process standardization
exists and all outputs follow the same path.
Characteristics Advantages Limitations
Standardization of Higher rate of Breakdown of one
product and process production with machine will stop an
sequence. reduced cycle time. entire production
Large volume of line.
products. Higher capacity Line layout needs
Shorter cycle time of utilization due to line major change with
production. balancing. the changes in the
Lower in process product design.
inventory. Less skilled High investment in
Flow of materials, operators are production facilities.
components and required. The cycle time is
parts is continuous determined by the
and without any back Low process slowest operation.
tracking. inventory.
Material handling Manufacturing cost
can be completely per unit is low.
automatic.

1.5.4. Continuous Production

Production facilities are arranged as per the sequence of production operations from the first
operations to the finished product. The items are made to flow through the sequence of
operations through material handling devices such as conveyors, transfer devices, etc.

Characteristics Advantages Limitations

Dedicated plant and Standardization of Flexibility to

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 equipment with zero product and process accommodate and
flexibility. sequence. process number of
products does not
Material handling is Higher rate of exist.
fully automated. production with
reduced cycle time. Very high investment
Process follows a for setting flow lines.
predetermined Higher capacity
sequence of utilization due to line Product
operations. balancing. differentiation is
limited.
Component materials Manpower is not required for
cannot be readily material handling as it is
identified with final completely automatic.
product.

Planning and
scheduling is a
routine action.

1.6. Productivity

Productivity is a relationship between the output (product/service) and input (resources consumed in
providing them) of a business system. The ratio of aggregate output to the aggregate input is called
productivity.

Productivity = output/Input

For survival of any organization, this productivity ratio must be at least 1. If it is more than 1, the
organization is in a comfortable position. Otherwise, the firm status is critical and its sustainable is
questionable.

1.6.1. Importance of productivity

Benefits derived from higher productivity are as follows:

 It helps to cut down cost per unit and thereby improve the profits.
 Gains from productivity can be transferred to the consumers in form of lower priced Products
or better quality products.
 These gains can also be shared with workers or employees by paying them at higher rate.
 A more productive entrepreneur can have better chances to exploit expert opportunities.
 It would generate more employment opportunity.
 Overall productivity reflects the efficiency of production system.
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  More output is produced with same or less input.
 The same output is produced with lesser input.
 More output is produced with more input.
 The proportional increase in output being more than the proportional increase in input.

1.6.2. Productivity Measurement

Productivity may be measured either on aggregate basis or on individual basis, which are called total
and partial measure.

Total productivity Index/measure = Total output/ Total input

Total production of goods and services/ SUM (Labor, material, capital, Energy and management)

Partial productivity indices, depending upon factors used, it measures the efficiency of individual
factor of production.

Labour productivity Index/Measure = Output in unit/ Man hours work

Management productivity Index/Measure = Output /Total cost of management
Machine productivity Index/Measure = Total output/ Machine hours worked
Land productivity Index/Measure = Total output/ Area of Land used
Partial Measure = Output/Labour or Output/Capital or Output/Energy or Output/materials

Illustration-1 The input and output data for an industry given in the table. Find out various productivity
measures like total, multifactor and partial measure. Output and Input production data in dollar ($)

Output in $ Inputs in $
1. Finished units 10,000 1. Human 3,000
2. Work in progress 2,500 2. Material 153
3. Dividends 1,000 3. Capital 10,000
4. Bonds 0 4. Energy 540
5. Other income 0 5. Other Expenses 1,500

Solution:
Total measure = Total Output/ Total Input = 13,500/ 15,193 = 0.89
Multi factor measure = Total Output/ Human+Material = 13,500/ 3,153 = 4.28
Multi factor measure = Finished units/ Human+Material = 10,000/ 3,153 = 3.17
Partial Measure1 = Total Output/ Energy = 13,500/ 540= 25
Partial Measure2= Finished units/ Energy = 10,000/ 540= 18.52
Note: For multifactor and partial measures it is not necessary to use total output as numerator. Often,
it is described to create measures that represent productivity as it relates to some particular output of
interest.

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Illustration-2 A furniture manufacturing company has provided the following data. Compare the
labour, raw materials and supplies and total productivity of 1996 and 1997. Output: Sales value of
production in dollar ($) 22,000 (in 2016) and 35,000 (in 2017)

Input 2016 2017

Labour 10,000 15,000
Raw materials and Supplies 8,000 12,500
Capital equipment depreciation 700 1,200
Other 2,200 4,800
Total 20,900 33,500
Partial productivities
Labour 2.2 2.33
Raw materials and Supplies 2.75 2.80
Total Productivity 1.05 1.04

1.6.3. Productivity measurement approaches at the enterprises level

As stated above total productivity is expressed as the ratio of aggregate output to the aggregate input.
That the total overall performance is captured in this ratio, becomes apparent, if we examine the
relationship between this ratio and the age-old performance measure of profit. If the outputs and input
for the period for which productivity is measured, are expressed in currencies, then under such
restrictive assumptions one can write:
Aggregate output =Gross Sales=G
Aggregate input=Cost =C
Total Productivity (P)= G/C (1)
From the definition of profit, we have; Profit= π = G-C (2)
By dividing eqn (2) by C, /C G / C  1
So from (1),  / C =P-1
For Zero profit (  =0), P 1
For a Loss, (   0), P1
For a profit, 0,P1
Zero profit will give a productivity value of 1, while a loss will give productivity value less than 1.
The profit to cost ratio will determine the increase in productivity. The above relationship that
demonstrates that increased profit to cost ratio will lead to increased overall productivity, is constituent
with our expectation on how an overall performance measure should behave. However, it suffers from
a number of drawbacks. Some of which are listed here,
 Given that our objective in productivity measurement is to capture the efficiency of utilization
of resources, the effect of price variations over time need to be corrected. Thus aggregate
output should be equal to gross sales suitably inflated or deflated with respect to a base year.
 Equating output to sales implies, whatever is produced in the particular period is sold.
Possibility of inventory, material manufactured for own use, etc. are not taken in to
consideration.

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  Equating aggregate input to cost raises a host of problems and involves several restrictive
assumptions. How to account for the fixed investment and working capital, whether to take
the fringe benefits in to account etc. are some of the problems.
The different approaches to measurement have arisen mainly in the context of correcting the above
drawbacks.

Higher productivity in organization leads to national prosperity and better standard of living for the
whole community. The methods contribute to the improvement of productivity are method study and
work measurement by reducing work content and Ineffective time. Work content means the amount
of work “contained in” a given product or process measured in man-hour or machine-hour. Except in
some cases like in processing industries, actual operation times are far in excess of the theoretical
minimum. Ineffective time is the time for which the worker or machine or both are idle due to the
shortcomings of the management or the worker.

1.7.Concept of Production Management

Production management is ‘a process of planning, organizing, directing and controlling the

activities of the production function. It combines and transforms various resources used in
the production subsystem of the organization into value added product in a controlled manner
as per the policies of the organization’.
Buffa defines production management as follows: Production management deals with decision-
making related to production processes so that the resulting goods or services are produced according
to specifications, in the amount and by the schedule demanded and out of minimum cost.

1.7.1. Objectives of Production Management

The objective of the production management is ‘to produce goods and services of Right
Quality and Quantity at the Right time and Right manufacturing cost’.
1. Right Quality: The quality of product is established based upon the customers
need. The right quality is not necessarily being the best quality. It is determined by
the cost of the product and the technical characteristics as suited to the specific
requirements.
2. Right Quantity: The manufacturing organization should produce the products in right
number. If they are produced in excess of demand the capital will block up in the
form of inventory and if the quantity is produced in short of demand, leads to
shortage of products.
3. Right Time: Timeliness of delivery is one of the important parameter to
judge the effectiveness of production department. So, the production department
has to make the optimal utilization of input resources to achieve its objective.
4. Right Manufacturing Cost: Manufacturing costs are established before the
product is actually manufactured. Hence, all attempts should be made to produce the
products at pre-established cost, so as to reduce the variation between actual and the
standard (pre-established) cost.

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1.8. Operations Systems

An operation was defined in terms of the mission it serves for the organization, technology it
employs and the human and managerial processes it involves. Operations in an organization
can be categorized into Manufacturing Operations and Service Operations. Manufacturing
Operations is a conversion process that includes manufacturing yields a tangible output: a
product, whereas, a conversion process that includes service yields an intangible output: a
deed, a performance, an effort.

Operations system converts inputs in order to provide outputs, which are required by a
customer. It converts physical resources into outputs, the function of which is to satisfy
customer wants.
Everett E. Adam & Ronald J. Ebert defines as ‘An operating system is the part of
an organization that produces the organization’s physical goods and services’.
Ray Wild defines operations system as ‘a configuration of resources combined for the
provision of goods or services.

1.8.1. Framework of Operations Management

Operation managers are concerned with planning, organizing, and controlling the activities,
which affect human behavior through models.

Planning is the activity that establishes a course of action and guide future decision-making.
The operations manager defines the objectives for the operations subsystem of the
organization, and the policies, and procedures for achieving the objectives. This stage
includes clarifying the role and focus of operations in the organization’s overall strategy. It
also involves product planning, facility designing and using the conversion process.

Organizing is the activities that establish a structure of tasks and authority. Operation
managers establish a structure of roles and the flow of information within the operations
subsystem. They determine the activities required to achieve the goals and assign
authority and responsibility for carrying them out.

Controlling is the activities that assure the actual performance in accordance with
planned performance. To ensure that the plans for the operations subsystems are
accomplished, the operations manager must exercise control by measuring actual outputs and
comparing them to planned operations management. Controlling costs, quality, and
schedules are the important functions here.

1.9.Strategic Roles of Operations

Primary goals of the organizations are related market opportunities. Economy and
efficiency of conversion operations are the secondary goals, which will be predominant with
the study and practice of operations management.
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 The four most important characteristics - the 4Vs of operations management - are:
1. The volume of the output - how many units of a given type of product are produced.
2. The variety of the offering - how many types (or versions) of a product have to be
manufactured by the same facility.

3. The variation in demand for the output - how the required number of products may
differ from day to day, or week to week.

4. The degree of visibility - how much customers can see of the manufacture of the
product, or the delivery of the service. This applies mainly to the service sector,
because for most services the customer's presence as a transformed resource is vital
to the process. organization’s efforts.
5. Strategizing: aiding in the development of corporate strategy, and devising and
implementing operations strategies to support it
6. Performance management: devising methods to increase the performance of the
entire organization
7. Change management: engaging in initiatives to continually update and improve
the organization and re-engineer processes to meet ever-increasing competitive
pressures
8. Design of products and services: where once the scope of operations was limited
to the manufacture of products to an existing design, these days it is increasingly
absorbing the design work, because the design of the product and the design of the
process of manufacture are carried out concurrently.
Assignments of the operations manager
1. Managing process: This is still the keystone of the operations manager's role. It
requires skills in process planning and systems thinking, coupled with an
understanding of technology and the ability to utilize it effectively, in addition to the
ability to manage the people elements that facilitate any process.
2. Managing complexity: With the size and diversity of today's operations, the
challenge is not in the individual tasks or decisions that are taken, but in how they
interact as a whole, and the complex relationships that result.
3. Linking conception and execution: For Taylor the designer designed the process and
the worker worked within the process. These days, in many organizations, both
conception and execution are carried out under the banner of operations.
4. Balancing today and tomorrow: A balance must be struck between doing what is
important today and planning for what may be important tomorrow.

1.10. The Trend: Manufacturing and Non-Manufacturing System

An increasingly significant trend in the Indian economy is the gradual shift of productive effort
from manufacturing (industrial) to service and information based products. With this, the
demand for communication and information based product is gradually restructuring the
society.
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Traditional ways of doing things are being replaced by efficient methods. Computers play a
major role in this transition along with fiber optics, microwaves, lasers and other
communication technologies.
Following characteristics can be considered for distinguishing Manufacturing Operations
with Service Operations:
 Tangible/Intangible nature of output
 Production and consumption
 Nature of work(job)
 Customer participation in conversion
 Measurement of performance
 Quality output
 Inventory accumulated
Manufacturing is characterized by tangible outputs (products). Consumption of outputs at
overtime. Jobs useless labor and more equipment, little customer contact, no customer
participation in the conversion process (in production). Sophisticated methods for
measuring production activities and resource consumption as product are made.

Service is characterized by intangible outputs. In addition, it possess a potential for high

variability in quality of output. Production and consumption occurs simultaneously. Jobs
use more labor and less equipment, direct consumer contact, frequent customer
participation in the conversion process. Elementary methods for measuring conversion
activities and resource consumption are used.

1.11. Scope of Production and Operations Management

Operations Management concern with the conversion of inputs into outputs, using physical
resources, so as to provide the desired utilities to the customer while meeting the other
organizational objectives of effectiveness, efficiency and adoptability. It distinguishes
itself from other functions such as personnel, marketing, finance, etc. by its primary concern
for ‘conversion by using physical resources’. Following are the activities, which are listed
under Production and Operations Management functions:

1) Operations decision-making
2) System design and capacity
3) Facility location and layout
4) Project scheduling and control
5) Linear programing and forecasting
6) Inventory control
7) Maintenance

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CHAPTER II: OPERATIONS DECISION-MAKING

1.1.Introduction

Thousands of business decisions are made every day. Not all the decisions will make or
break the organization. But each one adds a measure of success or failure to the operations.
Hence decision-making essentially involves choosing a particular course of action, after
considering the possible alternatives. This chapter examines management as a science and
the characteristics of decisions. The use of economic and statistical models is discussed
along with decision trees.

The success or failure that an individual or an organization experiences, depends to a large extent,
on the ability of making appropriate decisions. To make a decision requires an enumeration of
feasible and viable alternatives (courses of action).

2.2. Characteristics of decisions

Operations decision range from simple judgments to complex analyses, which also involves
judgment. Judgment typically incorporates basic knowledge, experience, and common
sense. They enable to blend objectives and sub-objective data to arrive at a choice.
The appropriateness of a given type of analysis depends on:
1. The significant or long lasting decisions,
2. The time availability and the cost of analysis, and
3. The degree of complexity of the decision.
The significant or long lasting decisions deserve more considerations than routine ones.
Plant investment, which is a long-range decision, may deserve more thorough analysis.
The time availability and the cost of analysis also influence the amount of analysis. The
degree of complexity of the decision increases when many variables are involved, variables
are highly independent and the data describing the variables are uncertain.

Business decision-makers have always had to work with incomplete and uncertain
data. In some situations a decision-maker has complete information about the decision
variables; at the other extremes, no information is available. Operations management
decisions are made all along this continuum.

Complete certainty in decision-making requires data on all elements in the population. If

such data are not available, large samples lend more certainty than do small ones. Beyond this,
subjective information is likely to be better than no data at all.

2.3. Framework of decision making

An analytical and scientific framework for decision implies the following systematic
steps
i. Identify and define the problem
ii. List possible future events (states of nature)
iii. Identify the courses of action (alternatives)
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 iv. Express the payoff resulting from each pair of courses action and states of nature expressed
in terms of monetary value
v. Apply an appropriate mathematical decision theory model to select the best course of action
from a list on the basis of criterion (measure of alternatives, options).

2.3.1. Defining the problem

Defining the problem enables to identify the relevant variables and the cause of the problem.
Careful definition of the problem is crucial. Finding the root cause of a problem needs some
questioning and detective work. If a problem defined is too narrow, relevant variable may be
omitted. If it is broader, many tangible aspects may be included which leads to the complex
relationships.

2.3.2. List possible future events

Establish the decision criterion is important because the criterion reflects the goals and
purpose of the work efforts. For many years profits served as a convenient and accepted
goal for many organizations based on economic theory. Nowadays organization will have
multiple goals such as employee welfare, high productivity, stability, market share, growth,
industrial leadership and other social objectives.

2.3.3. Generating alternatives

Alternatives are generated by varying the values of the parameters Mathematical and
statistical models are particularly suitable for generating alternatives because they can be
easily modified. The model builder can experiment with a model by substituting different
values for controllable and uncontrollable variable.

2.3.4. Express the payoff through Model

Modeling a decision situation usually requires both formulating a model and collecting the
relevant data to use in the model. Mathematical and statistical models are most useful models
for understanding the complex business of the problem. Mathematical models can incorporate
factor that cannot readily be visualized. With the aid of computers and simulation techniques,
these quantitative models are flexible.

2.3.5. Evaluating the alternatives

Evaluation of the alternatives is relatively objective in an analytical decision process

because the criteria for evaluating the alternatives have been precisely defined. The best
alternative is the one that most closely satisfies the criteria. Some models like LPP model
automatically seek out a maximizing or minimizing solution. In problems, various heuristic
and statistical techniques can be used to suggest the best course of action.

2.4. Decision environment

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To arrive at good decision, it is required to consider all available data, an exhaustive list of
alternatives, knowledge of decision environment and use of appropriate quantitative approach for
decision making. Following environments are in place: certainty, uncertainty, risk and conflict. To
know the environment helps to choose the appropriate quantitative approach for decision making.

Decision theory is the combination of descriptive and prescriptive business modeling approach to
classify the degree of knowledge, divided in 4 categories. The complete knowledge is the
“certainty” is on the far right, while the far ignorance is the far left.

IGNORANCE UNCERTAINTY RISK CERTAINTY

Increasing knowledge

Decision alternatives: there is a finite number of alternatives available to decision maker at each
point in time. These alternatives are the courses of action or strategies.

States of nature: these are the future conditions (also called consequences, events or scenarios) that
are not under the control of the decision maker (PESTE Factors).

Payoffs: a numerical value (outcome) resulting from each possible combination of alternatives and
state of nature. The payoff is measured within a specific period (1 month, 1year).

Example:

A firm manufactures 3 products, Fixed cost and variable cost are given

Product Fixed cost Variable cost/Unit

A 25,000 12
B 35,000 9
C 53,000 7
The demand (in units) of products is given:

i. Poor demand:3,000
ii. Moderate demand: 7,000
iii. High demand: 11,000

If the selling price per unit is RWF 25, prepare the payoff matrix.

Solution:

Let’s D1,D2,D3 be poor, moderate, high respectively.

Payoff= sales-Total Cost

The calculation of the payoff(,000RWF) for each pair of alternative demand (course of action) and
type of action, while the type of product is the state of nature:

D1

18
A[3*25]-[25+3*12]=14
B[3*25]-[35+3*9]=13
C[3*25]-[53+3*7]=1
D2

A[7*25]-[25+7*12]=66
B[7*25]-[35+7*9]=77
C[7*25]-[53+7*7]=73
D3

A[11*25]-[25+11*12]=118
B[11*25]-[35+11*9]=141
C[11*25]-[53+11*7]=145
Product D1 D2 D3
A 14 66 118
B 13 77 171
C 1 73 145
It is clear that the D3 Is the best with highest payoff

2.4.1. Decision making under Ignorance

In the case of ignorance environment, the decision maker has not knowledge about the nature of the
problem, the potential future events, the alternatives as well as the model expression to evaluate the
later. Therefore, in this environment there is no decision.

2.4.2. Decision making under Uncertainty

In this case, the decision maker is unable to specify the probability with which the states of nature
will occur. This is not the decision making under ignorance, because the possible states of nature are
known.

In the absence of knowledge about probability of any state of nature occurring, the decision maker
must arrive at a decision only on actual conditional payoff values, together with a policy. Different
criteria of decision making in this situation are:

 Optimistic (maximax or minimin)criterion

 Pessimistic (maximin or minimax) criterion
 Equal probabilities (Laplace) criterion
 Coefficient of optimism(Hurwicz) criterion

1. Optimistic (maximax or minimin) criterion

In this criterion, the decision maker ensures that he should not miss the opportunity to achieve the
largest possible profit(maximax) or the lowest possible cost (minimin). Thus, he selects the
alternative that represents the maximum of maxima or minimum of minima.

19
Working method

 Locate the maximum or minimum payoff values corresponding to each alternative.

 Select an alternative with best anticipated payoff values (max for profit or min for cost)
 The decision maker selects the largest (lowest) possible payoff value: optimistic decision
criterion.

2. Pessimistic criterion (maximin or minimax)

In this criterion the decision maker ensures he would earn not less (or pay not more) the
specified amount. Then, he selects the maximum of minima for profit or the minimum of
maxima in the case of cost.

Working method:
 Locate the minimum or the maximum for either profit or cost corresponding to each
alternative
 Select an alternative that provides the best anticipated payoff value (max for profit
and min for cost)
 The decision maker is conservative about the future and always anticipated possible
outputs minimum for profit and maximum for cost
 The pessimistic decision maker is also called Wald’s criterion

3. Equal probabilities (Laplace) criterion

The states of nature of probabilities are not known, it is assumed that all states will occur
with equal probabilities. Each states of nature is assigned an equal probability. As states of
nature are mutually exclusive, probabilities of each are equal to 1/number of states (Pi=1/n)

Working method

 Assign equal probabilities value to each state of nature (Pi=1/n)

 Complete expected average payoff for each alternative (choice) by adding all payoffs
and dividing by number of possible states of nature or apply: Pi*(Payoff value for
the combination of alternatives I and states of nature j)
 Select the best expected payoff value (max for profit or min for cost)

4. Coefficient optimism (Hurwicz) criterion

This criterion suggests that a rational decision maker should be neither completely optimistic
nor pessimistic. He has to display the mixture of both. Hurwicz introduced the idea of a
coefficient of optimism not (ɑ) to measure the decision maker’s degree of optimism. This
coefficient is between 0 and 1. 0 represent a complete pessimistic, while 1 represent a
complete optimistic attitude.

Thus, ɑ represent the coefficient of optimism and (1- ɑ) is the coefficient of pessimism.
Hurwitz suggests that a decision maker must select all alternatives that maximize
20
H (Criterion of realism) = ɑ (maximum in column+(1- ɑ) minimum in column

Working method

 Decide the coefficient of optimism (ɑ=Alpha) and the coefficient of pessimism (1- ɑ)
 For each alternative select the largest and lowest payoff value respectively. The calculate
the weighted average (H) by using the above
 Select the alternative with best anticipated weighted average payoff value.

Example
A food products’ company is contemplating the introduction of a revolutionary new product
with new packaging or replacing the existing product at much higher price (S1). It may even
make a moderate change in the composition of the existing product with a new packaging
at a small increase in the price (S2). It may also make a small change in the composition of
the existing product, backing it with word “New” and a negligible increase in the price (S3).
Three possible states of the nature are: High increase in sales (N1), no change in sales (N2)
and a decrease in sales (N3). The marketing department of the company worked out payoffs
in terms of yearly net profits for each strategy of three expected sales.
State of nature
Strategies
N1 N2 N3
S1 700,000 300,000 150,000
S2 500,000 450,000 ----
S3 300,000 300,000 300,000

Which strategy should the concerned executive choose on the basis of

 Maximin
 Maximax
 Minimax
 Laplace
The payoff matrix is rewritten as follow:
a) Maximin criterion
Course of Action
Strategies
S1 S2 S3
N1 700,000 500,000 300,000
N2 300,000 450,000 300,000
N3 150,000 - 300,000
Column 300,000
150,000.00 -
min (Maxmin)
The maximum of column minima is 300,000. Hence, the company should adopt the strategy
S3
b) Maximax

21
 States of Course of Action
nature S1 S2 S3
N1 700,000 500,000 300,000
N2 300,000 450,000 300,000
N3 150,000 - 300,000
Column 700,000
500,000 300,000
max maximax
The maximum of column maxima is 700,000. Hence, the company should adopt the strategy
S1.

c) Laplace criterion
Since we do not know the probabilities of states of nature, assume that they are equal. For
this example, we would assume that each state of nature has the probability 1/3 of
occurrence. Thus,
States of nature Expected Returns in RWF
S1 (700,000+300,000+150,000)1/3=383,333.33
S2 (500,000+450,000+0)1/3=316,666.66
S3 (300,000+300,000+300,000)1/3=300,000
Since the largest expected return is from the strategy S1, the executive must select the course
of action S1.

Example 2
A manufacturer manufactures a product, of which the principal ingredient is chemical X, at
the moment, the manufacturer spends RWF 1,000 per year on supply of X, but there is a
possibility that the price may soon increase to four times its present figure because of a
worldwide shortage of the chemical. There is another chemical Y, which the manufacturer
could use in conjunction with a third chemical Z in order to give the same effect as chemical
X. chemicals Y and Z would together cost the manufacturer RWF 3,000 per year, but their
prices are unlikely to rise. What actions should the manufacturer take if he’s optimistic/
pessimistic decision maker? Give two sets of solutions. If the coefficient of optimism is 0.4,
then find the course of actions that minimize the cost.
Solution
Course of Action
States of nature
S1(Y&Z) S2 (X)
N1( X Price is stable) 3,000 1,000
N2(X Price increases) 3,000 4,000
a) Minmin/minMax
Course of Action
States of nature
S1(Y&Z) S2 (X)
N1( X Price is stable) 3,000 1,000
N2(X Price increases) 3,000 4,000
Pessimistic minMax decision 3,000
Optimistic MinMin decision 1,000
The optimistic decision maker opts for the Minmin ( FRW 1,000) while the pessimistic opts
for (FRW 3,000).
22
 b)Hurwicz criterion
As the the coefficient of optimism is given 0.4, the coefficient of pessimism will be
1-0.4=0.6. Then, according to Hurwicz, select the course of action that optimizes
(maximum for profit and minimum for the cost) the

H= ɑ (Best Payoff) + (1- ɑ)(Worst Payoff)

= ɑ (Maximum in column) + (1- ɑ) (Minimum in Column)

Course of Best Worst

H
action Payoff Payoff
S1 3,000 3,000 3,000
S2 1,000 4,000 2,800

Since course of action S2 has the least cost (Maximum profit) = 0.4(1,000) + 0.6(4,000)=
2,800; The manufacturer should adopt this.

2.4.3. Decision under risk

Decision making under risk is probabilistic decision situation in which more than one state
of nature exists and the decision maker has sufficient information to assign the probability
values to the likely occurrence of each of these states. Knowing the probability distribution
of the states of nature, the best decision is to select the best course of action which has the
largest expected payoff value. The expected (Average) payoff of an alternative is the sum
of all possible payoffs of that alternative, weighted by probabilities of the occurrence of
those payoffs.
The widely used u criterion for evaluating various course of action (alternatives) under risk
is the expected monetary value (EMV) or expected utility.

1. Expected Monetary Value (EMV)

EMV for a given course of action is the weighted sum of possible payoffs for each
alternative. This is obtained through:
𝑚

𝐸𝑀𝑉(𝐶𝑜𝑢𝑟𝑠𝑒 𝑜𝑓 𝑎𝑐𝑡𝑖𝑜𝑛, 𝑆𝑗) = ∑ 𝑃𝑖𝑗 𝑝𝑖

𝑖=1
Where:
m = number of possible states of nature
pi = probability of occurrence of the state of nature, Ni
Pij= payoff associated with states of nature, Ni and course of action, Sj

Steps involved in computing the EMV

1. Construct a payoff matrix listing all possible courses of action and states of nature.
Enter conditional payoff values associated with each possible combination of course of
action and state of nature along with probabilities of the occurrence of each state of
nature

23
 2. Calculate the EMV for each course of action by multiplying the conditional payoff by
the associated probabilities and adding these weighted values for each course of action
3. Select the course of action that yields the optimal EMV
Example1:
Mr X flies quite often from town A to town B. he can use the airport bus which cost $25,
but if he takes, there is a 0.08 chance that he will miss the flight. The stay in a hotel cost $
270 with a 0.96 chance of being on time for the flight. For $350 he can use a taxi which will
make 99% chance for being on time for the flight. If Mr X catches the plane on time, he will
conclude a business transaction that will produce a profit of $ 10,000. Otherwise, he will
lose it which mode of transport should use Mr X? Answer on the basis of EMV Criterion.
Courses of actions
state of
Bus stay in hotel taxi
nature
cost Prob EV Cost prob EV Cost prob EV
Catch the
10000-25=9975 0.92 9,177 10000-270=9370 0.96 9,340.8 10000-350=9650 0.99 9,553.5
flight
miss the
-25 0.08 -2 -270 0.04 -10.8 -350 0.01 -3.5
flight
EMV 9,175 9,330 9,550

Example
The manager of a flower shop promises to customers a delivery within four hours on all
flower orders. All flowers are purchased on the previous day and delivery to Parker by
8.00am the next morning. The daily demand for roses is as follow:

Dozens of roses 70 80 90 100

Probability 0.1 0.2 0.4 0.3

The manager purchases roses for RWF 10 per dozen and sells them for RWF 30. All unsold
roses are donated to a local hospital. How many dozens of roses should Parker should order
for each evening to maximize its profits? What is the optimum expected profits?

Solution

Since number of roses (in dozens) purchased is under control by the decision maker,
purchase per day is considered as a course of action(decision choice) and the daily demand
of flowers is uncertain and only known by probability, therefore it is considered as the
states of nature(event). From the data it is clear that flowers shop must not purchase less
than 70 and more than 100 dozens of roses per day and each dozen of roses is sold within
a day yields profits a profits of 30-10=20 and otherwise it is a loss RWF 10

Marginal profit MP= Selling price – Cost= 30 – 10= 20

Marginal loss= loss of unsold roses = 10
Conditional profit = MP * roses sold - roses not sold
20𝐷 𝑖𝑓 𝐷 ≥ 𝑆
={ }
20𝐷 − 10(𝑆 − 𝐷) = 30𝐷 − 10𝑆; 𝑖𝑓 𝐷 < 𝑆

24
 Where D is the number of roses sold within a day and S the roses stocked
state of Conditional profit due to expected payoff due to course of
nature(D Probability courses of action(Purchase action [Purchase per day]
emand 70 80 90 100 70 80 90 100
per Day) 1 2 3 4 5 1*2 1*3 1*4 1*5
70 0.1 1400 1300 1200 1100 140 130 120 110
80 0.2 1400 1600 1500 1400 280 320 300 280
90 0.4 1400 1600 1800 1700 560 640 720 680
100 0.3 1400 1600 1800 2000 420 480 540 600
Expected Monetary Value (EMV) 1,400 1,570 1,680 1,670
Since the highest EMV of RWF 1,680 corresponds to the course of action 90, the flower
shop should purchase 9 dozens of roses every day.
2. Expected Opportunity Loss (EOL)
The name itself mentions that the loss incurred due to missing the best opportunity is the
expected opportunity loss. EOL is an alternative to EMV approach. The EOL for an outcome
is the difference between the best payoff of an event and the payoff of the realized event.
𝑚

𝐸𝑂𝐿(𝐶𝑜𝑢𝑟𝑠𝑒 𝑜𝑓 𝑎𝑐𝑡𝑖𝑜𝑛, 𝑆𝑗) = ∑ 𝑃𝑖𝑗 𝑝𝑖

𝑖=1
Example:
Suppose a bakery owner cost a type of cake for $ 5 and sales it to $6 each. Now the problem
to the bakery owner is that any unsold cake is the net loss as it is a perishable item. So, how
much should he prepare if he expects the sale of 100 per day with a probability of 0.5; 150
items with a probability 0.4 and 200 items with 0.1 probability. Then how much should he
prepare so than the expected opportunity loss is minimum.
expected Opportunity
courses of
state of Loss due to course of
action(Production per
nature(sal Probability action [Production per
day)
es per day]
Day) 100 150 200 100 150 200
1 2 3 4 1*2 1*3 1*4
100 0.5 0 250 500 0 125 250
150 0.4 50 0 250 20 0 100
200 0.1 100 50 0 10 5 0
Expected Opportunity Loss (EOL) 30 130 350

In the above table, the loss for the act of production of 100 and sale of 100 is zero, as the
shopkeeper production is fully sold so there is no loss opportunity. Whereas production of
150 and sales of 100, 50 remain unsold, the loss of 250 is incurred. And so on.
Since the minimum expected opportunity loss is $30 for the course of action to produce100
items. The shopkeeper should not go beyond this, otherwise he will incur a high loss.

2.5.Break-Even-Analysis as an economic model of certainty decision making

25
Break-even Analysis is an economic model describing cost-price-volume relationships. It is a
complete certainty type of model because costs and revenues are known quantities.

One of the techniques to study the total cost, total revenue and output relationship is
known as Break-even Analysis. ‘A Break-even Analysis indicates at what level of output,
cost and revenue are in equilibrium’. In other words, it determines the level of operations in
an enterprise where the undertaking neither gains a profit nor incurs a loss.
Notations and terminology

Break-even chart (BEC): It is a graph showing the variation in total costs at different
levels of output (cost line) as well as the variation in the total revenues at various
levels of output.
 Break-even point: It is that point of activity (sales volume) where total revenues and
total expenses are equal. It is point of zero profit, i.e. stage of no profit and no loss.
BEP can be used to study the impact of variations in volume of sales and cost of
production on profits.
 Angle of incidence: It is an angle at which total revenue line intersects total cost line.
The magnitude, of this angle indicates the level of profit. Larger the angle of
incidence, higher will be the profits per unit increase in sales and vice versa.
 Margin of safety: It is excess of budgeted or actual sales over the break-even sales
volume i.e. margin of safety = (actual sales minus sales at BEP)/actual sales. A high
margin of safety would mean that even with a lean period, where sales go down, the
company would not come in loss area. A small margin of safety means a small
reduction in sale would take company to cross BEP and come in red zone.
CALCULATION OF BEP

Relationship between costs and activity level (AL) is also assumed to be linear. For every
elemental cost, actual cost figures at different activity levels are plotted, and by ‘least square
analysis’ a ‘line of best fit’ is obtained. This would give a fixed cost component and a variable
cost component for the elemental cost.
This analysis is carried out for all elemental costs. The total cost function would give total
fixed cost and total variable cost for the company. The Break-even Point is that volume where
the fixed and variable costs are covered. But no profit exists. Thus at BEP, the total revenues
equal to the total costs.

If F – Fixed Costs, which are independent on quantity produced

 a – Variable Cost per unit
 b – Selling Price per unit
 Q – Quantity (Volume of output)
The total costs are given by
Total Cost (TC) = Fixed Cost +Variable Cost
TC = (F + aQ)

Sales Revenue (SR) = Selling price per unit×Quantity

SR = b.Q

The point of Intersection of Total Cost line and the sales revenue is the Break-even

26
Point i.e. at Break-even Point, Total Cost (TC) = Sales Revenue (SR)
F + aQ = bQ

F = Q(b – a)

𝑄
𝐹=
𝑏−𝑎

Profit volume ratio (PVR) is defined as the ratio between Contribution Margin and Sales Revenue.

Contribution
Profit Volume Ratio =
Sales Revenues
𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠−𝑇𝑜𝑡𝑎𝑙 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
Or 𝑃𝑉𝑅 = 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠

𝑏𝑄−𝑎𝑄 𝑄(𝑏−𝑎)
𝑃𝑉𝑅 = = (2)
𝑏𝑄 𝑏𝑄

𝐹
From the equation 1; whereas F=Q(b-a); therefore the PVR = 𝑏𝑄

𝐹
𝑄𝐵𝐸𝑃 = 𝑃𝑉 𝑅𝑎𝑡𝑖𝑜
The following graph presents the status of the BEP

Margin of safety (MOS) is defined as the ratio between Operating Profit and Contribution
Margin. It signifies the fractional reduction in the current activity level required to reach the
break-even point.

Sales turnover (STO) is defined as ratio between Sales Revenue and the Capital Employed.

27
It represents the number of times capital employed is turned over to reach the sales revenue
level that is called Operating management performance [OMP].

Ways of improving the company operating management Performance

A company interested in improving its OMP will have to improve its operating profit.
Following any of the strategies given below or a combination of them can do this:
(a) By reducing variable costs
(b) By reducing fixed costs
(c) By increasing sales price
(d) By increasing the activity level.

(a) A reduction in variable costs will bring down BEP, increase PV ratio and increase
margin of safety. To achieve a required Targeted Profit (Z), variable cost would have to be
controlled at

V=SR – (F+Z)

(b) A reductin in fixed costs will bring down BEP and increase margin of safety. It will
have no effect on PV ratio. To achieve a required TP by controlling fixed cost alone,
the fixed cost would have to be controlled as
F=(SR – V) – Z

28
(c) An increase in selling price will bring BEP down, it will increase PV ratio and it
will also increase the margin of safety. To get the targeted profit level the increase
required in selling price is given by
(𝐹 + 𝑍)
𝑏′ = ∗𝑏
(𝑏 − 𝑎)

(d) An increase in activity level will of course have no effect on BEP, it will not
change PV ratio, but will increase the margin of safety. The new activity level
required to achieve the desired TP is given by

(𝐹 + 𝑍) (𝐹 + 𝑍)
𝑁𝑒𝑤 𝑆𝑅 = 𝑜𝑟 ∗ 𝑆𝑅
𝑃𝑉 𝑅𝑎𝑡𝑖𝑜 𝑆𝑅 − 𝑉
If now is the existing activity level, the activity level required in terms of number of units
Nnew to achieve a targeted profit is given by

(𝐹 + 𝑍) (𝐹 + 𝑍)
𝑁 𝑛𝑒𝑤 = 𝑜𝑟 ∗ 𝑁 𝑛𝑒𝑤
𝐶𝑀 (𝑆𝑅 − 𝑉)
29
 With the help of this analysis, discreet decisions regarding control of variable costs, fixed
costs, fixing sales price and activity level can be taken to achieve the desired targeted
profit.
ILLUSTRATION 1 : The owner of shop is contemplating adding a new product,
which will require additional monthly payment of Rwf 6,000. Variable costs would be
Rwf. 2. per new product, and its selling price is Rwf 7. each.

(a) How many new products must be sold in order to break-even?

(b) What would the profit (loss) be if 1,000 units were sold in a month?
(c) How many units must be sold to realize a profit of Rwf.4, 000?

SOLUTION
Fixed Cost (F) = Rwf 6,000, Variable Cost (a ) = Rwf 2
per unit, Sales Price (b) = Rwf7 per unit
𝐹 6,000
𝑎)𝑄𝐵𝐸𝑃 = (𝑏−𝑎)= =1,200 units per month
7−2

(b) For Q = 1000,

Operating Profit (Z) = Q (b – a) – F = 1000 (7 – 2) – 6000 = Rwf.(1000)

(c) Operating Profit (Z) =Rwf 4000: Solve for Q

(𝑍 + 𝐹) (4000 + 6000)
𝑄= = = 2000 𝑢𝑛𝑖𝑡𝑠
(𝑏 − 𝑎 ) (7 − 2)

ILLUSTRATION 2 : A manager has the option of purchasing one, two, or three

machines. Fixed costs and potential volumes are as follows:
N0 of Annual fixed Corresponding
machines costs (Rwf) range of output
1 9,600 0 to 300
2 15,000 301 to 600
3 20,000 601 to 900

Variable cost is Rwf10 per unit, and revenue is Rwf40 per unit.
(a) Determine the break-even point for each range.

(b) If projected annual demand is between 580 and 660 units, how many
machines should the manager purchase?
SOLUTION
a) Compute the break-even point for each range using the formula

𝐹
𝑄𝐵𝐸𝑃 =
(𝑏 − 𝑎)

30
 9600
For one machine: 𝐵𝐸𝑃 = (40−10) = 320 𝑢𝑛𝑖𝑡𝑠

15000
For two machines: 𝐵𝐸𝑃 = 40−10 = 500 𝑢𝑛𝑖𝑡𝑠

20000
For three machines: 𝐵𝐸𝑃 = (40−10) = 666.67 𝑢𝑛𝑖𝑡𝑠

(b) Comparing the projected range of demand to the two ranges for which a break-even
point occurs, we can see that the break-even point is 500, which is in the range 301 to
600. This means that even if demand were at the low end of the range, it would be above the
break-even point and thus yield a profit. That is not true of range 601 to 900. At the top
end of projected demand, the volume would still be less than the break-even point for that
range, so there would be no profit. Hence, the manager should choose two machines.

ILLUSTRATION 3 : AMEKI COLOR Paint Co. produces 9,000 paint sprayers per
year and obtains Rwf 675, 000 revenue from them. Fixed costs are Rwf 210,000 per
year, and total costs are Rwf 354,000 per year. How much does each sprayer contribute
to fixed costs and profit?
SOLUTION
Contribution Margin (CM) = SP – VC
675000 Total Variable Cost
Where Sales Price = 9000 = Rwf 75per unit and VC = Quantity
Where TVC = Total Cost – Fixed Cost = Rwf 354,000 – Rwf 210,000 = Rwf 144,000

144000
= = Rwf 16 per unit
9000
Therefore, C = Rwf 75 – Rwf16 = Rwf 59/unit

Exercises
1. Fixed costs are Rwf. 40,000 per year, variable costs are Rwf. 50 per unit, and the
selling price is Rwf. 90 each. Find the BEP.

2. Florida Citrus produced 40,000 boxes of fruit that sold for Rwf. 3 per box. The total
variable costs for the 40,000 boxes were Rwf. 60,000, and the fixed costs were
Rwf.75,000. (a) What was the break-even quantity? (b) How much profit (or loss)
resulted?
3. A travel agency has an excursion package that sells for Rwf . 125. Fixed costs are
Rwf. 80,000; and at the present volume of 1,000 customers, variable costs
31
 are Rwf. 25,000 and profits are Rwf. 20,000. (a) What is the break-even point
volume? (b) Assuming that fixed costs remain constant, how many additional
customers will be required for the agency to increase profit by Rs.1000?

4. Given the pay-off table below showing the profit (present value Rwf.in Hundred
thousand), a firm might expect in a foreign country for three alternative factory
investments (X, Y, and Z) under different levels of inflation. Economists have
assigned probabilities of 0.2, 0.3, 0.4, and 0.1 to the possible inflation levels A,
B, C and D, respectively. Find the preferred investment alternative using
criteria of (a) Maximax, (b) Maximin, (c) Laplace, (d) Maximum probability, and
(e) Expected monetary value.

State of nature: Amount of inflation

A = 2% B = 5% C =10% D =15%
Build factory X 10 30 50 120
Build factory Y 40 50 60 70
Lease plant Z 10 40 80 10

32
CHAPTER III: CORPORATE CAPACITY ANALYSIS

3.1.Introduction

Before products can flow into a market, someone must design and invest in the facilities
and organization to produce them. This chapter concerns the planning of the systems needed
to produce goods and services. Capacity Planning for manufacturing and service systems
are different. Both must be designed with capacity limitations in mind. The approaches for
long-term and short-term capacity planning will help the managers to make best use of
resources.

3.2.Manufacturing and service systems

Manufacturing and service systems are arrangements of facilities, equipment, and people to
produce goods and services under controlled conditions.

Manufacturing systems produce standardized products in large volumes. This plant and
machinery have a finite capacity and contribute fixed costs that must be borne by the
products produced. Variable costs are added as labor is employed to combine or process the
raw materials and other components. Value addition will takes place during the production
process for the product. The cost of output relative to the cost of input can be measured, as
the actual cost is known i.e. productivity is measurable quantity.

Service systems present more uncertainty with respect to both capacity and costs. Services
are produced and consumed in the presence of the customer and there is little or no
opportunity to store value, as in a finished goods inventory. As a result capacity of service
systems like hospitals, restaurants and many other services must be sufficiently flexible to
accommodate a highly variable demand. In addition, many services such as legal and
medical involves professional or intellectual services judgments that are not easily
standardized. This makes more difficult to accumulate costs and measure the productivity
of the services.

3.3.Design and system capacity

Production systems design involves planning for the inputs, transformation activities, and
outputs of a production operation. Design plays a major role because they entail significant
investment of funds and establish cost and productivity patterns that continue in future.

The capacity of the manufacturing unit can be expressed in number of units of output
per period. In some situations measuring capacity is more complicated when they
manufacture multiple products. In such situations, the capacity is expressed as man-hours or
machine hours.

33
The relationship between capacity and output is shown in the Figure 3.1.

Fig. 3.1 Capacity and output relationship

DESIGN CAPACITY

Designed capacity of a facility is the planned or engineered rate of output of goods or services
under normal or full scale operating conditions. For example, the designed capacity of the
cement plant is 100 TPD (Tones per day). Capacity of the sugar factory is 150 tons of
sugarcane crushing per day. The uncertainty of future demand is one of the most perplexing
problems faced by new facility planners.

Organization does not plan for enough regular capacity to satisfy all their immediate
demands. Design for a minimum demand would result in high utilization of facilities but
results in inferior service and dissatisfaction of customers because of inadequate capacity.
The design capacity should reflect management’s strategy for meeting the demand. The
best approach is to plan for some in-between level of capacity.

System/effective capacity: System capacity is the maximum output of the specific product
or product mix the system of workers and machines is capable of producing as an integrated
whole. System capacity is less than design capacity or at the most equal it because of the
limitation of product mix, quality specification, and breakdowns. The actual is even less
because of many factors affecting the output such as actual demand, downtime due to
machine/equipment failure, unauthorized absenteeism.

The system capacity is less than design capacity because of long-range uncontrollable
factors. The actual output is still reduced because of short-term effects such as breakdown
of equipment, inefficiency of labor. The system efficiency is expressed as ratio of actual
measured output to the system capacity.
34
These different measures of capacity are useful in defining two measures of system
effectiveness: efficiency and utilization. Efficiency is the ratio of actual output to effective
capacity. Utilization is the ratio of actual output to design capacity.

Actual Output
Efficiency =
Effective capacity

Actual output
Utilization =
Design Capacity

It is common for managers to focus exclusively on efficiency, but in many instances, this
emphasis can be misleading. This happens when effective capacity is low compared with
design capacity. In those cases, high efficiency would seem to indicate effective use of
resources when it does not.

3.4.Capacity planning

Design of the production system involves planning for the inputs, conversion process and
outputs of production operation. The effective management of capacity is the most important
responsibility of production management. The objective of capacity management (i.e. planning
and control of capacity) is to match the level of operations to the level of demand.

Capacity planning is to be carried out keeping in mind future growth and expansion plans,
market trends, sales forecasting, etc. It is a simple task to plan the capacity in case of
stable demand. But in practice the demand will be seldom stable. The fluctuation of
demand creates problems regarding the procurement of resources to meet the customer
demand. Capacity decisions are strategic in nature. Capacity is the rate of productive
capability of a facility. Capacity is usually expressed as volume of output per period of time.

Production managers are more concerned about the capacity for the following reasons:
1. Sufficient capacity is required to meet the customers demand in time.
2. Capacity affects the cost efficiency of operations
3. Capacity affects the scheduling system.
4. Capacity creation requires an investment.
Capacity planning is the first step when an organization decides to produce more or new products.

3.5.Process of capacity planning

Capacity planning is concerned with defining the long-term and the short-term capacity needs
of an organization and determining how those needs will be satisfied. Capacity planning
decisions are taken based upon the consumer demand and this is merged with the human,
35
material and financial resources of the organization.

Capacity requirements can be evaluated from two perspectives—long-term capacity

strategies and short-term capacity strategies.

1. Long-term capacity strategies: Long-term capacity requirements are more difficult

to determine because the future demand and technology are uncertain. Forecasting for five or
ten years into the future is more risky and difficult. Even sometimes company’s today’s
products may not be existing in the future. Long-range capacity requirements are dependent
on marketing plans, product development and life-cycle of the product. Long-term capacity
planning is concerned with accommodating major changes that affect overall level of the output
in long-term. Marketing environmental assessment and implementing the long-term capacity
plans in a systematic manner are the major responsibilities of management. Following
parameters will affect long-range capacity decisions.

Multiple products: Company’s produce more than one product using the same facilities in
order to increase the profit. The manufacturing of multiple products will reduce the risk of
failure. Having more than on product helps the capacity planners to do a better job. Because
products are in different stages of their life cycles, it is easy to schedule them to get maximum
capacity utilization.

Phasing in capacity: In high technology industries, and in industries where technology

developments are very fast, the rate of obsolescence is high. The products should be
brought into the market quickly. The time to construct the facilities will be long and there is
no much time, as the products should be introduced into the market quickly. Here the solution
is phase in capacity on modular basis. Some commitment is made for building funds and
men towards facilities over a period of 3-5 years. This is an effective way of capitalizing on
technological breakthrough.

Phasing out capacity: The outdated manufacturing facilities cause excessive plant
closures and down time. The impact of closures is not limited to only fixed costs of plant and
machinery. Thus, the phasing out here is done with humanistic way without affecting the
community. The phasing out options makes alternative arrangements for men like shifting
them to other jobs or to other locations, compensating the employees, etc.

2. Short-term capacity strategies: Managers often use forecasts of product demand

to estimate the short-term workload the facility must handle. Managers looking ahead up to
12 months, anticipate output requirements for different products, and services.
Managers then compare requirements with existing capacity and then take decisions as to
when the capacity adjustments are needed.
For short-term periods of up to one year, fundamental capacity is fixed. Major facilities will
not be changed. Many short-term adjustments for increasing or decreasing capacity are
36
possible. The adjustments to be required depend upon the conversion process like whether it
is capital intensive or labor intensive or whether product can be stored as inventory.

Capital-intensive processes depend on physical facilities, plant and equipment. Short-term

capacity can be modified by operating these facilities more or less intensively than normal. In
labor intensive processes short-term capacity can be changed by laying off or hiring people or
by giving overtime to workers. The strategies for changing capacity also depend upon how
long the product can be stored as inventory.

The short-term capacity strategies are:

1. Inventories: Stock finished goods during slack periods to meet the demand during peak
period.
2. Backlog: During peak periods, the willing customers are requested to wait and their
orders are fulfilled after a peak demand period.
3. Employment level (hiring or firing): Hire additional employees during peak
demand period and layoff employees as demand decreases.
4. Employee training: Develop multi skilled employees through training so that they can be
rotated among different jobs. The multi skilling helps as an alternative to hiring employees.
5. Subcontracting: During peak periods, hire the capacity of other firms temporarily to
make the component parts or products.
6. Process design: Change job contents by redesigning the job.

3.6. Importance of capacity decisions

1. Capacity decisions have a real impact on the ability of the organization to meet future
demands for products and services; capacity essentially limits the rate of output possible.
Having capacity to satisfy demand can allow a company to take advantage of tremendous
opportunities.
2. Capacity decisions affect operating costs. Ideally, capacity and demand requirements
will be matched, which will tend to minimize operating costs. In practice, this is not
always achieved because actual demand either differs from expected demand or tends to
vary (e.g., cyclically). In such cases, a decision might be made to attempt to balance the costs
of over and under capacity.
3. Capacity is usually a major determinant of initial cost. Typically, the greater the capacity
of a productive unit, the greater its cost. This does not necessarily imply a one for-one
relationship; larger units tend to cost proportionately less than smaller units.
4. Capacity decisions often involve long-term commitment of resources and the fact that,
once they are implemented, it may be difficult or impossible to modify those decisions
without incurring major costs.

5. Capacity decisions can affect competitiveness. If a firm has excess capacity, or can quickly
add capacity, that fact may serve as a barrier to entry by other firms. Then too, capacity can
37
affect delivery speed, which can be a competitive advantage.
6. Capacity affects the ease of management; having appropriate capacity makes management
easier than when capacity is mismatched.

ILLUSTRATION 1: Given the information below, compute the efficiency and the
utilization of the vehicle repair

Department: Design capacity = 50 trucks per

day Effective capacity = 40 trucks per day
Actual output = 36 trucks per day

Effeciency 36trucks
Effeciency = = = 90%
Effeciency 40 trucks

Actual output 36 trucks

Utilization = = = 72%
Design Capacity 50 trucks

ILLUSTRATION 2: The design capacity for engine repair in our company is 80

trucks per day. The effective capacity is 40 engines per day and the actual output is 36
engines per day. Calculate the utilization and efficiency of the operation. If the
efficiency for next month is expected to be 82%, what is the expected output?

Actual output 36
Utilization = = = 45%
Design Capacity 80

Actual output 36
Efficiency = = = 90%
Effective Capacity 40

Expected output = (Effective capacity)(Efficiency)

(40)(0.82)=32.8

Exercise

1. An automatic drive-in teller at American National Bank has the capacity of handling
2,000 entries per regular banking day (according to the firm that sold it to the bank).
However, because of limitations imposed by automobile access, the teller is available
only 60 per cent of the time. It is actually being used for about 800 entries per day.
What is the system efficiency?

38
CHAPTER IV. BASICS OF PROJECT MANAGEMENT

4.1. Introduction

1.1. What is a project?

The word “project” was first used in or around the sixteenth century and derives from the Latin word
projicere (= throw forward). The Latin root thus suggests movement, a trajectory, a certain
relationship with space and time. The implied process involves:

A project is a scientifically evolved one-off piece of work plan devised to use specific resources to
achieve specific objective(s) within a specified period of time.

The four basic attributes are:

 a course of action-work plan

 specific resources
 specific objectives and;
 definite time perspective
A project is a temporary effort to create a unique product or service. Projects usually include
constraints and risks regarding cost, schedule or performance outcome.

1.2. Project Characteristics

A project is a temporary endeavor undertaken to create a unique product, service, or result.

1. Temporary (Temporariness)

Temporary means that every project has a definite beginning and a definite end. The end is reached
when the project’s objectives have been achieved, or it becomes clear that the project objectives will
not or cannot be met, or the need for the project no longer exists and the project is terminated.
Temporary does not necessarily mean short in duration; many projects last for several years. In every
case, however, the duration of a project is finite. Projects are not ongoing efforts. In addition,
temporary does not generally apply to the product, service or result created by the project. Most
projects are undertaken to create a lasting outcome.

2. Unique Products, Services, or Results:

The individuality of the product or service turned out by a project means the accomplishing of
something not done before. A project creates unique deliverables, which are products, services, or
results.

Projects can create:

• A product or artifact that is produced, is quantifiable, and can be either an end item in itself or a
component item

39
• A capability to perform a service, such as business functions supporting production or distribution

• A result, such as outcomes or documents. For example, a research project develops knowledge that
can be used to determine whether or not a trend is present or a new process will benefit society.

Uniqueness is an important characteristic of project deliverables.

Based on these two main characteristics, others can be described as follows:

3. Non-repetitive enterprise: A project is an event that is not part of the company’s

routine. It is something new for the people who work on it.

4. Clear and logical sequence of events: Projects are characterized by logically linked activities so
as to allow accurate tracking and control during their execution.

5. Beginning, middle, and end: Every project follows a certain life cycle, which means it has a
temporary nature. Many times, the completion of one project coincides with the beginning of another.
However, a project without completion is not a project, but a routine activity.

6. Clear and defined objective: Every project has well-defined targets and results to be achieved on
its completion.

7. Conducted by people: The fundamental core of any project consists of people. Without them, the
project does not exist, even when modern management control tools are available.

8. Projects use resources: Every project uses resources specifically allocated to certain works.

9. Predefined parameters: Every project requires the establishment of rates for time, costs,
personnel, material, and equipment involved, as well as the desired quality of the project. It is
impossible to establish such parameters with total accuracy, in advance. All of them will be clearly
identified and quantified in the project plan. However, the initial parameters will act as reference
points for the project and its evaluation.

10. It usually has defined constraints or targets in terms of cost, schedule (time), and performance
requirements. An example is a time limit. The aircraft with the impact dam-age might have to be
repaired within a specific time frame or lose several hours in its flying schedule. If at all possible, the
repair should be completed within this time frame.

11. It uses skills and talents from multiple professions and organizations. Projects often involve
advanced technology and rely on task interdependencies that may intro-duce new and unique
problems. Task and skill requirements vary from project to project.

1.3. Causes of Project Failure

A project fails mainly because of the following reasons:

40
- Targets and objectives are poorly defined or are not understood by the lower ranks.

- There is little acknowledgment of the project’s complexity.

- The project includes many activities with not enough time to accomplish them.

- Financial estimates are poor and incomplete.

- The project is based on insufficient or inadequate data.

- The control system is inadequate.

- The project lacks a project manager or has too many, thus creating power circles parallel to those
previously established.

- There is excessive dependency on project management software.

- The project estimates are based on the intuitive experience, or gut feeling, of the people involved,
with little importance given to the historical data of similar projects or statistical analyses.

- Training and development are inadequate.

- The project manager lacks leadership.

- No time is spent on revising and improving the estimates.

- The needs for personnel, equipment, and material have not been evaluated.

- Integration of the key elements of the project scope has failed.

- The client and project team have different, often opposite expectations

- The key areas of the project are unknown.

- Nobody has checked whether the people involved in the activities have the necessary knowledge to
perform them.

- People are not working to the same standards, or work standards have not been established.

1.4. Constraints on the completion of projects

a) Time
Our definition of a project stated that it was an activity which had a defined beginning and ending
point. Most projects will be close-ended in terms of there being a requirement for completion by
a certain point in time. This point may be the result of an external factor such as new legislation,
or may be derived from organizational requirements. It may also be partly determined by other
constraints. There is likely to be some relationship between the time taken for a project and its
cost. A trade-off between the two constraining factors may then be necessary.

41
b) Resource Availability

There is likely to be a budget for the project and this will clearly be a major constraint. Cost constraints
may be set in a number of ways, for example as an overall cash limit or as a detailed budget broken
down over a number of expenditure headings. Labour resources in particular may be a limiting factor
on the completion of the project. In the short run it is likely that labour will be fixed in supply. Whilst
the overall resource available may in theory be sufficient to complete the project, there may be
difficulties arising out of the way in which the project has been scheduled. That is, there may be a
number of activities scheduled to take place at the same time and this may not be possible given the
amount of resources available.
c) Quality factors

Whether the project delivers the goods to the right quality.

There are techniques which can be used to overcome the problems referred to above. These include:

 Budgeting and the corresponding control of the project budget through budgetary control
procedures.
 Project planning and control techniques such as Gantt charts and network analysis.

2. Managing Projects

Competent project management methods keep track of what is required at start up, what has been
done, and what still needs to be done. Also, good project methods point to activities that are critical
for completion. Project managers expedite those activities that seem to be slipping. These points are
part of the five project life-cycle stages described here:

1. Describing goals requires developing and specifying the desired project outcomes. (Architects lay
out plans for building, cruise lines announce their schedules and destinations; everyone must set the
goals of their projects.)

2. Planning the project requires specifying the activities that are essential to accomplish the goals. It
involves planning the management of the project including the timing of the activities. (The project
manager lays out the charts of sequenced activities and estimates how long it will take to do them.
The time frame sets in motion the execution of the plan. The builder is usually the project planner.)

3. Carrying out the project requires doing the activities as scheduled. (Getting building permits,
ordering materials, assembling different kinds of work crews needed at the right times, and
constructing the building. The builder is usually the project manager.)

42
4. Completing the project can mean disbanding work groups and closing down the project-
management team. However, firms that are in the business of project management, such as companies
that build refineries, move their crews from project to project. Each project is goal-specific and finite.
That is the mission of project-management companies when compared to organizations that need to
use project management from time to time. The latter cannot avoid the fact that an ECO is a project
and needs to be managed as such.

5. The use of continuous project teams is an increasingly attractive option. There is significant
evidence that continuous project development is crucial to the success of twenty-first-century global
organizations. Companies that do not have a project orientation might bring out a new product and
then disband the project teams when the job is done. As will be discussed later, organizations
increasingly opt to maintain continuous project capability.

4.3. Project planning tools

4.3.1. Gantt charts.

A Gantt chart (or a bar chart, first used in 1917 by Henry Gantt) is a two-dimensional table where
horizontal axis represents time flow and vertical axis (the rows) represent activities. The duration of
each activity is represented by a horizontal bar. Bar charts can also be used for progress assessment
during running the project (painting the bars that correspond to the finished tasks with a different
color). Bar charts can be used for planning other resources as well (people, infrastructure, money etc).

A Gantt chart is a form of horizontal bar chart and horizontal bars are drawn against a time scale for
each project activity, the length of which represents the time taken to complete. To construct a Gantt
Chart the following steps are necessary:

1) Use the horizontal axis to represent time

2) Use the vertical axis to represent activities
3) Represent each activity by a horizontal bar of appropriate length
4) Take activity procedures into account by starting each activity bar to an appropriate point along
the time axis after its preceding activities. Normally the start point for an activity is the earliest
time that it could start after its preceding activities had finished.
It is possible to enhance the Gantt Chart in several ways. For instance, the number of staff required
to do a task can be entered into the bar on the diagram.

Gantt charts, also commonly known as milestone plans, are a low cost means of assisting the project
manager at the initial stages of scheduling. They ensure that:

1. all activities are planned for,

2. the sequence of activities is accounted for,
3. the activity time estimates are recorded; and
4. the overall project time is recorded.
They are therefore a simple, rough and ready means of planning a project and assessing progress and
are sufficient for most simple projects.

43
 Gantt charts also provide a summary of the project as a whole and can be used as a rough and ready
means of assessing progress at the project control phase. At any date, the project manager can draw a
dateline through the Gantt chart and see which activities are on-time, which are behind schedule and
generally record project status against plan.

Example 3.1. A bar chart for development and piloting a new university course (unit of measuring –
one week):

1 2 3 4 5 6 7 8 9 1 1 1 1 1 1 16
0 1 2 3 4 5

1. Planning seminars > > >

2. Revision of work plan > > >

3. Needs analysis > > >

4. Contracts with developers > >

and teachers/tutors

5. Course development > > > > > >

6. Creation of technical > > > > >

infrastructure

7. Testing of a module > >

8. Composition of a > > > >

questionnaire

9. Feedback analysis > > >

10. Modification of the course > >

11. Marketing the course > > >

12. Development of a support > > >

system for the curse

13. Piloting the course > > >

14. Assessment of the course >

44
For visualizing dependencies between the activities arrows from the preceding activity to subsequent
activity are used. Milestones can be represented by activities with no duration (that is, a dot or bold
line in corresponding cell).

Gantt chart advantages

1. Allows for efficient organization – In order for a Gantt chart to be successful, you first need to
identify project elements or tasks. If you are using this type of chart you are essentially forced
to focus on what truly needs to be done, thus making you somewhat more organized and
encouraging a potentially higher chance of success.

2. Helps establish timeframes – Because many project elements often depend on other tasks, it
can be tough to deduce how long one task should take and when to start and finish it by. Gantt
charts use bars to indicate how long a task should take and what this does is give you a better
perspective of the total project, and timeframe as a whole. Just be sure to consider time factors
outside of the project such as holidays.
3. Highly visual – Gantt charts are visual, and give you an excellent way to instantly see and
comprehend all of the different elements in once place, thus bringing thoughts and ideas
together. Beyond that the visuals provide users with an easy to see chart of what needs to be
done next.
Gantt chart disadvantages

1. Potentially overly complex – If you’ve ever worked on a complex project, and looked at the
Gantt chart, you know that these charts can be large and hard to read. For big projects
businesses may need to hire specific managers to look after the details of the project,
something which could be costly for small businesses that don’t have an in house project
manager.
2. Need to be updated – Gantt charts are developed early in the planning stages of a project,
there is a good chance that the project will change, thus the chart will need to be updated.
Also, as tasks are completed or reviewed the chart will need to be updated to reflect these
changes too. Any amendments take time, especially if there are dependent tasks that need to
also be revised. It is a pretty sure thing that most people involved in the project probably don’t
have the time to do this
3. Don’t show the whole picture – Gantt charts show what tasks need to be done and the time
they should take. They don’t show how much work each task will involve or how many
people/resources each task will require. This can give some people an incomplete picture or
the wrong idea about an individual task, which can cause issues as the project gets underway
Exercise of Gantt charts
1. A project comprises the following activities:

Activity Immediate Activity

Predecessors Time (days)

45
 A - 12
B - 6
C A 13
D A, B 12
E C, D 11
F D 13
G E, F 11

Construct a Gantt chart which will provide an overview of the planned project.

4.3.2 PERT and CPM

1. Background
The two most common and widely used project management techniques that can be classified under
the title of Network Analysis are Program Evaluation and review Technique (PERT) and Critical Path
Method (CPM). Both were developed in the 1950's to help managers schedule, monitor and control
large and complex projects. CPM was first used in 1957 to assist in the development and building of
chemical plants within the DuPont corporation. Independently developed, PERT was introduced in
1958 following research within the Special Projects Office of the US Navy. It was initially used to plan
and control the Polaris missile program which involved the coordination of thousands of contractors.
The use of PERT in this case was reported to have cut eighteen months off the overall time to
completion.

PERT/CPM is a time-based method. Time and cost estimates will be related at a later point. For now,
time is the crucial parameter. The goal is to determine the project duration with the aim in mind to
achieve the shortest project completion time and then, control of project-cycle time to meet the goals
of the plan. The critical path is the longest towards the project completion.

2. The PERT/CPM Procedure

There are six stages common to both PERT and CPM:
1. Define the project and specify all activities or tasks.
2. Develop the relationships amongst activities. Decide upon precedence.
3. Draw network to connect all activities.
4. Assign time and/or costs to each activity.
5. Calculate the longest time path through the network: this is the "critical path".
6. Use network to plan, monitor and control the project.

Finding the critical path (step 5) is a major in controlling a project. Activities on the critical path
represent tasks which, if performed behind schedule, will delay the whole project. Managers can derive
flexibility by identifying the non-critical activities and re-planning, rescheduling and reallocating
resources such as manpower and finances within identified boundaries.

PERT and CPM differ slightly in their terminology and in network construction. However, their
objectives are the same and, furthermore, their project analysis techniques are very similar. The major
46
difference is that PERT employs three time estimates for each activity. Probabilities are attached to
each of these times which, in turn, is used for computing expected values and potential variations for
activity times. CPM, on the other hand, assumes activity times are known and fixed, so only one time
estimate is given and used for each activity. Given the similarities between PERT and CPM, their
methods will be discussed together. The student will then be able to use either, deciding whether to
employ variable (PERT) or fixed (CPM) time estimates within the network.

PERT and CPM can help to answer the following questions for projects with thousands of activities
and events, both at the beginning of the project and once it is underway:

 When will the project be completed?

 What are the critical activities (i.e.: the tasks which, if delayed, will effect time for overall
completion)?
 Which activities are non-critical and can run late without delaying project completion time?
 What is the probability of the project being completed by a specific date?
 At any particular time, is the project on schedule?
 At any particular time, is the money spent equal to, less than or greater than the budgeted amount?
 Are there enough resources left to complete the project on time?
 If the project is to be completed in a shorter time, what is the least cost means to accomplish this
and what are the cost consequences?

3. PERT and Activity Time Estimation

The major distinguishing difference between PERT and CPM is the use of three time estimates for each
activity in the PERT technique, with CPM using only one time for each activity using CPM.

The three time estimates specified for each activity in PERT are:

i) the optimistic time;

ii) the most probable time; and
iii)the pessimistic time.

The optimistic, most likely and pessimistic time estimates are used to calculate an expected activity
completion time which, because of the skewed nature of the beta distribution, is marginally grater than
the most likely time estimate. In addition, the three time estimates can be used to calculate the variance
for each activity. The formulae used are as follows:

o4m p
t 6
 po
2

v  
 6 

 

47
Where:

o, m, p - optimistic, most likely, and pessimistic times

t - expected completion time for task
v - variance of task completion time
Knowing the details of a project, its network and values for its activity times (t) and their variances (v)
a complete PERT analysis can be carried out. This includes the determination of the ES, EF, LS, LF
and S for each activity as well as identifying the critical path, the project completion time (T) and the
variance (V) for the entire project.

Normally when using PERT, the expected times (t) are calculated first from the three values of activity
time estimates, and it is these values of t that are then used exactly as before in CPM. The variance
values are calculated for the various activity times and the variance of the total project completion time
(i.e. the sum of the activity expected times of those activities on the critical path) is the sum of the
variances of the activities lying on that critical path.

Example:

The optimistic, most probable, and pessimistic times (in days) for completion of activities for a
certain project are as follows:

IMMEDIATE OPTIMISTIC MOST PROBABLE PESSIMISTIC

ACTIVITY
PREDECESSOR TIME (o) TIME (m) TIME (p)
A - 4 5 6
B - 6 8 10
C A 6 6 6
D B 3 4 5
E B 2 3 4
F C,D 8 10 12
G E 6 7 8
H C,D 12 13 20
I F,G 10 12 14

a) Find the critical path.

Solution:

a) The expected times are obtained by using the formula (o + 4m + p) / 6 and the variances are
2
obtained by using the formula ((p-o)/6) and are summarized in the following table:

48
 EXPECTED
ACTIVITY VARIANCE
TIME
A 5 0.11
B 8 0.44
C 6 -
D 4 0.11
E 3 0.11
F 10 0.44
G 7 0.11
H 14 1.78
I 12 0.44

The project network diagram based on the expected values in the table above is depicted below:

Critical Path Analysis

The objective of critical path analysis is to determine times for the following:

 ES = Earliest Start Time. This is the earliest time an activity can be started, allowing for the fact
that all preceding activities have been completed.
 LS = Latest Start Time. This is the latest time an activity can be started without delaying the start
of following activities which would put the entire project behind schedule.
 EF = Earliest Finish Time. The earliest time an activity can be finished.
 LF = Latest Finish Time. The latest time that an activity can finish for the project to remain on
schedule.
 S = Activity Slack Time. The amount of slippage in activity start or duration time which can be
tolerated without delaying the project as a whole.

4. Early Start and Early Finish Times

The critical path gives the project duration. However, it does not tell when to start an activity and when
to finish an activity. We find out the Early Start (ES) time and the Early Finish (EF) time of each
activity. Determine ES and EF values for all activities in the project: The Forward Pass through the
network.

EF = ES + t

ACTIVITY IMMEDIATE EXPECTED Latest Latest

PREDECESSOR TIME Start Finish
A - 5 1 6
B - 8 0 8
49
 C A 6 6 12
D B 4 8 12
E B 3 12 15
F C,D 10 12 22
G E 7 15 22
H C,D 14 20 34
I F,G 12 22 34

The calculations start by fixing the deadline for project completion which is the LF time by which the
last activity of the project has to be finished. Calculate LS and LF values for all activities by conducting
a Backward Pass through the network

LF = LS + t

Analysis of the project normally involves:

Determining the Critical Path. The critical path is the group of activities in the project that have a slack
time of zero. This path of activities is critical because a delay in any activity along it would delay the
project as a whole.

1. Calculating the total project completion time, T. This is done by adding the activity times of those
activities on the critical path.

The steps in critical path analysis are as follows:

Identify the critical path which will be those activities with zero slack (i.e.: ES=LS and EF=LF).
50
Calculate total project completion time.

The slack time of an activity is the time by which the activity can be delayed without delaying the
project completion time. Slack is the allowable slippage in time. Slack time, by definition, can be
wasted without changing project-completion time. It is calculated by using one of the following
equations. Both of them give the same answer.

S = LS - ES or S = LF - EF

The numbers in brackets above the arrows show the earliest start (ES) and earliest finish (EF) for each
activity respectively whereas the numbers in brackets below the arrows show the latest start (LS) and
latest finish (LF) times respectively. EF = ES + activity duration and LF = LS + activity duration Activity
slack = LS - ES = LF - EF. Activity slack shows how much an activity can be delayed without affecting
the project completion time. For example, in our problem slack for activity E = 12 - 8 = 4 ; hence we can
delay activity E for 4 days and still finish the project in the expected completion time of 34 days.

EXPECTED Standard
ACTIVITY VARIANCE Slack Time
TIME deviation

A 5 0.11
0.33 1.00

B 8 0.44
0.67 -

C 6 -
- 1.00

D 4 0.11
0.33 -

E 3 0.11
0.33 4.00

F 10 0.44
0.67 -

G 7 0.11
0.33 4.00

H 14 1.78
1.33 8.00

I 12 0.44
0.67 -

51
On the other hand, when the activity slack is zero, that activity can be delayed zero days, meaning that it
can't be delayed; hence an activity is critical whenever its slack is zero. Such an activity is called critical
because any delay in the completion of that activity would delay the whole project. In our example,
activities B, D, F and I have zero slack; hence they are critical activities. All other activities in our
example are non-critical. Knowing which activities are critical and which are non- critical may be quite
useful; whenever there is an unexpected delay in critical activities we can shift resources like capital,
manpower, etc. from non-critical activities that can be delayed to the critical activities which can't be
delayed.

In our problem, the critical path can be depicted as follows:

Critical path: B D F I or 1  3 4  6  7

Expected completion time,  = 34 days.

Expected Time of the Standard

Paths Variance
path deviation

ACH 26 1.89 1.37

ACFI 34 1.00 1.00

BDFI 34 1.44 1.20

BEGI 34 1.11 1.05

Benefits of PERT

PERT is useful because it provides the following information:

 Expected project completion time.

 Probability of completion before a specified date.
 The critical path activities that directly impact the completion time.
 The activities that have slack time and that can lend resources to critical path activities.
 Activities start and end dates.

Limitations of PERT

The following are some of PERT's limitations:

 The activity time estimates are somewhat subjective and depend on judgment. In cases where
there is little experience in performing an activity, the numbers may be only a guess. In other
cases, if the person or group performing the activity estimates the time there may be bias in
the estimate.

52
  The underestimation of the project completion time due to alternate paths becoming critical is
perhaps the most serious.

CHAPTER V: FACILITY LOCATION AND LAYOUT

4.1.Introduction

Plant location or the facilities location problem is an important strategic level

decision-making for an organization. One of the key features of a conversion process
(manufacturing system) is the efficiency with which the products (services) are transferred
to the customers. This fact will include the determination of where to place the plant or
facility.
The selection of location is a key-decision as large investment is made in building plant
and machinery. It is not advisable or not possible to change the location very often. So an improper
location of plant may lead to waste of all the investments made in building and machinery,
equipment.
Before a location for a plant is selected, long range forecasts should be made
anticipating future needs of the company. The plant location should be based on the
company’s expansion plan and policy, diversification plan for the products, changing
market conditions, the changing sources of raw materials and many other factors that
influence the choice of the location decision. The purpose of the location study is to find
an optimum location one that will result in the greatest advantage to the organization.

The need for selecting a suitable location arises because of three situations.
 When starting a new organization, i.e., location choice for the first time.
 In case of existing organization.
 In case of Global Location.
4.1. Location Choice for the First Time or New Organizations
Cost economies are always important while selecting a location for the first time, but
should keep in mind the cost of long-term business/organizational objectives. The
following are the factors to be considered while selecting the location for the new
organizations:
1. Identification of region: The organizational objectives along with the various long-
term considerations about marketing, technology, internal organizational strengths and
weaknesses, region-specific resources and business environment, legal-governmental
environment, social environment and geographical environment suggest a suitable region for
locating the operations facility.
2. Choice of a site within a region: Once the suitable region is identified, the next
step is choosing the best site from an available set. Choice of a site is less dependent
on the organization’s long-term strategies. Evaluation of alternative sites for their tangible and
intangible costs will resolve facilities-location problem.

53
4.3. Location Choice for Existing Organization

In this case a manufacturing plant has to fit into a multi-plant operations strategy. That
is, additional plant location in the same premises and elsewere under following
circumstances:
1. Plant manufacturing distinct products.
2. Manufacturing plant supplying to specific market area.
3. Plant divided on the basis of the process or stages in manufacturing.
4. Plants emphasizing flexibility.
The different operations strategies under the above circumstances could be:
1. Plants manufacturing distinct products: Each plant services the entire market area
for the organization. This strategy is necessary where the needs of technological and resource
inputs are specialized or distinctively different for the different product-lines.
For example, a high-qu al i t y precision product-line should not be located along with
other product-line requiring little emphasis on precision. It may not be proper to have
too many contradictions such as sophisticated and old equipment, highly skilled and semi-
skilled personnel, delicate processes and those that could permit rough handlings, all under
one roof and one set of managers. Such a setting leads to much confusion regarding the
required emphasis and the management policies.
Product specialization may be necessary in a highly competitive market. It may be
necessary to exploit the special resources of a particular geographical area. The more
decentralized these pairs are in terms of the management and in terms of their physical
location, the better would be the planning and control and the utilization of the resources.
2. Manufacturing plants supplying to a specific market area: Here, each
plant manufactures almost all of the company’s products. This type of strategy is useful
where market proximity consideration dominates the resources and technology
considerations. This strategy requires great deal of coordination from the corporate
office. An extreme example of this strategy is that of soft drinks bottling plants.
3. Plants divided on the basis of the process or stages in manufacturing:
Each production process or stage of manufacturing may require distinctively different
equipment capabilities, labor skills, technologies, and managerial policies and emphasis.
Since the products of one plant feed into the other plant, this strategy requires much
centralized coordination of the manufacturing activities from the corporate office that are
expected to understand the various technological aspects of all the plants.
4. Plants emphasizing flexibility: This requires much coordination between plants to
meet the changing needs and at the same time ensure efficient use of the facilities and
resources. Frequent changes in the long-term strategy in order to improve be efficiently
temporarily, are not healthy for the organization. In any facility location problem the central
question is: ‘Is this a location at which the company can remain competitive for a long
time?’

For an established organization in order to add on to the capacity, following are the ways:
54
(a) Expansion of the facilities at the existing site: This is acceptable when it does not
violate the basic business and managerial outlines, i.e., philosophies, purposes, strategies
and capabilities. For example, expansion should not compromise quality, delivery, or customer
service.
(b) Relocation of the facilities (closing down the existing ones): This is a drastic step
which can be called as ‘Uprooting and Transplanting’. Unless there are very compelling
reasons, relocation is not done. The reasons will be either bringing radical changes in
technology, resource availability or other destabilization.
All these factors are applicable to service organizations, whose objectives, priorities and
strategies may differ from those of hardcore manufacturing organizations.

4.2. Global Location

Because of globalization, multinational corporations are setting up their organizations in India

and Indian companies are extending their operations in other countries. In case of global
locations there is scope for virtual proximity and virtual factory.

4.2.1. Reasons for a global/foreign location

A. Tangible Reasons

The tangible reasons for setting up an operations facility abroad could be as follows:
Reaching the customer: One obvious reason for locating a facility abroad is that of
capturing a share of the market expanding worldwide. The phenomenal growth of the GDP
of India is a big reason for the multinationals to have their operations facilities in our country.
An important reason is that of providing service to the customer promptly and economically
which is logistics-dependent. Therefore, cost and case of logistics is a reason for setting up
manufacturing facilities abroad. By logistics set of activities closes the gap between production
of goods/services and reaching of these intended goods/services to the customer to his
satisfaction. Reaching the customer is thus the main objective. The tangible and intangible
gains and costs depend upon the company defining for itself as to what that ‘reaching’
means. The tangible costs could be the logistics related costs; the intangible costs may be
the risk of operating is a foreign country. The tangible gains are the immediate gains; the
intangible gains are an outcome of what the company defines the concepts of reaching and
customer for itself.
The other tangible reasons could be as follows:
(a) The host country may offer substantial tax advantages compared to the home country.
(b) The costs of manufacturing and running operations may be substantially less in
that foreign country. This may be due to lower labor costs, lower raw material cost,
better availability of the inputs like materials, energy, water, ores, metals, key
personnel etc.
(c) The company may overcome the tariff barriers by setting up a manufacturing plant
in a foreign country rather than exporting the items to that country.
B. Intangible Reasons
55
 The intangible reasons for considering setting up an operations facility abroad could
be as follows:
1. Customer-related Reasons
1) With an operations facility in the foreign country, the firm’s customers may feel
secure that the firm is more accessible. Accessibility is an important ‘service quality’
determinant.
2) The firm may be able to give a personal tough.
3) The firm may interact more intimately with its customers and may thus understand
their requirements better.
4) It may also discover other potential customers in the foreign location.

2. Organizational Learning-related Reasons

1) The firm can learn advanced technology. For example, it is possible that cutting-
edge technologies can be learn by having operations in an technologically more
advanced country. The firm can learn from advanced research
laboratories/universities in that country. Such learning may help the entire product-
line of the company.
2) The firm can learn from its customers abroad. A physical location there may be
essential towards this goal.
3) It can also learn from its competitors operating in that country. For this reason, it may
have to be physically present where the action is.
4) The firm may also learn from its suppliers abroad. If the firm has a manufacturing
plant there, it will have intensive interaction with the suppliers in that country from
whom there may be much to learn in terms of modern and appropriate technology,
modern management methods, and new trends in business worldwide
3. Other Strategic Reasons
1) The firm by being physically present in the host country may gain some ‘local boy’
kind of psychological advantage. The firm is no more a ‘foreign’ company just
sending its products across international borders. This may help the firm in lobbying
with the government of that country and with the business associations in that
country.
2) The firm may avoid ‘political risk’ by having operations in multiple countries.
3) By being in the foreign country, the firm can build alternative sources of supply; the
firm could, thus, reduce its supply risks.
4) The firm could hunt for human capital in different countries by having operations in
those countries. Thus, the firm can gather the best of people from across the globe.
5) Foreign locations in addition to the domestic locations would lower the market risks
for the firm. If one market goes slow the other may be doing well, thus lowering the
overall risk.

4.2.2. Factors influencing facility plant location/facility location

Facility location is the process of determining a geographic site for a firm’s operations.
Managers of both service and manufacturing organizations must weigh many factors when
assessing the desirability of a particular site, including proximity to customers and suppliers,
56
labor costs, and transportation costs.
Location conditions are complex and each comprises a different Characteristic of a tangible
(i.e. Freight rates, production costs) and non-tangible (i.e. reliability, Frequency security,
quality) nature.
It is appropriate to divide the factors, which influence the plant location or facility location
on the basis of the nature of the organization as:
1) General locational factors, which include controllable and uncontrollable factors
for all type of organizations.
2) Specific locational factors specifically required for manufacturing and
service organizations.
Location factors can be further divided into two categories:
1 ) Dominant factors are those derived from competitive priorities (cost, quality,
time, and flexibility) and have a particularly strong impact on sales or costs.
2) Secondary factors also are important, but management may downplay or even
ignore some of them if other factors are more important.
Following are the general factors required for location of plant in case of all types of organizations.
1.General Locational Factors

controllable factors
1. Proximity to markets: Every company is expected to serve its customers by providing
goods and services at the time needed and at reasonable price organizations may choose to
locate facilities close to the market or away from the market depending upon the product.
When the buyers for the product are concentrated, it is advisable to locate the facilities close
to the market.
Locating nearer to the market is preferred if
1 ) The products are delicate and susceptible to spoilage.
2) After sales services are promptly required very often.
3) Transportation cost is high and increase the cost
significantly.
4) Shelf life of the product is low.
Nearness to the market ensures a consistent supply of goods to customers and reduces the
cost of transportation.
2. Supply of raw material: It is essential for the organization to get raw material in right
qualities and time in order to have an uninterrupted production. This factor becomes very
important if the materials are perishable and cost of transportation is very high.
General guidelines suggested by Yaseen regarding effects of raw materials on plant location
are:
i. When a single raw material is used without loss of weight, locate the plant at the
raw material source, at the market or at any point in between.
ii. When weight loosing, raw material is demanded, locate the plant at the raw material
source.
iii. When raw material is universally available, locate close to the market area.
57
 iv. If the raw materials are processed from variety of locations, the plant may be situated
so as to minimize total transportation costs.
Nearness to raw material is important in case of industries such as sugar, cement, jute and
cotton textiles.
3. Transportation facilities: Speedy transport facilities ensure timely supply of raw materials
to the company and finished goods to the customers. The transport facility is a prerequisite
for the location of the plant. There are five basic modes of physical transportation, air,
road, rail, water and pipeline. Goods that are mainly intended for exports demand a location
near to the port or large airport. The choice of transport method and hence the location will
depend on relative costs, convenience, and suitability. Thus transportation cost to value added
is one of the criteria for plant location.
4. Infrastructure availability: The basic infrastructure facilities like power, water and
waste disposal, etc., become the prominent factors in deciding the location. Certain types
of industries are power hungry e.g., aluminum and steel and they should be located close
to the power station or location where uninterrupted power supply is assured throughout the
year. The non-availability of power may become a survival problem for such industries.
Process industries like paper, chemical, cement, etc., require continuous. Supply of water in
large amount and good quality, and mineral content of water becomes an important factor.
A waste disposal facility for process industries is an important factor, which influences the
plant location.
5. Labor and wages: The problem of securing adequate number of labor and with skills
specific is a factor to be considered both at territorial as well as at community level during
plant location. Importing labor is usually costly and involve administrative problem. The
history of labor relations in a prospective community is to be studied. Prospective
community is to be studied. Productivity of labor is also an important factor to be
considered. Prevailing wage pattern, cost of living and industrial relation and bargaining
power of the unions’ forms in important considerations.

6. External economies of scale: External economies of scale can be described as

urbanization and locational economies of scale. It refers to advantages of a company by
setting up operations in a large city while the second one refers to the “settling down”
among other companies of related Industries. In the case of urbanization economies, firms
derive from locating in larger cities rather than in smaller ones in a search of having access
to a large pool of labor, transport facilities, and as well to increase their markets for
selling their products and have access to a much wider range of business services.

Location economies of scale in the manufacturing sector have evolved over time and have
mainly increased competition due to production facilities and lower production costs as a
result of lower transportation and logistical costs. This led to manufacturing districts
where many companies of related industries are located more or less in the same area. As
large corporations have realized that inventories and warehouses have become a major cost
factor, they have tried reducing inventory costs by launching “Just in Time” production
system (the so called Kanban System). This high efficient production system was one main
factor in the Japanese car industry for being so successful. Just in time ensures to get spare

58
parts from suppliers within just a few hours after ordering. To fulfill these criteria
corporations have to be located in the same area increasing their market and service for
large corporations.

7. Capital: By looking at capital as a location condition, it is important to distinguish the

physiology of fixed capital in buildings and equipment from financial capital. Fixed capital
costs as building and construction costs vary from region to region. But on the other hand
buildings can also be rented and existing plants can be expanded. Financial capital is highly
mobile and does not very much influence decisions. For example, large Multinational
Corporations such as Coca-Cola operate in many different countries and can raise capital
where interest rates are lowest and conditions are most suitable.
Capital becomes a main factor when it comes to venture capital. In that case young, fast
growing (or not) high tech firms are concerned which usually have not many fixed assets.
These firms particularly need access to financial capital and also skilled educated
employees.
Uncontrollable factors
8. Government policy: The policies of the state governments and local bodies concerning
labor laws, building codes, safety, etc., are the factors that demand attention.
In order to have a balanced regional growth of industries, both central and state governments
in our country offer the package of incentives to entrepreneurs in particular locations.
The incentive package may be in the form of exemption from a safes tax and excise duties
for a specific period, soft loan from financial institutions, subsidy in electricity charges and
investment subsidy. Some of these incentives may tempt to locate the plant to avail these
facilities offered.
9. Climatic conditions: The geology of the area needs to be considered together with
climatic conditions (humidity, temperature). Climates greatly influence human efficiency
and behaviour. Some industries require specific climatic conditions e.g., textile mill will require
humidity.
10. Supporting industries and services: Now a day the manufacturing organization will
not make all the components and parts by itself and it subcontracts the work to vendors.
So, the source of supply of component parts will be the one of the factors that influences
the location.
The various services like communications, banking services professional consultancy services
and other civil amenities services will play a vital role in selection of a location.
11. Community and labor attitudes: Community attitude towards their work and towards
the prospective industries can make or mar the industry. Community attitudes towards
supporting trade union activities are important criteria. Facility location in specific location
is not desirable even though all factors are favouring because of labor attitude towards
management, which brings very often the strikes and lockouts.
12. Community infrastructure and amenity: All manufacturing activities require access
to a community infrastructure, most notably economic overhead capital, such as roads,
railways, port facilities, power lines and service facilities and social overhead capital like
schools, universities and hospitals.
These factors are also needed to be considered by location decisions as infrastructure is
59
enormously expensive to build and for most manufacturing activities the existing stock
of infrastructure provides physical restrictions on location possibilities.
2. Specific Locational Factors for Manufacturing Organization

Dominant factors
Factors dominating location decisions for new manufacturing plants can be broadly classified
in six groups. They are listed in the order of their importance as follows.
1. Favorable labor climate: A favorable labor climate may be the most important
factor in location decisions for labor-intensive firms in industries such as textiles furniture
and consumer electronics. Labor climate includes wage rates, training requirements attitudes
toward work, worker productivity and union strength. Many executives consider weak
unions or al low probability of union organizing efforts as a distinct advantage.
2. Proximity to markets: After determining where the demand for goods and services is
greatest, management must select a location for the facility that will supply that demand.
Locating near markets is particularly important when the final goods are bulky or heavy
and outbound transportation rates are high. For example, manufacturers of products such
as plastic pipe and heavy metals all emphasize proximity to their markets.
3. Quality of life: Good schools, recreational facilities, cultural events, and an attractive
lifestyle contribute to quality of life. This factor is relatively unimportant on its own, but
it can make the difference in location decisions.
4. Proximity to suppliers and resources: In many companies, plants supply parts to other
facilities or rely on other facilities for management and staff support. These require
frequent coordination and communication, which can become more difficult as distance
increases.
5. Utilities, taxes, and real estate costs: Other important factors that may emerge
include utility costs (telephone, energy, and water), local and state taxes, financing
incentives offered by local or state governments, relocation costs, and land costs.
Secondary factors
There are some other factors needed to be considered, including room for expansion,
construction costs, accessibility to multiple modes of transportation, the cost of shuffling
people and materials between plants, competition from other firms for the workforce,
community attitudes, and many others. For global operations, firms are emphasizing local
employee skills and education and the local infrastructure.

3.Specific Locational Factors for Service Organization

Dominant factors
The factors considered for manufacturers are also applied to service providers, with one
important addition — the impact of location on sales and customer satisfaction. Customers
usually look about how close a service facility is, particularly if the process requires
considerable customer contact.
Proximity to customers
Location is a key factor in determining how conveniently customers can carry on business
with a firm. For example, few people would like to go to remotely located dry cleaner or
supermarket if another is more convenient. Thus the influence of location on revenues
60
tends to be the dominant factor.
Transportation costs and proximity to markets
For warehousing and distribution operations, transportation costs and proximity to markets
are extremely important. With a warehouse nearby, many firms can hold inventory closer
to the customer, thus reducing delivery time and promoting sales.
Location of competitors
One complication in estimating the sales potential at different location is the impact of
competitors. Management must not only consider the current location of competitors but also
try to anticipate their reaction to the firm’s new location. Avoiding areas where competitors
are already well established often pays. However, in some industries, such as new-car sales
showrooms and fast-food chains, locating near competitors is actually advantageous. The
strategy is to create a critical mass, whereby several competing firms clustered in one
location attract more customers than the total number who would shop at the same stores at
scattered locations. Recognizing this effect, some firms use a follow –the leader strategy
when selecting new sites.

4.3.Location theories

Alfred weber’s theory of the location of industries

Alfred Weber (1868–1958), with the publication of Theory of the Location of Industries in 1909,
put forth the first developed general theory of industrial location. His model took into account
several spatial factors for finding the optimal location and minimal cost for manufacturing plants.
The point for locating an industry that minimizes costs of transportation and labor
requires analysis of three factors:
1. The point of optimal transportation based on the costs of distance to the ‘material
index’—the ratio of weight to intermediate products (raw materials) to finished
product.
2. The labor distortion, in which more favourable sources of lower cost of labor may
justify greater transport distances.
3. Agglomeration and degglomerating.
Agglomeration or concentration of firms in a locale occurs when there is sufficient
demand for support services for the company and labor force, including new investments
in schools and hospitals. Also supporting companies, such as facilities that build and service
machines and financial services, prefer closer contact with their customers.
Degglommeration occurs when companies and services leave because of over concentration
of industries or of the wrong types of industries, or shortages of labor, capital, affordable
land, etc. Weber also examined factors leading to the diversification of an industry in the
horizontal relations between processes within the plant.
The issue of industry location is increasingly relevant to today’s global markets and trans-
national corporations. Focusing only on the mechanics of the Weberian model could
justify greater transport distances for cheap labor and unexploited raw materials. When
resources are exhausted or workers revolt, industries move to different countries.

61
4.4.Location Models

Various models are available which help to identify the ideal location. Some of the popular
models are:
1. Factor rating method
2. Weighted factor rating method
3. Center of gravity m ethod

1. Factor rating
methods
The process of selecting a new facility location involves a series of following
steps:
1. Identify the important location factors.
2. Rate each factor according to its relative importance, i.e., higher the ratings is indicative
of prominent factor.
3. Assign each location according to the merits of the location for each factor.
4. Calculate the rating for each location by multiplying factor assigned to each location with
basic factors considered.
5. Find the sum of product calculated for each factor and select best location having highest
total score.
ILLUSTRATION 1: Let us assume that a new medical facility, Health-care, is to
be located in Kigali. The location factors, factor rating and scores for two potential
sites are shown in the following table. Which is the best location based on factor
rating method?

Factor Rating Score

SN Location factor
rating Location 1 Location 2 Location 1 Location 2
1 Facility utilization 8 3 5 24 40
2 Total patient per month 5 4 3 20 15
Average time per
3 6 4 5 24 30
emergency trip
Land and construction
4 3 1 2 3 6
costs
5 Employee preferences 5 5 3 25 15
Total score 96 106
The total score for location 2 is the higher than that of location 1. Hence location 2, is the
best choice.
2. Weighted Factor Rating Method
In this method to merge quantitative and qualitative factors, factors are assigned weights
based on relative importance and weightage score for each site using a preference matrix is
calculated. The site with the highest weighted score is selected as the best choice.
ILLUSTRATION 2: Let us assume that a new medical facility, Health-care, is to
62
be located in Kigali. The location factors, weights, and scores (1 = poor, 5 = excellent)
for two potential sites are shown in the following table. What is the weighted score for
these sites? Which is the best location?
Rating weighted Score
SN Location factor weight
Location 1 Location 2 Location 1 Location 2
1 Facility utilization 25 3 5 75 125
2 Total patient per month 25 4 3 100 75
Average time per
3 25 3 3 75 75
emergency trip
Land and construction
4 15 1 2 15 30
costs
5 Employee preferences 10 5 3 50 30
Total weighted score 315 335

Location 2 is the best site based on total weighted scores.

3. Center of Gravity method

Center of gravity is based primarily on cost considerations. This method can be used to
assist managers in balancing cost and service objectives. The center of gravity method
takes into account the locations of plants and markets, the volume of goods moved, and
transportation costs in arriving at the best location for a single intermediate warehouse.

The center of gravity is defined to be the location that minimizes the weighted distance
between the warehouse and its supply and distribution points, where the distance is
weighted by the number of tones supplied or consumed. The first step in this procedure
is to place the locations on a coordinate system. The origin of the coordinate system and
scale used are arbitrary, just as long as the relative distances are correctly represented. This
can be easily done by placing a grid over an ordinary map. The center of gravity is
determined by the formula.

∑ 𝐷𝑖𝑊𝑖 ∑ 𝐷𝑖𝑊𝑖
𝐶𝑥 = ∑ 𝑊𝑖
𝐶𝑦 = ∑ 𝑊𝑖

Cx = x-coordinate of the center of gravity

Cy = y-coordinate of the center of gravity
Dix = x-coordinate of location i
Diy = y-coordinate of location i
ILLUSTRATION 4: The new Health-care facility is targeted to serve seven census
tracts in Delhi. The table given below shows the coordinates for the center of each
census tract, along with the projected populations, measured in thousands. Customers
will travel from the seven census tract centers to the new facility when they need
health-care. Two locations being considered for the new facility are at (5.5, 4.5)
63
and (7, 2), which are the centers of census tracts C and F. Details of seven census
tract centers, coordinate distances along with the population for each center are
given below. Find the target area’s center of gravity for the Health-care medical
facility.

SOLUTION: To calculate the center of gravity, start with the following information,
where population is given in thousands.
Coordinates
SN Sectors Population LX LY
(X,Y)
1 A 2.5 4.5 2 5 9
2 B 2.5 2.5 5 12.5 12.5
3 C 5.5 4.5 10 55 45
4 D 5 2 7 35 14
5 E 8 5 10 80 50
6 F 7 2 20 140 40
7 G 9 2.5 14 126 35
Total 68 453.5 205.5
Next we find Cx and Cy.
Cx = 453.5/68 = 6.67
Cy = 205.5/68 = 3.02
The center of gravity is (6.67, 3.02). Using the center of gravity as starting point, managers
can now search in its vicinity for the optimal location.

4. Locational Economics

An ideal location is one which results in lowest production cost and least distribution cost per
unit. These costs are influenced by a number of factors as discussed earlier. The various
costs which decide locational economy are those of land, building, equipment, labor, material,
etc. Other factors like community attitude, community facilities and housing facilities will also
influence the selection of best location. Economic analysis is carried out to decide as to which
locate best location.

The following illustration will clarify the method of evaluation of best layout selection.
ILLUSTRATION 6: From the following data select the most advantageous location
for setting a plant for making transistor radios.

64
 SN Particulars Site X Site Y Site Z
1 Total initial investment 200,000 200,000 200,000
2 Total expected sales 250,000 300,000 250,000
3 Distribution expenses 40,000 40,000 75,000
4 Raw material expenses 70,000 80,000 90,000
5 Power and water supply expenses 40,000 30,000 20,000
6 Wages and salaries 20,000 25,000 20,000
7 Other expenses 25,000 40,000 30,000
Total Expenditures (3-7) 195,000 215,000 235,000

𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 =
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
250,000−195,000
𝑅𝑂𝑅 𝑥 = *100=27.5%
200,000

300,000 − 215,000
𝑦= ∗ 100 = 42.5%
200,000
250,000 − 235,000
𝑧= ∗ 100 = 7.5%
200,000

Location Y can be selected because of higher rate of return.

4.5.Plant layout

Plant layout refers to the physical arrangement of production facilities. It is the configuration
of departments, work centers and equipment in the conversion process. It is a floor plan
of the physical facilities, which are used in production.

4.5.1. Objectives of Plant Layout

The primary goal of the plant layout is to maximize the profit by arrangement of all the
plant facilities to the best advantage of total manufacturing of the product.
The objectives of plant layout are:
1. Streamline the flow of materials through the plant.
2. Facilitate the manufacturing process.
3. Maintain high turnover of in-process inventory
4. Minimize materials handling and cost.
5. Effective utilization of men, equipment and space.
6. Make effective utilization of cubic space.
7. Flexibility of manufacturing operations and arrangements
8. Provide for employee convenience, safety and comfort.
9. Minimize investment in equipment.
10. Minimize overall production time.
65
11. Maintain flexibility of arrangement and operation.
12. Facilitate the organizational structure.

4.5.2. Principles of Plant Layout

1. Principle of integration: A good layout is one that integrates men, materials,

machines and supporting services and others in order to get the optimum utilization
of resources and maximum effectiveness.
2. Principle of minimum distance: This principle is concerned with the minimum
travel (or movement) of man and materials. The facilities should be arranged such
that, the total distance travelled by the men and materials should be minimum and
as far as possible straight line movement should be preferred.
3. Principle of cubic space utilization: The good layout is one that utilize both
horizontal and vertical space. It is not only enough if only the floor space is utilized
optimally but the third dimension, i.e., the height is also to be utilized effectively.
4. Principle of flow: A good layout is one that makes the materials to move in
forward direction towards the completion stage, i.e., there should not be any
backtracking.
5. Principle of maximum flexibility: The good layout is one that can be altered
without much cost and time, i.e., future requirements should be taken into account
while designing the present layout.
6. Principle of safety, security and satisfaction: A good layout is one that gives
due consideration to workers safety and satisfaction and safeguards the plant and
machinery against fire, theft, etc.
7. Principle of minimum handling: A good layout is one that reduces the material
handling to the minimum.

4.6.Classification of layouts

Layouts can be classified into the following five categories: 1.

Process layout
2. Product layout
3. Combination layout
4. Fixed position layout

1. Process Layout

Process layout is recommended for batch production. All machines performing similar type
of operations are grouped at one location in the process layout e.g., all lathes, milling
machines, etc. are grouped in the shop will be clustered in like groups.

Thus, in process layout the arrangement of facilities are grouped together according to their
66
functions. The flow paths of material through the facilities from one functional area to
another vary from product to product. Usually the paths are long and there will be possibility
of backtracking.

Process layout is normally used when the production volume is not sufficient to justify a
product layout. Typically, job shops employ process layouts due to the variety of
products manufactured and their low production volumes.

Advantages
1. In process layout machines are better utilized and fewer machines are required.
2. Flexibility of equipment and personnel is possible in process layout.
3. Lower investment on account of comparatively less number of machines and lower cost
of general purpose machines.
4. Higher utilization of production facilities.
5. A high degree of flexibility with regards to work distribution to machineries and workers.
6. The diversity of tasks and variety of job makes the job challenging and interesting.
7. Supervisors will become highly knowledgeable about the functions under their department.
Limitations
1. Backtracking and long movements may occur in the handling of materials thus, reducing
material handling efficiency.
2. Material handling cannot be mechanized which adds to cost.
3. Process time is prolonged which reduce the inventory turnover and increases the in-
process inventory.
4. Lowered productivity due to number of set-ups.
5. Throughput (time gap between in and out in the process) time is longer.
6. Space and capital are tied up by work-in-process.

2. Product Layout

In this type of layout, machines and auxiliary services are located according to the
processing sequence of the product. If the volume of production of one or more products
is large, the facilities can be arranged to achieve efficient flow of materials and lower cost
per unit. Special purpose machines are used which perform the required function quickly
and reliably.
The product layout is selected when the volume of production of a product is high such that
a separate production line to manufacture it can be justified. In a strict product layout,
machines are not shared by different products. Therefore, the production volume must be
sufficient to achieve satisfactory utilization of the equipment.

Advantages
1. The flow of product will be smooth and logical in flow lines.
2. In-process inventory is less.
67
 3. Throughput time is less.
4. Minimum material handling cost.
5. Simplified production, planning and control systems are possible.
6. Less space is occupied by work transit and for temporary storage.
7. Reduced material handling cost due to mechanised handling systems and straight
flow. 8. Perfect line balancing which eliminates bottlenecks and idle capacity.
9. Manufacturing cycle is short due to uninterrupted flow of materials.
10. Small amount of work-in-process inventory.
11. Unskilled workers can learn and manage the production.
Limitations
1. A breakdown of one machine in a product line may cause stoppages of machines in
the downstream of the line.
2. A change in product design may require major alterations in the layout.
3. The line output is decided by the bottleneck machine.
4. Comparatively high investment in equipment is required.
5. Lack of flexibility. A change in product may require the facility modification.

3. Combination Layout

A combination of process and product layouts combines the advantages of both types of
layouts. A combination layout is possible where an item is being made in different types and
sizes. Here machinery is arranged in a process layout but the process grouping is then arranged
in a sequence to manufacture various types and sizes of products. It is to be noted that
the sequence of operations remains same with the variety of products and sizes.

4. Fixed Position Layout

This is also called the project type of layout. In this type of layout, the material, or
major components remain in a fixed location and tools, machinery, men and other materials
are brought to this location. This type of layout is suitable when one or a few pieces of
identical heavy products are to be manufactured and when the assembly consists of large
number of heavy parts, the cost of transportation of these parts is very high.

Advantages

The major advantages of this type of layout are:

1. Helps in job enlargement and upgrades the skills of the operators.
2. The workers identify themselves with a product in which they take interest and pride in
doing the job.
3. Greater flexibility with this type of layout.
4. Layout capital investment is lower.

68
CHAPTER 5: LINEAR PROGRAMING AND DEMAND FORECASTING

5.1 Introduction to Linear Programming

Linear programming is a mathematical technique for finding optimal solutions to problems that can
be expressed using linear equations and inequalities. If a real-world problem can be represented
accurately in the mathematical equations of a linear program, the method will find the best solution
to the problem. Of course, few complex real-world problems can be expressed perfectly in terms of a
set of linear functions.

Decision variable

The variables in a linear program are a set of quantities that need to be determined in order to solve
the problem; i.e., the problem is solved when the best values of the variables have been identified.
The variables are sometimes called decision variables because the problem is to decide what value
each variable should take. Typically, the variables represent the amount of a resource to use or the
level of some activity. Frequently, defining the variables of the problem is one of the hardest and/or
most crucial steps in formulating a problem as a linear program. Sometimes creative variable
definition can be used to dramatically reduce the size of the problem or make an otherwise non-linear
problem linear.

Objective Function

The objective of a linear programming problem will be to maximize or to minimize some numerical
value. This value may be the expected net present value of a project or a forest property; or it may be
the cost of a project; it could also be the amount of wood produced, the expected number of visitor-
days at a park, the number of endangered species that will be saved, or the amount of a particular type
of habitat to be maintained. Linear programming is an extremely general technique, and its
applications are limited mainly by our imaginations and our ingenuity. The objective function
indicates how much each variable contributes to the value to be optimized in the problem. The
objective function takes the following general form:

Z= ∑ CiXi

69
Where

ci = the objective function coefficient corresponding to the ith variable, and

Xi = the ith decision variable.

The coefficients of the objective function indicate the contribution to the value of the objective
function of one unit of the corresponding variable. For example, if the objective function is to
maximize the present value of a project, and Xi is the ith possible activity in the project, then ci (the
objective function coefficient corresponding to Xi ) gives the net present value generated by one unit
of activity i. As another example, if the problem is to minimize the cost of achieving some
goal, Xi might be the amount of resource i used in achieving the goal. In this case, ci would be the cost
of using one unit of resource i.

Constraints

Constraints define the possible values the variables of a linear programming problem may take. They
typically represent resource constraints, or the minimum or maximum level of some activity. They
take the following general form:

where

Xi = the ith decision variable,

aj, i = the coefficient on Xi in constraint j, and
bj = the right-hand-side coefficient on constraint j.

Note that j is an index that runs from 1 to m, and each value of j corresponds to a constraint. Thus, the
above expression represents m constraints (equations, or, more precisely, inequalities) with this form.
Resource constraints are a common type of constraint. In a resource constraint, the coefficient aj,
i indicates the amount of resource j used for each unit of activity i, as represented by the value of the
variable Xi . The right-hand side of the constraint (bj ) indicates the total amount of resource j available
for the project.

Non-negativity of Constraints

For technical reasons, the variables of linear programs must always take non-negative values (i.e.,
they must be greater than or equal to zero). In most cases, where, for example, the variables might
represent the levels of a set of activities or the amounts of some resource used, this non-negativity
requirement will be reasonable -- even necessary. There are formulation "tricks" that can be employed
if you actually want to allow a variable to take on a negative value. These tricks are beyond the scope
of this class, however. In any case, the non-negativity constraints are part of all LP formulations, and
you should always include them. They are written as follows:

70
 Xi 0 i = 1, 2, . . ., n

5.2. The Fundamental Assumptions of Linear Programming

Now that you have seen how some simple problems can be formulated and solved as linear programs,
it is useful to reconsider the question of when a problem can be realistically represented as a linear
programming problem. A problem can be realistically represented as a linear program if the following
assumptions hold:

1. The constraints and objective function are linear.

 This requires that the value of the objective function and the response of each resource
expressed by the constraints is proportional to the level of each activity expressed in the
variables.
 Linearity also requires that the effects of the value of each variable on the values of the
objective function and the constraints are additive. In other words, there can be no interactions
between the effects of different activities; i.e., the level of activity X1 should not affect the
costs or benefits associated with the level of activity X2.

2. Divisibility -- the values of decision variables can be fractions. Sometimes these values only
make sense if they are integers; then we need an extension of linear programming called
integer programming.
3. Certainty -- the model assumes that the responses to the values of the variables are exactly
equal to the responses represented by the coefficients.
4. Data -- formulating a linear program to solve a problem assumes that data are available to
specify the problem.

Linear Programming Problem Formulation

We are not going to be concerned in this class with the question of how LP problems are solved.
Instead, we will focus on problem formulation -- translating real-world problems into the
mathematical equations of a linear program -- and interpreting the solutions to linear programs. We
will let the computer solve the problems for us. This section introduces you to the process of
formulating linear programs. The basic steps in formulation are:

1. Identify the decision variables;

2. Formulate the objective function; and
3. Identify and formulate the constraints.
4. A trivial step, but one you should not forget, is writing out the non-negativity constraints.

Advantages of linear programing

1. Help to make optimum use of production resources

2. Improves the quality of decisions
3. Provides practical and possible solutions
4. Highlights bottlenecks in production process

71
Limitations on LP

1. It treats all relationships as linear, while non-linear relationships exists

2. No guarantee to get integer in computations
3. No consideration of time and uncertainty
4. Parameters are assumed to be constant but really, they are frequently non constant

Application of LP

The LP is used in Agriculture, Production, Finance and personnel allocation for optimum use of
resources

5.3. Graphic Method for LP

An optimal solution to an LP problem is obtained by choosing a value from several possible values of
decision variable(x1,x2,x3) the one set for values that satisfies the given set of constraints
simultaneously providing optimum(max, min)

In this method, two graphical solution

 Extreme point solution method

 Iso-profit(cost) function line method)

Some definitions

 A solution is a set of values of the decision variable that satisfies the constraints
 The feasible solution is a set of values of the decision variable that satisfy all constraints and
the non-negativity condition
 The infeasible solution does not satisfy the all constraints requirements and non-negativity
conditions
 Optimum basic solution is that optimizing (max, min) the objective function value for an LP
 Unbounded solution is a solution that can indefinitely increase or decrease the value of the
objective function

Extreme point solution method

The coordinates of all corner points of the feasible region are determined and then values of the
objective function at these points are computed and compared, because the mathematical theory of LP
states that an optimal solution lies at one corner point. Following are required steps:

1. Develop the LP Model

2. Plot constraints on graph and decide the feasible region
 Replace inequality by equality in the constraints and solve equations
 Draw the straight line at each time and find the feasible region
 The final shaded area is the feasible region
3. Examine the extreme point of the feasible solution to get the optimum
72
The only way to learn how to formulate linear programming problems is to do it. The two examples
below will take you through the steps involved in formulating a couple of relatively simple problems.

Example:You need to buy some filing cabinets. You know that Cabinet X costs $10 per unit, requires
six square meter of floor space, and holds eight cubic meter of files. Cabinet Y costs $20 per unit,
requires eight square feet of floor space, and holds twelve cubic feet of files. You have been given
$140 for this purchase, though you don't have to spend that much. The office has room for no more
than 72 square feet of cabinets. How many of which model should you buy, in order to maximize
storage volume? The question ask for the number of cabinets I need to buy, so my variables will stand
for that:

x: number of model X cabinets purchased

y: number of model Y cabinets purchased

Naturally, x > 0 and y > 0. I have to consider costs and floor space (the "footprint" of each
unit), while maximizing the storage volume, so costs and floor space will be my constraints,
while volume will be my optimization equation.

cost: 10x + 20y < 140, or y < –( 1/2 )x + 7

space: 6x + 8y < 72, or y < –( 3/4 )x + 9
objective function to max volume: V = 8x + 12y

This system (along with the first two constraints) graphs as:

10𝑥 + 20𝑦 ≤ 140

{ }
6𝑥 + 4𝑦 ≤ 72
10x+20y=140
If x=0;20y=140; y=140/20=7 (0,7)
If y=0;10x=140;x=140/10=14(14,0)
6x+4y=72
If x=0; 4y=72;y=72/4=18; (0,18)
If y=0; 6x=72; x=72/6=12 (12,0)

73
 {10𝑥 + 20𝑦 ≤ 140}/10
6𝑥 + 8𝑦 ≤ 72}/2
X+2y=14 (-3)
3x+4y=36(1)
-3x-6y=-42
3x+4y=36
-2y=-6
Y=3
X+2y=14
X+6=14
X=8
(8,3)

coordinates 8x 12y 8x+12y

(0,7) 0 84 84
(12,0) 96 0 96
(8,3) 64 36 100

When you test the corner points at (8, 3), (0, 7), and (12, 0), you should obtain a maximal volume
of100 cubic feet by buying eight of model X and three of model Y.

Example 2: A store has requested a manufacturer to produce pants and sports jackets.
For materials, the manufacturer has 750 m 2 of cotton textile and 1,000 m 2 of
polyester. Every pair of pants (1 unit) needs 1m 2 of cotton and 2 m 2 of polyester.
Every jacket needs 1.5 m 2 of cotton and 1 m 2 of polyester. The price of the pants is
fixed at $50 and the jacket, $40. What is the number of pants and jackets that the
manufacturer must give to the stores so that these items obtain a maximu m sale?

x = number of pants
y = number of jackets
f(x,y)= 50x + 40y objective function.
Constraints as a system of inequalities. To write the constraints, use a table:

Pants jackets available

Cotton 1 1,5 750
polyester 2 1 1,000
x + 1.5y ≤ 750 2x+3y ≤ 1500
2x + y ≤ 1000
As the number of pants and jackets are natural numbers, there are two more
constraints:
x≥0
y≥0
Represent the constraints graphically.
As x ≥ 0 and y ≥ 0, work in the first quadrant.
Represent the straight lines from their points of intersection with the axes.

74
 Solve the inequation graphically:
(i) 2x +3y ≤ 1500, Replace the inequation with equation
2 x + 3y= 1,500
If x=0, 3y=1500; then y=500; (0,500)
If y=0, 2x=1500; then x=750; (750,0)

(ii) 2x + y ≤ 1000, Replace the inequation with equation

2x+y=1000
If x=0, y=1000; (0,1000)
If y=0, 2x=1000; then x=500,(500,0)

The area of intersection of the solutions of the inequalities would be the solution
to the system of inequalities, which is the set of feasible solutions.

Calculate the coordinates of the vertices from the compound of feasible solutions.
The optimal solution, if unique, is in a vertex. These are the solutions to the
systems:
2𝑥 + 3𝑦 ≤ 1500
{ }
2𝑥 + 𝑦 ≤ 1000

{2x+3y=1500(1)
{2x+y=1000(-1)
{2x+3y=1500
{-2x-y=-1000
0x+2y=500; y=250
2x+500=1000; 2x=750
X=375
(375,250)

75
Calculate the value of the objective function at each of the vertices to determine
which of them has the maximum o r minimum values. It must be taken into account
the possible non-existence of a solution if the compound is not bounded.
In the objective function, place each of the vertices that were determined in the
previous step.
coordinates 50x 40y 50x+40y
(0,500) 0 20,000 20,000
(500,0) 25,000 0 25,000
(375,250) 18,750 10,000 28,750

The optimum solution is to make 375 pants and 250 jackets to obtain a benefit of
$28,750.

5.4. Demand forecasting

5.4.1. Introduction

 Forecasts are essential for the smooth operations of business organizations. They
provide information that can assist managers in guiding future activities toward
organizational goals.
 Forecasts are estimates of the occurrence, timing, or magnitude of uncertain future
events. Forecasts are essential for the smooth operations of business organizations.
They provide information that can assist managers in guiding future activities toward
organizational goals.
 Operations managers are primarily concerned with forecasts of demand—which
are often made by (or in conjunction with) marketing. However, managers also use
forecasts to estimate raw material prices, plan for appropriate levels of personnel,
help decide how much inventory to carry, and a host of other activities. This results
in better use of capacity, more responsive service to customers, and improved
profitability.

5.5. Forecasting Decision Variables

Forecasting activities are a function of:

(1) the type of forecast (e.g., demand, technological),
(2) the time horizon (short, medium, or long range),
(3) the database available, and
(4) the methodology employed (qualitative or quantitative).
Forecasts of demand are based primarily on non-random trends and relationships, with an
allowance for random components. Forecasts for groups of products tend to be more accurate
than those for single products, and short-term forecasts are more accurate than long-term
forecasts (greater than five years). Quantification also enhances the objectivity and precision
of a forecast.

76
5.6. Forecasting Methods

There are numerous methods to forecasting depending on the need of the decision-maker.
These can be categorized in two ways:

1. Opinion and Judgmental Methods or Qualitative Methods.

2. Time Series or Quantitative Forecasting Methods.

5.6.1. Opinion and Judgmental Methods

Some opinion and judgment forecasts are largely intuitive, whereas others integrate data and
perhaps even mathematical or statistical techniques. Judgmental forecasts often consist of
(1) forecasts by individual sales people, (2) Forecasts by division or product-line managers, and
(3) combined estimates of the two. Historical analogy relies on comparisons; Delphi relies
on the best method from a group of forecasts. All these methods can incorporate experiences
and personal insights. However, results may differ from one individual to the next and they
are not all amenable to analysis. So there may be little basis for improvement over time.

5.6.2. Time series Methods

A time series is a set of observations of a variable at regular intervals over time. In

decomposition analysis, the components of a time series are generally classified as trend T,
cyclical C, seasonal S, and random or irregular R. (Note: Autocorrelation effects are
sometimes included as an additional factor.)

Time series are tabulated or graphed to show the nature of the time dependence. The
forecast value (Ye) is commonly expressed as a multiplicative or additive function of its
components; examples here will be based upon the commonly used multiplicative model.
Yc T. S. C. R multiplicative model
Y=T+S+C+R additive model c )

where T is Trend, S is Seasonal, C is Cyclical, and R is Random components of a

series.

Trend is a gradual long-term directional movement in the data (growth or

decline).
Seasonal effects are similar variations occurring during corresponding periods, e.g.,
December retail sales. Seasonal can be quarterly, monthly, weekly, daily, or even hourly
indexes.
Cyclical factors are the long-term swings about the trend line. They are often associated
with business cycles and may extend out to several years in length.
Random component are sporadic (unpredictable) effects due to chance and
unusual occurrences. They are the residual after the trend, cyclical, and seasonal
variations are removed.

Forecasting procedure for using time series

77
Following are the steps in time series forecasting:
1. Plot historical data to confirm relationship (linear, exponential)
2. Develop a trend equation (T) to describe the data
3. Develop a seasonal index (SI) eg: monthly index values
4. Project trend into the future (eg.,monthly trend values)
5. Multiply trend by corresponding seasonal index values.
6. Modify projected values by any knowledge of:
(C)Cyclical business conditions, (R) Anticipated irregular
effects.

Trend: Three methods for describing trend are: (1) Moving average, (2) Hand fitting,
and (3) Least squares.
1.Naive method
Naïve method: The forecast for next period (period t+1) will be equal to this period's actual demand
(At).In this illustration we assume that each year (beginning with year 2) we made a forecast, then
waited to see what demand unfolded during the year. We then made a forecast for the subsequent
year, and so on right through to the forecast for year 7.

Actual
Forecast
Year Demand
(Ft)
(At)

1 310 --

2 365 310

3 395 365

4 415 395

5 450 415

6 465 450

7 465

2. Moving Average

A centered moving average (MA) is obtained by summing and averaging the values from a
given number of periods repetitively, each time deleting the oldest value and adding a new
value. Moving averages can smooth out fluctuations in any data, while preserving the
general pattern of the data (longer averages result in more smoothing). However, they do not
yield a forecasting equation, nor do they generate values for the ends of the data series.

78
 𝑥
𝑀𝐴 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑

I LLUSTRATION 1: Shipments (in tons) of welded tube by an aluminum producer are

shown below:

Year 1 2 3 4 5 6 7 8 9 10 11
Tons 2 3 6 10 8 7 12 14 14 18 19

(a) Compute a 3-year moving average, plot it as a dotted line, and use it to forecast
shipments in year 12. (c) Using a weight of 3 for the most recent data, 2 for the next, and
1 for the oldest, forecast shipments in year 12.

Table 5.1 3-year moving average

Actual 3-Year 3-year
Year Demand moving Moving
(At) Total Averg
1 2 -- --
2 3 --
3 6 11 2
4 10 19 3.7
5 8 24 6.3
6 7 25 8
7 13 28 8.3
8 14 34 9.3
9 14 41 11.3
10 18 46 13.7
11 19 51 15.3
20 17
The MA forecast for year 12 would be that of the latest average, 17.0 tons.

3. Weighted Moving Average

Weighted moving average method: The forecast for next period (period t+1) will be equal to a
weighted average of a specified number of the most recent observations.

A weighted moving average (MAw) allows some values to be emphasized by varying the weights
assigned to each component of the average. Weights can be either percentages or a real number.

79
 𝑀𝐴𝑤𝑡 = ∑(𝑤𝑡)𝑋
In this illustration we assume that a 3-year weighted moving average is being used. We will also
assume that, in the absence of data at startup, we made a guess for the year 1 forecast (300). Then,
after year 1 elapsed, we used a naïve method to make a forecast for year 2 (310) and year 3 (365).
Beyond that point we had sufficient data to let our 3-year weighted moving average forecasts unfold
throughout the years. The weights that were to be used are as follows: Most recent year,0.5; year
prior to that,0.3; year prior to that,0.2

Actual
Year Demand Forecast(Ft)
(At)
1 310 --
2 365 310
3 395 365
4 415 369
5 450 399
6 465 428.5
7 450.5

4. Exponential smoothing method

The new forecast for next period (period t) will be calculated as follows:

(this box contains all you need to know to apply exponential smoothing)

Ft = Ft-1 + (At-1 – Ft-1) (equation 1)

Ft = At-1 + (1-)Ft-1 (alternate equation 1 – a bit more user friendly)

Where  is a smoothing coefficient whose value is between 0 and 1.

New forecast = Last period’s forecast + (Last period’s actual demand – Last period’s forecast)
The exponential smoothing method only requires that you dig up two pieces of data to apply it (the
most recent actual demand and the most recent forecast).

An attractive feature of this method is that forecasts made with this model will include a portion of
every piece of historical demand. Furthermore, there will be different weights placed on these
historical demand values, with older data receiving lower weights. In this illustration, we assume that,
in the absence of data at startup, we made a guess for the year 1 forecast (300). Then, for each
subsequent year (beginning with year 2) we made a forecast using the exponential smoothing model.
After the forecast was made, we waited to see what demand unfolded during the year. We then made
a forecast for the subsequent year, and so on right through to the forecast for year 7.
80
 Actual
Forecast
Year Demand
(Ft)
(At)
1 310 300.0
2 365 301.0
3 395 307.4
4 415 316.2
5 450 326.0
6 465 338.4
7 351.1

5. Least squares
Least squares are a mathematical technique of fitting a trend to data points. The resulting
line of best fit has the following properties: (1) the summation of all vertical deviations
about it is zero, (2) the summation of all vertical deviations squared is a minimum, and (3)
the line goes through the means X and Y. For linear equations, the line of best fit is found by
the simultaneous solution for a and b of the following two normal equations:
Σy=na+bΣx

Σxy=aΣx+bΣx2

The above equations can be used in the form shown above and are used in that form
for regression. However, with time series, the data can also be coded so that
Σx=0

Two terms then dropout, and the equations are simplified to:

Σy=na; a= Σy/n

Σxy=bΣx2 b= Σxy/Σx2

To code the time series data, designate the center of the time span as X = 0 and let
each successive period be ±1 more unit away. (For an even number of periods, use values
of ±0.5, 1.5, 2.5, etc.).
I LLUSTRATION 3: Use the least square method to develop a linear trend equation
for the data from illustration 1. State the equation and forecast a trend value for year
16.

Year X year Y XY X2
coded shipments
(tons)
1 –S 2 – 10 25
2 –4 3 – 12 16
3 –3 6 – 18 9
4 –2 10 – 20 4
81
 5 –1 8 –8 1
6 0 7 0 0
7 1 12 12 1
8 2 14 28 4
9 3 14 42 9
10 4 18 72 16
11 5 19 95 25
12 0 113 181 110

a= Σy/n=113/11=10.3
b= Σxy/ Σx2=181/110=1.6

y=a+bx
y= 10.3+1.6(12)= 29.5

6. Regression and Correlation

Regression and correlation techniques quantify the statistical association between two or more
variables. (a) Simple regression expresses the relationship between a dependent
variable Y and an independent variable X in terms of the slope and intercept of the line
of best fit relating the two variables.
(b) Simple correlation expresses the degree or closeness of the relationship between two
variables in terms of a correlation coefficient that provides an indirect measure of the
variability of points from the line of best fit. Neither regression nor correlation gives proof of
a cause-effect relationship.

Regression

The simple linear regression model takes the formc Y = a + bX, where Y is the dependent
variable and X the independent variable. Values for the slope b and intercept α are obtained
by using the normal equations written in the convenient form:

ΣXY − nx̅ ȳ
𝑏=
Σx 2 − 𝑛𝑥 2

a = ȳ − b x̅

In Equations. (1) and (2), x̅ = (ΣX ) / n and ȳ = (ΣY) / n Y are the means of the independent and
dependent variables respectively, and n is the number of pairs of observations made.

I LLUSTRATION 7: The general manager of a building materials production plant feels that
the demand for plasterboard shipments may be related to the number of construction permits
issued in the county during the previous quarter. The manager has collected the data shown in
Table 5.5.

82
(a) Compute values for the slope b and intercept a.
(b) Determine a point estimate for plasterboard shipments when the number of
construction permits is 30.

SOLUTION: (a)
Table

X Y XY X2 Y2
15 6 90 225 36
9 4 36 81 16
40 16 640 1,600 256
20 6 120 400 36
25 13 325 625 169
25 9 225 625 81
15 10 150 225 100
35 16 560 1,225 256
184 80 2,146 5,006 950
184
n = 8 pairs of observations X = ΣX / n or X= =23
8
ȳ = (ΣY) / n= 80/8=10

ΣXY − nx̅ ȳ
𝑏=
Σx 2 − 𝑛𝑥 2

2146 − (8)(23)(10)
𝑏= = 0.395
5006 − 8(23)(23)

83
 a = Y −bX or
a=10 − 0.395(23) =0.91
(b)The regression equation is
Yc = 0.91 + 0.395 X (X = permits, Y = shipments)
Then, letting X = 30,
Yc = 0.91 + 0.395(30) = 12.76 ~ 13
shipments.

Correlation

The simple linear correlation coefficient r is a number between –1 and + 1 that tells how
well a linear equation describes the relationship between two variables. It is designated as
positive if Y increases as X increases and negative if Y decreases as X increases. An r of
zero indicates an absence of any relationship between the two variables.

The deviation of all points (Y ) from the regression line (Yc ) consists of deviation accounted
for by the regression line (explained) and random deviation (unexplained). Fig. 5.3
illustrates this for one point, Y. Squaring the deviation we have variation.
When the sample size is sufficiently large (e.g., greater than 50), the value of r can be
computed more directly form:

𝑛 ∑ 𝑋𝑌 − ∑ 𝑋 ∑ 𝑌
𝑟=
√[𝑛 ∑ 𝑋 2 − (∑ 𝑋)2 ][𝑛 ∑ 𝑌 2 − (∑ 𝑌)2

I LLUSTRATION 10: A study to determine the correlation between plasterboard

shipments X and construction permits Y revealed the following:
ΣX = 184 ΣY = 80’ n=8
ΣX 2 = 5,006 ΣY 2 = 950 ΣXY = 2,146
Compute the correlation coefficient.

8(2146) − (184)(80)
𝑟=
√[8(5006) − (184)(184)][8(950) − (80)(80)]

2448
𝑟= = 0.90
√7430400

84
CHAP 6: STORAGE AND INVENTORY MANAGEMENT

6.1.Storage Management

1. Meaning

Stores play a vital role in the operations of company. It is in direct touch with the user
departments in its day-to-day activities. The most important purpose served by the stores is to
provide uninterrupted service to the manufacturing divisions. Further, stores are often
equated directly with money, as money is locked up in the stores.

2. FUNCTIONS OF STORES
The functions of stores can be classified as follows:
1. To receive raw materials, components, tools, equipment’s and other items and
account for them.
2. To provide adequate and proper storage and preservation to the various items.
3. To meet the demands of the consuming departments by proper issues and account
for the consumption.
4. To minimize obsolescence, surplus and scrap through proper codification,
preservation and handling.
5. To highlight stock accumulation, discrepancies and abnormal consumption and effect
control measures.
6. To ensure good housekeeping so that material handling, material preservation,
stocking, receipt and issue can be done adequately.
7. To assist in verification and provide supporting information for effective purchase action.

3. Codification

It is one of the functions of stores management. Codification is a process of representing each

item by a number, the digit of which indicates the group, the sub-group, the type and the
dimension of the item. Many organizations in the public and private sectors, railways have
their own system of codification, varying from eight to thirteen digits. The first two digits
represents the major groups, such as raw materials, spare parts, sub-contracted items,
hardware items, packing material, tools, oil, stationery etc. The next two digits indicate the
sub-groups, such as, ferrous, non-ferrous etc. Dimensional characteristics of length, width,
head diameter etc. constitute further three digits and the last digit is reserved for minor
variations.

Whatever may be the basis, each code should uniquely represent one item. It should be
simple and capable of being understood by all. Codification should be compact, concise,
consistent and flexible enough to accommodate new items. The groupings should be logical,
holding similar parts near to one another. Each digit must be significant enough to represent
some characteristic of the item.
4. Objectives of codification

85
The objectives of a rationalized material coding system are:
1. Bringing all items together.
2. To enable putting up of any future item in its proper
place. 3. To classify an item according to its
characteristics.
4. To give a unique code number to each item to avoid duplication and
ambiguity. 5. To reveal excessive variety and promote standardization and
variety reduction. 6. To establish a common language for the identification
of an item.
7. To fix essential parameters for specifying an item.
8. To specify item as per national and international
standards. 9. To enable data processing and analysis.

Advantages of codification

As a result of rationalized codification, many firms have reduced the number of items. It
enables systematic grouping of similar items and avoids confusion caused by long description
of items since standardization of names is achieved through codification, it serves as the starting
point of simplification and standardization. It helps in avoiding duplication of items and
results in the minimization of the number of items, leading to accurate record. Codification
enables easy recognition of an item in stores, thereby reducing clerical efforts to the
minimum.

If items are coded according to the sources, it is possible to bulk the items while ordering. To
maximize the aforesaid advantages, it is necessary to develop the codes as concerned, namely,
personnel from design, production, engineering, inspection, maintenance and materials.

6.2.Inventory control

1. Meaning of inventory

Inventory generally refers to the materials in stock. It is also called the idle resource of an
enterprise. Inventories represent those items which are either stocked for sale or they are
in the process of manufacturing or they are in the form of materials, which are yet to be
utilised. The interval between receiving the purchased parts and transforming them into final
products varies from industries to industries depending upon the cycle time of manufacture. It
is, therefore, necessary to hold inventories of various kinds to act as a buffer between supply
and demand for efficient operation of the system. Thus, an effective control on inventory is a
must for smooth and efficient running of the production cycle with least interruptions.

2. Reasons for keeping Inventory

1. To stabilize production: The demand for an item fluctuates because of the number
of factors, e.g., seasonality, production schedule etc. The inventories (raw materials and
components) should be made available to the production as per the demand failing which

86
 results in stock out and the production stoppage takes place for want of materials. Hence,
the inventory is kept to take care of this fluctuation so that the production is smooth.
2. To take advantage of price discounts: Usually the manufacturers offer discount for
bulk buying and to gain this price advantage the materials are bought in bulk even though it
is not required immediately. Thus, inventory is maintained to gain economy in purchasing.
3. To meet the demand during the replenishment period: The lead time for
procurement of materials depends upon many factors like location of the source, demand
supply condition, etc. So inventory is maintained to meet the demand during the procurement
(replenishment) period.
4. To prevent loss of orders (sales): In this competitive scenario, one has to meet the
delivery schedules at 100 per cent service level, means they cannot afford to miss the
delivery schedule which may result in loss of sales. To avoid the organizations have to
maintain inventory.
5. To keep pace with changing market conditions: The organizations have to anticipate
the changing market sentiments and they have to stock materials in anticipation of non-
availability of materials or sudden increase in prices.
Sometimes the organizations have to stock materials due to other reasons like suppliers
minimum quantity condition, seasonal availability of materials or sudden increase in prices.

3. Meaning of Inventory control

Inventory control is a planned approach of determining what to order, when to order and how
much to order and how much to stock so that costs associated with buying and storing are
optimal without interrupting production and sales. Inventory control basically deals with two
problems: (i) When should an order be placed? (Order level), and (ii) How much should be
ordered? (Order quantity).

These questions are answered by the use of inventory models. The scientific inventory
control system strikes the balance between the loss due to non-availability of an item and
cost of carrying the stock of an item. Scientific inventory control aims at maintaining optimum
level of stock of goods required by the company at minimum cost to the company.

4. Objectives of Inventory control

1. To ensure adequate supply of products to customer and avoid shortages as far as
possible. 2. To make sure that the financial investment in inventories is minimum
(i.e., to see that the working capital is blocked to the minimum possible extent).
3. Efficient purchasing, storing, consumption and accounting for materials is an
important objective.
4. To maintain timely record of inventories of all the items and to maintain the stock
within the desired limits
5. To ensure timely action for replenishment.
6. To provide a reserve stock for variations in lead times of delivery of materials.
7. To provide a scientific base for both short-term and long-term planning of materials.

5. Benefits of Inventory control

It is an established fact that through the practice of scientific inventory control, following
are the benefits of inventory control:
87
 1. Improvement in customer’s relationship because of the timely delivery of goods and
service. 2. Smooth and uninterrupted production and, hence, no stock out.
3. Efficient utilization of working capital. Helps in minimizing loss due to
deterioration, obsolescence damage and pilferage.
4. Economy in purchasing.
5. Eliminates the possibility of duplicate ordering.
6.
6. Techniques of Inventory control
In any organization, depending on the type of business, inventory is maintained. When the
number of items in inventory is large and then large amount of money is needed to create
such inventory, it becomes the concern of the management to have a proper control over
its ordering, procurement, maintenance and consumption. The control can be for order
quality and order frequency.
The different techniques of inventory control are: (1) ABC analysis, (2) HML
analysis, (3) VED analysis, (4) FSN analysis, (5) SDE analysis, (6) GOLF analysis and
(7) SOS analysis. The most widely used method of inventory control is known as ABC
analysis. In this technique, the total inventory is categorized into three sub-heads and then
proper exercise is exercised for each sub-heads.
1. ABC analysis: In this analysis, the classification of existing inventory is based on
annual consumption and the annual value of the items. Hence we obtain the quantity of
inventory item consumed during the year and multiply it by unit cost to obtain annual usage
cost. The items are then arranged in the descending order of such annual usage cost. The
analysis is carried out by drawing a graph based on the cumulative number of items and
cumulative usage of consumption cost. Classification is done as follows:
Table 7.1

Category Percentage of items Percentage of

annual
A 10–20 70–80
consumption
B 20–30 value 10–25
C 60–70 5–15
The classification of ABC analysis is shown by the graph given as follows (Fig. 7.5).

88
 Fig. 7.5 ABC classification
Once ABC classification has been achieved, the policy control can be formulated as follows:
(a) A-Item: Very tight control, the items being of high value. The control need be exercised
at
higher level of authority.
(b) B-Item: Moderate control, the items being of moderate value. The control need be
exercised at middle level of authority.
(c) C-Item: The items being of low value, the control can be exercised at gross root level
of authority, i.e., by respective user department managers.
2. HML analysis: In this analysis, the classification of existing inventory is based on
unit price of the items. They are classified as high price, medium price and low cost items.
3. VED analysis: In this analysis, the classification of existing inventory is based on
criticality of the items. They are classified as vital, essential and desirable items. It is
mainly used in spare parts inventory.
4. FSN analysis: In this analysis, the classification of existing inventory is based
consumption of the items. They are classified as fast moving, slow moving and non-moving
items.

89
5. SDE analysis: In this analysis, the classification of existing inventory is based on the items.
6. GOLF analysis: In this analysis, the classification of existing inventory is based sources
of the items. They are classified as Government supply, ordinarily available, local availability
and foreign source of supply items.
7. SOS analysis: In this analysis, the classification of existing inventory is based nature
of supply of items. They are classified as seasonal and off-seasonal items.
For effective inventory control, combination of the techniques of ABC with VED or ABC
with HML or VED with HML analysis is practically used.

6.3.Inventory control Model

ECONOMIC ORDER QUANTITY (EOQ)

Inventory models deal with idle resources like men, machines, money and materials. These
models are concerned with two decisions: how much to order (purchase or produce) and
when to order so as to minimize the total cost.
For the first decision—how much to order, there are two basic costs are considered
namely, inventory carrying costs and the ordering or acquisition costs. As the quantity
ordered is increased, the inventory carrying cost increases while the ordering cost decreases.
The ‘order quantity’ means the quantity produced or procured during one production cycle.
Economic order quantity is calculated by balancing the two costs. Economic Order Quantity
(EOQ) is that size of order which minimizes total costs of carrying and cost of ordering. i.e.,
Minimum Total Cost occurs when Inventory Carrying Cost = Ordering Cost.
Economic order quantity can be determined by two methods:
1. Tabulation method. 2. Algebraic method.

Fig. 7.6 Inventory cost curve

1. Determination of EOQ by tabulation (Trial & Error)
method This method involves the following steps:
Select the number of possible lot sizes to purchase.
Determine average inventory carrying cost for the lot purchased.

90
 (a) Determine the total ordering cost for the orders placed.
(b) Determine the total cost for each lot size chosen which is the summation of
inventory carrying cost and ordering cost.
(c) Select the ordering quantity, which minimizes the total cost.
The data calculated in a tabular column can plotted showing the nature of total cost,
inventory cost and ordering cost curve against the quantity ordered as in Fig. 7.6.

I LLUSTRATION 3: The XYZ Ltd. carries a wide assortment of items for its customers.
One of its popular items has annual demand of 8000 units. Ordering cost per order is
found to be Rs. 12.5. The carrying cost of average inventory is 20% per year and the
cost per unit is Re. 1.00. Determine the optimal economic quantity and make your
recommendations.

SOLUTION

No. of Lot Average Carryi Orderi Total

orders size (2) inventory ng cost ng cost cost/
/ year (3) (4) (5) year
1 8000 4000 800.0 12. 812.5
(1) (6) =(4) + (5)
2 4000 2000 0 5 0
4 2000 1000 400.0 25 425.0
8 1000 500 0 50 0
1 666.66 333.33 200.0 100 250.0
2 7 500 3 250 0 150 0
16 100.0 200 200.0
0 0
66.67 216.6
50.00 7
250.0
0

The table and the graph indicates that an order size of 1000 units will gives the lowest
total cost among the different alternatives. It also shows that minimum total cost occurs
when carrying cost is equal to ordering cost.

91
2. Determination of EOQ by analytical method
In order to derive an economic lot size formula following assumptions are
made: (a) Demand is known and uniform.
(b) Let D denotes the total number of units purchase/produced and Q denotes the lot
size in each production run.
(c) Shortages are not permitted, i.e., as soon as the level of the inventory reaches
zero, the inventory is replenished.
(d) Production or supply of commodity is
instantaneous. (e) Lead-time is zero.
(f) Set-up cost per production run or procurement cost is C3.
(g) Inventory carrying cost is1 C = CI, where C is the unit cost and I is called inventory
carrying cost expressed as a percentage of the value of the average inventory.
This fundamental situation can be shown on an inventory-time diagram, (Fig. 7.7) with
Q on the vertical axis and the time on the horizontal axis. The total time period (one year)
is divided into n parts.

Fig. 7.7
The most economic point in terms of total inventory cost exists where,
Inventory carrying cost = Annual ordering cost (set-up
cost)
Average inventory = 1/2 (maximum level + minimum
level) = (Q + 0)/2 = Q/2
Total inventory carrying cost = Average inventory× Inventory carrying cost per unit
i.e., Total inventory carrying cost = Q/2 × C1 = QC1/2
…(1
) Total annual ordering costs = Number of orders per year × Ordering cost
per order
i.e., Total annual ordering costs = (D/Q) × C3 = (D/Q)C3 …(2)
Now, summing up the total inventory cost and the total ordering cost, we get the total
inventory cost
C(Q).
i.e., Total cost of production run = Total inventory carrying cost + Total
annual ordering costs
C(Q) = QC1/2 + (D/Q)C3 (cost
equation) …(3)
92
But, the total cost is minimum when the inventory carrying costs becomes equal to the
total annual ordering costs. Therefore,

93
 QC 1/2 =
(D/Q)C 3 or QC 1 =
(2D/Q)C 3 or Q2
= 2C 3D/C1

2C3
or Q=
D C1

2C3
i.e., Optimal quantity (EOQ), ...(4)
Q0 = D C1

D
Optimum number of orders, (N ) = ...(5)
0 Q
0

365 1 Q0
Optimum order interval, (t0) = in daysN= in years or (t0) =
N 0 D
...(6) 0
Average yearly cost (TC) = 2C3 DC1 …(7)
I LLUSTRATION 4: An oil engine manufacturer purchases lubricants at the rate of Rs.
42 per piece from a vendor. The requirements of these lubricants are 1800 per year.
What should be the ordering quantity per order, if the cost per placement of an order
is Rs. 16 and inventory carrying charges per rupee per year is 20 paise.

SOLUTION
Given data are:
Number of lubricants to be purchased, D = 1800 per year
Procurement cost, C3 = Rs. 16 per order
Inventory carrying cost, CI = C 1 = Rs. 42 × Re. 0.20 = Rs. 8.40 per year

2C3
Then, optimal quantity (EOQ),
D C1
Q0 =

2 × 16 × 180
Q0 = 82.8 or 83 lubricants (approx
0
= 8.4

94
95