Nigel S., Chambers S., Johnson R. Operations Management
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and
H =
where
x
i
= the x coordinate of source or destination i
y
i
= the y coordinate of source or destination i
V
i
= the amount to be shipped to or from source or destination i.
Each of the garden centres is of a different size and has different sales volumes. In
terms of the number of truck loads of products sold each week, Table 6.3 shows the sales
of the four centres.
∑y
i
V
i
∑V
i
In this case
G ==5.34
and
H ==2.4
So the minimum cost location for the warehouse is at point (5.34, 2.4) as shown in
Figure 6.7. That is, at least, theoretically. In practice, the optimum location might also be
influenced by other factors such as the transportation network. So if the optimum loca-
tion was at a point with poor access to a suitable road or at some other unsuitable location
(in a residential area or the middle of a lake, for example) then the chosen location will need
to be adjusted. The technique does go some way, however, towards providing an indication
of the area in which the company should be looking for sites for its warehouse.
(2 × 5) + (3 × 10) + (1 × 12) + (4 × 8)
35
(1 × 5) + (5 × 10) + (5 × 12) + (9 × 8)
35
Table 6.3 The weekly demand levels (in truck
loads) at each of the four garden centres
Sales per week
(truck loads)
Garden centre A 5
Garden centre B 10
Garden centre C 12
Garden centre D 8
Total 35
Figure 6.7 Centre-of-gravity location for the garden centre warehouse
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Long-term capacity management
The next set of supply network decisions concern the size or capacity of each part of the
network. Here we shall treat capacity in a general long-term sense. The specific issues
involved in measuring and adjusting capacity in the medium and short terms are examined
in Chapter 11.
The optimum capacity level
Most organizations need to decide on the size (in terms of capacity) of each of their facilities.
An air-conditioning unit company, for example, might operate plants each of which has
a capacity (at normal product mix) of 800 units per week. At activity levels below this, the
average cost of producing each unit will increase because the fixed costs of the factory are
being covered by fewer units produced. The total production costs of the factory have some
elements which are fixed – they will be incurred irrespective of how much, or little, the
factory produces. Other costs are variable – they are the costs incurred by the factory for each
unit it produces. Between them, the fixed and variable costs make up the total cost at any
output level. Dividing this cost by the output level itself will give the theoretical average cost
of producing units at that output rate. This is the green line shown as the theoretical unit
cost curve for the 800-unit plant in Figure 6.8. However, the actual average cost curve may
be different from this line for a number of reasons:
● All fixed costs are not incurred at one time as the factory starts to operate. Rather they occur
at many points (called fixed-cost breaks) as volume increases. This makes the theoretically
smooth average cost curve more discontinuous.
● Production levels may be increased above the theoretical capacity of the plant, by using
prolonged overtime, for example, or temporarily subcontracting some parts of the work.
● There may be less obvious cost penalties of operating the plant at levels close to or above
its nominal capacity. For example, long periods of overtime may reduce productivity
levels as well as costing more in extra payments to staff; operating plant for long periods
with reduced maintenance time may increase the chances of breakdown, and so on. This
usually means that average costs start to increase after a point which will often be lower
than the theoretical capacity of the plant.
Fixed-cost breaks
Figure 6.8 Unit cost curves for individual plants of varying capacities and the unit cost curve
for this type of plant as its capacity varies
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The blue dotted line in Figure 6.8 shows this effect. The two other blue lines show similar
curves for a 600-unit plant and a 1,000-unit plant. Figure 6.8 also shows that a similar rela-
tionship occurs between the average-cost curves for plants of increasing size. As the nominal
capacity of the plants increases, the lowest-cost points at first reduce. There are two main rea-
sons for this:
● The fixed costs of an operation do not increase proportionately as its capacity increases.
An 800-unit plant has less than twice the fixed costs of a 400-unit plant.
● The capital costs of building the plant do not increase proportionately to its capacity. An
800-unit plant costs less to build than twice the cost of a 400-unit plant.
These two factors, taken together, are often referred to as economies of scale. However,
above a certain size, the lowest-cost point may increase. In Figure 6.8 this happens with plants
above 800 units capacity. This occurs because of what are called the diseconomies of scale,
two of which are particularly important. First, transportation costs can be high for large
operations. For example, if a manufacturer supplies its global market from one major plant
in Denmark, materials may have to be brought in to, and shipped from, several countries.
Second, complexity costs increase as size increases. The communications and coordination
effort necessary to manage an operation tends to increase faster than capacity. Although not
seen as a direct cost, it can nevertheless be very significant.
Scale of capacity and the demand–capacity balance
Large units of capacity also have some disadvantages when the capacity of the operation is
being changed to match changing demand. For example, suppose that the air-conditioning unit
manufacturer forecasts demand increase over the next three years, as shown in Figure 6.9,
to level off at around 2,400 units a week. If the company seeks to satisfy all demand by build-
ing three plants, each of 800 units capacity, the company will have substantial amounts of
over-capacity for much of the period when demand is increasing. Over-capacity means low
capacity utilization, which in turn means higher unit costs. If the company builds smaller
plants, say 400-unit plants, there will still be over-capacity but to a lesser extent, which means
higher capacity utilization and possibly lower costs.
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Figure 6.9 The scale of capacity increments affects the utilization of capacity
Economies of scale
Diseconomies of scale
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Balancing capacity
As we discussed in Chapter 1, all operations are made up of separate processes, each of
which will itself have its own capacity. So, for example, the 800-unit air-conditioning plant
may not only assemble the products but may also manufacture the parts from which they are
made, pack, store and load them in a warehouse and distribute them to customers. If demand
is 800 units per week, not only must the assembly process have a capacity sufficient for this
output, but the parts manufacturing processes, warehouse and distribution fleet of trucks
must also have sufficient capacity. For the network to operate efficiently, all its stages must
have the same capacity. If not, the capacity of the network as a whole will be limited to the
capacity of its slowest link.
The timing of capacity change
Changing the capacity of an operation is not just a matter of deciding on the best size of
a capacity increment. The operation also needs to decide when to bring ‘on-stream’ new
capacity. For example, Figure 6.10 shows the forecast demand for the new air-conditioning
unit. The company has decided to build 400-unit-per-week plants in order to meet the
growth in demand for its new product. In deciding when the new plants are to be introduced
the company must choose a position somewhere between two extreme strategies:
● capacity leads demand – timing the introduction of capacity in such a way that there is
always sufficient capacity to meet forecast demand;
● capacity lags demand – timing the introduction of capacity so that demand is always equal
to or greater than capacity.
Figure 6.10(a) shows these two extreme strategies, although in practice the company is
likely to choose a position somewhere between the two. Each strategy has its own advantages
and disadvantages. These are shown in Table 6.4. The actual approach taken by any com-
pany will depend on how it views these advantages and disadvantages. For example, if the
company’s access to funds for capital expenditure is limited, it is likely to find the delayed
capital expenditure requirement of the capacity-lagging strategy relatively attractive.
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Figure 6.10 (a) Capacity-leading and capacity-lagging strategies, (b) Smoothing with inventories means using the
excess capacity in one period to produce inventory that supplies the under-capacity period
Capacity leading
Capacity lagging
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‘Smoothing’ with inventory
The strategy on the continuum between pure leading and pure lagging strategies can be
implemented so that no inventories are accumulated. All demand in one period is satisfied
(or not) by the activity of the operation in the same period. Indeed, for customer-processing
operations there is no alternative to this. A hotel cannot satisfy demand in one year by
using rooms which were vacant the previous year. For some materials- and information-
processing operations, however, the output from the operation which is not required in
one period can be stored for use in the next period. The economies of using inventories are
fully explored in Chapter 12. Here we confine ourselves to noting that inventories can be
used to obtain the advantages of both capacity leading and capacity lagging. Figure 6.10(b)
shows how this can be done. Capacity is introduced such that demand can always be
met by a combination of production and inventories, and capacity is, with the occasional
exception, fully utilized. This may seem like an ideal state. Demand is always met and so
revenue is maximized. Capacity is usually fully utilized and so costs are minimized. There is
a price to pay, however, and that is the cost of carrying the inventories. Not only will these
have to be funded but the risks of obsolescence and deterioration of stock are introduced.
Table 6.5 summarizes the advantages and disadvantages of the ‘smoothing-with-inventory’
strategy.
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Table 6.4 The arguments for and against pure leading and pure lagging strategies of
capacity timing
Advantages
Capacity-leading strategies
Always sufficient capacity to meet demand,
therefore revenue is maximized and
customers satisfied
Most of the time there is a ‘capacity cushion’
which can absorb extra demand if forecasts
are pessimistic
Any critical start-up problems with new plants
are less likely to affect supply to customers
Capacity-lagging strategies
Always sufficient demand to keep the plants
working at full capacity, therefore unit costs
are minimized
Over-capacity problems are minimized if
forecasts are optimistic
Capital spending on the plants is delayed
Disadvantages
Utilization of the plants is always relatively low,
therefore costs will be high
Risks of even greater (or even permanent)
over-capacity if demand does not reach
forecast levels
Capital spending on plant early
Insufficient capacity to meet demand fully,
therefore reduced revenue and dissatisfied
customers
No ability to exploit short-term increases in
demand
Under-supply position even worse if there are
start-up problems with the new plants
Table 6.5 The advantages and disadvantages of a smoothing-with-inventory strategy
Advantages
All demand is satisfied, therefore customers are
satisfied and revenue is maximized
Utilization of capacity is high and therefore
costs are low
Very short-term surges in demand can be met
from inventories
Disadvantages
The cost of inventories in terms of working
capital requirements can be high. This is
especially serious at a time when the company
requires funds for its capital expansion
Risks of product deterioration and
obsolescence
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Break-even analysis of capacity expansion
An alternative view of capacity expansion can be gained by examining the cost implications
of adding increments of capacity on a break-even basis. Figure 6.11 shows how increasing
capacity can move an operation from profitability to loss. Each additional unit of capacity results
in a fixed-cost break that is a further lump of expenditure which will have to be incurred
before any further activity can be undertaken in the operation. The operation is unlikely
to be profitable at very low levels of output. Eventually, assuming that prices are greater
than marginal costs, revenue will exceed total costs. However, the level of profitability at the
point where the output level is equal to the capacity of the operation may not be sufficient
to absorb all the extra fixed costs of a further increment in capacity. This could make the
operation unprofitable in some stages of its expansion.
Chapter 6 Supply network design
159
A business process outsourcing (BPO) company is considering building some process-
ing centres in India. The company has a standard call centre design that it has found
to be the most efficient around the world. Demand forecasts indicate that there is
already demand from potential clients to fully utilize one process centre that would
generate $10 million of business per quarter (3-month period). The forecasts also
indicate that by quarter 6 there will be sufficient demand to fully utilize one further pro-
cessing centre. The costs of running a single centre are estimated to be $5 million per
quarter and the lead time between ordering a centre and it being fully operational is
two quarters. The capital costs of building a centre is $10 million, $5 million of which
is payable before the end of the first quarter after ordering, and $5 million payable
before the end of the second quarter after ordering. How much funding will the com-
pany have to secure on a quarter-by-quarter basis if it decides to build one processing
centre as soon as possible and a second processing centre to be operational by the
beginning of quarter 6?
Analysis
The funding required for a capacity expansion such as this can be derived by calculat-
ing the amount of cash coming in to the operation each time period, then subtracting
the operating and capital costs for the project each time period. The cumulative cash
flow indicates the funding required for the project. In Table 6.6 these calculations are
performed for eight quarters. For the first two quarters there is a net cash outflow
because capital costs are incurred by no revenue is being earned. After that, revenue is
being earned but in quarters four and five this is partly offset by further capital costs for
the second processing centre. However, from quarter six onwards the additional revenue
from the second processing centre brings the cash flow positive again. The maximum
funding required occurs in quarter two and is $10 million.
Table 6.6 The cumulative cash flow indicating the funding required for the project
Quarters
1 2 345 6 7 7
Sales revenue ($ millions) 0 0 10 10 10 20 20 20
Operating costs ($ millions) 0 0 −5 −5 −5 −10 −10 −10
Capital costs ($ millions) −5 −5 −0 −5 −5000
Required cumulative funding ($ millions) −5 −10 −5 −5 −5 +5 +15 +25
Worked example
Fixed-cost breaks are
important in determining
break-even points
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Figure 6.11 Repeated incurring of fixed costs can raise total costs above revenue
A specialist graphics company is investing in a new machine which enables it to make
high-quality prints for its clients. Demand for these prints is forecast to be around
100,000 units in year 1 and 220,000 units in year 2. The maximum capacity of each
machine the company will buy to process these prints is 100,000 units per year. They
have a fixed cost of a200,000 per year and a variable cost of processing of a1 per unit.
The company believe they will be able to charge a4 per unit for producing the prints.
Question
What profit are they likely to make in the first and second years?
Year 1 demand = 100,000 units; therefore company will need one machine
Cost of manufacturing = fixed cost for one machine + variable cost × 100,000
= a200,000 + (a1 × 100,000)
= a300,000
Revenue = demand × price
= 100,000 × a4
= a400,000
Therefore profit = a400,000 − a300,000
= a100,000
Year 2 demand = 220,000; therefore company will need three machines
Cost of manufacturing = fixed cost for three machines + variable cost × 220,000
= (3 × a200,000) + (a1 × 220,000)
= a820,000
Revenue = demand × price
= 220,000 × a4
= a880,000
Therefore profit = a880,000 – a820,000
= a60,000
Note: the profit in the second year will be lower because of the extra fixed costs associ-
ated with the investment in the two extra machines.
Worked example
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Chapter 6 Supply network design
161
Summary answers to key questions
Check and improve your understanding of this chapter using self assessment questions
and a personalised study plan, audio and video downloads, and an eBook – all at
www.myomlab.com.
➤ Why should an organization take a total supply network perspective?
■ The main advantage is that it helps any operation to understand how it can compete effectively
within the network. This is because a supply network approach requires operations managers
to think about their suppliers and their customers as operations. It can also help to identify
particularly significant links within the network and hence identify long-term strategic changes
which will affect the operation.
➤ What is involved in configuring a supply network?
■ There are two main issues involved in configuring the supply network. The first concerns the
overall shape of the supply network. The second concerns the nature and extent of outsourcing
or vertical integration.
■ Changing the shape of the supply network may involve reducing the number of suppliers to the
operation so as to develop closer relationships, any bypassing or disintermediating operations
in the network.
■ Outsourcing or vertical integration concerns the nature of the ownership of the operations within
a supply network. The direction of vertical integration refers to whether an organization wants
to own operations on its supply side or demand side (backwards or forwards integration). The
extent of vertical integration relates to whether an organization wants to own a wide span of
the stage in the supply network. The balance of vertical integration refers to whether operations
can trade with only their vertically integrated partners or with any other organizations.
➤ Where should an operation be located?
■ The stimuli which act on an organization during the location decision can be divided into
supply-side and demand-side influences. Supply-side influences are the factors such as labour,
land and utility costs which change as location changes. Demand-side influences include such
things as the image of the location, its convenience for customers and the suitability of the site
itself.
➤ How much capacity should an operation plan to have?
■ The amount of capacity an organization will have depends on its view of current and future
demand. It is when its view of future demand is different from current demand that this issue
becomes important.
■ When an organization has to cope with changing demand, a number of capacity decisions need
to be taken. These include choosing the optimum capacity for each site, balancing the various
capacity levels of the operation in the network, and timing the changes in the capacity of each
part of the network.
■ Important influences on these decisions include the concepts of economy and diseconomy
of scale, supply flexibility if demand is different from that forecast, and the profitability and
cash-flow implications of capacity timing changes.
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In August 2006, the company behind Disneyland Resort
Paris reported a 13 per cent rise in revenues, saying that
it was making encouraging progress with new rides aimed
at getting more visitors. ‘I am pleased with year-to-date
revenues and especially with third quarter’s, as well as with
the success of the opening of Buzz Lightyear Laser Blast,
the first step of our multi-year investment program. These
results reflect the group’s strategy of increasing growth
through innovative marketing and sales efforts as well as a
multi-year investment program. This performance is encour-
aging as we enter into the important summer months’, said
Chairman and Chief Executive Karl L. Holz. Yet it hadn’t
always been like that. The 14-year history of Disneyland Paris
had more ups and downs than any of its rollercoasters. From
12 April 1992 when EuroDisney opened, through to this more
optimistic report, the resort had been subject simultane-
ously to both wildly optimistic forecasts and widespread
criticism and ridicule. An essay on one critical Internet site
(called ‘An Ugly American in Paris’) summarized the whole
venture in this way. ‘When Disney decided to expand its
hugely successful theme park operations to Europe, it
brought American management styles, American cultural
tastes, American labor practices, and American marketing
pizzazz to Europe. Then, when the French stayed away in
droves, it accused them of cultural snobbery.’
The ‘magic’ of Disney
Since its founding in 1923, The Walt Disney Company had
striven to remain faithful in its commitment to ‘Producing
unparalleled entertainment experiences based on its rich
legacy of quality creative content and exceptional story-
telling’. In the Parks and Resorts division, according to the
company’s description, customers could experience the
‘Magic of Disney’s beloved characters’. It was founded
in 1952, when Walt Disney formed what is now known as
‘Walt Disney Imagineering’ to build Disneyland in Anaheim,
California. By 2006, Walt Disney Parks and Resorts oper-
ated or licensed 11 theme parks at five Disney destinations
around the world. They were: Disneyland Resort, California,
Walt Disney World Resort, Florida, Tokyo Disney Resort,
Disneyland Resort Paris, and their latest park, Hong Kong
Disneyland. In addition, the division operated 35 resort
hotels, two luxury cruise ships and a wide variety of other
entertainment offerings. But perhaps none of its ventures
had proved to be as challenging as its Paris Resort.
Service delivery at Disney resorts and parks
The core values of the Disney company and, arguably,
the reason for its success, originated in the views and
personality of Walt Disney, the company’s founder. He had
Case study
Disneyland Resort Paris (abridged)
10
what some called an obsessive focus on creating images,
products and experiences for customers that epitomized
fun, imagination and service. Through the ‘magic’ of
legendary fairytale and story characters, customers could
escape the cares of the real world. Different areas of
each Disney Park are themed, often around various ‘lands’
such as Frontierland, and Fantasyland. Each land con-
tains attractions and rides, most of which are designed
to be acceptable to a wide range of ages. Very few rides
are ‘scary’ when compared to many other entertainment
parks. The architectural styles, décor, food, souvenirs and
cast costumes were all designed to reflect the theme
of the ‘land’, as were the films and shows. And although
there were some regional differences, all the theme parks
followed the same basic set-up. The terminology used by
the company reinforced its philosophy of consistent enter-
tainment. Employees, even those working ‘backstage’, were
called ‘cast members’. They did not wear uniforms but
‘costumes’, and rather than being given a job they were
‘cast in a role’. All park visitors were called ‘guests’.
Disney employees were generally relatively young, often
of school or college age. Most were paid hourly on tasks
that could be repetitive even though they usually involved
constant contact with customers. Yet, employees were
still expected to maintain a high level of courtesy and
work performance. All cast members were expected to
conform to strict dress and grooming standards. Applicants
to become cast members were screened for qualities such
as how well they responded to questions, how well they
listened to their peers, how they smiled and used body
language, and whether they had an ‘appropriate attitude’.
Disney parks had gained a reputation for their obsession
with delivering a high level of service and experience through
attention to operations detail. All parks employed queue
management techniques such as providing information
and entertainment for visitors, who were also seen as
Source: Corbis/Jacques Langevin
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million Europeans visited the US Disney parks. The com-
pany’s brand was strong and it had over half a century
of translating the Disney brand into reality. The name
‘Disney’ had become synonymous with wholesome family
entertainment that combined childhood innocence with
high-tech ‘Imagineering’.
Initially, as well as France, Germany, Britain, Italy and
Spain were all considered as possible locations, though
Germany, Britain and Italy were soon discarded from the
list of potential sites. The decision soon came to a straight
contest between the Alicante area of Spain, which had
a similar climate to Florida for a large part of the year
and the Marne-la-Vallée area just outside Paris. Certainly,
winning the contest to host the new park was important for
all the potential host countries. The new park promised to
generate more than 30,000 jobs. The major advantage of
locating in Spain was the weather. However, the eventual
decision to locate near Paris was thought to have been
driven by a number of factors that weighed more heavily
with Disney executives. These included the following:
● There was a suitable site available just outside Paris.
● The proposed location put the park within a 2-hour
drive for 17 million people, a 4-hour drive for 68 million
people, a 6-hour drive for 110 million people and a
2-hour flight for a further 310 million or so.
● The site also had potentially good transport links.
The Channel Tunnel that was to connect England with
France was due to open in 1994. In addition, the French
autoroutes network and the high-speed TGV network
could both be extended to connect the site with the
rest of Europe.
● Paris was already a highly attractive vacation destination.
● Europeans generally take significantly more holidays
each year than Americans (five weeks of vacation as
opposed to two or three weeks).
● Research indicated that 85% of French people would
welcome a Disney park.
● Both national and local government in France were
prepared to give significant financial incentives (as were
the Spanish authorities), including an offer to invest in
local infrastructure, reduce the rate of value added tax
on goods sold in the park, provide subsidized loans,
and value the land artificially low to help reduce taxes.
Moreover, the French government was prepared to
expropriate land from local farmers to smooth the
planning and construction process.
Early concerns that the park would not have the same
sunny, happy feel in a cooler climate than Florida were
allayed by the spectacular success of Disneyland Tokyo in
a location with a similar climate to Paris, and construction
started in August 1988. But from the announcement that
the park would be built in France, it was subject to a
wave of criticism. One critic called the project a ‘cultural
Chernobyl’ because of how it might affect French cultural
values. Another described it as ‘a horror made of cardboard,
having a role within the park. They were not merely spec-
tators or passengers on the rides, they were considered to
be participants in a play. Their needs and desires were
analysed and met through frequent interactions with staff
(cast members). In this way they could be drawn into the
illusion that they were actually part of the fantasy.
Disney’s stated goal was to exceed their customers’
expectations every day. Service delivery was mapped and
continuously refined in the light of customer feedback and
the staff induction programme emphasized the company’s
quality assurance procedures and service standards
based on the four principles of safety, courtesy, show and
efficiency. Parks were kept fanatically clean. The same
Disney character never appears twice within sight – how
could there be two Mickeys? Staff were taught that cus-
tomer perceptions are both the key to customer delight,
but also are extremely fragile. Negative perceptions can
be established after only one negative experience. Disney
university-trained their employees in their strict service
standards as well as providing the skills to operate new
rides as they were developed. Staff recognition programmes
attempted to identify outstanding service delivery perform-
ance as well as ‘energy, enthusiasm, commitment, and
pride’. All parks contained phones connected to a central
question hotline for employees to find the answer to any
question posed by customers.
Tokyo Disneyland
Tokyo Disneyland, opened in 1982, was owned and oper-
ated by the Oriental Land Company. Disney had designed
the park and advised on how it should be run and it was
considered a great success. Japanese customers revealed
a significant appetite for American themes and American
brands, and already had a good knowledge of Disney
characters. Feedback was extremely positive with visitors
commenting on the cleanliness of the park and the
courtesy and the efficiency of staff members. Visitors also
appreciated the Disney souvenirs because giving gifts is
deeply embedded in the Japanese culture. The success of
the Tokyo Park was explained by one American living in
Japan. ‘Young Japanese are very clean-cut. They respond
well to Disney’s clean-cut image, and I am sure they had no
trouble filling positions. Also, young Japanese are generally
comfortable wearing uniforms, obeying their bosses, and
being part of a team. These are part of the Disney formula.
Also, Tokyo is very crowded and Japanese here are used
to crowds and waiting in line. They are very patient. And
above all, Japanese are always very polite to strangers.’
Disneyland Paris
By 2006 Disneyland Paris consisted of three parks: the
Disney Village, Disneyland Paris itself and the Disney Studio
Park. The Village was composed of stores and restaurants;
the Disneyland Paris was the main theme park; and Disney
Studio Park has a more general movie-making theme. At
the time of the European park’s opening more than two
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163
➔
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