UNIT 4.

OPERATIONS MANAGEMENT

TABLE OF CONTENTS

1.Costs and revenues ............................................................................................................................. 2

2. Break-even analysis............................................................................................................................ 3
3. Production planning ........................................................................................................................... 5
 1.Costs and revenues
Management decisions can cover a wide range of issues and they require much
information before effective strategies can be adopted. These business decisions include
location of the operations, which method of production to use, which products to continue
to make and whether to buy in components or make them within the business. Such
decisions would not be possible without cost data.
Here are some of the major uses of cost data:
● Business costs are a key factor in the ‘profit equation’. Profits or losses cannot be
calculated without accurate cost data. If businesses do not keep a record of their costs, then
they will be unable to take profitable decisions, such as where to locate.
● Cost data are important to departments, such as marketing. Marketing managers will
use cost data to help inform their pricing decisions.
● Keeping cost records also allows comparisons to be made with past periods of time. In
this way, the efficiency of a department or a product’s profitability may be measured and
assessed over time.
● Past cost data can help to set budgets for the future. These will act as targets to work
towards for the departments concerned.
● Cost variances can be calculated by comparing cost budgets with actual data.
● Comparing cost data can help a manager make decisions about resource use. For
example, if wage rates are very low, then labour-intensive methods of production may be
preferred over capital-intensive ones.
● Calculating the costs of different options can assist managers in their decision-making
and help improve business performance.
Types of costs
It is important for management to understand that not all costs will vary directly in line
with production increases or decreases. In the short run − the period in which no changes to
capacity can be made − costs may be classified as follows:

● Fixed costs – these remain fixed no matter what the level of output, such as rent of
premises.
● Variable costs – these vary as output changes, such as the direct cost of materials
used in making a washing machine or the electricity used to cook a fast-food meal.
● Semi-variable costs – these include both a fixed and a variable element, e.g. the
electricity standing charge plus cost per unit used, sales person’s fixed basic wage plus a
commission that varies with sales.
● Marginal costs – these are the additional variable costs of producing one more unit of
output.

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Revenue
Revenue is not the same as cash in a cash-flow forecast unless all goods have been
sold for cash. Revenue is recorded on a firm’s accounts whether the cash has been received
from the customer/debtor or not. Revenue is not the same as profit either. Revenue is the
income received from the sale of a product. All costs of operating the business during a time
period have to be subtracted from total revenue to obtain the profit figure.
A business may receive income from sources other than its normal operating
activities, for example from:
● the sale of non-current or fixed assets no longer required
● rent from factory or office space to another business
● dividends on shares held in another business
● interest on deposits held in a bank.

2. Break-even analysis
If a business is able to calculate the break-even quantity that must be sold to cover
all costs, it will be easier to make important production and marketing decisions. At the
break-even level of output and sales, profit is zero. This must mean that at break even:
Total costs = Total revenue
No profit or loss is made.
Break-even point of production: the level of output at which total costs equal total
revenue.

Calculating break even – methods

Break-even analysis can be undertaken in two ways:
A) graphical method
B) formula method
A) Graphical method

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 The chart itself is usually drawn showing three pieces of information:
● fixed costs, which, in the short term, will not vary with the level of output and
which must be paid whether the firm produces anything or not.
● total costs, which are the addition of fixed and variable costs; we will assume,
initially at least, that variable costs vary in direct proportion to output.
● sales revenue, obtained by multiplying selling price by output level.
Note the following points:
● The fixed cost line is horizontal showing that fixed costs are constant at all output
levels.
● The variable cost line starts from the origin (0). If no goods are produced, there will
be no variable costs. It increases at a constant rate and, at each level of output shows that
total variable costs = quantity × variable cost per unit. The line is not necessary to interpret
the chart and is often omitted.
● The total cost line begins at the level of fixed costs, but then follows the same
slope/gradient as variable costs.
● Sales revenue starts at the origin (0) as if no sales are made, there can be no
revenue. It increases at a constant rate and, at each level of output shows that total revenue
= quantity × price.
● The point at which the total cost and sales revenue lines cross (BE) is the break-
even point. At production levels below the break-even point, the business is making a loss;
at production levels above the breakeven point, the business is making a profit.
● Profit is shown by the positive difference between sales revenue and total costs –
to the right of the BE point.
● Maximum profit is made at maximum output and is shown on the graph.

B) Formula method
A formula can be used to calculate break even:

Contribution per unit= selling price of a product less variable costs per unit

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Break-even analysis – an evaluation
Usefulness of break-even analysis
● Charts are relatively easy to construct and interpret.
● It provides useful guidelines to management on break-even points, safety margins
and profit/loss levels at different rates of output.
● Comparisons can be made between different options by constructing new charts
to show changed circumstances. For example, the charts could be amended to show the
possible impact on profit and break-even point of a change in the product’s selling price.
● The equation produces a precise break-even result.
● Break-even analysis can be used to assist managers when taking important
decisions, such as location decisions, whether to buy new equipment and which project to
invest in.
Limitations of break-even analysis
● The assumption that costs and revenues are always represented by straight lines
is unrealistic. Not all variable costs change directly or ‘smoothly’ with output. For example,
labour costs may increase as output reaches maximum due to higher shift payments or
overtime rates. The revenue line could be influenced by price reductions made necessary to
sell all units produced at high output levels. The combined effects of these assumptions
could be to create two breakeven points in practice.
● Not all costs can be conveniently classified into fixed and variable costs. The
introduction of semivariable costs will make the technique much more complicated.
● There is no allowance made for stock levels on the break-even chart. It is assumed
that all units produced are sold. This is unlikely to always be the case in practice.
● It is also unlikely that fixed costs will remain unchanged at different output levels
up to maximum capacity.

3. Production planning
All businesses hold stocks of some kind. Banks and insurance companies will hold
stocks of stationery, and retailers have stocks of goods on display and in their warehouses.
Manufacturing businesses will hold stocks in three distinct forms:
1 Raw materials and components. These will have been purchased from outside
suppliers. They will be held in stock until they are used in the production process.
2 Work in progress. At any one time the production process will be converting raw
materials and components into finished goods and these are ‘work in progress’. For some
firms, such as construction businesses, this will be the main form of stocks held. Batch
production tends to have high work-in-progress levels.

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 3 Finished goods. Having been through the complete production process goods may
then be held in stock until sold and despatched to the customer.

Stock-holding costs
There are three costs associated with stock holding:
1 Opportunity cost. Working capital tied up in stocks could be put to another best
alternative use. The capital might be used to pay off loans, buy new equipment or pay off
suppliers, or could be left in the bank to earn interest.
2 Storage costs. Stocks have to be held in secure warehouses. They often require
special conditions, such as refrigeration. Staff will be needed to guard and transport the
stocks which should be insured against fire or theft.
3 Risk of wastage and obsolescence. If stocks are not used or sold as rapidly as
expected, then there is an increasing danger of goods deteriorating or becoming outdated.
This will lower the value of such stocks. Goods often become damaged while held in storage
– they can then only be sold for a much lower price.
Costs of not holding enough stocks
There are risks to holding very low stock levels – and these risks may have financial
costs for the firm. These costs are often called ‘stock-out’ costs:
1 Lost sales. If a firm is unable to supply customers ‘from stock’, then sales could be
lost to firms that hold higher stock levels. This might lead to future lost orders too. In
purchasing contracts between businesses, it is common for there to be a penalty payment
clause requiring the supplier to pay compensation if delivery dates cannot be met on time.
2 Idle production resources. If stocks of raw materials and components run out, then
production will have to stop. This will leave expensive equipment idle and labour with
nothing to do. The costs of lost output and wasted resources could be considerable.
3 Special orders could be expensive. If an urgent order is given to a supplier to
deliver additional stock due to shortages, then extra costs might be incurred in
administration of the order and in special delivery charges.
4 Small order quantities. Keeping low stock levels may mean only ordering goods
and supplies in small quantities. The larger the size of each delivery, the higher will be the
average stock level held. By ordering in small quantities, the firm may lose out on an
important economy of scale such as discounts for large orders.

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The optimum stock level will be at the lowest point of the total stock cost graph.

Optimum order size

Purchasing managers might be tempted to order huge quantities of stocks in order
to gain economies of scale and to ensure that the firm never runs out. Ordering and
administration costs will be low as few orders will need to be placed. Continuous production
should be ensured and special order costs for out-of-stock materials should be unnecessary.
However, stock-holding costs will be higher as the large orders will have to be stored
until they are needed. Opportunity costs will be higher due to more capital being tied up.
The danger of stock becoming obsolete and out of date is increased. What, then, is the
optimum order size? It will differ for every firm and every kind of stock. The economic order
quantity (EOQ) can be calculated for each product.
Economic order quantity (EOQ): the optimum or least-cost quantity of stock to re-
order taking into account delivery costs and stock-holding costs.
Controlling stock levels – a graphical approach
Stock-control charts or graphs are widely used to monitor a firm’s stock position.
These charts record stock levels, stock deliveries, buffer stocks and maximum stock levels
over time. They aid a stock manager in determining the appropriate order time and order
quantity.

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 Next figure has certain key features:

1 Buffer stocks. The more uncertainty there is about delivery times or production
levels, the higher the buffer stock level will have to be. Also, the greater the cost involved in
shutting production down and restarting, the greater the potential cost savings from holding
high buffer stocks.
2 Maximum stock level. This may be limited by space or by the financial costs of
holding even higher stock levels. One way to calculate this maximum level is to add the EOQ
of each component to the buffer stock level for that item.
3 Re-order quantity. This will be influenced by the economic order quantity concept
referred to above.
4 Lead time. The longer this period of time, then the higher will have to be the re-
order stock level. The less reliable suppliers are, the greater the buffer stock level might
have to be.
5 Re-order stock level. It is now very common for computers to be used to keep a
record of every sale and every delivery of stock. The re-order quantity and re-order stock
level can be programmed into the computer and it can then reorder automatically from the
supplier when stocks fall to the re-order stock level.
Definitions
Buffer stocks (stock de seguridad): the minimum stocks that should be held to
ensure that production could still take place should a delay in delivery occur or production
rates increase.
Re-order quantity: the number of units ordered each time.
Lead time (plazo de aprovisionamiento): the normal time taken between ordering
new stocks and their delivery.

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 Re-order stock level (punto de pedido): the level of stocks that will trigger a new
order to be sent to the supplier.
JUST IN TIME
Originating in Japan, the JIT approach to stock control is now influencing stock-
holding decisions in businesses all over the world. JIT requires that no buffer stocks are held,
components arrive just as they are needed on the production line and finished goods are
delivered to customers as soon as they are completed.

(Texto adaptado de P. & Smith, A. (2011) Business and management for the IB diploma.
Cambridge. Cambridge University Press)

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