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M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 138 Chapter 6 Supply network design Key questions Introduction ➤ Why should an organization take a No opera...

M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 138 Chapter 6 Supply network design Key questions Introduction ➤ Why should an organization take a No operation exists in isolation. Every operation is part of a total supply network perspective? larger and interconnected network of other operations. This ➤ What is involved in configuring a supply network will include suppliers and customers. It will also supply network? include suppliers’ suppliers and customers’ customers, and so ➤ Where should an operation be on. At a strategic level, operations managers are involved in located? ‘designing’ the shape and form of their network. Network design ➤ How much capacity should an starts with setting the network’s strategic objectives. This helps operation plan to have? the operation to decide how it wants to influence the overall shape of its network, the location of each operation, and how it should manage its overall capacity within the network. This chapter treats all these strategic design decisions in the context of supply networks (see Figure 6.1). Figure 6.1 This chapter examines supply network design 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. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 139 Chapter 6 Supply network design 139 Operations in practice Dell: no operating model lasts forever 1 When he was a student at the University of Texas at Austin, Michael Dell’s sideline of buying unused stock of PCs from local dealers, adding components, and re-selling the now higher-specification machines to local businesses was so successful he quit university and founded a computer company which was to Source: Corbis/Gianni Giansanti/Sygma revolutionize the industry’s supply network management. But his fledgling company was just too small to make its own components. Better, he figured to learn how to manage a network of committed specialist component manufacturers and take the best of what was available in the market. Dell says that his commitment to outsourcing was always done for the most positive of reasons. ‘We focus on how we can coordinate our activities to create the most value for customers’. Yet Dell still faced a cost disadvantage against its far bigger competitors, so they Sales of PCs to business users had become largely decided to sell its computers direct to its customers, a commodity business with wafer-thin margins, bypassing retailers. This allowed the company to cut out and this part of the market was growing slowly the retailer’s (often considerable) margin, which in turn compared to the sale of computers to individuals. allowed Dell to offer lower prices. Dell also realized that Selling computers to individuals provided slightly cutting out the link in the supply network between them better margins than the corporate market, but they and the customer also provided them with significant increasingly wanted up-to-date computers with learning opportunities by offering an opportunity to get a high design value, and most significantly, they to know their customers’ needs far more intimately. wanted to see, touch and feel the products before This allowed them to forecast based on the thousands buying them. This was clearly a problem for a company of customer contact calls every hour. It also allowed like Dell which had spent 20 years investing in its them to talk with customers about what they really telephone- and later, internet-based sales channels. want from their machines. Most importantly it allowed What all commentators agreed on was that in the Dell to learn how to run its supply chain so that fast-moving and cut-throat computer business, products could move through the supply chain where market requirements could change overnight, to the end-customer in a fast and efficient manner, operations resources must constantly develop reducing Dell’s level of inventory and giving Dell appropriate new capabilities. a significant cost advantage. However, Michael Dell says it could regain its spot However, what is right at one time may become a as the world’s number one PC maker by switching its liability later on. Two decades later Dell’s growth started focus to consumers and the developing world. He also to slow down. The irony of this is that, what had been conceded that the company had missed out on the boom one of the company’s main advantages, its direct sales in supplying computers to home users – who make up model using the Internet and its market power to squeeze just 15% of its revenues – because it was focused on price reductions from suppliers, were starting to be seen supplying businesses. ‘Let’s say you wanted to buy a as disadvantages. Although the market had changed, Dell computer in a store nine months ago – you’d have Dell’s operating model had not. Some commentators searched a long time and not found one. Now we have questioned Dell’s size. How could a $56 billion company over 10,000 stores that sell our products.’ He rejected remain lean, sharp, and alert? Other commentators the idea that design was not important to his company, pointed out that Dell’s rivals had also now learnt to run though he accepted that it had not been a top priority efficient supply chains (‘Getting a 20-year competitive when all the focus was on business customers. ‘As advantage from your knowledge of how to run supply we’ve gone to the consumer we’ve been paying quite chains isn’t too bad.’) However, one of the main factors a bit more attention to design, fashion, colors, textures was seen as the shift in the nature of the market itself. and materials.’ M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 140 140 Part Two Design The supply network perspective Supply network A supply network perspective means setting an operation in the context of all the other operations with which it interacts, some of which are its suppliers and its customers. Materials, parts, other information, ideas and sometimes people all flow through the network Supply side of customer–supplier relationships formed by all these operations. On its supply side an operation has its suppliers of parts, or information, or services. These suppliers themselves Demand side have their own suppliers who in turn could also have suppliers, and so on. On the demand side the operation has customers. These customers might not be the final consumers of the operation’s products or services; they might have their own set of customers. On the supply First-tier side is a group of operations that directly supply the operation; these are often called first-tier Second-tier suppliers. They are supplied by second-tier suppliers. However, some second-tier suppliers may also supply an operation directly, thus missing out a link in the network. Similarly, on the demand side of the network, ‘first-tier’ customers are the main customer group for the operation. These in turn supply ‘second-tier’ customers, although again the operation may at times supply second-tier customers directly. The suppliers and customers who have direct Immediate supply contact with an operation are called its immediate supply network, whereas all the operations network which form the network of suppliers’ suppliers and customers’ customers, etc., are called the Total supply network total supply network. Figure 6.2 illustrates the total supply network for two operations. First is a plastic home- ware (kitchen bowls, food containers, etc.) manufacturer. Note that on the demand side the Figure 6.2 Operations network for a plastic homeware company and a shopping mall M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 141 Chapter 6 Supply network design 141 homeware manufacturer supplies some of its basic products to wholesalers which supply retail outlets. However, it also supplies some retailers directly with ‘made-to-order’ products. Along with the flow of goods in the network from suppliers to customers, each link in the network will feed back orders and information to its suppliers. When stocks run low, the retailers will place orders with the wholesaler or directly with the manufacturer. The whole- saler will likewise place orders with the manufacturer, which will in turn place orders with its suppliers, which will replenish their own stocks from their suppliers. It is a two-way process with goods flowing one way and information flowing the other. It is not only manufacturers that are part of a supply network. The second (service) operation, an operation which manages an enclosed shopping mall, also has suppliers and customers that themselves have their own suppliers and customers. Figure 6.2 shows the supply network for an operation which manages an enclosed shopping mall. Why consider the whole supply network? There are three important reasons for taking a supply network perspective: It helps an understanding of competitiveness. Immediate customers and immediate suppliers, quite understandably, are the main concern to competitively minded companies. Yet some- times they need to look beyond these immediate contacts to understand why customers and suppliers act as they do. Any operation has only two options if it wants to understand its ultimate customers’ needs at the end of the network. It can rely on all the intermediate customers and customers’ customers, etc., which form the links in the network between the company and its end-customers. Alternatively, it can look beyond its immediate customers and suppliers. Relying on one’s immediate network is seen as putting too much faith in someone else’s judgement of things which are central to an organization’s own competitive health. It helps identify significant links in the network. The key to understanding supply networks lies in identifying the parts of the network which contribute to those performance objectives valued by end-customers. Any analysis of networks must start, therefore, by understanding Downstream the downstream end of the network. After this, the upstream parts of the network which Upstream contribute most to end-customer service will need to be identified. But they will not be equally significant. For example, the important end-customers for domestic plumbing parts and appliances are the installers and service companies that deal directly with domestic con- sumers. They are supplied by ‘stock holders’ which must have all parts in stock and deliver them fast. Suppliers of parts to the stock holders can best contribute to their end-customers’ competitiveness partly by offering a short delivery lead time but mainly through depend- able delivery. The key players in this example are the stock holders. The best way of winning end-customer business in this case is to give the stock holder prompt delivery which helps keep costs down while providing high availability of parts. It helps focus on long-term issues. There are times when circumstances render parts of a supply network weaker than its adjacent links. A major machine breakdown, for example, or a labour dispute might disrupt a whole network. Should its immediate customers and suppliers exploit the weakness to enhance their own competitive position, or should they tolerate the problems, and hope the customer or supplier will eventually recover? A long-term supply-network view would be to weigh the relative advantages to be gained from assisting or replacing the weak link. Design decisions in supply networks The supply-network view is useful because it prompts three particularly important design decisions. These are the most strategic of all the design decisions treated in this part of the book. It is necessary to understand them at this point, however, because, as well as having M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 142 142 Part Two Design a particularly significant impact on the strategy of the organization, they set the context in which all other process design decisions are made. The three decisions are: 1 How should the network be configured? This means, first, how can an operation influence the shape which the network might take? Second, how much of the network should the Outsourcing operation own? This may be called the outsourcing, vertical integration or do-or-buy Vertical integration decision. Do or buy 2 Where should each part of the network be located? If the homeware company builds a new factory, should it be close to its suppliers or close to its customers, or somewhere in Location between? This decision is called the operations location decision. 3 What physical capacity should each part of the network have? How large should the homeware factory be? Should it expand in large-capacity steps or small ones? These type Long-term capacity of decisions are called long-term capacity management decisions. management Note that all three of these decisions rely on assumptions regarding the level of future demand. The supplement to this chapter explores forecasting in more detail. Also, in Chapter 13, we will cover the more operational day-to-day issues of managing operations networks. In this chapter we deal with these three related strategic decisions. Configuring the supply network Changing the shape of the supply network Even when an operation does not directly own, or even control, other operations in its network, it may still wish to change the shape of the network. This involves attempting to manage network behaviour by reconfiguring the network so as to change the scope of the activities performed in each operation and the nature of the relationships between them. Reconfiguring a supply network sometimes involves parts of the operation being merged – not necessarily in the sense of a change of ownership of any parts of an operation, but rather in the way responsibility is allocated for carrying out activities. The most common example of network reconfiguration has come through the many companies that have recently reduced the number of direct suppliers. The complexity of dealing with many hundreds of suppliers may both be expensive for an operation and (sometimes more important) prevent the operation from developing a close relationship with a supplier. It is not easy to be close to hundreds of different suppliers. Disintermediation Another trend in some supply networks is that of companies within a network bypassing customers or suppliers to make contact directly with customers’ customers or suppliers’ Disintermediation suppliers. ‘Cutting out the middlemen’ in this way is called disintermediation. An obvious example of this is the way the Internet has allowed some suppliers to ‘disintermediate’ tradi- tional retailers in supplying goods and services to consumers. So, for example, many services in the travel industry that used to be sold through retail outlets (travel agents) are now also available direct from the suppliers. The option of purchasing the individual components of a vacation through the web sites of the airline, hotel, car hire company, etc., is now easier for consumers. Of course, they may still wish to purchase an ‘assembled’ product from retail travel agents which can have the advantage of convenience. Nevertheless the process of disintermediation has developed new linkages in the supply network. Co-opetition One approach to thinking about supply networks sees any business as being surrounded by four types of players: suppliers, customers, competitors and complementors. Complementors enable one’s products or services to be valued more by customers because they can also have the M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 143 Chapter 6 Supply network design 143 complementor’s products or services, as opposed to when they have yours alone. Competitors are the opposite: they make customers value your product or service less when they can have their product or service, rather than yours alone. Competitors can also be complementors and vice versa. For example, adjacent restaurants may see themselves as competitors for customers’ business. A customer standing outside and wanting a meal will choose between the two of them. Yet, in another way they are complementors. Would that customer have come to this part of town unless there was more than one restaurant to choose from? Restaurants, theatres, art galleries and tourist attractions generally, all cluster together in a form of cooperation to increase the total size of their joint market. It is important to distinguish between the way companies cooperate in increasing the total size of a market and the way in which they then compete for a share of that market. Customers and suppliers, it is argued, should have ‘symmetric’ roles. Harnessing the value of suppliers is just as important as listening to the needs of customers. Destroying value in a supplier in order to create it in a customer does not increase the value of the network as a whole. So, pressurizing suppliers will not necessarily add value. In the long term it creates value for the total network to find ways of increasing value for suppliers and well as customers. All the players in the network, whether they are customers, suppliers, competitors or complementors, can be both friends and enemies at Co-opetition different times. The term used to capture this idea is ‘co-opetition’.2 In-house or outsource? Do or buy? The vertical integration decision No single business does everything that is required to produce its products and services. Bakers do not grow wheat or even mill it into flour. Banks do not usually do their own credit check- ing: they retain the services of specialist credit checking agencies that have the specialized information systems and expertise to do it better. This process is called ‘outsourcing’ and has become an important issue for most businesses. This is because, although most companies have always outsourced some of their activities, a larger proportion of direct activities are now being bought from suppliers. Also many indirect processes are now being outsourced. This is often referred to as ‘business process outsourcing’ (BPO). Financial service companies in particular are starting to outsource some of their more routine back-office processes. In a similar way many processes within the human resource function from simply payroll services through to more complex training and development processes, are being outsourced to specialist companies. The processes may still be physically located where they were before, but the staff and technology are managed by the outsourcing service provider. The reason for doing this is often primarily to reduce cost. However, there can sometimes also be significant gains in the quality and flexibility of service offered. ‘People talk a lot about looking beyond cost cutting when it comes to outsourcing companies’ human resource functions’, says Jim Madden, CEO of Exult, the California-based specialist outsourcing company, ‘I don’t believe any com- pany will sign up for this [outsourcing] without cost reduction being part of it, but for the clients whose human resource functions we manage, such as BP, and Bank of America, it is not just about saving money.’ The outsourcing debate is just part of a far larger issue which will shape the fundamental nature of any business. Namely, what should the scope of the business be? In other words, what should it do itself and what should it buy in? This is often referred to as the ‘do-or-buy decision’ when individual components or activities are being considered, or ‘vertical integration’ when it is the ownership of whole operations that is being decided. Vertical integration is the extent to which an organization owns the network of which it is a part. It usually involves an organization assessing the wisdom of acquiring suppliers or customers. Vertical integration can be defined in terms of three factors.3 1 The direction of vertical integration. Should an operation expand by buying one of its suppliers or by buying one of its customers? The strategy of expanding on the supply side of the network is sometimes called ‘backward’ or ‘upstream’ vertical integration, M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 144 144 Part Two Design and expanding on the demand side is sometimes called ‘forward’ or ‘downstream’ vertical integration. 2 The extent of vertical integration. How far should an operation take the extent of its vertical integration? Some organizations deliberately choose not to integrate far, if at all, from their original part of the network. Alternatively, some organizations choose to become very vertically integrated. 3 The balance among stages. How exclusive should the relationship be between operations. A totally balanced network relationship is one where one operation produces only for the next stage in the network and totally satisfies its requirements. Less than full balance allows each operation to sell its output to other companies or to buy in some of its supplies from other companies. Making the outsourcing / vertical integration decision Whether it is referred to as do-or-buy, vertical integration or no vertical integration, in-house or outsourced supply, the choice facing operations is rarely simple. Organizations in different circumstances with different objectives are likely to take different decisions. Yet the question itself is relatively simple, even if the decision itself is not: ‘Does in-house or outsourced supply in a particular set of circumstances give the appropriate perform- ance objectives that it requires to compete more effectively in its markets?’ For example, if the main performance objectives for an operation are dependable delivery and meeting short-term changes in customers’ delivery requirements, the key question should be: ‘How does in-house or outsourcing give better dependability and delivery flexibility performance?’ This means judging two sets of opposing factors – those which give the potential to improve performance and those which work against this potential being realized. Table 6.1 sum- marizes some arguments for in-house supply and outsourcing in terms of each performance objective. Table 6.1 How in-house and outsourced supply may affect an operation’s performance objectives Performance objective ‘Do it yourself’ in-house supply ‘Buy it in’ outsourced supply Quality The origins of any quality problems are usually Supplier may have specialized knowledge easier to trace in-house and improvement can and more experience, also may be motivated be more immediate but there can be some risk through market pressures, but communication of complacency. more difficult. Speed Can mean synchronized schedules which Speed of response can be built into the speeds throughput of materials and information, supply contract where commercial pressures but if the operation has external customers, will encourage good performance, but there internal customers may be low-priority. may be significant transport/delivery delays. Dependability Easier communications can help dependability, Late-delivery penalties in the supply contract but, if the operation also has external can encourage good delivery performance, customers, internal customers may receive but organizational barriers may inhibit in low priority. communication. Flexibility Closeness to the real needs of a business Outsource suppliers may be larger with wider can alert the in-house operation to required capabilities than in-house suppliers and have changes, but the ability to respond may be more ability to respond to changes, but may limited by the scale and scope of internal have to balance conflicting needs of different operations. customers. Cost In-house operations do not have to make the Probably the main reason why outsourcing margin required by outside suppliers so the is so popular. Outsourced companies can business can capture the profits which would achieve economies of scale and they are otherwise be given to the supplier, but relatively motivated to reduce their own costs because low volumes may mean that it is difficult to gain it directly impacts on their profits, but costs economies of scale or the benefits of process of communication and coordination with innovation. supplier need to be taken into account. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 145 Chapter 6 Supply network design 145 Figure 6.3 The decision logic of outsourcing Deciding whether to outsource Although the effect of outsourcing on the operation’s performance objective is important, there are other factors that companies take into account when deciding if outsourcing an activity is Outsourcing is a strategic a sensible option. For example, if an activity has long-term strategic importance to a company, decision it is unlikely to outsource it. For example, a retailer might choose to keep the design and development of its web site in-house even though specialists could perform the activity at less cost because it plans to move into web-based retailing at some point in the future. Nor would a company usually outsource an activity where it had specialized skills or knowledge. For example, a company making laser printers may have built up specialized knowledge in the production of sophisticated laser drives. This capability may allow it to introduce product or process innovations in the future. It would be foolish to ‘give away’ such capability. After these two more strategic factors have been considered the company’s operations performance can be taken into account. Obviously if its operations performance is already too superior to any potential supplier, it would be unlikely to outsource the activity. But also even if its perform- ance was currently below that of potential suppliers, it may not outsource the activity if it feels that it could significantly improve its performance. Figure 6.3 illustrates this decision logic. Short case Behind the brand names 4 The market for notebook computers is a fast-evolving and competitive one. Brands such as Dell, Sony, Fujitsu and Apple as well as many smaller brands vie for customers’ attention. Yet few who buy these products know that the majority of the world’s notebooks, including most of those sold by the big names, are made by a small number of Taiwanese and Korean manufacturers. Taiwanese firms Source: Rex Features alone make around 60 per cent of all notebooks in the world, including most of Dell, Compaq and Apple machines. And this group of Taiwanese manufacturers is dominated by Hon Hai, Quanta and Compal. In a market with unremitting technological innovation and fierce price competition, it makes sense to outsource production to companies that can achieve the economies that come with policy is the requirement to keep costs at a competitive high-volume manufacture as well develop the expertise level, but says that it can ensure product quality and which enables new designs to be put into production performance through its relationship with its suppliers. without the cost overruns and delays which could ruin a ‘The production lines are set up by Dell and managed by new product launch. However, the big brand names are Dell’, says Tony Bonadero, Director of Product Marketing keen to defend their products’ performance. Dell, for for Dell’s laptop range. Dell also imposes strict quality example, admits that a major driver of its outsourcing control and manages the overall design of the product. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 146 146 Part Two Design Figure 6.4 Offshoring and outsourcing are related but different Outsourcing and offshoring Two supply network strategies that are often confused are those of outsourcing and offshoring. Outsourcing means deciding to buy-in products or services rather than perform the activities in-house. Off-shoring means obtaining products and services from operations that are based outside one’s own country. Of course, one may both outsource and offshore as illustrated in Figure 6.4. Offshoring is very closely related to outsourcing and the motives for each may be similar. Offshoring to a lower-cost region of the world is usually done to reduce an operation’s overall costs as is outsourcing to a supplier that has greater expertise or scale or both.5 Critical commentary In many instances there has been fierce opposition to companies outsourcing some of their processes. Trade unions often point out that the only reason that outsourcing companies can do the job at lower cost is that they either reduce salaries or reduce working condi- tions, or both. Furthermore, they say, flexibility is only achieved by reducing job security. Employees who were once part of a large and secure corporation could find themselves as far less secure employees of a less benevolent employer with a philosophy of permanent cost-cutting. Even some proponents of outsourcing are quick to point out the problems. There can be significant obstacles, including understandable resistance from staff who find themselves ‘outsourced’. Some companies have also been guilty of ‘outsourcing a problem’. In other words, having failed to manage a process well themselves, they ship it out rather than face up to why the process was problematic in the first place. There is also evidence that, although long-term costs can be brought down when a process is outsourced, there may be an initial period when costs rise as both sides learn how to manage the new arrangement. The location of capacity It was reputedly Lord Sieff, one-time boss of Marks and Spencer, the UK-based retail organization, who said, ‘There are three important things in retailing – location, location and location’, and any retailing operation knows exactly what he meant. Get the location wrong and it can have a significant impact on profits, or service. For example, mislocating a fire service station can slow down the average journey time of the fire crews in getting to the fires; M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 147 Chapter 6 Supply network design 147 locating a factory where there is difficulty attracting labour with appropriate skills will affect the effectiveness of the factory’s operations. Location decisions will usually have an effect on an operation’s costs as well as its ability to serve its customers (and therefore its revenues). Also, location decisions, once taken, are difficult to undo. The costs of moving an operation can be hugely expensive and the risks of inconveniencing customers very high. No operation wants to move very often. Reasons for location decisions Not all operations can logically justify their location. Some are where they are for historical reasons. Yet even the operations that are ‘there because they’re there’ are implicitly making a decision not to move. Presumably their assumption is that the cost and disruption involved in changing location would outweigh any potential benefits of a new location. Two stimuli often cause organizations to change locations: changes in demand for their goods and services, and changes in supply of their inputs. Changes in demand. A change in location may be prompted by customer demand shifting. For example, as garment manufacture moved to Asia, suppliers of zips, threads, etc. started to follow them. Changes in the volume of demand can also prompt relocation. To meet higher demand, an operation could expand its existing site, or choose a larger site in another location, or keep its existing location and find a second location for an additional operation; the last two options will involve a location decision. High-visibility operations may not have the choice of expanding on the same site to meet rising demand. A dry cleaning service may attract only marginally more business by expanding an existing site because it offers a local, and therefore convenient, service. Finding a new location for an additional operation is probably its only option for expansion. Changes in supply. The other stimulus for relocation is changes in the cost, or availability, of the supply of inputs to the operation. For example, a mining or oil company will need to relocate as the minerals it is extracting become depleted. A manufacturing company might choose to relocate its operations to a part of the world where labour costs are low, because the equivalent resources (people) in its original location have become relatively expensive. Sometimes a business might choose to relocate to release funds if the value of the land it occupies is worth more than an alternative, equally good, location. Short case The Tata Nano finds a new home6 Finding a suitable site for any operation can be a political as well as an economic problem. It certainly was when Tata, the Indian company, unveiled its plans for the Source: Getty Images Nano in 2007. Named the ‘1 lakh car’ (in India one lakh means 100,000), it would be the cheapest car in the world, with the basic model priced at 100,000 rupees, or $2,500, excluding taxes. The price was about half of existing low-cost cars. And the site chosen by Tata was equally bold. It was to be made at Singur, in the Indian state of West Bengal, a populous state with the Nano plant. It would bring much-needed jobs and Calcutta (now called Kolkata) as its capital. Although the send a message that the state welcomed inward Communist Party had ruled the state for four decades, investment. In fact, it had won the plant against stiff the West Bengal government was keen to encourage competition from rival states. ➔ M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 148 148 Part Two Design Controversially, the state government had move. They blocked roads, threatened staff and even expropriated land for the factory using an old law dating assaulted an employee of a Tata supplier. In response, from 1894, which requires private owners to sell land Ratan Tata, chairman of the Tata group, threatened to for a ‘public purpose’. The government justified this move the Nano plant from the state if the company action by pointing out that over 13,000 people had really was not wanted, even though the company some kind of claim to parts of the land required for the had already invested 15 billion rupees in the project. new plant. Tata could not be expected to negotiate, one Eventually, exasperated with being caught in the by one, with all of them. Also financial compensation was ‘political crossfire’, Tata said it would abandon its offered at significantly above market rates. Unfortunately factory in the state. Instead, the company selected a about 2,250 people refused to accept the offered location in Gujarat, one of India’s most industrialized compensation. The political opposition organized mass states, which quickly approved even more land than protests in support of the farmers who did not want to the West Bengal site. The objectives of the location decision The aim of the location decision is to achieve an appropriate balance between three related objectives: Spatially variable costs the spatially variable costs of the operation (spatially variable means that something changes with geographical location); the service the operation is able to provide to its customers; the revenue potential of the operation. In for-profit organizations the last two objectives are related. The assumption is that the better the service the operation can provide to its customers, the better will be its potential to attract custom and therefore generate revenue. In not-for-profit organizations, revenue potential might not be a relevant objective and so cost and customer service are often taken as the twin objectives of location. In making decisions about where to locate an operation, operations managers are concerned with minimizing spatially variable costs and maximizing revenue and customer service. Location affects both of these but not equally for all types of operation. For example, with most products, customers may not care very much where they were made. Location is unlikely to affect the operation’s revenues significantly. However, the costs of the operation will probably be very greatly affected by location. Services, on the other hand, often have both costs and revenues affected by location. The location decision for any operation is determined by the relative strength of supply-side and demand-side factors (see Fig. 6.5). Figure 6.5 Supply-side and demand-side factors in location decisions M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 149 Chapter 6 Supply network design 149 Short case Tesco Thailand7 Tesco is an international retailer with sales in excess of £50 billion, operating around 4,000 stores worldwide, employing almost half a million people and serving millions of customers each week. It sells a wide range of items including groceries, petrol, financial services, electrical goods, household items, toys and even furniture. Although based in the UK Tesco now trades all over the world. One of its big successes is Thailand, where it has 476 stores and employs over 36,000 people. Tesco’s expansion strategy is founded on the need to provide quality products, convenient locations and opening hours and value for money. The company has come to realize that international markets need differing local approaches, with local supply Malls contain the flagship hypermarket stores and other chains, different store formats and sensitivity to local shops, including restaurants and banks, promoting traditions. So how does Tesco (branded ‘Tesco Lotus’ in high-quality local brands rather than expensive imported Thailand) adapt its operating practice to local conditions? brands. ‘These “lifestyle shopping malls” provide better Some things are relatively straightforward. For service and increased convenience to our customers. example, those stores with limited opening hours open at The biggest beneficiaries will be our upcountry customers 9.09 precisely, as Thais believe these numbers bring good who have previously lived a long way from the nearest fortune. Other things are based on a thorough understanding cinema’ (Gwyn Sundhagul, Tesco Lotus Director and of local customers. They discovered that around 5% of Chief Marketing Officer). their customers were actually small family-run stores Community Malls are smaller and emphasize easy taking advantage of Tesco’s lower prices. Rather than access to local neigbourhoods. discourage this they developed their ‘Club Pack’ products Other local developments take account of cultural that shopkeepers could break up and sell in their own sensitivities. Thais greatly admire individuals and stores at a good profit. They also investigated the shopping organizations that help the poor. So Tesco set up experience their Thai customers really want. ‘We started ‘Tesco for Thais’, a non-profit charitable foundation. out by asking our customers what they want our stores to The green agenda is also important in Thailand and sell and look like. From the responses that we received, we large organizations are expected to lead the way. In 2004 realized that the optimal solution would be best delivered Tesco opened its first ‘green’ superstore in Bangkok. by Tesco Lotus constructing its own malls’ (Mrs Veena This store includes a range of energy-saving initiatives Arunyakasem, Mall and Media Director, Tesco Lotus). including recycling and the use of rainwater, with its air So, they developed two new concepts, the Lifestyle conditioning run by solar panels, the size of three football Shopping Mall and Community Mall. Lifestyle Shopping pitches, on the roof. Supply-side influences Labour costs. The costs of employing people with particular skills can vary between different areas in any country, but are likely to be more significant when international comparisons are made. Labour costs can be expressed in two ways. The ‘hourly cost’ is what firms have to pay workers on average per hour. However, the ‘unit cost’ is an indication of the labour cost per unit of production. This includes the effects both of productivity differences between countries and of differing currency exchange rates. Exchange rate variation can cause unit costs to change dramatically over time. Yet in spite of this, labour costs exert a major influence on the location decision, especially in some industries such as clothing, where labour costs as a proportion of total costs are relatively high. Land costs. The cost of acquiring the site itself is sometimes a relevant factor in choosing a location. Land and rental costs vary between countries and cities. At a more local level, land costs are also important. A retail operation, when choosing ‘high-street’ sites, will pay a particular level of rent only if it believes it can generate a certain level of revenue from the site. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 150 150 Part Two Design Energy costs. Operations which use large amounts of energy, such as aluminium smelters, can be influenced in their location decisions by the availability of relatively inexpensive energy. This may be direct, as in the availability of hydroelectric generation in an area, or indirect, such as low-cost coal which can be used to generate inexpensive electricity. Transportation costs. Transportation costs include both the cost of transporting inputs from their source to the site of the operation, and the cost of transporting goods from the site to customers. Whereas almost all operations are concerned to some extent with the former, not all operations transport goods to customers; rather, customers come to them (for example, hotels). Even for operations that do transport their goods to customers (most manufacturers, for example), we consider transportation as a supply-side factor because as location changes, transportation costs also change. Proximity to sources of supply dominates the location decision where the cost of transporting input materials is high or difficult. Food processing and other agriculture-based activities, for example, are often carried out close to growing areas. Conversely, transportation to customers dominates location decisions where this is expensive or difficult. Civil engineering projects, for example, are constructed mainly where they will be needed. Community factors. Community factors are those influences on an operation’s costs which derive from the social, political and economic environment of its site. These include: local tax rates capital movement restrictions government financial assistance government planning assistance political stability local attitudes to ‘inward investment’ language local amenities (schools, theatres, shops, etc.) availability of support services history of labour relations and behaviour environmental restrictions and waste disposal planning procedures and restrictions. Figure 6.6 A major influence in where businesses locate is the cost of operating at different locations. But, total operating cost depends on more than wage costs, or even total labour costs (which includes allowances for different productivity rates). The chart illustrates what makes up the cost of shirts sold in France. Remember, the retailer will often sell the item for more than double the cost 8 M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 151 Chapter 6 Supply network design 151 Short case Developing nations challenge Silicon Valley 9 Similar companies with similar needs often cluster together in the same location. For example, knitted Source: Getty Images/AFP garment manufacturers dominate parts of Northern Italy. Perhaps the most famous location cluster is in the area south of San Francisco known as Silicon Valley, acknowledged as the most important intellectual and commercial hub of high-tech business. Yet Silicon Valley is being challenged by up-and-coming locations, especially in developing countries. Here are two examples. Bangalore in India has for many years been attractive in the computer industry. Back in the 1980s the area The high-tech research and development activities attracted software code-writing business from Western around Shanghai in China do not have the pedigree multinationals attracted by the ready availability of of those in India, but are increasingly seen as well-educated, low-cost English-speaking software significant in the global technology industry. ‘Over technicians. Now the area has attracted even more, and the next ten years, China will become a ferociously even more sophisticated, business. Companies such as formidable competitor for companies that run the entire Intel, Sun Microsystems, Texas Instruments and Cisco length of the technology food chain’, according to have a presence in the area and are using their Bangalore Michael J. Moritz, a Californian venture-capital firm development centres to tackle cutting-edge projects. The specializing in high-tech businesses. And although biggest draw is still India’s pool of high-quality, low-cost most industry commentators admit that China has far software engineers. Each year Bangalore alone graduates to go, the combination of the availability of a highly 25,000 computer science engineers, almost the number skilled and well-educated workforce, often at even who graduate in the entire USA. More significantly, the lower cost than in India, together with the Chinese average wage of a top-class graduate software engineer government encouragement of joint ventures with is around one fifth of that in the USA. Nor is there any multinationals is seen as a big impetus to high-tech lack of multinational experience. For years Western growth. Multinationals such as Alkatel, the French (especially US) high-tech companies have employed telecom giant, and Matsushita, Japan’s largest senior Indian-born engineers. Equipped with Silicon consumer electronics company, as well as chip Valley experience, some of these engineers are happy manufacturer Intel are all investing in research and to return home to manage development teams. development facilities. Demand-side influences Labour skills. The abilities of a local labour force can have an effect on customer reaction to the products or services which the operation produces. For example, ‘science parks’ are usually located close to universities because they hope to attract companies that are interested in using the skills available at the university. The suitability of the site itself. Different sites are likely to have different intrinsic character- istics which can affect an operation’s ability to serve customers and generate revenue. For example, the location of a luxury resort hotel which offers up-market holiday accommoda- tion is very largely dependent on the intrinsic characteristics of the site. Located next to the beach, surrounded by waving palm trees and overlooking a picturesque bay, the hotel is very attractive to its customers. Move it a few kilometres away into the centre of an industrial estate and it rapidly loses its attraction. Image of the location. Some locations are firmly associated in customers’ minds with a particular image. Suits from Savile Row (the centre of the up-market bespoke tailoring dis- trict in London) may be no better than high-quality suits made elsewhere but, by locating its operation there, a tailor has probably enhanced its reputation and therefore its revenue. The M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 152 152 Part Two Design product and fashion design houses of Milan and the financial services in the City of London also enjoy a reputation shaped partly by that of their location. Convenience for customers. Of all the demand-side factors, this is, for many operations, the most important. Locating a general hospital, for instance, in the middle of the countryside may have many advantages for its staff, and even perhaps for its costs, but it clearly would be very inconvenient to its customers. Those visiting the hospital would need to travel long distances. Because of this, general hospitals are located close to centres of demand. Similarly with other public services and restaurants, stores, banks, petrol filling stations etc., location determines the effort to which customers have to go in order to use the operation. Locations which offer convenience for the customer are not always obvious. In the 1950s Jay Pritzker called into a hotel at Los Angeles airport for a coffee. He found that, although the hotel was full, it was also for sale. Clearly there was customer demand but presumably the hotel could not make a profit. That is when he got the idea of locating luxury hotels which could command high revenues at airports where there was always demand. He called his hotel chain Hyatt; it is now one of the best-known hotel chains in the world. Location techniques Although operations managers must exercise considerable judgement in the choice of altern- ative locations, there are some systematic and quantitative techniques which can help the Weighted-score method decision process. We describe two here – the weighted-score method and the centre-of-gravity Centre-of-gravity method method. Weighted-score method The procedure involves, first of all, identifying the criteria which will be used to evaluate the various locations. Second, it involves establishing the relative importance of each criterion and giving weighting factors to them. Third, it means rating each location according to each criterion. The scale of the score is arbitrary. In our example we shall use 0 to 100, where 0 represents the worst possible score and 100 the best. Worked example An Irish company which prints and makes specialist packaging materials for the pharma- ceutical industry has decided to build a new factory somewhere in the Benelux countries so as to provide a speedy service for its customers in continental Europe. In order to choose a site it has decided to evaluate all options against a number of criteria, as follows: the cost of the site; the rate of local property taxation; the availability of suitable skills in the local labour force; the site’s access to the motorway network; the site’s access to the airport; the potential of the site for future expansion. After consultation with its property agents the company identifies three sites which seem to be broadly acceptable. These are known as sites A, B and C. The company also investigates each site and draws up the weighted-score table shown in Table 6.2. It is important to remember that the scores shown in Table 6.2 are those which the manager has given as an indication of how each site meets the company’s needs specifically. Nothing is necessarily being implied regarding any intrinsic worth of the locations. Likewise, the weightings are an indication of how important the company finds each criterion in the circumstances it finds itself. The ‘value’ of a site for each criterion is then calculated by multiplying its score by the weightings for each criterion. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 153 Chapter 6 Supply network design 153 For location A, its score for the ‘cost-of-site’ criterion is 80 and the weighting of this criterion is 4, so its value is 80 × 4 = 320. All these values are then summed for each site to obtain its total weighted score. Table 6.2 indicates that location C has the highest total weighted score and therefore would be the preferred choice. It is interesting to note, however, that location C has the lowest score on what is, by the company’s own choice, the most important criterion – cost of the site. The high total weighted score which location C achieves in other criteria, however, outweighs this deficiency. If, on examination of this table, a company cannot accept what appears to be an inconsistency, then either the weights which have been given to each criterion, or the scores that have been allocated, do not truly reflect the company’s preference. Table 6.2 Weighted-score method for the three sites Criteria Importance Scores weighting Sites A B C Cost of the site 4 80 65 60 Local taxes 2 20 50 80 Skills availability 1 80 60 40 Access to motorways 1 50 60 40 Access to airport 1 20 60 70 Potential for expansion 1 75 40 55 Total weighted scores 585 580 605* *Preferred option. The centre-of-gravity method The centre-of-gravity method is used to find a location which minimizes transportation costs. It is based on the idea that all possible locations have a ‘value’ which is the sum of all trans- portation costs to and from that location. The best location, the one which minimizes costs, is represented by what in a physical analogy would be the weighted centre of gravity of all points to and from which goods are transported. So, for example, two suppliers, each send- ing 20 tonnes of parts per month to a factory, are located at points A and B. The factory must then assemble these parts and send them to one customer located at point C. Since point C receives twice as many tonnes as points A and B (transportation cost is assumed to be directly related to the tonnes of goods shipped) then it has twice the weighting of point A or B. The lowest transportation cost location for the factory is at the centre of gravity of a (weightless) board where the two suppliers’ and one customer’s locations are represented to scale and have weights equivalent to the weightings of the number of tonnes they send or receive. Worked example A company which operates four out-of-town garden centres has decided to keep all its stocks of products in a single warehouse. Each garden centre, instead of keeping large stocks of products, will fax its orders to the warehouse staff who will then deliver replenishment stocks to each garden centre as necessary. The location of each garden centre is shown on the map in Figure 6.7. A reference grid is superimposed over the map. The centre-of-gravity coordinates of the lowest-cost location for the warehouse, G and H, are given by the formulae: ∑xiVi G= ∑Vi ➔ M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 154 154 Part Two Design Figure 6.7 Centre-of-gravity location for the garden centre warehouse and ∑yiVi H= ∑Vi where xi = the x coordinate of source or destination i yi = the y coordinate of source or destination i Vi = 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. 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 In this case (1 × 5) + (5 × 10) + (5 × 12) + (9 × 8) G= = 5.34 35 and (2 × 5) + (3 × 10) + (1 × 12) + (4 × 8) H= = 2.4 35 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. M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 155 Chapter 6 Supply network design 155 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 Fixed-cost breaks 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. 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 M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 156 156 Part Two Design 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. Economies of scale 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 Diseconomies of scale 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. Figure 6.9 The scale of capacity increments affects the utilization of capacity M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 157 Chapter 6 Supply network design 157 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 leading capacity leads demand – timing the introduction of capacity in such a way that there is always sufficient capacity to meet forecast demand; Capacity lagging 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. 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 M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 158 158 Part Two Design Table 6.4 The arguments for and against pure leading and pure lagging strategies of capacity timing Advantages Disadvantages Capacity-leading strategies Always sufficient capacity to meet demand, Utilization of the plants is always relatively low, therefore revenue is maximized and therefore costs will be high customers satisfied Most of the time there is a ‘capacity cushion’ Risks of even greater (or even permanent) which can absorb extra demand if forecasts over-capacity if demand does not reach are pessimistic forecast levels Any critical start-up problems with new plants Capital spending on plant early are less likely to affect supply to customers Capacity-lagging strategies Always sufficient demand to keep the plants Insufficient capacity to meet demand fully, working at full capacity, therefore unit costs therefore reduced revenue and dissatisfied are minimized customers Over-capacity problems are minimized if No ability to exploit short-term increases in forecasts are optimistic demand Capital spending on the plants is delayed Under-supply position even worse if there are start-up problems with the new plants ‘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. Table 6.5 The advantages and disadvantages of a smoothing-with-inventory strategy Advantages Disadvantages All demand is satisfied, therefore customers are The cost of inventories in terms of working satisfied and revenue is maximized capital requirements can be high. This is Utilization of capacity is high and therefore especially serious at a time when the company costs are low requires funds for its capital expansion Very short-term surges in demand can be met Risks of product deterioration and from inventories obsolescence M06A_SLAC0460_06_SE_C06A.QXD 10/20/09 9:27 Page 159 Chapter 6 Supply network design 159 Worked example 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 $10 million. Table 6.6 The cumulative cash flow indicating the funding required for the project Quarters 1 2 3 4 5 6 7 7 Sales revenue ($ 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 −5 0 0 0 Required cumulative funding ($ millions) −5 −10 −5 −5 −5 +5 +15 +25 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 Fixed-cost breaks are in a fixed-cost break that is a further lump of expenditure which will have to be incurred important in determining before any further activity can be undertaken in the operation. The operation is unlikely break-even points 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