Operations Management

1 Introduction

The syllabus requires you to be able to describe how the finance function interacts with operations: the main role of operations, the areas where operations and finance meet, and the key performance indicators (KPIs) used to manage operations. Three linked chapters cover this ground. This chapter explains what operations management is – process management, product and service management and supply chain management – and looks in detail at the value chain and the supply chain. Chapter 6 examines how relationships within the supply chain are managed, and Chapter 7 covers process technology and quality.

Throughout, keep the finance angle in view: finance does not run operations, but it costs them, funds them, measures them and helps to improve them.

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2 The main role of operations

Operations management refers to the activities required to make and deliver products, or to deliver services. The operations function takes inputs – materials, labour, machinery, energy, information – and transforms them into the outputs that customers actually pay for. For a manufacturing organisation these activities include:

• Procurement/purchasing

• Receipt of raw materials

• Warehousing of raw materials

• Issuing materials to the production lines

• Manufacturing the product

• Warehousing the finished goods

• Receiving orders

• Despatching goods

A service organisation has an equivalent chain: an insurance company receives claims, gathers evidence, assesses them and pays them; a hospital admits, diagnoses, treats and discharges patients. In every case operations is the part of the organisation that creates and delivers what the customer buys.

The syllabus breaks the main role of operations into three areas:

2.1 Process management

A process is any sequence of activities that turns inputs into outputs: a production line, an order-fulfilment routine, a claims-handling procedure. Process management means:

• Designing processes – deciding the steps, the layout, the technology and the capacity needed to meet expected demand.

• Running them – scheduling work, allocating people and machines, and matching output to orders.

• Monitoring them – measuring output, speed, cost and quality against targets (this is where KPIs, covered at the end of this chapter, come in).

• Improving them – removing bottlenecks, waste and errors, increasingly with the help of automation and real-time data (Chapter 7).

Well-managed processes deliver the things customers judge operations on: cost, quality, speed, dependability and flexibility. A weakness in any of these quickly becomes a financial problem – higher unit costs, rework and warranty claims, lost sales, idle capacity – which is why finance monitors process performance so closely.

2.2 Product and service management

Operations is also responsible, together with marketing and research and development, for managing the products and services themselves:

• Turning designs into products and services that can actually be made and delivered reliably and at an acceptable cost ('design for manufacture')

• Planning capacity, tooling and materials for new product launches

• Managing the range – variants, customisation, packaging and complementary services such as installation, training, maintenance and support

• Managing products through their life: ramping production up as demand grows, and down as products decline and are withdrawn (the product life cycle is covered in Chapter 9)

Service elements matter even for manufacturers: repairs, service contracts, spare parts and customer support are often highly profitable, and they influence whether customers buy again.

3 The value chain

Michael Porter, a professor at Harvard Business School, introduced the concept of the value chain, which sets out the activities organisations carry out:

The five primary activities run along the bottom: inbound logistics (receiving and handling materials), operations (making the product or delivering the service), outbound logistics (getting goods to customers), marketing and sales (finding customers and winning orders) and service (everything after the sale – installation, repairs, support). The four support activities – firm infrastructure (including finance), human resource management, technology development and procurement – serve all of the primary activities.

By carrying out these activities organisations aim to make a profit: the total amount customers pay must exceed the total cost of all the activities, and the difference is the margin. It is essential for the organisation to understand what gives it the ability to earn that margin. Why do customers pay enough to allow a profit to be made? It might be because:

• The organisation possesses know-how that customers pay for.

• The organisation offers flexibility.

• The organisation offers economies of scale that customers could never achieve themselves.

• The organisation takes on risks that customers do not want to bear.

Whatever it is that customers value is the key to the organisation's success, and its performance there needs to be carefully managed. If an organisation is carrying out tasks that are not valued by customers, performance could well improve if these were changed or discontinued.

4 The supply chain

4.1 Suppliers – company – customers

The supply chain is the network that links an organisation's suppliers, the organisation itself and its customers. In contrast to Porter's value chain, supply chain thinking treats procurement as a central, value-creating activity rather than a support function, and it extends beyond the boundaries of one company:

• Upstream = the supply chain before materials and goods reach the organisation (suppliers, and their suppliers).

• Downstream = the supply chain for products after they leave the organisation and are on their way to customers (distributors, retailers, consumers).

Together they form a value network that creates value through the operation of the whole chain: improving efficiency, delivery accuracy and delivery times, reducing costs and minimising inventories. The important additional emphasis is on collaboration between upstream suppliers and downstream customers – sharing forecasts, plans and live information rather than simply exchanging orders and invoices.

Collaboration is greatly facilitated by information technology. Cloud-based systems can integrate online orders received from customers with manufacturing schedules, inventory management and purchases of raw materials and components from suppliers, so that the whole chain reacts as one.

4.2 Push and pull supply chain models

A push model (build-to-forecast) relies on manufacturers producing according to forecast and historical demand patterns and pushing products out to distributors and customers. Inventory is held at various points as a buffer against unexpected demand or production delays.

By contrast, in a pull model (build-to-order), demand triggers production and delivery. Just-in-time inventory control is a pull model: ordering and production are triggered by customers' orders, and no orders are raised nor production started until there is downstream demand. The customer activates the flow by ordering from the retailer, who reorders from the wholesaler, who reorders from the manufacturer, who reorders materials from suppliers – orders flow backwards, up the chain. Because there are no buffer inventories, great care is needed to ensure that delays as orders flow up the chain do not jeopardise delivery of the final products.

How demand-driven a business can be varies along a spectrum:

• Largely forecast-driven (push). All production and inventory decisions are based on forecasts. Fashion clothing is an example – garments must be designed and made before anyone can order them – as is much of the beverage industry.

• Fully demand-driven (pull). The order is received before production begins. Commercial aircraft manufacture fits this description: in most cases no production occurs until the order is received.

Pure push or pull models exist only in theory: demand for a product will never cause a supply chain to start mining iron ore, and a push model cannot guarantee that products made will be bought. At some point in every supply chain, push meets pull, and inventory accumulates there. Long geographical distances between suppliers and customers, or processes that inherently take time (such as growing crops), make pull systems more difficult to operate.

Inventory can be minimised and customer service improved if all parties in the supply chain are better synchronised and can react quickly. A traditional model of replenishing supermarket inventory relies on each supermarket issuing an order – often by electronic data interchange (EDI) – once inventory falls below its reorder level. But orders then arrive 'out of the blue' at suppliers, who must either hold spare production capacity or carry inventories of their own to respond quickly.

A better approach is to give suppliers direct access to the supermarket's live inventory and sales data – today typically through a cloud platform rather than a private extranet. Suppliers can monitor inventory levels and rates of sale in real time and despatch replenishments without waiting for an order (an arrangement known as vendor-managed inventory). Suppliers can anticipate demand and produce accordingly: better synchronisation, lower inventory levels and fewer stock-outs.

4.3 Supply chain pathways and networks

A supply chain network shows the links between organisations and how information and materials flow between them. For example:

As with many other functions, outsourcing is widely used in supply chain management. Third-party logistics (3PL) companies can perform transport, warehousing and distribution more efficiently and economically than they can be done in-house, and some organisations coordinate suppliers who deliver directly to customers without the goods ever passing through the organisation itself.

Real networks can be complex. Here, simplified, is the supply chain network for an orange juice brand:

Oranges, bottles and labels each have their own upstream chains; the juice is squeezed, bottled and labelled; and the finished product reaches consumers through supermarkets, wholesalers, caterers and airlines – with logistics firms moving goods at every link. Getting such a network to work reliably, at low cost and with fresh product takes considerable organisation, information sharing and monitoring.

5 Supply portfolios

5.1 Introduction

Not all supplies and raw materials are of equal importance. A supply portfolio approach (Kraljic) allows organisations to classify what they buy according to:

• The profit impact of the supply (how much is spent on it, and how much it affects the organisation's ability to earn profit).

• The supply difficulty (how hard the item is to obtain: the number of suppliers, supply risk and internal constraints).

5.2 The supply portfolio matrix

Segmenting purchases in this way makes it possible to decide the required approach to suppliers and the most effective way to buy each type of resource:

• Non-critical (acquisition) quadrant – low profit impact, low supply difficulty. Example: stationery. Buyers might be tempted to spend a lot of time here, but the return on that time would be small. These items should be bought in a standardised, simplified, low-cost way – ideally through automated e-procurement systems or online catalogues, with minimal human involvement.

• Bottleneck (critical) quadrant – low profit impact, high supply difficulty. Typically the supply market is difficult because there are few suppliers, or supply is exposed to disruption. These items do not have a high profit impact – until they are not available, when production can stop for want of a small part. A supply risk analysis should be carried out; an aggressive cost-reduction strategy is inappropriate here in case supplies dry up. Ways of reducing risk include holding buffer inventory, over-ordering while supplies are good, and finding or developing alternative suppliers.

• Leverage quadrant – high profit impact, low supply difficulty. Example: packaging. Time invested here earns a real return: there are many capable suppliers who can be played off against one another, so a planned cost-reduction strategy (competitive tendering, negotiation, consolidating volumes) is appropriate.

• Strategic quadrant – high profit impact, high supply difficulty. Example: key bespoke components or specialised software. These items call for long-term strategies that secure continuity of supply: forming very close links or partnerships with a supplier, or even acquiring one. Alternatively the organisation can try to create competition – for example by developing a second source or self-supplying – and so drive the item towards the leverage quadrant.

Some of the main choices to be made in supply chain pathways are:

• Who transports the goods? The buyer with its own transport, the seller with its own transport, or a logistics company?

• What delivery pathways are best (air, road, rail or sea)?

• Who stores the goods – the organisation, the supplier, or a logistics company? (Critical for goods such as chilled food and medicines, where an unbroken 'cold chain' must be guaranteed.)

• Which manufacturing, packaging, labelling, kitting or completion tasks are carried out by the organisation and which by other parties? (Kitting relates to processes such as adding batteries, plugs or local-language instructions.)

• Who is responsible for quality assurance and proper handling of the goods?

• How should returns be handled?

• How can fast and responsive deliveries be arranged?

• Who handles customs clearance?

6 Technology in modern operations

The technologies described in Chapter 3 are transforming how operations and supply chains are run. The main applications to recognise:

• E-procurement – purchasing through online catalogues, marketplaces and automated ordering systems, cutting the cost of routine buying and enforcing buying policies.

• Cloud platforms – shared systems that give suppliers and customers access to the same live data (orders, inventory, forecasts), enabling the collaboration and vendor-managed inventory described above.

• The internet of things (IoT) – sensors on machines, vehicles and containers that report location, temperature and condition in real time, so goods can be tracked along the chain and problems spotted immediately.

• Data analytics and AI – improving demand forecasts, optimising delivery routes and inventory levels, and predicting machine failures before they happen.

• Automation and robotics – in factories and warehouses (covered in detail in Chapter 7).

• Blockchain – shared tamper-evident records used in some chains to prove where goods have come from (provenance), useful for food safety and ethical sourcing.

7 Operations and finance: areas of interface

Finance and operations meet constantly. The main areas of interface are:

Interaction runs in both directions: operations gives finance the volumes, usage and capacity data that budgets and standard costs are built on, and finance gives operations the cost and performance information it needs to improve.

8 Key performance indicators for operations

A KPI is a measure used to track performance in an area that matters to the organisation's objectives. Good operations KPIs are specific, measurable and – ideally – shared: operations manages the activity, finance validates the numbers and links them to profit and cash. Common operations KPIs include:

KPIs work best when the measures used by operations and the measures used by finance are aligned – both looking at the same definitions and the same data, so that improving an operational KPI visibly improves a financial one. If operations is rewarded for maximum output while finance worries about excess inventory, the KPIs are pulling in different directions and behaviour will suffer.

9 Test your knowledge

Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.