5.6 Production planning
Full video class on YouTube, summary and notes on Instagram, class extracts on TikTok, text below. Have fun!
The main point of this class is to learn to construct stock control chart, calculate a bunch of stuff that relates to production planning and learn the differences between local/global supply chains and JIT/JIC.
Supply chain
Supply chain is a series of processes involved in production and distribution of goods to the end customer or consumer. It can also be defined as a network of suppliers, producers and distributors. Regardless of the definition that you prefer, the key words here are process and network. Supply chain management (SCM) refers to dealing with the flow of goods in the supply chain in the most efficient way. In other words, it is an area of management that is responsible for maximising the efficiency of the supply chain.
By the way, it is called “chain” for a reason. The word “chain” emphasises that its elements are interrelated, and failure of one element impacts the entire chain.
One thing that you have to be aware of is that supply chain is not the same as distribution channels or location decision that we have already learnt before in Units 4 and 5. Supply chain includes distribution channels and location decisions as part of supply chain management (see Figure 1 above), but they are not synonymous.
One more thing that supply chain refers to is sectors of industry that we learnt in the very first class. The flow of goods in supply chain may go through all the sectors of economy or may happen between one and the same sector of industry only, which corresponds to vertical and horizontal integration accordingly.
The assessment objective for this part of class is to distinguish local supply chain and global supply chains. Since we already know what supply chain is, we’re ready to achieve this objective. Copy the table below and fill it in as you read the next two paragraphs.
Local supply chain is the one that operates on a smaller scale. Distances between suppliers, producers and distributors are relatively short. Local supply chains usually cover a region (province, city, town, county, or even neighbourhood). For example, production and distribution of fresh dairy products involves local supply chain: local farmers supply milk from local cows to local producers who then sell dairy products in local supermarkets. Pestravka take pride in the fact that they use local supply chains to manufacture and distribute their products. The main advantage of local supply chain is that local community benefits from it. The main drawback is limited choices — what’s available on a local scale is very limited compared to the global scale.
Global supply chain is the one that operates on a larger scale. Distances between suppliers, producers and distributors are relatively long. Global supply chains are usually trans-national, which means that they involve several countries. For example, production and distribution of iPhones involves global supply chain: they are designed in the US, assembled in China and sold all over the world. The main advantage of global supply chain is that costs are minimised because organisations are able to find locations with the lowest labour or material costs in the world. The main drawback is high risk — organisations that operate globally have to rely on suppliers, manufacturers and distributors from different countries, with different legislation and culture and with different degree of political stability.
JIT and JIC
Stock (inventory) refers to raw materials, components, work-in-progress (semi-finished goods) and finished goods that are held by organisations. For a fruit juice manufacturer, stock (inventory) might include oranges, apples, sugar, water, plastic bottles, etc. Buffer stock is inventory that is kept “just in case” (for demand fluctuations or for supply chain problems). For example, if juice manufacturer receives a sudden order for 1000 litres of orange juice and it had enough oranges in stock to produce that much of orange juice, those oranges would refer to a buffer stock.
Stock management is an important element of supply chain management. It helps to minimise costs and to facilitate swift circulation of materials, components, work-in-progress and finished goods. There are two approaches to stock management: just-in-time and just-in-case. The main difference between them is how they handle buffer stock.
Copy the table below and fill it in as you read through the next two paragraphs.
Just-in-case (JIC) is stock control system that holds buffer stocks. One of the main pros of this approach is the ability to use purchasing economies of scale by negotiating discounts with suppliers in exchange for purchasing higher quantities of goods or materials. However, since more things are held in stock, storage costs (insurance, security, utility bills, rent) are higher as well. JIC stock management allows to minimise the effect on demand fluctuations. If suddenly an organisation gets a special order to produce large quantities of output, there will be materials in stock to cater to this special order. But, JIC has negative effect on working capital because cash is tied up in stocks. Working capital is the difference between current assets and current liabilities. In other words, working capital is cash that is used to sustain daily operations. If cash is used to cover storage costs, then less cash is available for other things. And lastly, because of higher costs, break-even quantity would be higher for organisations that use JIC, compared to the ones that use JIT.
Just-in-time (JIT) is stock control system that aims at zero buffer stocks. We’ve already discussed JIT in class 5.3, so it might be a good idea to review that class. Organisations that use JIT stock management have to rely on and develop close relationships with suppliers because JIT is impossible without swift deliveries from suppliers on short notice. Since there are minimal (or even zero) buffer stocks, storage costs (insurance, security, utility bills, rent) are low. However, if demand fluctuates suddenly, it might have a significant effect on the organisation. If, suddenly, an organisation gets a special order to produce large quantities of output, there might not be enough materials in stock to cater to this special order and suppliers might not deliver enough materials on short notice, so that special order might not be fulfilled. On the other hand, JIT has a positive effect on working capital because cash is freed up for day-to day operations, as opposed to being tied up in stocks. Additionally, because of lower costs, break-even quantity would be lower for organisations that use JIT, compared to the ones that use JIC.
Stock control
As we learnt in the previous part of class, stock (or inventory) refers to raw materials, components, WIP (work-in-progress, i.e. semi-finished goods) and finished goods that are held by organisations. Stock control is the process of ensuring that appropriate amounts of stock are held. The two aims of stock control are:
- Meet customer demand without delay — make sure that customers always have an opportunity to purchase products at any time.
- Keep costs associated with stocks low — make sure that all the costs that are related to keeping stocks (insurance, utility bills, wages, etc) are minimised in order to maintain higher profitability.
Given the two aims above, organisations try to balance and keep appropriate stock levels that are not too expensive to keep and at the same time big enough to make sure there are always things in stock to keep up with demand. Basically, the two aims of stock control correspond to avoiding high levels of stockpiling (keeping excessive levels of stock that are expensive to maintain) and avoiding stockout (the situation when stocks are insufficient to meet customers’ demand).
The diagram that shows how stock control is managed is called (surprise-surprise!) stock control chart.
There are several aspects of stock control chart that are quite self-explanatory, so why don’t you try to match them to what they indicate using the unlabelled stock control chart below?
Please check with the labelled stock control chart below. Congratulations if you did it right and don’t feel bad if you made some mistakes. You are learning, so making mistakes is natural.
I’m sure that you identified maximum stock level, minimum stock level and delivery of stock correctly. The remaining 4 aspects of stock control chart is something that needs to be explained in more detail not only because they are more complicated but also because IBO requires you to learn these 4 aspects of stock control charts. So, here we go:
Lead time is period between ordering new stock and receiving it. As you can see on the stock control chart, it is the interval between the actual delivery of stock and the time when the order was placed (i.e. when the stocks reached reorder level).
Buffer stock is minimum amount of stock. If stocks are at a level lower than the buffer stock, then production is compromised.
To learn more about buffer stocks, see JIT and JIC in the previous part of this class and 5.3.
Reorder level is the level of stock at which the new order is placed. As you can see on the stock control chart, when stocks reach reorder level, order is placed and, ideally, supplies should be delivered before the stocks go lower than buffer stock level.
Reorder quantity is the amount of ordered stock. As you can see on the stock control chart, it is the difference between maximum stock level and buffer stocks.
Rates
The 6 rates that we are going to learn in this part of class are:
- Capacity utilisation rate
- Defect rate
- Productivity rate
- Labour productivity rate
- Capital productivity rate
- Operating leverage
As you read through the next few paragraphs, please copy the table below and fill it in.
Capacity utilisation is a measure of existing output relative to productive capacity. Productive capacity is the maximum possible level of output. So, capacity utilisation rate expresses how much of productive capacity is used. The formula is:
Capacity utilisation rate = actual output ÷ productive capacity ⨉ 100
For example, if a school can accommodate 1000 students, but there are only 890, capacity utilisation rate is 89%.
Defect is a characteristic/fault/problem of a product that hinders its usability. For example, if you buy a new smartphone and its screen does not work, it is clearly a defect. However, in different industries there is different tolerance towards what is considered a defect, and what is just a feature. What exactly is considered to be a defect depends quality standards. The formula for defect rate is:
Defect rate = number of defective units ÷ total output ⨉ 100
For example, if out of 50 chairs that XYZ manufactured, 2 have defects, then defect rate would be 4%.
Productivity is a measure of efficiency of production. It is always relative to internal or external (competitors’) benchmarks, which means that simply knowing productivity rates of a certain organisation does not provide many insights unless it is compared to standards (benchmarks) and competitors. The formula of productivity rate is:
Productivity rate = total output ÷ total input
Keep in mind that this is a general rate that has to be contextualised, depending on the type of input. We’ve already learnt what inputs (or resources, or factors of production) are in the first class of the course: physical inputs (land), financial inputs (capital) and human inputs (labour). So, productivity rate can measure literally anything, as long as you are able to contextualise inputs and outputs. The next two rates (labour productivity and capital productivity) are two contextualised kinds of productivity rate, because they refer to specific types of inputs (human resources and financial resources accordingly).
Labour productivity is a measure of worker’s efficiency. It can be applied to calculate a single worker’s productivity, or a group, or the entire workforce. Again, it all depends on the context and on organisational needs. Regardless, the formula is:
Labour productivity = total output ÷ hours worked
For example, if Ivan assembles 24 chairs in his 8-hour shift, then his productivity is 3 chairs per hour.
Capital productivity is a measure of efficiency of organisation’s capital, especially working capital. Working capital, as we learnt in 3.5 is cash that is used to sustain daily operations of the business. Its formula is:
Working capital = current assets — current liabilities
The value of current assets and current liabilities can be found in a balance sheet. Working capital productivity can be calculated using the formula below:
Working capital productivity = sales revenue ÷ working capital
If current assets in a balance sheet are worth $1000, current liabilities are $400 and sales revenue is $1200, then capital productivity is 2:1. It means that every dollar of working capital generates $2 revenue.
All productivity rates are contextual. As long as you know what input and output is, you are able to measure productivity of anything.
Operating leverage is a measure of the effect of fixed costs on profit given different sales levels. This rate uses the same data as break-even analysis: fixed costs, variable costs, contribution. For starters, a few reminders from 5.5 about how to calculate contribution:
Total contribution = (P – AVC) ⨉ Q
If formulae above make sense to you, you can move on. If not, please review 5.5. The formula of operating leverage is:
Operating leverage = total contribution ÷ profit
The formula above is a quick formula. In different sources, you might see a breakdown of this formula where contribution is expressed as P – AVC and profit is expressed as TR – (TFC + AVC ⨉ Q). As long as you know how to calculate contribution and profit, there should not be any problem. See 5.5 and 3.3 for more information.
Operating leverage, by itself, is pretty much just a meaningless number. In order to make judgements about operating leverage, it has to be compared to other organisations' operating leverage, or to organisation's own operating leverage in the past.
The magic of operating leverage is that if you want to calculate the percentage change in profit given the change in sales (simply speaking, if you want to answer this question: "how will my profit change if I sell more?"), then you can just use this formula:
Change in profit (%) = change in sales (%) ⨉ operating leverage
Let's see an example of operating leverage calculation and then pros and cons of high and low operating leverages. It will help you to (finally) understand what it has to do with fixed costs, as stated in definition.
As you can see in the example above, there are two scenarios for the same organisation. In the first scenario, it has high level of fixed costs and thus high operating leverage, and in the second scenario it’s the opposite: lower fixed costs and lower operating leverage. Let’s see what the implications of each of the scenarios are.
This is usually the case: high fix costs imply high operating leverage and low fixed costs imply low operating leverage. You don't have to calculate operating leverage to make this conclusion. However, you do have to calculate operating leverage if you want to measure the effect on change in profits if sales increase.
High operating leverage is common for businesses with high levels of fixed costs. Usually, these are capital-intensive businesses that rely on machinery in production. On the one hand, high operating leverage means that more sales would lead to more profit. That is because fixed costs do not change with the increase in output, so the more output is sold, the higher the profits are. However, on the other hand, in addition to high levels of fixed costs, high operating leverage also implies higher risk if sales are low. That is because lower sales will not be able to cover fixed costs and thus they jeopardise profitability.
Low operating leverage is common for businesses with low level of fixed costs. Usually, these are labour-intensive businesses that rely on workers in production. On the one hand, low operating leverage implies low risk if sales are low. That is because most of the costs the organisation bears are variable. And, as you hopefully remember, if sales revenue is low, then variable costs are also low because they are proportional to the level of output (i.e. low output means low variable costs). However, on the other hand, more sales do not have much effect on profit. This is, again, because mosts of the costs are variable, so an increase in sales will have proportional increase in costs, thus not having as much of a positive effect on profitability, compared to high operating leverage.
High operating leverage is not better than low operating leverage. Low operating leverage is not better than high operating leverage. Each of them have there own advantages and disadvantages and might work better/worse in different situations.
CTB and CTM
Make-or-buy decision is a choice between purchasing from supplier and manufacturing on one’s own. For example, a pizza restaurant might face a make-or-buy decision if its managers are thinking whether to buy tomato sauce from a supplier or producing their own. Making this decision would involve consideration of some qualitative and quantitative factors. Qualitative factors might be supplier’s reputation and reliability, product quality, ethics. Quantitative factors might be break-even analysis, investment appraisal, budgets, and costs: cost to buy (CTB) & cost to make (CTM).
Cost to buy (CTB) is the cost of purchasing from supplier. It is calculated by simply multiplying price per item bought from supplier by quantity:
Cost to make (CTM) is the cost of manufacturing on one’s own. It is calculated by adding all costs (fixed and variable) together.
If you forgot what costs are, please review 3.3 and 5.5.
Assessment objective for this part of class is not only to learn how to calculate CTB and CTM but also to evaluate them. So, here we go.
On the one hand, CTB and CTM are simple, quick, easy and helpful tools for making a make-or-buy decision. However, considering CTB and CTM only provides decision-makers with quantitative perspective, so qualitative factors should also be considered in make-or-buy decisions. In addition to evaluating CTB and CTM as decision-making tools, you might use them and qualitative factors to evaluate different make-or-buy decisions.
Now let’s look back at class objectives. Do you feel you’ve achieved them?
Make sure you can define all of these:
- Supply chain
- Supply chain management (SCM)
- Local supply chain
- Global supply chain
- Stock (inventory)
- Buffer stock
- Just-in-time (JIT)
- Just-in-case (JIC)
- WIP (work-in-progress)
- Stock control
- Stockpiling
- Stockout
- Stock control chart
- Lead time
- Buffer stock
- Reorder level
- Reorder quantity
- Capacity utilisation
- Productive capacity
- Defect
- Productivity
- Labour productivity
- Capital productivity
- Operating leverage
- Make-or-buy decision
- Cost to buy (CTB)
- Cost to make (CTM)