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8e

Andrew J. DuBrin

ESSENTIALS OFMANAGEMENT

Professor Emeritus of ManagementCollege of Business

Rochester Institute of Technology

Australia • Brazil • Japan • Korea • Mexico • Singapore • Spain • United Kingdom • United States

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Copyright 2008 Cengage Learning. All Rights Reserved.May not be copied, scanned, or duplicated, in whole or in part.

Essentials of Management, 8th EditionAndrew J. DuBrin

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186

Stores throughout the 7-Eleven empire have been turned

into logistical marvels. In a matter of seconds, any store

manager can tap into 7-Eleven’s proprietary computer

system and pull up real-time data on what products are selling

best at that location or across the country. Instant weather

reports, too, can dictate whether more umbrellas are needed for

an impending storm of if a store should stock up on a muffi n

that sells particularly well when the temperature drops below

40 degrees F. Employees are trained to stay current on upcoming

sporting events or school functions to prepare for a surge in beer

runs or notebook purchases. The constant tweaking means that

slow-moving items are cleared away, so managers can make way

for some of the 50 or so new ones 7-Eleven introduces every

week. That leads to fewer overstocks and understocks, which

begets happier customers.

“There’s no replenishment model in the world that can respond

like the eyes and ears of a retailer,” says CEO Jim Keyes. But even

the most informed manager would fl ounder without the strong

tech backbone. 7-Eleven stores are equipped with NEC hand-

helds designed exclusively for the chain. Using the handhelds,

store operators place orders each morning for items that need

replenishing the next day, and many of those requests are beamed

to one of the 23 third-party distribution centers 7-Eleven has

ObjectivesAfter studying this chapter and doing the exercises, you should be able to:

1 Explain how managers use data-based decision making.

2 Explain the use of forecasting techniques in planning.

3 Describe how to use Gantt charts, milestone charts, and PERT planning techniques.

4 Describe how to use break-even analysis and decision trees for problem solving and decision making.

5 Describe how to manage inventory by using the economic order quantity (EOQ), the just-in-time (JIT) system, and LIFO versus FIFO.

6 Describe how to identify problems using a Pareto diagram.

Quantitative Techniques for Planning and Decision Making

6chapter

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Quantitative Techniques for Planning and Decision Making | Chapter 6 187

partnered with in the past decade. (The data also go to headquarters to be stored

and analyzed.) At the centers, in warehouses akin to enormous refrigerators, local

suppliers drop off their inventory for sorting.

The system is a godsend for entrepreneurially minded store managers like

Andrey Vinogradsky. At 8:30 on a recent morning, Vinogradsky prowls the aisles

of his San Francisco store with the NEC handheld, scanning best-sellers like the

King’s Hawaiian Sweet Roll. The device instantly calculates how many have moved

since last week and suggests an order, but Vinogradsky decides to up the number

to 17, knowing that tomorrow is Thursday, his busiest day. As he works his way

through the store, he passes several items that are there only because of his own

initiative. Six months ago, for example, when Vinogradsky arrived at the outlet, he

immediately noticed a fl ood of tourists who came in asking for maps, postcards,

and other items that the story didn’t carry. Now it does, because Vinogradsky lined

up a local vendor and began stocking them.

“All of these tools allow me to provide what my customers really want,”

Vinogradsky says. “Without them, my job would be twice as hard.”

The technological overhaul has done more than empower store managers. It

has helped 7-Eleven regain control over distribution and product decisions that for

decades had been dictated but its major suppliers. Now 7-Eleven is getting suppliers

to play by its rules, in part because the precise sales data it generates help the sup-

pliers predict demand for their products nationwide. “They’d been doing it the old

way for a hundred years,” Keyes says. Anheuser, for one, resisted giving up control.

But, Keyes says, it eventually saw the economic advantage in ceding stocking and

distribution decisions to 7-Eleven. Today store managers can communicate directly

with Anheuser’s delivery staff (most often by handheld computer) to customize

their mix of beverages. For the past four years, Keyes has seen a 6 to 10 percent

annual increase in sales of Anheuser beer (including Budweiser) at 7-Eleven—a

startling jump in an industry where 2 percent growth is considered healthy.1

The 7-Eleven push toward making better merchandising decisions based on quantitative facts illustrates how the modern manager often uses data-based decision making to improve profitability. To make planning and decision making more accurate, a variety of techniques based on the scientific method, mathematics, and statistics have been developed. This chapter will provide sufficient information for you to acquire basic skills in

1 Excerpted from Elizabeth Esfahani, “7-Eleven Gets Sophisticated,” Business 2.0, January/February 2005, pp. 96, 98, 100.



188 Chapter 6 | Quantitative Techniques for Planning and Decision Making

several widely used techniques for planning and decision making. You can find more details about these techniques in courses and books about pro-duction and operations management and accounting. All these quantitative tools are useful, but they do not supplant human judgment and intuition. For example, a decision-making technique might tell a manager that it will take four months to complete a project. She might say, “Could be, but if I put my very best people on the project, we can beat that estimate.”

As you read and work through the various techniques, recognize that software is available to carry them out. A sampling of appropriate software is presented in Exhibit 6-1. Before using a computer to run a technique, however, it is best to understand the technique and try it out manually or with a calculator. Such firsthand knowledge can prevent accepting computer-generated information that is way offtrack. Similarly, many people use spell checkers without a good grasp of word usage. The results can be misleading and humorous, such as “Each of our employees is assigned to a manger” or “The company picnic will proceed as scheduled weather or not we have good whether.”

Managers and professionals generally rely on computers to make use of quantitative planning and decision-making techniques. Examples of applicable software are presented at the right, and should be referred to for on-the-job-application of these techniques.

Forecasting Techniques Excel-Based ForecastX™ (John Galt Solutions Inc.); Forecast Pro (Business Forecast Systems Inc.); PROPHIX; spreadsheet programs can also be used to make forecasts based on trend data.

Gantt Charts and SmartDraw; E Project Management SoftwareMilestone ChartsPERT Diagrams MinuteMan Plus (MinuteMan Systems); Envision Software; PERT Chart EXPERT

(Critical Tools Inc.)Break-Even Analysis Orion Business Center; Business Plan SoftwareDecision Trees TreeAge; SmartDrawEconomic Order Quantity Software would be superfluous, use pocket calculator. However, the EOQs that you

calculate can be entered into a spreadsheet and updated as needed.Just-in-Time (JIT) Blue Claw Database Design; Just-in-Time Software SolutionsInventory ManagementPareto Diagrams Envision Software; SPC for ExcelAll Techniques Enterprise software controls an entire company’s operations, linking them together. Combined The software automates finance, manufacturing, and human resources, incorporating

stand-alone software such as that designed for PERT and break-even analysis. Enterprise software also helps make decisions based on market research. Specific types of enterprise software have several different names. (Four key suppliers are SAP; Oracle, Siebel; and NEC Enterprise Software Solutions.)

Software for Quantitative Planning and Decision-Making Techniques

exh ib i t 6-1




DATA-BASED DECISION MAKINGThe chapter opener about 7-Eleven stores making extensive use of quantita-tive data to make merchandising decisions illustrates how numbers and facts influence managerial decision making. Data-driven management refers to the idea that decisions are based on facts rather than impressions or guesses.2 The idea is straightforward: before making a decision of consequence the managerial worker should gather facts that could influence the outcome of the decision. The quantitative techniques described in this chapter assist the process of data-driven management, yet simply gathering relevant facts can make data-driven management possible.

The discussion about using high-quality information in making decisions (Chapter 5) is part of data-driven management. Also, people who are scien-tifically oriented use data-driven management quite naturally. Executive dashboards, described in Chapter 14, give managers access to a wide variety of real-time information such as items sold, profit, and spending versus budget.

Many managers want to see the data before accepting a suggestion from a subordinate. Marissa Mayer, the vice president for search products and user experiences at Google Inc., is one such manager. One of her “9 notions of innovation” is “Don’t politic, use data.” She discourages the use of “I like” in meetings, pushing staffers instead to use “metrics.”3 How might this use of data work in practice?

During a meeting with Mayer, a staff member might make the comment, “I don’t think we have much to worry about from A9.com, the Amazon search engine. Almost nobody has heard about it or is using it.” Mayer might reply, “Get back to me when you can cite some hard data about how many people are using A9.com instead of Google when they conduct a search. At that point we can decide on the competitive threat posed by A9.”

Data-driven management is more of an attitude and approach rather than a specific technique, and it is hardly new. You attempt to gather relevant facts before making a decision of consequence. Suppose a small-business owner wants to repaint the walls inside the office. The office manager suggests buying a premium brand of paint because such paint stays fresher looking longer and does not chip as readily. The data-driven manager would say, “Where is the evidence that if we have the painter use premium paint the walls will look better longer and resist chipping? Show me the evidence.”

Although data-driven management is preferable in most situations, intuition and judgment still contribute to making major decisions. At times relevant data may not be available, so acting on hunches can be essential. A major new source of recruiting for truckers is early retiree couples who enjoy heavy travel.4 Before actively recruiting older people as potential truckers to help with the acute trucker shortage, several trucking association executives guessed that this

2 http://www.pheatt.emporia.edu/courses/2002/, accessed November 17, 2006.3 Michele Conlin, “Champions of Innovation,” Business Week, June 2006, p. IN 20.4 Stephanie Chen, “How Baby Boomers Turn Wanderlust Into Trucking Careers,” The Wall Street Journal, August 24, 2006,

pp. A1, A8.

LearningObjective 1Explain how managers use data-based decision making.

LearningObjective 1Explain how managers use data-based decision making.

data-driven managementAn attitude and approach to management rather than a specifi c technique that stems from data-based decision making.

data-driven managementAn attitude and approach to management rather than a specifi c technique that stems from data-based decision making.




demographic group might be attracted to trucking. Now trucking managers have some data to work with in terms of recruiting retiree couples as truckers.

The accompanying Management in Action presents more details of how a successful manager relies heavily on data before making major decisions.

Data-Driven Decision Making at Hewlett-Packard

m a n a g e m e n t i n a c t i o n

When Mark Hurd was named chief executive of Hewlett-Packard Co. in March 2005, the board gave him a clear mission: fix the giant computer and printer make, which was suffering from slow growth and inconsistent results. Hurd took a big step forward attempting to fulfill that mandate when he embarked on a sweeping plan in July 2005 to cut costs and restructure the company. He planned to lay off 14,500 employees, or about 10 percent of the company’s global workforce, modify its pension benefits, and revamp its sales force in an effort to make the company more effi-cient and better able to service customers. (All of these plans were implemented by 2007.)

But before Hurd could attempt to fix HP, he had to figure out HP. So, shortly after arriving at the Palo Alto, California, company, the 48-year-old former chief executive of NCR Corp. set about to collect information methodically. He spent time with senior executives, conducted extensive business reviews and even traveled with sales people to meet HP customers firsthand. He visited HP offices and factories from Boise to Beijing. At each site he spoke to employees and sought feedback. In all, he has collected more than 5,000 e-mails from HP staffers. With his find-ings, Hurd built two computer models—one financial and the other an operating model—designed to help plot the company’s course.

“I have a pretty standard process,” Hurd said. Getting out into the field “is some of the best market research I can get.”

After reviewing the businesses at each site, Hurd typically held an employee “coffee talk” in the afternoon. For him, the aim is to trigger feedback from employees so that they can unearth facts not covered by managers. Many visits are

dominated “by the biggest personalities,” he says. “But it’s some of the people who don’t speak up who send the crispest two-page e-mails.”

About 320 new e-mails arrive every day, the company says. Hurd has also encouraged staffers to call him directly: Hearing someone’s voice helps him understand what they are emphasizing and their emotion, he says.

Then came the rigorous analysis. Back at his Palo Alto office, Hurd reviewed the findings from a site visit or business review with executives. Based on a series of spreadsheets, these models change daily as Hurd adds new facts and thoughts from his travels, such as the number of salespeo-ple in an office versus the size of a sales territory, and ruminations on what kinds of capabilities need to be added or subtracted from a facility.

The goal of the models is to winnow down all the information being collected onto a single page that lays out a vision of HP’s future and how to get there. “I want to get everything between us and the goal line on a piece of paper,” says Hurd.

Questions1. Why might employees and customers be a

valuable source of input for Hurd in making decisions about the future of HP?

2. In what way is employee input shaping the future of HP?

3. What, if any, ethical issues might there be in collecting input from employees about fixing the company, then laying off 14,500 of them?

Source: Excerpted from Pui-Wing Tam, “Rewiring Hewlett-Packard,” The Wall Street Journal, July 20, 2005, p. B1.




FORECASTING METHODSAll planning involves making forecasts, or predicting future events. Forecasting is important because if a manager fails to spot trends and react to them before the competition does, the competition can gain an invaluable edge. As noted in an executive newsletter: “The handwriting is on the wall. The way your business reacts to newly emerging trends is perhaps the best barometer of your future success.”5 The forecasts used in strategic planning are especially difficult to make because they involve long-range trends. Unknown factors might crop up between the time the forecast is made and the time about which predictions are made. This section will describe approaches to and types of forecasting.

Qualitative and Quantitative ApproachesForecasts can be based on both qualitative and quantitative information. Most of the forecasting done for strategic plan-ning relies on a combination of both. Qualitative methods of forecasting consist mainly of subjective hunches. For exam-ple, an experienced executive might predict that the high cost of housing will create a demand for small, less-expensive homes, even though this trend cannot be quantified. One qualitative method is a judgmental forecast, a prediction based on a collection of subjective opinions. It relies on anal-ysis of subjective inputs from a variety of sources, including consumer surveys, sales representatives, managers, and pan-els of experts. For instance, a group of potential homebuyers might be asked how they would react to the possibility of purchasing a compact, less-expensive home.

Quantitative forecasting methods involve either the extension of historical data or the development of models to identify the cause of a particular outcome. A widely used historical approach is time-series analysis. This technique is sim-ply an analysis of a sequence of observations that have taken place at regular intervals over a period of time (hourly, weekly, monthly, and so forth). The underlying assumption of this approach is that the future will be much like the past. Exhibit 6-2 shows a basic example of a time-series analysis chart. This information might be used to make forecasts about when people would be will-ing to take vacations. Such forecasts would be important for the resort and travel industry. A time-series forecast works best in a relatively stable situation. For example, an unusually strong or weak hurricane season makes it difficult to predict the demand for home improvement materials. Home Depot faced this problem in 2006 when a mild hurricane season contributed to lower numbers than forecast for sales to building contractors. If you use a spreadsheet program such as Excel to make forecasts, you will find that the input data are part of a time-series analysis. The future trends projected are based on historical data.

Many firms use quantitative and qualitative approaches to forecasting. Forecasting begins with a quantitative prediction, which provides basic data

5 Daniel Levinas, “How to Stop the Competition from Eating Your Lunch,” Executive Focus, May 1998, pp. 55–58.

Learning objective 2Explain the use of forecasting techniques in planning.

Learning objective 2Explain the use of forecasting techniques in planning.

judgmental forecastA qualitative forecasting method based on a collection of subjective opinions.

time-series analysisAn analysis of a sequence of observations that have taken place at regular intervals over a period of time (hourly, weekly, monthly, and so forth).

judgmental forecastA qualitative forecasting method based on a collection of subjective opinions.

time-series analysisAn analysis of a sequence of observations that have taken place at regular intervals over a period of time (hourly, weekly, monthly, and so forth).

QUANTITATIVE TECHNIQUES

FOR PLANNING AND

DECISION MAKING

“Go to academic.cengage.com/management/dubrin and view the video. Does Cold Stone Creamery represent a high performance approach to planning? Why or why not?”




about a future trend. An example of a quantitative prediction is the forecast of a surge in demand for flat-screen television receivers, 50 inches or greater. Next, the qualitative forecast is added to the quantitative forecast, some-what as a reality check. For example, a quantitative forecast might predict that if the current growth trend continues, every household in North America will contain three 50-inch TV sets by 2012.

The quantitative forecast is then adjusted according to the subjective data supplied by the qualitative forecast. In this case, it could be reasoned that the growth trend was extrapolated too aggressively. In many instances, a quantitative forecast will serve as a reality check on the qualitative fore-casts because numerical data is more accurate than intuition.

Three errors or traps are particularly prevalent when making forecasts or estimates.6 One is the overconfidence trap, whereby people overestimate the accuracy of their forecasts. A CEO might be so confident of the growth of her business that she moves the company into expensive new headquar-ters. Based on her confidence, she does not prepare contingency plans in case the estimated growth does not take place. A second problem is the prudence trap, in which people make cautious forecasts “just to be on the safe side.” Being safe can mean taking extra measures just not to be caught short, such as a restaurant owner buying ten extra boxes of strawberries “just to be safe.” If the strawberry desserts go unsold, the owner is stuck unless he can make strawberry pudding for tomorrow’s menu.

A third problem is the recallability trap whereby our forecasts are influ-enced by extremely positive or negative incidents we recall. If a manager vividly recalls success stories from global expansion to Singapore, he might overestimate the chances of succeeding in that country.

6 John S. Hammond, Ralph L. Keeney, and Howard Raiffa, “The Hidden Traps in Decision Making,” Harvard Business Review, September–October 1998, pp. 55–58.

A time-series analysis uses the past to make

predictions.

exh ib i t 6-2 Time-Series Analysis Chart

Percentage of PeopleTaking VacationsDuring NonsummerMonths

100

75

50

25

01997 1999 2001 2003 2005 2007 2009 2011 2013

Forecasted Data




Being aware of these traps can help you take a more disciplined approach to forecasting. For example, to reduce the effect of the overconfidence trap, start by considering the extremes—the possible highs and lows. Try to imag-ine a scenario in which your forecast could be way too high or way too low and make appropriate adjustments if necessary. For a reality check, discuss your forecasts with other knowledgeable people. To become a good fore-caster, you need to make a large number of predictions and then look for feedback on the accuracy of these predictions.

Types of ForecastsThree types of forecasts are used most widely: economic, sales, and techno-logical. Each of these forecasts can be made by using both qualitative and quantitative methods. Forecasts that are updated regularly with fresh data are referred to as rolling forecasts. The presence or absence of hurricanes, as mentioned above, would be useful in updating a yearly sales forecast in the building-supply industry.

Economic ForecastingNo single factor is more important in managerial planning than predicting the level of future business activity. Strategic planners in large organizations rely often on economic forecasts made by specialists they hire. Planners in smaller firms are more likely to rely on government forecasts, or speaking to other business people. However, forecasts about the general economy do not necessarily correspond to business activity related to a particular product or service. Assume that you are a manager at an office-supply company, such as Office Max or Staples. The following forecast prepared by the World Future Society might prompt you to stock up on home-office systems:

More than 100 million people will telecommute to work by the year 2015. This increase will distribute worldwide wealth more rapidly, save energy, reduce global pollution, and transfer real estate values.7

A major factor in the accuracy of forecasts is time span: Short-range predictions are more accurate than long-range predictions. Strategic planning is long-range planning, and many strategic plans have to be revised frequently to accommodate changes in business activity. For example, a sudden reces-sion may abort plans for diversification into new products and services.

Sales ForecastingThe sales forecast is usually the primary planning document for a busi-ness. Even if the general economy is robust, an organization needs a promising sales forecast before it can be aggressive about capitalizing on new opportunities. Strategic planners themselves may not be involved in making sales forecasts, but to develop master plans they rely on forecasts from the marketing unit. For instance, the major tobacco companies have embarked on strategic plans to diversify into a number of nontobacco businesses, such as soft drinks and food products. An important factor in

7 Special Report: Forecasts for the Next 25 Years, p. 3 (Published by the World Future Society, 2004).




the decision to implement this strategic plan was a forecast of decreased demand for tobacco products in the domestic market. The cause for decreased demand was health concerns of the public, and numerous anti-smoking campaigns.

According to marketing consultant Terry Elliott, sales forecasts are likely to be more accurate if they are based on several types of data. A man-ager of a home-electronics store might include the following data sources in preparing a sales forecast for the present year: (1) average sales volume per square foot for similar stores in similar locations and size, (2) the number of households within five miles who intend to purchase home electronic devices, and (3) sales revenues for each type of item or service offered. A service might be in-home installation of electronic products. Elliott also recommends that the owner generate three figures: pessimistic, optimistic, and realistic. The pessimistic forecast might alert the owner to the impor-tance of lining up credit or conserving cash.8

Technological ForecastingA technological forecast predicts what types of technological changes will take place. Technological forecasts allow a firm to adapt to new technologies and thus stay competitive. For example, forecasts made in the late 1990s about the explosive growth of e-commerce have enabled many firms to ready themselves technologically for the future. At first a lot of the activity was unprofitable, yet the majority of industrial and consumer companies that prepared to buy and sell over the Internet soon found it to be profitable. By mid-2000 technological forecasts were made of the abundant availability of Wi-Fi at places of work, airports, hotels, and restaurants. This forecast encouraged the manufacturing and marketing of portable computers and personal digital assistants suited for the wireless environment. (Wi-Fi refers to Wireless Fidelity, a high-speed, high-capacity network built on radio signals.)

GANTT CHARTS AND MILESTONE CHARTSTwo basic tools for monitoring the progress of scheduled projects are Gantt charts and milestone charts. Closely related to each other, they both help a manager keep track of whether activities are completed on time. Both tech-niques include the use of numbers, so they can be classified as quantitative.

Gantt ChartsDuring the era of scientific management, Henry Gantt developed a chart for displaying progress on a project. An early application was tracking the prog-ress of building a ship.9

A Gantt chart graphically depicts the planned and actual progress of work over the period of time encompassed by a project. Gantt charts are

8 Terry Elliott, “Sales Forecasting by Multiple Methods Is Most Accurate,” About Small Business: Canada(http://www.sbinfocanada.about.com), Accessed November 17, 2006.

9 “Gantt Chart,” NetMBA (http://www.netmba.com/operations/project/gantt), accessed November 17, 2006, p. 1.

LearningObjective3

Describe how to use Gantt charts, milestone charts,

and PERT planning techniques.

LearningObjective3

Describe how to use Gantt charts, milestone charts,

and PERT planning techniques.




especially useful for scheduling one-time projects such as constructing buildings, making films, or building an airplane. Charts of this type are also called time-and-activity charts, because time and activity are the two key variables they consider. Time is plotted on the horizontal axis; activities listed on the vertical axis.

Despite its simplicity, the Gantt chart is a valuable and widely used con-trol technique. It also provides the foundation of more sophisticated types of time-related charts, such as the PERT diagram described later.

Exhibit 6-3 shows a Gantt chart used to schedule the opening of a small office building. Gantt charts used for most other purposes would have a similar format. At the planning phase of the project, the manager lays out the schedule by using rectangular boxes. As each activity is completed, the appropriate box is shaded. At any given time, the manager can see which activities have been com-pleted on time. For example, if the building owner has not hired a contractor for the grounds by August 31, the activity would be declared behind schedule.

The Gantt also depicts dependent activities, such as, in Exhibit 6-3, hiring contractors being dependent on first getting the building permit. The dependent activities must be completed in sequence. However, some of the activities are nondependent or “parallel.” For example, some developers obtain leases before a building is completed.

The Gantt chart presented here is quite basic. On most Gantt charts, the bars are movable strips of plastic. Different colors indicate scheduled and actual progress. Mechanical boards with pegs to indicate scheduled dates and actual progress can also be used. Some managers and specialists now use

A Gantt chart helps keep track of progress on a project.

exh ib i t 6-3 A Gantt Chart Used for Opening a Small Offi ce Building

Feb Mar

Jul 30

Production Activities

01. Locate site

02. Get building permit

03. Hire contractors

04. Supervise construction

05. Hire contractor for grounds

06. Supervise installation of grass and trees

07. Advertise office building

08. Hire building manager

09. Obtain leases

10. Open for business

Apr May Jun Jul Aug Sep

Scheduled

Completed

Gantt chartA chart that depicts the planned and actual progress of work during the life of the project.




computer graphics to prepare their own high-tech Gantt charts. You can also use a spreadsheet to readily construct a Gantt chart.

Because Gantt charts are used to monitor progress, they also act as control devices. When the chart shows that the building-permit activity has fallen behind schedule, the manager can investigate the problem and solve it. The Gantt chart gives a convenient overall view of the progress made against the schedule. However, its disadvantage is that it does not furnish enough details about the subactivities that need to be performed to accomplish each general item.

Milestone ChartsA milestone chart is an extension of the Gantt chart. It provides a listing of the subactivities that must be completed to accomplish the major activities listed on the vertical axis. The inclusion of milestones, which are the comple-tion of individual phases of an activity, adds to the value of a Gantt chart as a scheduling and control technique. Each milestone serves as a checkpoint on progress. In Exhibit 6-4, the Gantt chart for constructing a small office building has been expanded into a milestone chart. The numbers in each

milestone chartAn extension of the

Gantt chart that provides a listing of

the subactivities that must be completed to accomplish the major activities listed on the

vertical axis.

milestone chartAn extension of the

Gantt chart that provides a listing of

the subactivities that must be completed to accomplish the major activities listed on the

vertical axis.

exh ib i t 6-4 A Milestone Chart Used for Opening a Small Offi ce Building

Feb MarProduction Activities

01. Locate site

02. Get building permit

03. Hire contractors

04. Supervise construction

05. Hire contractor for grounds

06. Supervise installation of grass and trees

07. Advertise office building

08. Hire building manager

09. Obtain leases

10. Open for business

Apr May Jun Jul Aug Sep

33

1 2 3

4 5 6 7 8 9 10

11 12 13

14 15 16 17 18 19

20 21

22 23 24

25 26

27 28

29 30 31 32

Milestones to Be Accomplished

•••29. Speak to friends and acquaintances about space availability.

30. Put ad in local newspaper.

31. Conduct interviews with rental applicants and check credit history of best potential tenants.

32. Offer lease to most creditworthy candidates.

33. Have grand-opening celebration September 5.




rectangle represent milestones. A complete chart would list each of the 33 milestones. In Exhibit 6-4 only the milestones for obtaining leases (includ-ing screening tenants) and the opening date are listed.

PROGRAM EVALUATION AND REVIEW TECHNIQUEGantt and milestone charts are basic scheduling tools, exceeded in their basic versions only in simplicity by a to-do list. A more complicated method of scheduling activities and events uses a network model. The model depicts all the interrelated events that must take place for a project to be completed. The most widely used network-modeling tool is the program evaluation and review technique (PERT). It is used to track the planning activities required to complete a large-scale, nonrepetitive project. PERT was originally devel-oped in 1958 by the United States Department of Defense to assist with the Polaris mobile submarine launch project. PERT has the potential to reduce the time and cost required to complete a project because activities can be sequenced efficiently.

A scheduling technique such as PERT is useful when certain tasks have to be completed before others if the total project is to be completed on time. In the small office building example, the site of the building must be specified before the owner can apply for a building permit. (The building commission will grant a permit only after approving a specific location.) The PERT diagram indicates such a necessary sequence of events.

PERT is used most often in engineering and construction projects. It has also been applied to such business problems as marketing campaigns, com-pany relocations, and convention planning. Here we examine the basics of PERT, along with a few advanced considerations.

Key PERT ConceptsTwo concepts lie at the core of PERT: event and activity. An event is a point of decision or the accomplishment of an activity or task. Events are also called milestones. The events involved in the merger of two companies would include sending out announcements to shareholders, changing the company name, and letting customers know of the merger.

An activity is the time-consuming aspect of a project or simply a task that must be performed. Before an activity can begin, its preceding activities must be completed—such as installing dry wall before painting the wall. One activity in the merger example is working with a public relations firm to arrive at a suitable name for the new company. Activities that have to be accomplished in the building example include supervising contractors and interviewing potential tenants.

Steps Involved in Preparing a PERT NetworkThe events and activities included in a PERT network are laid out graphi-cally, as shown in Exhibit 6-5. Preparing a PERT network consists of four steps:

program evaluation and review technique (PERT)A network model used to track the planning activities required to complete a large-scale, nonrepetitive project. It depicts all of the interrelated events that must take place.

eventIn the PERT method, a point of decision or the accomplishment of a task.

activityIn the PERT method, the physical and mental effort required to complete an event.

program evaluation and review technique (PERT)A network model used to track the planning activities required to complete a large-scale, nonrepetitive project. It depicts all of the interrelated events that must take place.

eventIn the PERT method, a point of decision or the accomplishment of a task.

activityIn the PERT method, the physical and mental effort required to complete an event.




1. Prepare a list of all the activities and events necessary to complete the project. In the building example, the activities include locating the site, getting the building permit, and so forth. Many more activities and subactivities could be added to this example. The events are the completion of the activities such as (C) hiring the contractors.

2. Design the actual PERT network, relating all the activities to each other in the proper sequence. Anticipating all the activities in a major project requires considerable skill and judgment. In addition, activities must be sequenced—the planner must decide which activity must precede another. In the building example, the owner would want to hire a grounds contractor before hiring a building manager.

3. Estimate the time required to complete each activity. This step must be done carefully because the major output of the PERT method is a statement of the total time required by the project. Because the time estimate is critical, several people should be asked to make three different estimates: optimistic time, pessimistic time, and probable time.

Optimistic time (O) is the shortest time an activity will take if everything goes well. In the construction industry, the optimistic time is rarely achieved because so many different trades are involved in completing a project.

Pessimistic time (P) is the amount of time an activity will take if everything goes wrong (as it sometimes does with complicated projects such as installing a new subway system).

Each numeral in the diagram equals the expected time for

an activity, such as 5 weeks to locate

site (between circles A and B) and 13

weeks to supervise installation of grass and trees (between circles E and F). The

critical path is the estimated time for all

the activities shown above the thick arrows (13 + 30 + 6 + 13 + 8

+ 14 + 8 + 1 = 93).

exh ib i t 6-5 A PERT Network for Opening a Building

AJ

C

D E

F

I

H

5

13

30

613

8

8

1

81430

GB

START




Most probable time (M) is the most realistic estimate of how much time an activity will take. The probable time for an activity can be an estimate of the time taken for similar activities on other projects. For instance, the time needed to build a cockpit for one aircraft might be based on the average time it took to build cockpits for comparable aircraft in the past.

After the planner has collected all the estimates, he or she uses a formula to calculate the expected time. The expected time is the time that will be used on the PERT diagram as the needed period for the completion of an activity. As the following formula shows, expected time is an “average” in which most probable time is given more weight than optimistic time and pessimistic time.

Expected time O 4M P

6=

+ +

(The denominator is six because O counts for one, M for four, and P for one.)

Suppose the time estimates for choosing a site location for the building are as follows: optimistic time (O) is two weeks; most probable time (M) is five weeks; and pessimistic time (P) is eight weeks. Therefore,

Expected time 2 (4 5) 8

6

306

5 weeks=+ × +

= =

As each event or milestone is completed, the project manager can insert the actual time required for its completion. The updates are helpful because if the completion time turns out to be the pessimistic one, more resources can be added to shorten the activity required to attain the next event.

4. Calculate the critical path, the path through the PERT network that includes the most time-consuming sequence of events and activities. The path with the longest elapsed time determines the length of the entire project. To calculate the critical path, you must first add the times needed to complete the activities in each sequence. The logic behind the critical path is this: A given project cannot be considered completed until its lengthiest compo-nent is completed. For example, if it takes six months to get the building construction permit, the office-building project cannot be completed in less than one year, even if all other events are completed earlier than scheduled. Sudden changes in the time required for an activity can change the critical path, such as unanticipated delays in obtaining enough plywood for the building project.

Exhibit 6-5 shows a critical path that requires a total elapsed time of 93 weeks. This total is calculated by adding the numerals that appear beside each thick line segment. Each numeral represents the number of weeks scheduled to complete the activities between each lettered label. Notice that activity completion must occur in the sequence of steps indicated by the direction of the arrows. In this case, if 93 weeks appeared to be an excessive length of time, the building owner would have to search for ways to shorten

expected timeThe time that will be used on the PERT diagram as the needed period for the completion of an activity.

expected timeThe time that will be used on the PERT diagram as the needed period for the completion of an activity.

critical pathThe path through the PERT network that includes the most time-consuming sequence of events and activities.

critical pathThe path through the PERT network that includes the most time-consuming sequence of events and activities.




the process. For example, the owner might be spending too much time supervising the construction.

When it comes to implementing the activities listed on the PERT diagram, control measures play a crucial role. The project manager must ensure that all critical events are completed on time. If activities in the critical path take too long to complete, the overall project will not be completed on time. If necessary, the manager must take corrective action to move the activity along. Such action might include hiring additional workers, dismissing substandard workers, or purchasing more productive equipment.

Advanced Considerations in PERTConsidering that PERT is used for projects as complicated as building a new type of airliner, the process can become quite complex. In practice, PERT networks often specify hundreds of events and activities. Each small event can have its own PERT diagram. Many computer programs are available to help perform the mechanics of computing paths. The PERT Chart EXPERT shown in Exhibit 6-6 is one such program. Here we look at two concepts that are used in complex applications of PERT.

exh ib i t 6-6 The PERT Chart EXPERT Software

Source: Reprinted with permission from http://www.criticaltools.com.




Refi ned Calculation of Expected TimesThe optimistic, pessimistic, and most probable times should be based on a frequency distribution of estimates. Instead of using one intuitive guess as to these durations, a specialist collects all available data about how long comparable activities took. For example: wiring a cockpit took seven weeks in ten different cases; six weeks in five cases; five weeks in three cases; and so forth. The optimistic and pessimistic times are then selected as the lower and upper ten percentiles of the distribution of times. In other words, it is optimistic to think that an event will be completed as rapidly as suggested by the briefest 10 percent of estimates. Also, it is pessimistic to think that the event will be completed in the longest 10 percent of estimated times. (Remember, the expected time is calculated based on a weighted average of the optimistic, most probable, and pessimistic times.)

It is often difficult to obtain data for comparable activities, so quantified guesswork will be required. To illustrate, a project manager might guess, “If we attempted to drill a hole for oil through that ice cap 100 times, I think it would take us 60 days 25 times, 90 days 35 times, 110 days 5 times, and 130 days 5 times.” The guesses provided by this project manager might be combined with the guesses of another specialist, before calculating the pessimistic, optimistic, and most probable times.

Resource and Cost EstimatesIn addition to estimating the time required for activities, advanced applica-tions of PERT estimate the amount of resources required. Before a building contractor would establish a price for erecting a building, it would be pru-dent to estimate how much and what types of equipment would be needed. It would also be essential to estimate how many workers of different skills would be required. Considering that payroll runs about two-thirds of the cost for manufacturing, miscalculating costs can eliminate profits.

The resource and cost estimates can be calculated in the same manner as time estimates. Resource and cost estimates can then be attached to events, thereby suggesting at which point in the project they will most likely be incurred. For example, the building contractor might estimate that siding specialists will not be needed until 90 days into the project.

BREAK-EVEN ANALYSIS“What do we have to do to break even?” is asked frequently in business. Managers often find the answer through break-even analysis, a method of determining the relationship between total costs and total revenues at various levels of production or sales activity. Managers use break-even analysis because—before adding new products, equipment, or human resources—they want to be sure that the changes will pay off. Break-even analysis tells manag-ers the point at which it is profitable to go ahead with a new venture.

Exhibit 6-7 illustrates a typical break-even chart. It deals with a proposal to add a new product to an existing line. The point at which the Total Costs

Learning objective 4Describe how to use break-even analysis and decision trees for problem solving and decision making.

Learning objective 4Describe how to use break-even analysis and decision trees for problem solving and decision making.




line and the Revenue line intersect is the break-even point. Sales shown to the right of the break-even point represent profit. Sales to the left of this point represent a loss.

Break-Even FormulaThe break-even point (BE) is the situation in which total revenues equal fixed costs plus variable costs. It can be calculated with the following stan-dard formula:

BEFC

P VC=

−

where P = selling price per unit

VC = variable cost per unit, the cost that varies with the amount produced FC = fixed cost, the cost that remains constant no matter how many

units are producedThe chart in Exhibit 6-7 is based on the plans of a small company to sell

furniture over the Internet. For simplicity, we provide data only for the din-ing room sets. The average selling price (P) is $1,000 per unit; the variable cost (VC) is $500 per unit, including Internet commission fees for sales made through major Web sites. The fixed costs are $300,000.

BE unit=−

= =$ ,$ , $

$ ,$

300 0001 000 500

300 000500

600

break-even analysis

A method of determining the

relationship between total costs and total revenues at various levels of production

or sales activity.

break-even analysis

A method of determining the

relationship between total costs and total revenues at various levels of production

or sales activity.

A break-even chart indicates at what

point a venture becomes profitable.

exh ib i t 6-7 Break-even Chart for Adding a New Product to an Existing Line

Revenuesand Costs($ in thousands)

800

0 100 200 300 400 500 600 700 800 900 1000

Sales(in units)

100

200

300

400

500

600

700

LOSS

VariableCosts

FixedCosts

TotalCosts

PROFITBreak-EvenPoint

Revenue




Under the conditions assumed and for the period of time in which these costs and revenue figures are valid, a sales volume of 600 dining room sets would be required for the furniture company to break even. Any volume above that level would produce a profit and anything below it would result in a loss. (We are referring to online sales only. Sales through their customary channels would have to be figured separately.) If the sales forecast for dining room sets sold through e-commerce is above 600 units, it would be a good decision to sell online. If the sales forecast is less than 600 units, the furniture company should not attempt e-commerce for now. However, if the husband-and-wife team is willing to absorb losses now to build for the long range, they might start e-commerce anyway. Break-even analysis would tell the owners how much money they are likely to lose. An encouraging note is that small operations like the furniture company in question have typically profited from e-tailing.

Break-even analyses must be calculated frequently because fixed and variable costs may change quite suddenly. Imagine that you were the man-ager of a package-delivery service. One of your variable costs, gasoline, might fluctuate weekly. And a fixed cost like truck insurance might change each six months. Also, as an enterprise grows, new fixed costs may arise, such as needing to hire a human resources consulting firm to take care of payroll and benefits administration.

Advantages and Limitations of Break-Even AnalysisBreak-even analysis helps managers keep their thinking focused on the vol-ume of activity that will be necessary to justify a new expense. The technique is also useful because it applies to a number of operations problems. Break-even analysis can help a manager decide whether to drop an existing product from the line, to replace equipment, or to buy rather than make a part.

Break-even analysis has some drawbacks. First, it is only as valid as the estimates of costs and revenues that managers use to create it. Second, the relationship between variable costs and sales may be complicated. Exhibit 6-7 indicates that variable costs and sales increase together in a direct relationship. In reality, unit costs may decrease with increased vol-ume. It is also possible that costs may increase with volume: Suppose that increased production leads to higher turnover because employees prefer not to work overtime.

Break-even analysis relates to decisions about whether to proceed or not to proceed. The next section will examine a more complicated decision-making technique that relates to the desirability of several alternative solutions.

DECISION TREESAnother useful planning tool is called a decision tree, a graphic illustration of the alternative solutions available to solve a problem. Analyzing the out-comes of a few alternative actions before making a decision is useful because it helps predict if you have made a decision that produces the most favorable,

decision treeA graphic illustra-

tion of the alternative solutions available to

solve a problem.

decision treeA graphic illustra-

tion of the alternative solutions available to

solve a problem.




or least painful, consequences.10 Decision trees are designed to estimate the outcome of a series of decisions. As the sequences of the major decision are drawn, the resulting diagram resembles a tree with branches.

To illustrate the essentials of using a decision tree for making financial decisions, return to the building owner who used the Gantt and milestone charts. One major decision facing the owner is whether to open an office building only or open an office building with an attached conference facility (rented to the public as needed). According to data from a local real-estate association, the probability of having a good first year is 0.6 and the proba-bility of a poor one is 0.4.

Discussion with an accountant indicates that the payout, or net cash flow, from a good year with the building only would be $100,000. The payout from a poor first year with the same alternative would be a loss of $10,000. Both these figures are conditional because they depend on business conditions and tenants paying their rent. The owner and accountant predict that a good first year with the alternative of a building and public conference facility would be $150,000. A poor first year would result in a loss of $30,000.

Using this information, the manager computes the expected values and adds them for the two alternatives. An expected value is the average value incurred if a particular decision is made a large number of times. Sometimes the alternative would earn more, and sometimes less, with the expected value being the alternative’s average return.

Expected value: Office building only = 0.6 × $100,000 = $60,000 0.4 × −$10,000 = −$4,000 $56,000Expected value: Office building = 0.6 × $150,000 = $90,000and conference facility 0.4 × −$30,000 = −$12,000 $78,000

As Exhibit 6-8 graphically portrays, the decision tree suggests that the building and conference room will probably turn a first-year profit of $78,000. The building-only alternative is likely to show a profit of $56,000. Over one year, operating a building and public conference center would be $22,000 more profitable.

The advantage of a decision tree is that it can be used to help make sequences of decisions. After having one year of experience in running a building and conference center, the owner may think of expanding. One logical possibility for expansion would be to open a public warehouse for the use of small business firms and individuals. The building owner would now have more accurate information about the conditional values for an office building and conference room—the choice the owner made when opening his new enterprise. With one year of success with the office building and conference center, the probability of having a second good season might

10 Carole Matthews, “Decision Making with Decision Trees,” Inc.com, April 2003, p. 1.

expected valueThe average return

on a particular decision being made

a large number of times.

expected valueThe average return

on a particular decision being made

a large number of times.




be raised to 0.8. With each successive year, the owner would have increas-ingly accurate information about the conditional values.

Following is an explanation of how the expected values are calculated for the new branch of the decision tree in question, shown in Exhibit 6-9.

exh ib i t 6-8 First-Year Decision Tree for Building Owner

Possible Alternatives States of NatureConditionalValues

ExpectedValues

DecisionPoint

Building only

Good season (0.6

) $100,000

$56,000

–$10,000$150,000

–$30,000

Poor season (0.4)

Good sea

son (0.

6)

Poor season (0.4)

Building andconference facility

$78,000

exh ib i t 6-9 Second-Year Decision Tree for Building Owner

Possible Alternatives States of NatureConditionalValues

ExpectedValues

DecisionPoint

Building and

conference fa

cility

Good season (0.8

) $180,000

$138,000

–$30,000$200,000

–$50,000

Poor season (0.2)

Good sea

son (0.

6)

Poor season (0.4)

Building andconference facility and warehouse $100,000




INVENTORY CONTROL TECHNIQUESManagers of manufacturing and sales organizations face the problem of how much inventory to keep on hand. If a firm maintains a large inven-tory, goods can be made quickly, customers can make immediate pur-chases, or orders can be shipped rapidly. However, stocking goods is expensive. The goods themselves are costly, and the money tied up in inventory cannot be invested elsewhere. Dell Computers and Wal-Mart are examples of companies that owe some of their competitive advantage to their efficient management of inventory. Dell minimizes the need for large inventory by building a computer only after an order is received. Of course, Dell still keeps lots of computer components on hand, but they do not have warehouses filled with yet-to-be sold computers. Wal-Mart collaborates with its suppliers to keep shelves stocked with the right amount and quan-tity of merchandise to minimize inventory accumulation.

This section will describe three decision-making techniques used to man-age inventory and control production: the economic order quantity (EOQ), the just-in-time (JIT) system, and brief mention of LIFO versus FIFO.

Economic Order QuantityThe economic order quantity (EOQ) is the inventory level that minimizes both administrative costs and carrying costs. The EOQ represents the reor-der quantity of the least cost. Carrying costs include the cost of loans, the interest foregone because money is tied up in inventory, and the cost of han-dling the inventory. EOQ is expressed mathematically as

EOQDOC

= 2

where

D = annual demand in units for the productO = fixed cost of placing and receiving an orderC = annual carrying cost per unit (taxes, insurance, storage cost, interest,

and other expenses)The economic order quantity is found to be the most useful when a

company has repetitive purchasing and demand for an item, such as truck tires or hospital supplies. Assume that the annual demand for coffee tables is 100 units and that it costs $1,000 to order each unit. Furthermore, suppose the carrying cost per unit is $200. The equation to calculate the most economic number of coffee tables to keep in inventory is

EOQ

coffee tables rou

= × ×

=

==

2 100 1 000200

200 000200

1 00032

$ ,$

$ ,$

,( nnded figure)

LearningObjective5

Describe how to manage inventory

by using the economic order

quantity (EOQ), the just-in-time (JIT) system, and LIFO

versus FIFO.

LearningObjective5

Describe how to manage inventory

by using the economic order

quantity (EOQ), the just-in-time (JIT) system, and LIFO

versus FIFO.

economic order quantity (EOQ)The inventory level

that minimizes both administrative costs and carrying costs.

economic order quantity (EOQ)The inventory level

that minimizes both administrative costs and carrying costs.




Therefore, the owners of the online furniture store conclude that the most economical number of coffee tables to keep in inventory during the selling season is 32. (The assumption is that the company has a large storage area.) If the figures entered into the EOQ formula are accurate, EOQ calcu-lations can vastly improve inventory management.

Just-in-Time SystemAn important thrust in manufacturing is to keep just enough parts and com-ponents on hand to fill current orders. The just-in-time (JIT) system is an inventory control method designed to minimize inventory and move it into the plant exactly when needed. Note also that JIT is part of a manufacturing system that focuses on making manufacturing more efficient by eliminating waste wherever possible. The key principle of the system is to eliminate excess inventory by producing or purchasing parts, subassemblies, and final products only when—and in the exact amounts—needed. JIT helps a manu-facturing division stay lean by minimizing waste. A lean manufacturing organization adopts a culture of continuously looking for ways to be more efficient. A specific example would be redesigning a work area from a linear operation to a U-shaped station to improve efficiency.11

The JIT is quantitative in the sense that it relies heavily on numbers, such as specifying the number of parts and components accumulated as inven-tory. Also, under JIT the company would track data such as the number of hours or days of accumulated inventory.

Imagine the small furniture company having raw wood delivered to its door within an hour or so after an order is received over the Internet. JIT is generally used in a repetitive, single-product, manufacturing environment. However, the system is now also used to improve operations in sales and service organizations.

Reducing waste is the core JIT philosophy. Three such wastes are over-production, waiting, and stock. Overproduction waste can be reduced by producing only what is needed when an order is received. Waiting waste can be reduced by synchronizing the work flow, such as technicians preparing a computer-monitor housing when the internal mechanisms are coming down the line. Stock waste can be reduced by keeping inventory at a minimum.

Procedures and TechniquesJust-in-time inventory control is part of a system of manufacturing control. Therefore, it involves many different techniques and procedures. Seven of the major techniques and procedures are described in the list that follows.12 Knowing them provides insight into the system of manufacturing used by many successful Japanese companies, and companies located in other countries as well.

1. Kanbans. The JIT system of inventory control relies on kanbans, or cards, to communicate production requirements from the final point of assembly to the

11 Neal Haldene, “Novi Center Teaches Lean Way of Working,” Detroit News (http://www.detnews.com), September 21, 2006.12 Ramon L. Aldag and Timothy M. Stearns, Management, 2nd ed. (Cincinnati: South-Western College Publishing, 1991),

pp. 645–646.

just-in-time (JIT) systemA system to minimize inventory and move it into the plant exactly when needed.

just-in-time (JIT) systemA system to minimize inventory and move it into the plant exactly when needed.




manufacturing operations that precede it. When an order is received for a prod-uct, a kanban is issued that directs employees to finish the product. The finish-ing department selects components and assembles the product. The kanban is then passed back to earlier stations. This kanban tells workers to resupply the components. New stock is ordered when stock reaches the reorder level. Kanban communication continues all the way back to the material suppliers. In many JIT systems, suppliers locate their companies so they can be close to major customers. Proximity allows suppliers to make shipments promptly. At each stage, parts and other materials are delivered just in time for use.

2. Demand-driven pull system. The JIT technique requires producing exactly what is needed to match the demand created by customer orders. Demand drives final assembly schedules, and assembly drives subassembly timetables. The result is a pull system—that is, customer demand pulls along activities to meet that demand.

3. Short production lead times. A JIT system minimizes the time between the arrival of raw material or components in the plant and the shipment of a fin-ished product to a customer.

4. High inventory turnover (with the goal of zero inventory and stockless produc-tion). The levels of finished goods, work in process, and raw materials are purposely reduced. Raw material in a warehouse is regarded as waste, and so is idle work in process. (A person who applied JIT to the household would regard backup supplies of ketchup or motor oil as shameful!)

5. Designated areas for receiving materials. Certain areas on the shop floor or in the receiving and shipping department are designated for receiving specific items from suppliers. At a Toyota plant in Japan, the receiving area is about half the size of a football field. The designated spaces for specific items are marked with yellow paint.

6. Designated containers. Specifying where to store items allows for easy access to parts, and it eliminates counting. For example, at Toyota the bed of a truck has metal frame mounts for exactly eight engines. A truckload of engines means eight engines—no more, no less. No one has to count them.

7. Neatness. A JIT plant that follows Japanese tradition is immaculate. All unnecessary materials, tools, rags, and files are discarded. The factory floor is as neat and clean as the showroom.

Advantages and Disadvantages of the JIT Inventory SystemManufacturing companies have realized several benefits from adopting JIT. The expenses associated with maintaining a large inventory can be dramatically reduced, providing suppliers do not raise their prices for making deliveries as needed. JIT controls can lead to organizational commitment to quality in design, materials, parts, employee–management and supplier–user relations, and finished goods. With minimum levels of inventory on hand, finished prod-ucts are more visible and defects are more readily detected. Quality problems can therefore be attacked before they escalate to an insurmountable degree. Low levels of inventory also shorten cycle times.




Despite the advantages JIT management can offer large manufacturers, it has some potential disadvantages. Above all, a JIT system must be placed in a supportive or compatible environment. JIT is applicable only to highly repetitive manufacturing operations such as car or residential furnace manu-facturing. Also, product demand must be predictable with a minimum of surges in demand. Reliable suppliers are also needed.

Small companies with short runs of a variety of products often may suf-fer financial losses from JIT practices. One problem they have is that suppli-ers are often unwilling to promptly ship small batches to meet the weekly needs of a small customer.

The savings from JIT management can be deceptive. Suppliers might simply build up inventories in their own plants and add that cost to their prices. JIT inventory practices also leave a company vulnerable to work stoppages, such as a strike. With a large inventory of finished products or parts, the company can continue to meet customer demand while the work stoppage is being settled.

The accompanying Management in Action will help you develop a feel for what it is like to work under a JIT management system and philosophy.

I worked for Arvin Sango Inc. The company sup-plies Toyota with instrument panels and body parts. Instead of using the “push” philosophy of producing as many parts as we could, we had a daily production. The trucks from Toyota arrived “just in time” to pick up the parts we pro-duced. Typically no more than four hours elapsed between the time the parts were made and when they were picked up. If the production line broke down, there was a possibility that we would miss our truck. We had to pay Toyota if our inability to keep them supplied resulted in them halting production.

When we had produced the number of parts that was set, we were done working for the day. We might help workers on another line, but we were not allowed to produce any more of our parts. JIT is the opposite of the warehousing philosophy, where you fill up your warehouse with inventory and wait for someone to order it. JIT

saves warehouse space and helps assure quality between the customer and the producer. Typically the producer and customer are both on a JIT schedule. Some times we would have a slight flaw in our parts and Toyota noticed it right away and notified us of the quality deficiency. We were then able to correct the deficiency before we produced a warehouse full of flawed parts.

Questions1. In what way did using just-in-time inventory

management help the supplier, Arvin Sango?2. In what way did using just-in-time inventory

management help the customer, Toyota?

Source: “What are Examples of a Company Using Just in Time (JIT) Management Philosophy?” Yahoo! Answers, accessed November 17, 2006.

Supervisor at a Toyota Supplier

m a n a g e m e n t i n a c t i o n




LIFO versus FIFOAnother method of inventory control is more of a method of accounting than a method of managing physical inventory, yet it does relate to stocking inventory. Imagine that you were running a tire warehouse, and had hun-dreds of tires of many sizes in stock. When an automotive service center ordered four tires, would you ship the center the oldest tires in your ware-house? Or would you ship the center, the tires you most recently acquired? Which tires you ship could have important implications.

Last in, First Out (LIFO) means that when there is more than one item in stock, you sell the last one received first. In the example at hand, you sell the latest four tires you received from the manufacturer, of the size ordered. The rationale here is that the newest is probably the most expensive. First in, First Out (FIFO) means that when there is more than one item in stock, you sell the one you have had in inventory the longest.

In choosing between LIFO and FIFO, you have both physical and finan-cial considerations. Getting rid of older inventory first can be a good idea because the longer it sits around, the higher the probability of the item get-ting damaged, including the packing looking old and being torn. In some situations, the company has borrowed money to purchase inventory, so you want to move the inventory you have been paying for the longest. This is particularly true for business firms such as automobile and boat dealers.

One of several financial, and tax, considerations is that if you value your inventory at the cost of the time you purchased it, your profits will look better when you sell at today’s prices. In returning to the tire example, suppose you sell your four tires to the service center for $400. If you ship four tires for which you paid $50 each three years ago, your gross profit would be $200 (four tires times $50). You have to pay income tax on $200. However, if you ship four tires for which you paid $75 each last month, your profit is now $100. You have earned less profit, but you will pay less tax. (Please consult your accounting professor or tax accountant for the latest rulings! For example, it might be possible to value the older tires at today’s prices, thus reducing your reported revenue.)

PARETO DIAGRAMS FOR PROBLEM IDENTIFICATIONManagers and professionals frequently must identify the major causes of their problem, such as “What features of our product are receiving the most com-plaints from consumers?” or “Our agency is offering more services to the public than we can afford. Which services might we drop without hurting too many people?” One problem-identification technique uses a Pareto diagram, a bar graph (or histogram) that ranks types of output variations by frequency of occurrence. Managers and other workers often use Pareto diagrams to identify the most important problems or causes of problems that affect output quality. Identification of the “vital few” allows management or product improvement teams to focus on the major cause of a production or service problem. Based on quantitative data, effort is then directed where it will do the most good.

Last In, First Out (LIFO)

Selling an item fi rst that was received last

in inventory.

First In, First Out (FIFO)

Selling an item fi rst that has been in

inventory the longest.

Last In, First Out (LIFO)

Selling an item fi rst that was received last

in inventory.

First In, First Out (FIFO)

Selling an item fi rst that has been in

inventory the longest.

LearningObjective6

Describe how to identify problems

using a Pareto diagram.

LearningObjective6

Describe how to identify problems

using a Pareto diagram.

Pareto diagramA bar graph that

ranks types of output variations

by frequency of occurrence.

Pareto diagramA bar graph that

ranks types of output variations

by frequency of occurrence.




An example of Pareto analysis is an investigation of the delay associated with processing credit card applications. The data are grouped in the follow-ing categories:13

• No signature

• Residential address not valid

• Non-legible handwriting

• Already a customer

• Other

As Exhibit 6-10 shows, the cause of a problem is plotted on the x-axis (horizontal). The cumulative effects both in frequency and percent are plot-ted on the y-axis (vertical). In a Pareto diagram, the bars are arranged in descending order of height (or frequency of occurrence) from left to right across the x-axis. As a consequence, the most important causes are at the left of the chart. Priorities are then established for taking action on the few causes that account for most of the effect. According to the Pareto principle, generally 20 percent or fewer of the causes contribute to 80 percent or more of the effects. It is widely recognized, for example, that about 20 percent of the customers of an industrial company account for 80 percent of sales. And also, about 20 percent of customers account for about 80 percent of complaints.

A while back a crisis-management team of Ford managers and profes-sionals did a Pareto analysis of problems with Bridgestone/Firestone tires used on the Ford Explorer. The Ford team analyzed the data based on tire

13 Kerri Simon, “Pareto Chart,” Six Sigma (http://www.isixsigma.com), accessed November 18, 2006.

exh ib i t 6-10 Sample Pareto Chart Depiction

Source: Kerri Simon, “Pareto Chart,” Six Sigma (http://www.isixsigma.com), accessed November 18, 2006.

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sizes that had more than 30 reported warranty claims. The key results of their analysis, reported as follows, strongly support the Pareto principle:

Of 2,498 complaints involving eight separate size categories, 2,030, or 81 percent, involved the 15-inch P235/75R15 models, which included the Firestone ATX and Wilderness tires. Of the 1,699 reported complaints of tread separations on 13 different size tires, 1,424, or 84 percent, were for the P234/75R15 series of tires used on Ford’s Explorer and Bronco SUVs and its F-150 and Ranger pickup trucks.14

As you probably observed, one model created 81 percent of the prob-lems, and another series 84 percent. Although, the 80/20 (Pareto) principle is a general guide, it is a close approximation of reality in many situations.

The Pareto Diagram fits data-driven management and decision making. In the example in Exhibit 6-10, the manager can say, “About 80 percent of our credit card applications are being rejected because the signature is miss-ing. I think we can coach our customers to do a better job signing their applications.”

14 Bill Vlasic, “Tire Recall Rife with Blame, Tragedy,” The Detroit News, March 9, 2000.




1 Explain how managers use data-based decision making.

Using data-driven management, decisions are based on facts rather than impressions or guesses. Many managers want to see the data before accepting a suggestion from a subordinate. Data-driven management is more of an attitude and approach rather than a specifi c technique. Although data-driven management is preferable in most situations, intuition and judgment still contribute to making major decisions.

2 Explain the use of forecasting techniques in planning.

All planning includes making forecasts, both qualitative and quantitative. A judgmental forecast makes predictions on subjective opinions. Time-series analysis is a widely used method of making quantitative forecasts. Three widely used forecasts are economic, sales, and technological.

3 Describe how to use Gantt charts, milestone charts, and PERT planning techniques.

Gantt and milestone charts are simple methods of monitoring schedules that are particularly useful for one-time projects. Gantt charts graphically depict the planned and actual progress of work over the period of time encompassed by a project. A milestone chart lists the subactivities that must be completed to accomplish the major activities.

Managers use PERT networks to track complicated projects when sequences of events must be planned carefully. In a PERT

network, an event is a point of decision or accomplishment. An activity is the task that must be performed to complete an event. To complete a PERT diagram, a manager must sequence all the events and estimate the time required for each activity. The expected time for each activity takes into account optimistic, pessimistic, and probable estimates of time. The critical path is the most time-consuming sequence of activities and events that must be followed to implement the project. The duration of the project is determined by the critical path. Frequency distributions are sometimes used to calculate expected times, and PERT can also be used to estimate resources and costs that will be needed.

4 Describe how to use break-even analysis and decision trees for problem solving and decision making.

Managers use break-even analysis to estimate the point at which it is profi table to go ahead with a new venture. It is a method of determining the relationship between total costs and total revenues at various levels of sales activity or operation. Break-even analysis determines the ratio of total fi xed costs to the difference between the selling price and the variable cost for each unit. The results of break-even analysis are often depicted on a graph. Break-even analysis has to be done frequently as fi xed and variable costs change.

A decision tree provides a quantitative estimate of the best alternative. It is a tool for estimating the outcome of a series of decisions. When the sequences of the major decisions are drawn, they resemble a tree with branches.

S U M M A R Y O F

Key Points




K E Y T E R M S A N D P H R A S E S

Data-driven management, 189Judgmental forecast, 191Time-series analysis, 191Gantt chart, 194Milestone chart, 196 Program evaluation and review technique (PERT), 197Event, 197Activity, 197Expected time, 199

Critical path, 199Break-even analysis, 202Decision tree, 203Expected value, 204Economic order quantity (EOQ), 206Just-in-time (JIT) system, 207Last in First Out (LIFO), 210First in First Out (FIFO), 210Pareto diagram, 210

5 Describe how to manage inventory by using the economic order quantity (EOQ), the just-in-time (JIT) system, and LIFO versus FIFO.

The economic order quantity (EOQ) is a decision-support technique widely used to manage inventory. The EOQ is the inventory level that minimizes both ordering and carrying costs. The EOQ technique helps managers in a manufacturing or sales organization decide how much inventory to keep on hand.

Just-in-time (JIT) inventory management minimizes stock on hand. Instead, stock is moved into the plant exactly when needed. Although not specifi cally a decision-making technique, JIT helps shape decisions about inventory. The key principle underlying JIT systems is the elimination of excess inventory by producing or purchasing items only when and in the exact amounts they are needed. JIT is part of lean manufacturing.

Just-in-time processes involve (1) kanbans, or cards for communicating production requirements to the previous operation, (2) a customer demand–driven system, (3) short production lead times,

(4) high inventory turnover, (5) designated areas for receiving materials, (6) designated containers, and (7) neatness throughout the factory.

JIT inventory management is best suited for repetitive manufacturing processes. One drawback of JIT is that it places heavy pressures on suppliers to build up their inventories to satisfy sudden demands of their customers who use the system.

LIFO versus FIFO helps manage inventory, but is mostly an accounting technique. With LIFO, you sell the last one received, fi rst. With FIFO, you sell the item fi rst that you have had in inventory the longest.

6 Describe how to identify problems using a Pareto diagram.

Problems or causes of problems can often be identifi ed by a problem-identifi cation technique called the Pareto diagram. The Pareto principle stems from the diagram, and suggests that about 20 percent or fewer of the causes contribute to 80 percent or more of the effects.




S K I L L - B U I L D I N G E X E R C I S E 6 - A : Developing a PERT Network

Use the following information about a safety improve-ment project to construct a PERT diagram. Be sure

to indicate the critical path with a dark arrow. Work individually or in small groups.

Q U E S T I O N S1. Visualize yourself as the manager of an athletic club.

Give three examples of data you might be able to use in making decisions about how to improve the profitability of the club.

2. What is the difference between a milestone chart and a to-do list?

3. Describe two possible job applications for a PERT network.

4. What similarities do you see between the purposes of break-even analysis and a decision tree?

5. How might the Pareto principle apply to the profits an automobile company earns on the sales of its vehicles?

6. At least one-half of new restaurants fail within the first couple of years, even when these restaurants appear to be busy much of the time. Describe how two of the techniques described in this chapter might help a person prevent opening a restaurant that is doomed to fail.

7. An important part of management is dealing with people. Where is the human touch in any of the techniques described in this chapter?

S K I L L - B U I L D I N G E X E R C I S E 6 - B : Break-Even Analysis

On recent vacation trips to Juarez, Mexico, you noticed retail stores and street vendors selling inexpensive digital cameras. (The photo stores also sold brand-name digital cameras at close to U.S. prices.) The prices for the inex-pensive cameras ranged from $25 to $40 U.S. A flash of inspiration hit you. Why not sell Mexican-assembled digital cameras back home to Americans, using a van as your store? Every three months you would drive the 350 miles to Mexico and load up on these novelty digital cameras. You are thinking of negotiating to receive large-quantity discounts.

You would park your van on busy streets and nearby parks, wherever you could obtain a permit. Typically you would display the cameras outside the van, but on a rainy day people could step inside. Your intention is to operate your traveling camera sale about 12 hours per week. If you could make enough money from your business, you could attend classes full-time during the day. You intend to sell the cameras at an average of $65 a unit.

Based on preliminary analysis, you have discovered that your primary fixed costs per month would be: $550

Event Description Time Required (units) Preceding Event

A Complete safety audit 6 noneB Benchmark 15 AC Collect internal information 6 AD Identify safety problems 3 B, CE Identify improvement practices 7 DF Elicit employee participation 20 AG Implement safety program 6 E, FH Measure results 8 G

Source: Adapted and reprinted with permission from Raymond L. Hilgert and Edwin C. Leonard Jr., Supervision: Concepts and Practices of Management, 6th ed. (Cincinnati: South-Western College Publishing, 1995), p. 191.




I N T E R N E T S K I L L - B U I L D I N G E X E R C I S E : The Reality of the Pareto Principle

The Pareto principle stating that 80 percent of effects are created by 20 percent of causes has become entrenched in management thinking. We regularly hear such glib statements as “20 percent of our customers account for 80 percent of our sales.” The text furnished other exam-ples of the Pareto principle. Conduct research on the

Internet to find at least five examples of the 80/20 rule. At the same time, see if you can find any evidence that refutes the reliability of this principle or rule. In other words, can you find an example of a situation in which 20 percent of the causes did not produce 80 percent of the effects?

for payments on a van, $175 for gas and maintenance, $75 for insurance, and $60 for a street vendor’s permit. You will also be driving down to Mexico every three months at $600 per trip, resulting in a $200 per month travel cost. Your variable costs would be an average of $30 per camera and 45¢ for placing each camera in an attractive box.

1. How many cameras will you have to sell each month before you start to make a profit?

2. If the average cost of your cameras rises to $35, how many cameras will you have to sell each month if you hold your price to $65 per unit?




Like many big hospitals, the University of Utah Hospital carries a 30-day supply of drugs, in part because it would be too costly or wasteful to stockpile more. Some of its hepatitis vaccine supply has been diverted to the hurri-cane-ravaged Gulf, leaving it vulnerable should an out-break occur closer to home. About 77 other drugs are in short supply because of manufacturing and other glitches, such as a drug maker shutting down a factory.

“The supply chain is horribly thin,” says Erin Fox, a drug-information specialist at the Salt Lake City Hospital. In the event of a pandemic flu outbreak, that chain is almost certain to break. Thousands of drug-company work-ers in the United States and elsewhere could be sickened, prompting factories to close. Truck routes could be blocked and borders may be closed, particularly perilous at a time when 80 percent of raw materials for U.S. drugs come from abroad. The likely result: shortages of important medi-cines—such as insulin, blood products, or the anesthetics used in surgery—quite apart from any shortages of medi-cine to treat the flu itself.

A problem facing Utah Hospital, as well as other hos-pitals, is that production of drugs takes place offshore because that’s cheaper. The federal government doesn’t intervene as a guaranteed buyer of flu drugs, as it does with weapons. Investors and tax rules conspire to elimi-nate redundancy and reserves. Antitrust rules prevent private companies from collaborating to speed develop-ment of new drugs.

A report issued by the Trust for America’s Health, a public-health advocacy group in Washington, concluded

that 40 percent of the states lack enough backup medical supplies to cope with a pandemic flu or other major dis-ease outbreak.

“Most if not all of the medical products or protec-tive-device companies in this country are operating almost at full capacity,” says Michael Osterholm, director of the Center for Infectious Disease Research and Policy at the University of Minnesota. “That’s the reality of today’s economy: just-in-time delivery with no surge capacity.”

One significant concern is what Michael Leavitt, the secretary of health and human services, described in an interview as the “Albertson’s syndrome,” refer-ring to the grocery-store chain. At the first sign of panic, all supplies disappear from shelves, something that routinely happens when there is the threat of even a modest storm.

Discussion Questions1. How suitable is the just-in-time inventory manage-

ment system for the University of Utah Hospital (as well as for other large hospitals)?

2. What recommendations would you make to the hospital in question to have drugs available to deal with a pandemic or other emergency?

Source: Bernard Wysocki Jr. and Sara Lueck, “Just-in-Time Inventories Make U.S. Vulnerable in a Pandemic,” The Wall Street Journal, January 12, 2006, pp. A1, A7.

Just-In-Time Worries at the University of Utah Hospital

6-ACase Problem




Case Problem

Gisela Sanchez is the director at Downtown Family Services, a social agency that provides various forms of assistance to low-income and no-income citizens in the northeast section of the city. Family Services receives funding from the city, state, and federal governments along with charitable contributions. Among the services the agency provides are family counseling, abortion coun-seling, home care for the infirm, and emergency shelters for battered or homeless people.

Seventeen professionals work at Family Services, including nurses and counselors, 19 paraprofessionals who assist the professionals, and a support staff of six people. Although the premises at Family Services are far from luxurious, the offices are adequately equipped with furniture, restrooms, break rooms, and office technology. The biggest problem facing the agency is an overworked staff, accompanied by complaints of burnout.

After the Christmas season, Sanchez was particularly worried about the haggard look of many staff members. As a preliminary step in dealing with the problem, Sanchez called a staff meeting at 4:30, two Fridays after the New Year. Sanchez served snacks and beverages. Sanchez began the meeting with these words: “I know you’ve been overworked, underpaid, and feel unappreci-ated, but I love you all. I think it’s time to take some managerial action about our problems.”

Gil Toomey, the director of social work, responded: “Oh, Gisela, are you going to merge us with another agency, and lay off duplicate positions?”

“Not at all Gil,” responded Sanchez. “I want to know where we are spending the most of our time, what’s drag-ging us down, and how we can improve the situation. We’ve known for a long time we’re spreading ourselves too thin.”

“I sure feel spread too thin,” said Marcie Beaudoin, the director of home-health care. “My staff is also spread dangerously thin.”

Sanchez then explained that she would like to analyze where the human resources are being used in the agency. She explained, “After we know what we are really doing with our time, we can develop a plan to ease the work-load. The most we can hope for in the budget is to hire one new professional, and one paraprofessional. My sus-picion is that a small number of our clients are draining us. Because of these needy people, we are not devoting enough attention to some other worthy clients.”

Discussion Questions1. Recommend a technique that Family Services can

use to evaluate how much of their time is being spent on a relatively few number of clients.

2. After making this analysis and perhaps furnishing some illustrative data, explain what can be done about the situation.

3. How might forecasting techniques help Family Services do a better job of managing their workload?

Imbalances at Family Services

6-B



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