OPERATIONS MANAGEMENT

Goods, Services and Value Chains

CHAPTER 3

Measuring Performance in Operations

DAVID A. COLLIER AND JAMES R. EVANS

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Chapter 3 Learning Objectives

1. To understand the principal types of performance measures used in organizations and by operations managers and to be able to identify important measures and indicators to manage and improve business performance.

2. To understand the importance of evaluating relationships and cause-and-effect linkages among performance measures and approaches that companies use to understand such relationships.

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Chapter 3 Learning Objectives

3. To understand the characteristics of a good measurement system and how to select appropriate measures to support operations.

4. To understand how measurement systems are integrated into comprehensive models of business performance as a basis for better design and improvement of operations.

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Chapter 3 Measuring Performance in Operations

Introduction Managers make many important decisions that affect how an organization provides value to its customers. To know if decisions are effective and to guide the organization on a daily basis, they need a means of understanding performance at all levels of the organization as well as in operations.
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Chapter 3 Measuring Performance in Operations

Introduction Good decisions are facilitated through measurement, the act of

quantifying the performance criteria of organizational units, goods and services, processes, people, and other business activities.

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Chapter 3 Measuring Performance in Operations

Introduction Key questions related to measurement in operations include: How should we measure the performance of goods and services? How should we measure the performance of processes throughout the value chain? How should we measure overall organizational performance and how does it relate to internal operations?
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Chapter 3 Measuring Performance in Operations

The Scope of Performance Measurement

Good performance measures enable managers to control processes and make decisions on the basis of facts, not opinions.
Selecting the right measuresnot too many and not too few is a very important decision that all managers must make.

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Chapter 3 Measuring Performance in Operations

The Scope of Performance Measurement The list below details various categories of Performance measurements.
Financial

Customer and market Safety Quality

Time Flexibility Innovation and learning Productivity

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Exhibit 3.1 The Scope of Business and Operations Performance Measurement

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Chapter 3 Measuring Performance in Operations

Financial Measures Often take top priority in for-profit organizations.

Traditional financial measures include revenue, return on investment, operating profit, pretax profit margin, asset utilization, growth, earnings per share, and other liquidity measures.

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Chapter 3 Measuring Performance in Operations

Financial Measures Cost of quality is not used in most organizations; it measures what poor quality is costing an organization. Nonprofit organizations focus more on minimizing costs and maximizing value to their target markets, customers, and society.

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Chapter 3 Measuring Performance in Operations Customer and Market Measures An effective customer-satisfaction measurement system provides a company with customer ratings of specific goods and service features and indicates the relationship between those rating and the customers likely future buying behavior. Measured in three areas: 1) goods quality, 2) service quality, and 3) response time.

Other customer focused measures include: customer complaints, loyalty, customer retention, warranty claims, service guarantee claims, service upsets/failures.
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Chapter 3 Measuring Performance in Operations

Safety
Measuring safety is vital to all organizations, as the well- being of its employees and customers should be an organization's principal concern. Performance measures include accident rates, parts per million of arsenic in public water supply, or security in a hotel room.

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Chapter 3 Measuring Performance in Operations

Safety
OM Spotlight: Dana Corporation Safety integrated with continuous quality improvement If an accident happens the entire facility is shut down. Factory lost time accident rates were 39 times lower than comparable factories.

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Chapter 3 Measuring Performance in Operations

Quality

Quality measures the degree to which the

output of a process meets customer requirements.

Goods quality relates to the physical performance and characteristics of a good.

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Chapter 3 Measuring Performance in Operations

Quality
A common measure of goods quality is the number of defects per unit, which is computed by dividing the total number of defects found by the number of items examined. Nonconformities per unit are often reported as rates per thousand or million, and the measure dpmodefects per million opportunitiesis often used.
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Chapter 3 Measuring Performance in Operations

There are many dimensions of quality including:

Performance: a goods primary operating characteristics. Example-automobile brakes stop the vehicle.

Features: bells and whistles. Example- reclining seats.

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Chapter 3 Measuring Performance in Operations

There are many dimensions of quality including: Reliability: probability of the manufactured good working over a certain time. Examplevehicle engine always starts on cold days. Conformance: the degree to which characteristics match preestablished standards. Examplevehicle door does not leak water.
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Chapter 3 Measuring Performance in Operations

Quality There are many dimensions of quality including (continued): Durability: use before it physically deteriorates. Exampleauto corrosion. Serviceability: speed, courtesy and competence of repair work. Example vehicle oil change. Aesthetics: how good a manufactured good looks, feels, sounds, tastes, or smells. Examplevehicles style and color.
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Chapter 3 Measuring Performance in Operations

Another Way to Think About Quality Critical defect -- one that judgment and

experience indicate will surely result in hazardous or unsafe conditions for individuals using or experiencing the good or service.
likely to materially reduce the usability of the good or service for its intended purpose.

Major defect -- one that is not critical but is

Minor defect -- one that is not likely to materially reduce the usability of the good or service for its intended purpose.
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Chapter 3 Measuring Performance in Operations Quality Service quality is consistently meeting or exceeding customer expectations and service delivery system performance for all service encounters. Tangibles -- physical facilities, uniforms, equipment, vehicles, and appearance of employees (i.e., the physical evidence). Reliability -- ability to perform the promised service dependably and accurately. Responsiveness -- willingness to help customers and provide prompt recovery to service upsets. Assurance -- knowledge and courtesy of the serviceproviders, and their ability to inspire trust and confidence in customers. Empathy caring attitude and individualized attention provided to its customers.
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Chapter 3 Measuring Performance in Operations

Service Quality Every service encounter provides an opportunity for error. Errors in service

creation and delivery are sometimes called service upsets or service failures.

In services, a measure of quality analogous to defects per unit is errors per million opportunities (epmo). Environmental quality focuses on
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designing and controlling work processes to improve the environment.

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Chapter 3 Measuring Performance in Operations

Service Quality
Example epmo: A hotel might determine that there are 100 opportunities for error during the hotel check-in process and yesterday the hotel had 200 check-ins so the total opportunities for error is 20,000.
A total of 40 service upsets were recorded by well-trained hotel check-in staff for an error rate of 40/20,000 or 2 per thousand, which is equivalent to 2,000 epmo.

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Chapter 3 Measuring Performance in Operations Time Time relates to two types of performance measures: the speed of doing something (average) and the reliability of doing something (variance).

Processing time is the time it takes to perform some task.

Queue time is a fancy word for wait timethe time spent
waiting.

Cycle time refers to the time it takes to accomplish one

cycle of a process that performs work.

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Chapter 3 Measuring Performance in Operations Time

Manufacturing lead time represents the time between

the release of an order to production and shipment to the customer.

Purchasing lead time is the time required to obtain the

purchased item, including order preparation, supplier lead time, transportation, and receiving and storage. Sometimes processing, cycle, and lead time are used interchangeably making things confusing in the real world. Always ask for a definition of these terms to see how the organization is using it.
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Chapter 3 Measuring Performance in Operations Flexibility Flexibility is the ability to adapt quickly and effectively to changing requirements.

Goods and service design flexibility is the ability to

develop a wide range of customized goods and services to meet different or changing customer needs.

Volume flexibility is the ability to respond quickly to

changes in the volume and type of demand. OM Spotlight: Nissan Flexibility Builds five models in one assembly factory. They use modular assemblies.
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Chapter 3 Measuring Performance in Operations Innovation and Learning

Innovation refers to the ability to create new and unique

goods and services that delight customers and create competitive advantage.

Learning refers to creating, acquiring, and transferring

knowledge and modifying the behavior of employees in response to internal and external change.

Microsoft is always two years away from failure. Bill Gates.

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Chapter 3 Measuring Performance in Operations Productivity

Productivity = Quantity of Output/Quantity of Input

Productivity is often confused with efficiency or effectiveness.

Efficiency is the degree to which a process generates outputs with the minimal consumption of inputs or generates a maximum amount of outputs for a given amount of inputs. Effectiveness is achieving the organization's objective, mission, or goal through the eyes of the customer; that is, doing the right things efficiently.
Productivity is more closely associate with value as defined in Chapter 1.
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Chapter 3 Measuring Performance in Operations Productivity Productivity = Quantity of Output/Quantity of Input Productivity is expressed in one of three forms: 1. Total Productivity = Total Output/Total Input 2. Multifactor Productivity = Total Output/Subset of Inputs 3. Partial Factor Productivity = Total Output/Single Input
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Exhibit 3.2 Examples of Partial Productivity Measures

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Exhibit 3.3 Productivity Calculations for Miller Chemicals

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Exhibit 3.4 Computing Productivity Indexes for Miller Chemicals

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Chapter 3 Measuring Performance in Operations

Linking Internal and External Performance Measures Managers must understand the cause-and-effect linkages between key measures of performance. These relationships often explain the impact of operational performance on external results. The quantitative modeling of cause-and-effect relationships between external and internal performance criteria is called interlinking.
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Chapter 3 Measuring Performance in Operations

Linking Internal and External Performance Measures Another example of an interlinking model is the financial value of a loyal customer (VLC), which quantifies the total revenue or profit each target market customer generates over some time frame. By multiplying the VLC times the absolute number of customers gained or lost, the total market value can be found.
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Exhibit 3.5 Interlinking Internal and External Performance Measures

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Chapter 3 Measuring Performance in Operations

Designing Performance Measurement Systems for Operations What makes a good performance measurement system for operations? Good performance measures are actionable, providing the basis for decisions at the level at which they are applied. To generate useful operational performance measures a systematic process is required.
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Chapter 3 Measuring Performance in Operations

Designing Performance Measurement Systems for Operations 1. Identify all customers of the value chain and determine their requirements and expectations. 2. Define the work process that provides the good or service. 3. Define the value-adding activities and outputs that compose the process. 4. Develop specific performance measures. 5. Evaluate the performance measures to ensure their usefulness.
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Exhibit 3.6 Example of a Pizza Ordering and Delivery Process

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Chapter 3 Measuring Performance in Operations

Models of Organizational Performance 1. Malcolm Baldrige National Quality Award Framework 2. Balanced Scorecard 3. Value Chain Model 4. Service-Profit Model

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Chapter 3 Measuring Performance in Operations

Models of Organizational Performance The first two models (Baldrige Award and Balanced Scorecard) provide more of a big picture or organizational performance.

The last two provide more detailed frameworks for operations managers.
It is important to understand these big picture models because operations managers must communicate with all functional areas.
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Chapter 3 Measuring Performance in Operations

Malcolm Baldrige National Quality Award Framework Organizations receive the awards in each of the original categories of manufacturing, small business, service, and nonprofit education and health care. Primary purpose of the program is to provide a framework for performance excellent through selfassessment to understand the organizations strengths and weaknesses.

www.baldrige.org
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Exhibit 3.7 Malcolm Baldrige National Quality Award Model of Organizational Performance

Source: 2005 Malcolm Baldrige National Quality Award Criteria, U.S. Dept. of Commerce

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Exhibit 3.8 Example OM-Related Questions in Baldrige Categories 4, 5, and 6, (slide 2)

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Exhibit 3.8 Example OM-Related Questions in Baldrige Categories 4, 5, and 6, (slide 1)

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Chapter 3 Measuring Performance in Operations

The Balanced Scorecard Model

Consists of four performance perspectives: 1) Financial

2) Customer
3) Innovation and Learning 4) Internal
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Exhibit 3.9 The Balanced Scorecard Performance Categories and Linkages

Source: Kaplan R. S., and Norton, D. P., The Balanced ScorecardMeasures That Drive Performance, Harvard Business Review, JanuaryFebruary 1992, p. 72.

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Chapter 3 Measuring Performance in Operations

The Value Chain Model Evaluates performance throughout the value chain: synchronized network of processes including suppliers and inputs, processes and associated resources, goods and service outputs and outcomes, customers and their market segments, synchronized information and feedback loops, and management of value chain.

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Exhibit 3.10 Examples of Value Chain Performance Measurements

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Chapter 3 Measuring Performance in Operations

Service-Profit Chain Model Most applicable to service environments. Model is based on a set of cause-andeffect linkages between internal and external performance and defines the key performance measurements on which service-based firms should focus.

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Exhibit 3.11 The Service-Profit Chain Model

Source: Adapted from J. L. Heskett, T. O. Jones, G. W. Loveman, W. E. Sasser, Jr., Jr., and L. A. Schlesinger, Putting the Service-Profit Chain to Work, Harvard Business Review, MarchApril 1994, pp. 164-174.

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Exhibit 3.12 IBM AS/400 Division Performance Measure Correlations (19841994 Data)

Source: Steven H. Hoisington and Tse-His Huang, Customer Satisfaction and Market Share: An Empirical Case Study of IBMs AS/400 Division, in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.

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Exhibit 3.13 IBM AS/400 Division Interlinking Model

Source: Steven H. Hoisington and Tse-His Huang, Customer Satisfaction and Market Share: An Empirical Case Study of IBMs AS/400 Division, in Customer-Centered Six Sigma, Earl Naumann and Steven H. Hoisington (Milwaukee, WI: ASQ Quality Press, 2001.

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Chapter 3 Solved Problem #1

Solved Problem # 1 Question: Costs, revenue, and other relevant information for two nursing units that admit and treat similar patients during a 6-month period are shown in Exhibit 3.14. Compare the total dollar value of inputs for each unit, total productivity, and the partial-productivity measure of direct nursing labor productivity. How do the units compare?

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Exhibit 3.14 Nursing Unit Productivity Analysis

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Chapter 3 Solved Problem #1 Answer: Total Productivity: Unit A: 1.12 Unit B: 0.95

Unit A is more productive than Unit B by 17.9%.

Partial-productivity: Unit A: 6.47 Unit B: 5.75 Unit A is also more productive based on labor (partial) productivity.
These productivity ratios assume that quality is the same in both nursing units.
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Chapter 3 Solved Problem #2 A factory department consists of three types of employees: laborers earning $10 per hour, machine operators earning $15 per hour, and machinists earning $30 per hour. For a certain job, over two periods, the performance shown below was collected: Type of Labor Hours per Period Employee Period 1 Period 2 Laborer 20 16 Machine operator 12 16 Machinist 6 11 Output increased by 20 percent in period 2. How has productivity changed?
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Chapter 3 Solved Problem #2

Solution: Because labor costs are given, we will use a total labor-cost productivity measure. With no knowledge of actual output figures, we index output for period 1 as 100 and for period 2 as 120 (or 1.0 and 1.2, for example). Then we divide the output index for each period by the sum of the input costs to obtain the productivity measure. The total labor costs for each period are shown below. Period 1Period 2 Laborer $200 $160 Machine operator $180 $240 Machinist $180 $330 Total $560 $730 The productivity index for period 1 is 100/560 = 0.1786; for period 2 it is 120/730 = 0.1644. The relative change in productivity in period 2 is (0.1644 - 0.1786)/0.1786 = -0.0795, or a decline of -7.95 percent. Management should identify possible reasons factory productivity decreased in period 2 and work to fix or improve the problem or situation.
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Chapter 3 Solved Problem #3 A steel company produces long, thin sheets of steel called coils that each weigh 10 to 15 tons. The slitting operation involves cutting the coils into smaller widths. An average of 5,000 tons per month is sold. The scrap rate from this operation is 3 percent. Material costs are $600 per ton. It takes .75 hours of labor at a rate of $20 per hour to produce one ton sold. a.How many tons per month must be produced to meet the sales demand? b. What annual savings would result from decreasing the scrap rate from 3 percent to 2 percent?

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Chapter 3 Solved Problem #3 Solution: a. The required production to make 5,000 tons of good steel with a 3 percent scrap rate is 5,000/(1 - 0.03) = 5,155 tons (not 5,000 times 1.03!). b. The required production to make 5,000 tons of good steel with a 2 percent scrap rate is 5,000/.98 = 5,102 tons. If the scrap rate is 3 percent, the additional 155 tons per month requires $93,000 ($600/ton*155 tons) in material and (.75)(20)(155) = $2,325 in labor, for a total of $95,325.

If the scrap rate is 2 percent, the additional 102 tons costs $61,200 in material and $1,530 in labor, for a total of $62,730. The difference incurred by reducing the scrap rate from 3 to 2 percent is $32,595 per month, or $391,140 annually. Even a small improvement in internal failure costs can result in big savings! Operations Management, 2e/Ch. 2 Measuring Performance in Operations
2007 Thomson South-Western

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Chapter 3 Solved Problem #4 What is the value of a loyal customer (VLC) in the small contractor target market segment who buys an electric drill on average for $100 every 4 years, when the gross margin on the drill averages 50 percent, and the customer retention rate is 60 percent? What if the customer retention rate increases to 80 percent? What is a 1 percent change in market share worth to the manufacturer if it represents 100,000 customers? What do you conclude?

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Chapter 3 Solved Problem #4

Solution: If customer retention rate is 60 percent, the average customer defection rate = (1- customer retention rate). Thus, the customer defection rate is 40 percent, or 0.4. The average buyers life cycle is 1/0.4 = 2.5 years. The repurchase frequency is every four years or 0.25 (1/4). Therefore, VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/0.4) = $31.25 per year The value of a 1 percent change in market share = (100,000 customers)*($31.25/customer/year) = $ 3,125,000. If customer retention rate is 80 percent, the average customer defection rate is 0.2, and the average buyers life cycle is 1/0.2 = 5 years. Then, VLC = P*RF*CM*BLC = $100*0.25*0.50*(1/.2) = $62.50 per year Thus, the value of a 1 percent change in market share = (100,000 customers)* ($62.50/customer/year) = $ 6,500,000.
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Exhibit 3.15 Greyhound Insurance Company Case: Sample of Check

Processing Performance Data

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Exhibit 3.16 BankUSA Case: Sample Internal and External Credit Card Division Performance Data

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