409 N

University of rizona Mining and Geological Engineering
409 - Management Operations Technology

Course Notes Spring 2006
Modules 1-6 Compiled by: Dr. Sean Dessureault
MGE 409 Management Operations Technology
2006
Table of Contents
MODULE 1: INTRODUCTION ......................................................................................................... 5
ADDITIONAL RESOURCES I................................................................................................................. 5 MODULE 2: OPERATIONS MANAGEMENT, ............................................................................... 6
2.1 AGGREGATE PLANNING ................................................................................................................. 7 2.1.1 Integrating Operations Management with Other Functions..................................................... 8 2.1.2 Planning for the Intermediate Term ......................................................................................... 9 2.1.3 Aggregate Planning Variables ............................................................................................... 12 2.1.4 General Aggregate Planning Strategies ................................................................................. 14 2.1.5 Aggregate Planning Methods ................................................................................................. 24 ADDITIONAL RESOURCES II ............................................................................................................. 25 2.2 FORECASTING .............................................................................................................................. 25 2.2.1 Choosing a Forecasting Method ............................................................................................ 26 2.2.2 Forecasting Model Types ....................................................................................................... 26 2.2.3 Time Series Components......................................................................................................... 27 2.2.4 Short-Term Forecasting.......................................................................................................... 29 2.2.5 Measuring Forecast Accuracy................................................................................................ 32 2.2.6 Estimating and Using Seasonal Indexes................................................................................. 36 2.2.7 Conclusions ............................................................................................................................ 41 ADDITIONAL RESOURCES III............................................................................................................ 41 2.3 MASTER SCHEDULING AND INVENTORY MANAGEMENT.............................................................. 41 ADDITIONAL RESOURCES IV............................................................................................................ 44 2.4 JUST-IN-TIME AND SYNCHRONOUS SYSTEMS .............................................................................. 44 2.4.1 JIT Perspectives on Inventory ................................................................................................ 45 2.4.2 Supply Chain and E-Commerce Considerations in JIT .......................................................... 46 2.4.3 Synchronous value-adding systems ........................................................................................ 47 2.4.4 Overview of Synchronous Systems.......................................................................................... 48 2.4.5 Performance Measures and Capacity Issues in TOC ............................................................. 49 2.4.6 Cost Accounting...................................................................................................................... 51 2.4.7 The Management Process....................................................................................................... 52 2.4.8 Detailed Scheduling: The Drum-Buffer-Rope System ............................................................ 52 ADDITIONAL RESOURCES V ............................................................................................................. 52 2.5 PROJECT MANAGEMENT .............................................................................................................. 52 ADDITIONAL RESOURCES VI............................................................................................................ 53 2.6 APPENDIX: THE CHRONOLOGICAL DEVELOPMENT OF OPERATIONS MANAGEMENT (OPTIONAL READINGS) ................................................................................................................................................ 53 2.6.1 The Industrial Revolution: The Birth of Mass Production ..................................................... 53 2.6.2 Scientific Management: Developing a Technical Understanding of Work............................. 54 2.6.3 Industrial Psychology and Industrial Sociology: Developing a Human Understanding of Work 55 2.6.4 Statistical Control of Quality.................................................................................................. 55 2.6.5 Management Science: Optimizing the Use of Limited Resources........................................... 56 2.6.6 Functionalization of OM: Bringing It All Together in One Function..................................... 56 2.6.7 The MRP Crusades: Computerizing Operational Decision Making ...................................... 57 2.6.8 JIT, the Quality Revolution, and Operations Strategy............................................................ 57 MODULE 3: MANAGEMENT SCIENCE....................................................................................... 60
3.1 NETWORK MODELS ..................................................................................................................... 60 3.1.1 Transportation Model............................................................................................................. 60 3.1.2 Transshipment model.............................................................................................................. 63 3.1.3 Maximum Flow Model............................................................................................................ 67 ADDITIONAL RESOURCES VII .......................................................................................................... 70
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3.2 JUSTIFICATION ............................................................................................................................. 70 3.2.1 Economic Justification ........................................................................................................... 71 3.2.2 Portfolio & Scoring models .................................................................................................... 77 3.2.3 Options Pricing....................................................................................................................... 87 ADDITIONAL RESOURCES VIII ....................................................................................................... 103 MODULE 4: ACCOUNTING.......................................................................................................... 104
4.1 BASIC NOMENCLATURE ............................................................................................................. 104 4.1.1 The Authority Underlying Accounting.................................................................................. 105 4.1.2 The Corporation ................................................................................................................... 106 4.1.3 Accounting Concepts ............................................................................................................ 106 4.1.4 Accounting Equation ............................................................................................................ 107 ADDITIONAL RESOURCES IX.......................................................................................................... 109 4.2 FINANCIAL STATEMENTS ........................................................................................................... 109 4.2.1 Income Statement.................................................................................................................. 110 4.2.2 Balance Sheet ....................................................................................................................... 112 4.2.3 Statement of Owner's Equity................................................................................................. 115 4.2.4 Statement of Cash Flows ...................................................................................................... 115 4.2.5 Financial Statement Headings.............................................................................................. 116 4.2.6 Analyzing Financial Statements ........................................................................................... 118 ADDITIONAL RESOURCES X ........................................................................................................... 121 4.3 PLANT ASSETS ........................................................................................................................... 122 4.3.1 Costs Associated to Types of Assets...................................................................................... 123 4.3.2 Capital Expenditures ............................................................................................................ 124 4.3.3 Natural Resources ................................................................................................................ 130 4.3.4 Intangible Assets................................................................................................................... 131 4.3.5 Research and Development Costs......................................................................................... 132 4.3.6 Ethics .................................................................................................................................... 132 ADDITIONAL RESOURCES XI.......................................................................................................... 132 4.4 ACCOUNTING INFORMATION SYSTEMS. ..................................................................................... 133 ADDITIONAL RESOURCES XII ........................................................................................................ 134 4.5 MANAGERIAL ACCOUNTING ...................................................................................................... 134 4.5.1 Cost Objects, Direct Costs, and Indirect Costs .................................................................... 136 4.5.2 Product Costing.................................................................................................................... 137 4.5.3 Overheads............................................................................................................................. 138 4.5.4 Cost Types ............................................................................................................................ 138 4.5.5 Budgets and Responsibility Accounting................................................................................ 139 4.5.6 The Master Budget................................................................................................................ 140 4.5.7 Responsibility centers ........................................................................................................... 142 ADDITIONAL RESOURCES XIII ....................................................................................................... 144 MODULE 5: INFORMATION TECHNOLOGY.......................................................................... 145
ADDITIONAL RESOURCES XIV....................................................................................................... 145 MODULE 6: MANAGEMENT STRATEGY ................................................................................ 145
6.1 MOTIVATION ............................................................................................................................. 145 6.1.1 What Is Motivation? ............................................................................................................. 146 6.1.2 Maslow's Hierarchy of Needs Theory................................................................................... 147 6.1.3 McGregor's Theory X and Theory Y..................................................................................... 148 6.1.4 Herzberg's Motivation-Hygiene Theory ............................................................................... 149 6.1.5 Three Needs .......................................................................................................................... 150 6.1.6 Goal Setting Theory.............................................................................................................. 151 6.1.7 Reinforcement Theory........................................................................................................... 152
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Table of Figures
FIGURE 2-1: OPERATIONS HAS TRADITIONALLY BEEN RESPONSIBLE FOR MANAGING THE "TRANSFORMATION" PROCESS ............................................................................................................... 6 FIGURE 2-2: PROJECT PLANNING AND CONTROL.............................................................................................. 7 FIGURE 2-3: PLANNING TO DELIVER THE PRODUCT-SERVICE BUNDLE ......................................................... 10 FIGURE 2-4: JIMBOBS MINERALS LEVEL PRODUCTION ............................................................................. 17 FIGURE 2-5: CHASE DEMAND STRATEGY...................................................................................................... 18 FIGURE 2-6: SIMONS ENGINEERING CONSULTING GROUP PEAK DEMAND STRATEGY. ................................... 20 FIGURE 2-7: JIMBOBS QUARRY MIXED STRATEGY .................................................................................... 22 FIGURE 2-8: TREND PATTERNS...................................................................................................................... 28 FIGURE 2-9: EXAMPLE FOR SMA AND SES................................................................................................... 31 FIGURE 2-10: MSE, MAD EXAMPLE ............................................................................................................ 34 FIGURE 2-11: AGGREGATE SALES ................................................................................................................. 37 FIGURE 2-12: SPREADSHEET SOLUTION FOR SEASONAL INDEXES .................................................................. 37 FIGURE 2-13: QUARTERLY DEMAND ............................................................................................................. 38 FIGURE 2-14: RESULTS OF REGRESSION ........................................................................................................ 39 FIGURE 2-15: DESEASONLIZATION ................................................................................................................ 40 FIGURE 2-16: MASTER SCHEDULING AND INVENTORY MANAGEMENT........................................................... 42 FIGURE 2-17: SYSTEM CHARACTERISTICS OF JIT PLANNING AND CONTROL ................................................ 45 FIGURE 2-18: INVENTORY MARGIN OF SAFETY .............................................................................................. 46 FIGURE 2-19: MANUFACTURING SYSTEMS.................................................................................................... 48 FIGURE 2-20: HOCKEY STICK SYNDROME ..................................................................................................... 50 FIGURE 2-21: OPERATIONS MANAGEMENT TIMELINE. .................................................................................. 59 FIGURE 3-1: TRANSPORTATION PROBLEM..................................................................................................... 61 FIGURE 3-2: TRANSPORTATION SOLUTION .................................................................................................... 62 FIGURE 3-3: TRANSSHIPMENT EXAMPLE ....................................................................................................... 64 FIGURE 3-4: TRANSSHIPMENT SOLUTION ...................................................................................................... 65 FIGURE 3-5: SOLUTION TO TRANSSHIPMENT PROBLEM .................................................................................. 67 FIGURE 3-6: MAXIMUM FLOW PROBLEM....................................................................................................... 67 FIGURE 3-7: MAXIMUM FLOW SPREADSHEET ................................................................................................ 69 FIGURE 3-8: MAXIMUM FLOW SOLUTION. .................................................................................................... 69 FIGURE 3-9: CLASSIFICATION SCHEME FOR JUSTIFICATION APPROACHES ..................................................... 70 FIGURE 3-10: SELECTING THE APPROPRIATE JUSTIFICATION TECHNIQUE ...................................................... 71 FIGURE 3-11: OPTIMAL SOLUTION FOR MINECOMP EXAMPLE ...................................................................... 78 FIGURE 3-12: OPTIMAL SOLUTION FOR THE OPMC EXAMPLE ...................................................................... 80 FIGURE 3-13: PAIRWISE COMPARISON MATRIX SOLUTION FOR 3X3 EXAMPLE .............................................. 83 FIGURE 3-14: PAIRWISE COMPARISON MATRIX FOR OBJECTIVES FOR IOM EXAMPLE .................................. 84 FIGURE 3-15: NORMALIZED PAIRWISE COMPARATIVE MATRIX .................................................................... 84 FIGURE 3-16: PAIRWISE COMPARISON MATRIX OF OPTIONS FOR FRAGEMENTATION FOR IOM EXAMPLE ... 86 FIGURE 3-17: FINAL SOLUTION FOR IOM EXAMPLE ..................................................................................... 86 FIGURE 3-18: BINOMIAL FLUCTUATIONS ...................................................................................................... 90 FIGURE 3-19: OPTION PAYOFF ...................................................................................................................... 91 FIGURE 3-20 SPREADSHEET MODEL SHOWING EQUATION IN CELL L32. ........................................................ 95 FIGURE 3-21: SPREADSHEET MODEL SHOWING EQUATION IN CELL K33........................................................ 96 FIGURE 3-22: SPREADSHEET MODEL AND EQUATION FOR TECHNOLOGY OPTION........................................... 98 FIGURE 3-23: NORMAL CURVE DISTRIBUTION P(CF) VS. CF ....................................................................... 102 FIGURE 4-1: KEY ACCOUNTING ORGANIZATIONS ....................................................................................... 106 FIGURE 4-2 THAT INCREASE OR DECREASE OWNER'S EQUITY .................................................................... 108 FIGURE 4-3: THE INCOME STATEMENT: AN OVERVIEW .............................................................................. 111 FIGURE 4-4: INCOME STATEMENT FOR ABC CORPORATION........................................................................ 112 FIGURE 4-5: COMPARING BALANCE SHEETS AND INCOME STATEMENTS.................................................... 113 FIGURE 4-6: THE BALANCE SHEET: AN OVERVIEW .................................................................................... 113 FIGURE 4-7: RELATIONSHIPS BETWEEN FINANCIAL STATEMENTS................................................................ 117 FIGURE 4-8: OVERVIEW OF A COMPUTERIZED ACCOUNTING SYSTEM......................................................... 133 FIGURE 4-9: TERMINOLOGY USED IN ACCOUNTING FOR PLANT ASSETS AND INTANGIBLES ....................... 122 Dessureault 1/11/2006
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FIGURE 4-10: UNDERSTATING NET INCOME BY EXPENSING A CAPITAL EXPENDITURE. ................................ 125 FIGURE 4-11: DATA FOR DEPRECIATION EXAMPLES. ................................................................................... 127 FIGURE 4-12: STRAIGHT-LINE DEPRECIATION SCHEDULE .......................................................................... 127 FIGURE 4-13: DOUBLE-DECLINING-BALANCE DEPRECIATION SCHEDULE .................................................. 128 FIGURE 4-14: CASH-FLOW ADVANTAGE OF ACCELERATED OVER STRAIGHT-LINE DEPRECIATION FOR TAX PURPOSES ........................................................................................................................................... 130 FIGURE 4-15: COMPARISON OF BUSINESS TYPES ........................................................................................ 136 FIGURE 4-16: VALUE CHAIN ....................................................................................................................... 136 FIGURE 6-1: THE MOTIVATION PROCESS .................................................................................................... 146 FIGURE 6-2: MASLOW'S HIERARCHY OF NEEDS .......................................................................................... 148 FIGURE 6-3: HERZBERG'S MOTIVATION-HYGIENE THEORY ........................................................................ 149 FIGURE 6-4: CONTRASTING VIEWS OF SATISFACTION-DISSATISFACTION ................................................... 150 FIGURE 6-5: GOAL SETTING THEORY .......................................................................................................... 152
List of Tables
TABLE 2-1: AGGREGATE PLANNING STRATEGIES. ........................................................................................ 14 TABLE 2-2: JIMBOB MINERALS ..................................................................................................................... 16 TABLE 2-3: LUISS QUARTZITE POWDERS CHASE STRATEGY........................................................................ 18 TABLE 4: PEAK DEMAND STRATEGY SIMONS STRATEGY ........................................................................... 20 TABLE 2-5: JIMBOBS QUARRY. .................................................................................................................... 23 TABLE 3-1: A) CAPACITIES B)DEMANDS .................................................................................................. 61 TABLE 3-2: SHIPPING COSTS ......................................................................................................................... 61 TABLE 3-3: ECONOMIC VARIABLES FOR PAYBACK EXAMPLE ....................................................................... 72 TABLE 3-4: PAYBACK EXAMPLE RESULTS .................................................................................................... 72 TABLE 3-5: PAYBACK EXAMPLE RESULTS USING DISCOUNT FACTOR ........................................................... 73 TABLE 3-6: DATA TO BE USED IN NPV EXAMPLE .......................................................................................... 75 TABLE 3-7: NPV EXAMPLE ........................................................................................................................... 75 TABLE 3-8: IRR EXAMPLE DATA ................................................................................................................... 76 TABLE 3-9: IRR EXAMPLE RESULTS .............................................................................................................. 76 TABLE 3-10: DATA FOR MINECOMP EXAMPLE .............................................................................................. 78 TABLE 3-11: RESTRICTIONS FOR MINECOMP EXAMPLE ................................................................................ 78 TABLE 3-12: GOALS FOR OPMC EXAMPLE ................................................................................................... 79 TABLE 3-13: IMPROVEMENT METHODS FOR OPMC EXAMPLE ..................................................................... 79 TABLE 3-14: WEIGHTED SCORES FOR UMC EXAMPLE ................................................................................. 81 TABLE 3-15: RESULTS OF WEIGHTED AVERAGE METHOD FOR UMC EXAMPLE ........................................... 82 TABLE 3-16: INTERPRETATION OF VALUES IN PAIRWISE COMPARISON MATRIX ........................................... 83 TABLE 3-17: OBJECTIVES AND SOLUTION OPTIONS FOR IOM EXAMPLE ........................................................ 84 TABLE 3-18:RANDOM INDICES FOR CONSISTENCY CHECK ........................................................................... 86 TABLE 3-19: BINOMIAL PRICE LATTICE FOR GOLD OVER A 10 YEAR PERIOD ................................................. 92 TABLE 3-20: VALUE OF GOLD PRODUCTION ($MILLION) USING GOLD PRICE FLUCTUATIONS AND MINE MODEL FOR BASE CASE ..................................................................................................................................... 93 TABLE 3-21: VALUE OF GOLD PRODUCTION ($MILLION) USING GOLD PRICE FLUCTUATIONS AND MINE MODEL FOR OPTION 1 ....................................................................................................................................... 93 TABLE 3-22: TABLE OF VALUES WHEN NOT EXERCISING THE OPTION TO SHUT DOWN. ................................. 97 TABLE 3-23: SENSITIVITY ANALYSIS ............................................................................................................ 97 TABLE 3-24: PRESENT VALUE OF GOLD PRODUCTION WITH DESIGN MODIFICATION ..................................... 99 TABLE 3-25: VARIABLES FOR THE BLACK-SCHOLES MINING EXAMPLE ...................................................... 100 TABLE 4-1: MANAGEMENT AND FINANCIAL ACCOUNTING COMPARED ...................................................... 135 TABLE 4-2: COMPARATIVE TABLE. ............................................................................................................. 137
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Module 1:
Introduction
The information necessary to pass this course will be presented in these notes and through other medium such as lectures and field trips. To guide the student to additional resources either out of interest or mandated by the course requirements, a list of additional resources are indicated after every major topic. The appearance of this list will be as seen below: ADDITIONAL RESROUCES [NUMBER] The above information is additionally supplemented by: Readings (Mandatory or Optional) Field trip (Always mandatory) Assignment (Always mandatory) Lecture
ADDITIONAL RESOURCES I
The information in the above notes is additionally complimented by: 409 Lecture Module 6 (mandatory)
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Module 2:
Operations Management 1 ,2
Management entails planning, leading, organizing, and controlling an organization's human and capital resources in order to accomplish its objectives. Operations management is the administration of processes that transform inputs of labor, capital, and materials into output bundles of products and services that are valued by customers. Figure 2-1 presents the traditional conception of operations management consistent with this definition.
Figure 2-1: Operations has traditionally been Responsible for Managing the "Transformation" Process
OM is about both manufacturing (of which mining is a form of) and services. Some of the ways that operations are used to add value include physical change, transportation, storage and distribution, inspection, exchange, information, and physiological change. Notice that some of the ways that value is added seem to fit manufacturing operations and some fit service operations. In most cases, customers require more than one of these forms of value, and they usually don't distinguish between them in their mind. They simply expect the value provider to bundle the required elements together in one package. Customers don't usually buy their service value and manufactured value from different sources. In other words, customers usually buy a product-service bundle. (discussion point: what services do mining companies produce for their stakeholders?) There are several varying opinions on exactly what fields or tools are within the scope of operations management. The evolution of this field is presented for interested readers in the appendices.
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Much of the text for this module is taken directly from - Hanna, Mark, and W. Rocky Newman, Integrated Operations Management. Prentice Hall activebook. (available on internet to university professors). It has been edited for content and relevance. Many of the slides in the lectures for this module were taken directly from Russel, Roberta S. and Bernard W. Taylor. Operations Management: Focusing on Quality and Competitiveness. New York: Prentice Hall. 3rd ed. 2000. (PowerPoint presentations available on internet to university professors). Some of the slides were modified for content and relevance. 1/11/2006
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The operations management segment of this course is separated into two modules, planning & control, and general management science. The planning and control module, focuses on the operations management theory and tools used for planning and controlling current mineral exploitation and large-scale earthmoving businesses. The operations management module discusses general management science tools that are used in businesses. Note that not all management science tools that are applicable, are presented, only the most applicable at this time. The purpose is to expose engineering students so that they can recognize and apply tools to facilitate or address industrial challenges that are available and can be applied. Figure 2-2 shows the project planning and control concepts and their relation to each other. Project planning and control is a complex and variable process that has several tools available. The project planning discussed here does not refer to the CAD design planning commonly associated with mine planning. Most mine planning involves the organization, budgeting, and scheduling of the actions needed to fulfill the CAD design. The functional tools used in the planning process is organized into several sub-sections: Aggregate Planning Forecasting Materials Requirement Planning & Inventory Just-in-time and theory of constraints Project management.
Figure 2-2: Project planning and control.
2.1 Aggregate Planning

The decisions we describe in this chapter set the stage for more detailed planning in every functional area. For example, cash flow projections in
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finance, sales projections in marketing, and hiring plans in human resources must all take into account the overall capacity plans of the firm. Intermediate term operational plans focus on ensuring that resources are in place to meet overall demand 6 to 18 months into the future. Aggregate planners have a very limited set of variables to use. They can change workforce size through hiring and layoff decisions. They can make plans to extend the hours contributed by each worker through such mechanisms as overtime. In some situations they can shift capacity to a later month by building inventory or shift demand to a later month by finding other sources. Finally, in some cases subcontracting can be used to expand capacity. Aggregate planners may pursue a variety of different strategies in their attempt to match resource availability to expected demand. This subsection describes strategies that (1) keep capacity stable at an average demand level, (2) match capacity to expected changes in demand, (3) ensure adequate capacity for peak demand periods, and (4) combine the other three strategies in some way. The strategy selected by an aggregate planner is generally a function of their business, process type, and competitive strategy. Numerous quantitative methods have been suggested and used by aggregate planners. This subsection describes methods that model manager decisions, optimizing methods, and the spreadsheet-based cut and try approach. While it might seem that managers would use techniques that provide an optimal solution, this is often not the case because of the uncertainty surrounding demand projections. In fact, the cut and try approach is the most used technique and, as such, we describe this approach in the greatest detail. Note that e-commerce and supply-chain management (SCM) practices have had a positive influence on the effectiveness of aggregate planning. In particular, SCM and e-commerce have created closer linkages and greater trust between an organization and its customers and suppliers. This information and trust can result in plans that are both more effective and more stable. Material on these more advanced topics can be provided upon request.
2.1.1 Integrating Operations Management with Other Functions

Intermediate-range plans, by their very nature, have to take into account the considerations of all functions, because the more detailed plans in each area have to fit within this plan. The cash flow projections and working capital plans prepared by financial managers must be consistent with the aggregate plan for operations. Accountants have to prepare pro forma statements, allocate costs, and value operating assets, such as inventories, in a way that is consistent with the intermediate-range plans of the firm. Human resource professionals must make necessary adjustments to workforce size and contracts based on the aggregate plan. Engineering changes applied to
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products (such as mine openings) and processes must be timed correctly and play a role in intermediate-range performance expectations. Finally, management information systems need to be capable of providing the same information to managers in all functional areas. When managers are all working with the same data and operational plans, their decisions are more likely to be consistent and they are more likely to accomplish the results they desire.
2.1.2 Planning for the Intermediate Term

Intermediate-range planners typically look 6 to 18 months forward; they plan in monthly increments and generally revise their plans each month based on intermediate-range forecasts. Some firms look further forward than others, depending on their time frame for decision making In the intermediate range, separate plans are made for groups of productservice bundles with similar value-delivery characteristics or marketing requirements. Resources are then allocated to product groups according to those plans. For example, the mining operations at INCO could plan in terms of the number of nickel pounds produced per month, rather than in terms of nickel foam units, nickel pellets, or nickel ingots. Because demand is considered in the aggregate, the intermediate-range planning task is often called aggregate planning. An aggregate plan indicates the ways in which existing resources will be used to meet expected levels of demand for product groups over the intermediate range. It sets target levels for the size of the workforce, the extent of subcontracting, the monthly production rate, and the level of inventory. These decisions must typically be made several months in advance. In contrast, short-term plans address day-to-day decisions with relatively short lead times. In this type of operations planning, time is divided into weekly or daily increments, and plans must continually be revised. The shortterm plan includes a master schedule, or detailed description of the productservice bundles scheduled to be completed over the near term. It also indicates how workers and equipment will be used, how the in-house creation of various parts of the product-service bundle will be coordinated, and how outsourced materials and services will be procured. Figure 2-3 summarizes the differences between short- and intermediate-range planning.
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Figure 2-3: Planning to Deliver the Product-Service Bundle
The firm's competitive priorities determine what is included in its intermediate- and short-range plans. Companies that emphasize customization of their product-service bundles must cope with a great deal of complexity and uncertainty in their planning (example: some aggregate companies). Every job is different; each goes through a different set of work centers, and geological requirements. For companies that emphasize lowcost delivery of a standardized product-service bundle, planning and control of operations is much simpler (most cases in metal mines delivering concentrate or ore). Because the product is standardized, the process is as well; the main task is to schedule operations at a flow rate that matches the level of demand. Due to the semi-construction nature of mining, and the complexities in fulfilling aggregate demands, both types would be experienced. Short-term plans must be closely monitored to ensure their feasibility. Managers may be tempted to make unrealistic commitments in order to please customers, but in most organizations, there is usually very little flexibility in short-term capacity. As a result, companies need to be effective in their short-term scheduling and very careful about the promises they make to customers regarding delivery dates. Regardless of the time frame, operations planning is based on a rolling planning horizon, which is a planning period whose beginning- and endpoints slide forward with the passage of time. At least once a year, the long-range plan will be updated, across both the product and process life cycle.
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Intermediate-range plans are updated more frequently than the long-range plan, often on a monthly basis. Companies must pay particular attention to their staffing plans over the intermediate term. If more skilled workers are needed and the labor market is particularly tight, the time horizon for the intermediate-range plan may need to be longer than a year. If labor is readily available, the intermediate-range plan might not extend so far forward. Production lead-times also affect the length of the intermediaterange plan. A mine can reliably predict workforce requirements several years ahead, because the sequence of mine stopes may be in production for several years. A mining consultant will not have the same luxury, however. Once projects have been completed or contracted, consulting companies must respond rapidly to staffing needs. Short-range plans are updated on an ongoing basis, daily or weekly. If the cumulative lead-time required to provide the product-service bundle is six weeks, schedules will need to be revised at least once a week, looking at least six weeks forward. In that case, planners will usually create a tentative schedule that looks forward more than six weeks (say, 10 to 20 weeks), so that the company will be prepared for an unusually busy or slow period. Since the short-range, intermediate-range, and long-range plans all pertain to the same set of resources, they must fit together. A small change in the long-range plan, such as the decision to delay an expansion, could produce very different scenarios over the short and intermediate range. Similarly, a decision by intermediate-range planners to limit the use of overtime could cause significant capacity shortages and reduce flexibility over the short run. Finally, short-range decisions can affect the intermediate- and long-range plans. For instance, week-to-week scheduling that produces a continually growing backlog may lead to heavier use of subcontracting over the intermediate range or even to a decision to expand capacity. Different types of processes produce vastly different levels of complexity in short-term scheduling. From a planning standpoint, job shops and batch processes that produce customized product-service bundles are a highly complex environment. A mining environment can be considered a job shop in some respects as it is a construction environment. In contrast, planning and control for a continuous or repetitive process such as mucking a stope quite simple. All the inputs and outputs are standardized, so the only real question planners must answer is, how fast should we run the process? For high-volume processes that create standardized product-service bundles, deterministic approaches to planning and control are most useful. In these environments, the schedule is "hardwired" into the process, so that it represents a firm commitment to a rate of production. The planner's task is simply to specify the rate of production for each product-service bundle. Then, on the basis of the resulting schedule, suppliers will provide parts, supervisors will prepare work and overtime schedules, and the sales force
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will sell product-service bundles. This type of production environment is easy to model and schedule. Whenever a group of jobs must compete for limited resources, however, the planning environment becomes complicated. Highly complex environments like the job shop, where many different product-service bundles are produced and value is added in a variety of ways, cannot be modeled in a deterministic way. In these environments, probabilistic approaches to planning are more useful. Planners first estimate processing times, waiting times, transfer times, and the probability of breakdowns. They then make planning and control decisions based on expected processing times and lot sizes. But while managers can indicate when they expect a job to be completed, delays can occur for many reasons. When the value-adding steps are executed, they may take more or less time than expected. The schedule is therefore more a guideline than a binding commitment, and time buffers are built into most job completion estimates. Figure 2-2 illustrates the relationships between intermediate- and shortrange planning and control in various environments that we have just discussed and helps you to understand how the subsections that follow relate to the material we will cover in this subsection.
2.1.3 Aggregate Planning Variables

Aggregate planning, or the development of a month-by-month intermediaterange schedule for families of product-service bundles, is based on an intermediate-term demand forecast. To understand aggregate planning, then, one must first have at least a basic understanding of the forecasting process. (Forecasting methods are covered in more detail the next section.) To begin with, because demand follows patterns, future demand is predictable, or "forecastable." However, the precision with which future demand can be predicted decreases the farther into the future one attempts to look. Depending on the planning system a business uses, this characteristic of forecasting may be more or less significant. Some companies use make-toorder planning (MTO) and control systems; others, make-to-stock (MTS) or assemble-to-order systems. In a make-to-stock system, the entire schedule is based on forecasted demand figures (mining businesses). In contrast, in make-to-order systems, managers have purchase orders in hand when they are planning, so they know the demand for products and services at least as far forward as their processing lead-times (mineral-aggregate businesses). Looking several months forward, however, their forecasts may be based primarily on predicted orders. Assemble-to-order systems are a combination of the make-to-stock and make-to-order approaches: Production of customer orders are scheduled using components and subassemblies that have been made to stock.
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Fortunately, the precision of a forecast can be estimated. Thus, an aggregate plan can be based on expected demand, best-case scenarios, and worst-case scenarios. As more information becomes available, forecasts should be updated. The aggregate plan is effectively based on a moving target. Typically, in the intermediate time frame, no new facilities can be built, no old facilities can be shut down, and no productivity improvement programs can have their full effect. These kinds of structural changes simply take too long to plan and implement. For example, several years would be required to exploit a new orezone within a mine, and the lead-time from identification to construction of new mine is several years. Though the firm's structure is fixed in the intermediate term, the demand for each family of product-service bundles is likely to vary from month to month. Aggregate planners must therefore determine how to vary monthly volumes in order to meet demand in the most effective way. The set of planning variables available to the aggregate planner is quite limited: It includes only the inventory account, the monthly production rate, the size of the workforce, and the extent of subcontracting. Of course, not all these variables are equally available to all businesses. In capital-intensive processes such as mining, production rates and workforce requirements are largely fixed. The inventory account, if there is one, may be positive or negative. A positive inventory account indicates that the plan is to have materials on hand. A negative inventory account indicates a planned production backlog, or a deliberate amount of unmet demand. The planned level of the inventory account can be changed by producing more or less in any given month than the forecasted level of demand. This goal may be accomplished in several ways. The planned monthly production rate can be changed by varying the number of overtime hours worked in a month. The planned size of the workforce can be changed by hiring or laying off workers. For instance, to meet demand during a holiday rush, retailers often hire temps to staff their stores and catalog operations. Finally, subcontracting plans can be changed, within certain limitations and for a limited time. To the aggregate planner, each of these variables has a cost. No checks are actually written to cover the cost estimates associated with an aggregate plan; rather, the figures are used to compare the opportunity cost of meeting demand through various approaches. The cost of carrying inventory, for instance, is much higher than the investment income lost on money tied up in warehoused goods. It includes items such as the rental fee for warehouse space, the administrative expense associated with monitoring and tracking the extra inventory, potential loss from damage to goods in storage or transit, tax and insurance costs, and the risk that the warehoused materials will become obsolete while they are in storage. By comparison, the cost of a planned backlog includes sales lost due to delays in customer service, the
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administrative expense associated with keeping track of unfilled orders, and the cost of maintaining the systems that respond to customer inquiries about orders (more about inventory in another section). Changing the production rate by adding extra overtime typically inflates the hourly cost of labor at least 50 percent. Hiring or laying off workers obviously requires a significant amount of administrative time and record keeping. New workers must be trained and oriented; laid-off workers usually receive some severance pay or outplacement services or both. Finally, subcontracting requires extra administrative effort and may erode profit margins or the quality of customer service. Ultimately, the aggregate planner's goal is to meet customer requirements, based on some forecasted demand pattern, through whatever mix of inventory, overtime, workforce size, and subcontracting minimizes the firm's costs. An alternative goal, particularly when the service component of the product-service bundle is significant, might be to ensure sufficient capacity to meet the expected peak level of demand. For example, the aggregate plan for a consulting company should ensure that enough engineers are on contract to handle the highest expected level of monthly demand. In operations in which service is not a significant part of the product-service bundlesuch as a mine that makes a specified productmaintaining a level workforce might be important. In those cases, inventory might be varied in order to level production.
2.1.4 General Aggregate Planning Strategies

Aggregate planners may employ several strategies to meet expected customer demand. For instance, in a level production strategy (where demand is met by altering only the inventory account), demand is met by altering only the inventory account. In a chase demand strategy (where demand is met by matching planned monthly production with forecasted demand, while the inventory account is held constant), demand is met by matching planned monthly production with forecasted demand, while the inventory account is held constant. In a peak demand strategy (where capacity is varied to meet the highest level of demand at particular times), particularly useful in service settings, capacity is varied to meet the highest level of demand at particular times. Planners can also combine aspects of these approaches. The strategy that planners select should depend on the company's competitive priorities and the ways in which its product-service bundles add value for customers. Table 2-1 summarizes four aggregate planning strategies discussed in detail in the following pages.
Table 2-1: Aggregate Planning Strategies.
Strategy
Peak
Variables Used
Undertime or Excess
Compatible Competitive Priorities

Delivery Speed
Environments Where Most Common

Emergency Services
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MGE 409 Management Operations Technology Demand Strategy Level Production Strategy Capacity Subcontracting Inventory/Backlog Conformance Quality Flexibility Low Cost Design Quality Delivery Speed Chase Demand Strategy Workforce Size Overtime/Undertime Subcontracting Flexibility Design Quality Delivery Speed Mixed Strategies Inventory/Backlog Workforce size Overtime/Undertime Subcontracting Excess Capacity* any
2006 Easily Obtainable Substitutes Cost of Back Orders High Repetitive Manufacturing Continuous Processes Highly Skilled Professionals Cost of Capacity Changes High Pure Service Job Shops Batch Manufacturing Cost of Inventory High Somewhat balance cost tradeoffs
2.1.4.1 The Level Production Strategy In the level production strategy, changes in the inventory account are used to balance mismatches between monthly demand and output. Workforce size, production rates, and subcontracting are held constant. This strategy boosts worker morale, because it eliminates the disruptions in employment associated with changing production rates. From the employer's viewpoint, it also eliminates the cost and paperwork associated with the hiring and laying off of workers, while providing a low-cost, high-quality production system. But other benefits are lost in a level production strategy, including flexibility, the ability to provide a high level of customization, and the ability to always satisfy all a customer's requirements. The level production strategy is especially desirable in businesses that can afford to hold inventory or carry backlogs. Capital-intensive businesses, such as mining and other basic materials producers, are often forced by the nature of their processes to use this strategy. The strategy is also compatible with make-to-stock planning and control systems. However, many service businesses cannot employ a level production strategy, because most of the value they add cannot be held in inventory or back ordered. Table 11.2 shows an aggregate plan for Jimbobs quarry. The upper left hand corner of the spreadsheet displays a group of fixed production parameters, including the desired safety stock, the production rate in units per worker hour, the number of regular time (RT) hours in a month, the normal wage per hour, and other costs. The main portion of the spreadsheet shows the
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level production plan and the costs associated with it. At the beginning of May, Jimbob expects to have 12,000 units in inventory (column 1). Beginning inventory in other months will depend on production and usage after this starting point. The expected demand column (column 2) shows the demand forecasts for quarry products.
Safety stock desired Units/worker hour RT hours/month RT wage/hour OT wage/hour Subcontract cost/unit Hiring cost/worker Layoff cost/worker Inventory cost/unit/month Back ordering cost/unit/month 12000 20 160 $12 $18 $2.50 $500.00 $1,500.00 0 $0.05 Total Cost = $364,125.00
Table 2-2: Jimbob Minerals
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) ExBeginpectning ed InvenDetory mand ProSubWorkInCumuEndducconer Work- Reg. Over- House CumuHir- Laylative ing tion tracting off Hires force Time time Prolative ProducInvenReed (lay- Size Hours Hours ducCost Cost Demand tory quirProduc- tion offs) tion ed tion 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 10 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 1,600 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 32,000 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 44,000 76,000 109,000 28,500 57,000 85,500 15,500 19,000 22,500 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
Month
May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. March April May June July August October
12,000 28,500 28,500 15,500 28,500 25,000 19,000 28,500 21,500 22,500 33,000 22,500 21,500 33,000 23,500 20,500 33,000 24,500 19,500 33,000 25,500 15,800 38,000 31,500 12,500 32,000 31,500 12,500 28,500 28,000 16,000 28,500 24,500 19,500 28,500 21,000 23,000 30,000 19,000 25,000 30,000 17,000 27,000 30,000 15,000 29,000 35,000 18,000 23,000 35,000 24,000
140,000 118,500 21,500 172,000 151,500 20,500 204,000 184,500 19,500 236,000 217,500 18,500 268,000 255,500 12,500 300,000 287,500 12,500 332,000 316,000 16,000 364,000 344,500 19,500 396,000 373,000 23,000 428,000 403,000 25,000 460,000 433,000 27,000 492,000 463,000 29,000 524,000 498,000 26,000 556,000 533,000 23,000 588,000 568,000 20,000
September 26,000 35,000 21,000
Jimbobs quarry has 10 workers at the beginning of May (column 5); the size of the workforce in any given month will depend on the amount of firing and hiring that occurs after this point. The number of regular time hours in the 16
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month (column 6) is a function of the workforce size. The assumption is that each worker works and is paid for all the regular time hours in the month. Overtime and subcontracted hours (columns 7 and 9) are numeric values plugged in by the aggregate planner. Monthly in-house production is simply a function of the production rate (units per worker hour) and the number of regular time and overtime labor hours in the month. Ending inventory (column 12) is equal to cumulative production minus cumulative demand (column 11). Notice that monthly production stays the same, while the inventory account (whether beginning or ending) changes from month to month. Costs are a direct function of the aggregate plan. Thus, the last seven columns in Table 11.2 relate directly to the cost parameters in the upper left-hand corner. It is sometimes useful to graph cumulative production and cumulative demand. Figure 2-4 illustrates the mismatches between the rate of production and the rate of demand in a level production strategy. By studying this type of graph, aggregate planners may be able to improve their monthly plans.
Figure 2-4: Jimbobs Minerals Level Production
2.1.4.2 The Chase Demand Strategy In the chase demand strategy, changes in the use of overtime and the size of the workforce are used to adjust monthly output to match changes in forecasted demand. Inventory levels are held constant. This strategy is suitable for both manufacturing and service operations in which holding inventory or keeping a backlog is costly or impossible. It is particularly appropriate in operations that produce highly customized product-service
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bundles, as well as in make-to-order environments in general, which is somewhat common in industrial minerals production.
Figure 2-5: Chase Demand Strategy. Table 2-3 shows an aggregate plan for Luis's Quartzite powders. This spreadsheet was generated using the same set of formulas as that used in Table 2-2; however, in this plan, the goal was to match monthly production with monthly demand. Notice that the inventory account does not change from month to month, but the size of the workforce and the amount of overtime vary, depending on forecasted demand. Consider the labor pool saturated with temporary equipment operators therefore hiring operators on a temporary basis does not impact on safety or morale. Figure 2-5 shows the close relationship between cumulative production and cumulative demand in a chase demand strategy.
Safety stock desired Units/worker hour RT hours/month RT wage/hour OT wage/hour Subcontract cost/hour Hiring cost/worker Layoff cost/worker Inventory cost/unit/month Back ordering cost/unit/month Maximum overtime/month 0 0.1 160 $18 $27 $30.00 $500.00 $1,500.00 $20.00 $4.00 100 hours Total Cost = $193,620.00
Table 2-3: Luiss Quartzite powders Chase Strategy.
Month BeExWork- Work- Reg. Ove Sub- Total CumuCumuEndHirLay-
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gin- pecter ning ed De- Hires In- mand (layvenoffs) tory May June July August September October November December January February March April May June July August September October 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 75 56 48 40 40 35 45 100 80 40 30 40 35 40 50 40 40 40 0 (1) 0 (1) 0 0 0 4 (1) (3) (1) 1 0 0 1 (1) 0 0
force Time time con- ProSize Hours Hours tract- duced tion Hours 4 3 3 2 2 2 2 6 5 2 1 2 2 2 3 2 2 2 640 480 480 320 320 320 320 960 800 320 160 320 320 320 480 320 320 320 100 80 0 80 80 30 100 40 0 80 100 80 30 80 20 80 80 80 10 0 0 0 0 0 30 0 0 0 40 0 0 0 0 0 0 0 75 56 48 40 40 35 45 100 80 40 30 40 35 40 50 40 40 40
lative Production 103 159 207 247 287 322 367 467 547 587 617 657 692 732 782 822 862 902
lative ing Demand Inventory 75 131 179 219 259 294 339 439 519 559 589 629 664 704 754 794 834 874 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28 28
ing Cost
off Cost
0 0 0 0 0 0 0 $2,000 0 0 0 $500 0 0 $500 0 0 0
0 $1,500 0 $1,500 0 0 0 0 $1,500 $4,500 $1,500 0 0 0 0 $1,500 0 0
$3,000 $12,000
2.1.4.3 The Peak Demand Strategy In the peak demand strategy, changes in overtime and in the size of the workforce are used to match monthly capacity to the anticipated maximum monthly demand. This strategy is generally used in service operations in which the immediate availability of customized service is critical. The Simons Engineering Consulting group may receive a contract from important mineral producers. The labor pool is very tight as ever fewer mining engineering are available. Because these types of service cannot be inventoried, the peak demand strategy may be thought of as a special case of the chase demand strategy. (If there is no inventory, then obviously there can be no variation in inventory.) The peak demand strategy is particularly appropriate in operations in which the product-service bundle is highly customized.
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Figure 2-6: Simons Engineering Consulting group peak demand strategy.
Table 4 shows an aggregate plan for Cheryl's emergency room; along with Figure 2-6, it illustrates the chase demand strategy. Notice that there is no inventory at any time. (How could emergency health services be inventoried?) Apart from the absence of inventory, however, the arithmetic in this spreadsheet is identical to that in Table 2-2 and Table 2-3 spreadsheets. While the inventory account doesn't change, the size of the workforce and the amount of overtime vary from month to month, depending on forecasted demand. In months in which the size of the workforce is more than adequate to meet demand, the consulting company simply carries extra capacityjust in case it is needed.
Peak Demand Strategy Design components / engineer Hours/month for staff engineers Engineering in office wage/hour Engineer call fee (OT pay) Hiring cost/engineer Layoff cost/ engineer Current staffing level (engineers) 3 168 $200.00 $100.00 $2,500.00 $2,500.00 10 Total Cost = $4,947,280.00
Table 4: Peak Demand Strategy Simons Strategy
Expected Design Load 5,000 5,200 6,000 Eng. Hires Staff (lay- Size offs) 0 0 1 10 10 11 Staff OncovCall ered desiDesing ng Load units 5,040 5,040 5,544 0 160 456 Cumulative desiNg coverd 5,040 10,240 16,240 Cumulative expected load 5,000 10,200 16,200 Hiring Cost 0 0 $ 2,500 Layoff Cost 0 0 0 OnCall Cost 0 $16,000 $45,600
Month
Staffed Hours
May June July
1,680 1,680 1,848
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August September October November December January February March April May June July August September October
5,500 5,000 4,000 3,500 5,000 5,000 3,000 3,000 4,000 5,000 5,200 6,500 5,600 5,100 4,000
0 0 (3) (1) 3 0 (4) 0 2 2 0 3 (2) (1) (2)
11 11 8 7 10 10 6 6 8 10 10 13 11 10 8
1,848 1,848 1,344 1,176 1,680 1,680 1,009 1,009 1,344 1,680 1,680 2,184 1,848 1,680 1,344
5,544 5,544 4,032 3,528 5,040 5,040 3,024 3,024 4,032 5,040 5,040 6,552 5,544 5,040 4,032
0 0 0 0 0 0 0 0 0 0 160 0 56 60 0
21,784 27,328 31,360 34,888 39,928 44,968 47,992 51,016 55,048 60,098 65,288 71,840 77,440 82,540 86,572
21,700 26,700 30,700 34,200 39,200 44,200 47,200 50,200 54,200 59,200 64,400 70,900 76,500 81,600 85,600
0 0 0 0 $ 7,500 0 0 0 $ 5,000 $ 5,000 0 $ 7,500 0 0 0 $27,500
0 0 $ 7,500 $ 2,500 0 0 $10,000 0 0 0 0 0 $ 5,000 $ 2,500 $ 5,000 $32,500
0 0 0 0 0 0 0 0 0 0 $16,000 0 $ 5,600 $ 6,000 0 $89,200
2.1.4.4 Mixed Strategies In mixed strategies, changes in subcontracting, the production rate, and the size of both inventory and the workforce are used to adjust monthly output. By manipulating all these variables, planners can often significantly reduce costs, minimize the disruption of operations, enhance customer service, or otherwise improve on an aggregate plan based on a pure strategy. For example, the hiring costs associated with a chase demand strategy might be significantly reduced by holding a small quantity of inventory for a month or two. Or the well-timed use of temporary personnel could offset a significant amount of the inventory holding cost or back-ordering cost associated with a level production plan, with no reduction in quality or customer service. Mixed strategies may be used in both manufacturing and service operations in which some form of inventory (perhaps only partially complete) can be held. Table 2-5 shows a revised aggregate plan for Jimbobs Quarry. Note that the level production strategy shown in Table 2-2 has been adapted by allowing some variation in hiring, layoffs, and overtime. This plan is not based on a chase demand strategy, because the inventory levels vary. A similar mixed strategy could be used in Luis's quartzite powders, if inventory could be built up in periods preceding an anticipated surge in demand. (Even though Luis doesn't make Quartzite powder in high volumes, partially extracted quartzite could be inventoried for later processing. For example, overburden could be stripped and blastholes drilled.) In periods following a surge in demand, the backlog could be worked off. As was mentioned earlier, a graph of cumulative demand versus cumulative production can be very helpful in determining how to improve an aggregate plan; that is certainly the case with a mixed strategy (see Table 2-5). The distance between the two curves shows the size of the inventory or production backlog. If the graph for a level production plan shows that the inventory (or backlog) is growing rapidly, then clearly layoffs (or hiring) are
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likely. Similarly, a rapid change in the slope of the curve for a chase demand plan indicates a period in which inventory might be used to significantly reduce costs. Inventory is selectively used to level out significant changes in the slope of the cumulative production line.
Figure 2-7: Jimbobs quarry Mixed Strategy
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Table 2-5: Jimbobs Quarry.

Worker Hires (layoffs) -1 0 0 1 0 0 0 0 0 -1 0 0 0 0 0 2 0 0 InHouse Production 28,800 28,800 28,800 32,100 33,000 33,000 33,000 38,000 32,000 28,800 28,800 28,800 29,100 30,000 30,000 35,200 35,200 35,200 Subcontracted Production 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 Cumulative Production 40,800 69,600 98,400 130,500 163,500 196,500 229,500 267,500 299,500 328,300 357,100 385,900 415,000 445,000 475,000 510,200 545,400 580,600 Cumulative Demand 28,500 57,000 85,500 118,500 151,500 184,500 217,500 255,500 287,500 316,000 344,500 373,000 403,000 433,000 463,000 498,000 533,000 568,000 Ending Inventory 12,300 12,600 12,900 12,000 12,000 12,000 12,000 12,000 12,000 12,300 12,600 12,900 12,000 12,000 12,000 12,200 12,400 12,600 Subcontracting Cost 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
Workforce Size
Reg. Time Hours
Overtime Hours
Hiring Cost
Layoff Cost
Inventory Cost
Backlog Cost
Reg. Time Cost
Overtime Cost
9 9 9 10 10 10 10 10 10 9 9 9 9 9 9 11 11 11
1,440 1,440 1,440 1,600 1,600 1,600 1,600 1,600 1,600 1,440 1,440 1,440 1,440 1,440 1,440 1,760 1,760 1,760
0 0 0 5 50 50 50 300 0 0 0 0 15 60 60 0 0 0
0 0 0 $500 0 0 0 0 0 0 0 0 0 0 0 $1,000 0 0 $1,500
$1,500 0 0 0 0 0 0 0 0 $1,500 0 0 0 0 0 0 0 0 $3,000
$615 $630 $645 $600 $600 $600 $600 $600 $600 $615 $630 $645 $600 $600 $600 $610 $620 $630 $11,040
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
$17,280 $17,280 $17,280 $19,200 $19,200 $19,200 $19,200 $19,200 $19,200 $17,280 $17,280 $17,280 $17,280 $17,280 $17,280 $21,120 $21,120 $21,120 $334,090
0 0 0 $90 $900 $900 $900 $5,400 0 0 0 0 $270 $1,090 $1,090 0 0 0 $10,620
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2.1.5 Aggregate Planning Methods

2.1.5.1 Optimizing Methods Optimizing methods are used to minimize the cost of an aggregate plan. There are several optimizing methods, including the linear decision rule, the search decision rule, and various forms of linear programming. In linear decision rule (LDR) models, the costs of the aggregate plan are represented in the form of quadratic equations, and differential calculus is used to find the lowest-cost plan. In search decision rule (SDR) models, a mathematical search process is used to find the best plan among thousands of possible alternatives. In linear programming (LP) models, algebra is used to build and optimize mathematical models of the aggregate planning problem. While they may sound impressive, these optimizing methods are optimizing only to the extent that they fit the real situation. Since the aggregate plan is based on relatively imprecise forecasts and is updated regularly, many managers question the practical value of so-called optimal plans. 2.1.5.2 Methods that Model Manager Decisions The management coefficients method (MCM) is another technique used in aggregate planning. In this method, the assumption is made that past managerial decisions have been good, and multiple regression is used to develop a model of those decisions. The regression weights, called management coefficients, can then be used as a basis for future decisions or for an evaluation of the consistency with which managers pursue a given aggregate planning strategy. Like the optimizing methods, however, MCM is complicated and difficult to use. 2.1.5.3 The Cut and Try Method How do managers actually come up with their aggregate plans? Most often, seasoned managers rely on experience to develop a trial plan and then adapt that plan by tinkering. The tinkering involves using spreadsheets such as those that are shown in the sub-section above describing aggregate planning strategies. By considering alternative plans, managers can evaluate the cost implications of their decisions to hire, layoff workers, use overtime, build inventory for demand in later months, and so on. In addition, they can compare alternative plans under a variety of demand scenariossuch as unexpected declines and sudden increases in demand. By doing so, they are likely to develop a plan that performs well in many situations and is acceptable in a worst-case scenario. This approach is called the cut and try method. The cut and try method doesn't sound scientific, but for many reasons it is a very workable approach. Its primary strength is its reliance on years of managerial experience in planning and running operations. In most cases,
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managers have seen a similar forecasted demand pattern before. No amount of technical sophistication can replace the insights they have gained through experience with that demand pattern. Furthermore, the aggregate plan is based on a forecast, and forecasts are always uncertain. Managers are not likely to invest the time and energy required to optimize a plan that is based on uncertain numbers. Given the level of uncertainty most businesses face as they look forward 6 to 18 months, a plan that performs well in many situations and has an acceptable worst-case outcome may be better than a plan that minimizes costs based on the assumption that demand forecasts are correct. What is more, the aggregate plan is typically updated on a monthly basis. Forecasts will change as more information becomes available; inventory levels will change based on actual events; personnel decisions will change the composition of the workforce. Because of the dynamic nature of the value-adding system, managers recognize the necessity of taking an adaptive approach to aggregate planning. They are not overly concerned with developing an optimal plan based on the data available at a given time. Finally, an "optimal" solution often has a narrow focus that renders it problematic. For example, most optimizing methods attempt to minimize the costs associated with an aggregate plan. Sometimes that requires a lot of hiring and firingclearly not an ideal plan from the standpoint of worker morale. Minimizing the costs of an aggregate plan may also reduce the company's ability to respond effectively to customer expectations based on competitive priorities such as quality and flexibility.
ADDITIONAL RESOURCES II
The information in the above notes is additionally complimented by: Lecture Module 2.1 Aggregate Planning Readings selections from Chapter 11 of: Shaffer, Scott M and Jack R. Meredith. Operations Management: A process approach with spreadsheets. New York: John Wiley & Sons. 1998. (optional but advised as it helps with assignment 2) Assignment 2.
2.2 Forecasting
An important consideration in any decision-making situation, regardless of whether it is for the long-intermediate-or short-term, is the determination of the conditions under which the decision is to be made. When the relevant conditions are in the future, as is generally the case, this means forecasting. Since forecasts tend to be close, rather than exactly right, we need to consider not only what the forecast is, but also some estimate of how far off it is likely to be.
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2.2.1 Choosing a Forecasting Method

The first, and possibly most important point, is that no forecasting system will be best, or even good, for all possible situations. Choosing an appropriate forecasting method involves matching the characteristics, strengths, and weaknesses of the situation with those of the method. When considering the situational characteristics, the most important is what is being forecasted. Are we interested in the value of a variable at some point in time; in the time at which a series will change direction; or in the time when some event of particular interest (for example, the next generation of some technology) might occur? Besides this overriding consideration, the other situational characteristics usually considered important include: 1. The time horizon for the forecast, divided generally into short-term (up to about three months), intermediate-term (from three months to two years), or long-term (over two years). These time divisions are somewhat arbitrary and may vary considerably from industry to industry. 2. The level of detail, or how much aggregation there will be. For example, are we talking about a product, a product line, a company's division, or the entire company? 3. The number of items. If we are developing forecasts for thousands of items on a monthly basis, we will probably want a simpler technique than if we are forecasting the demand for only one or two items once or twice a year. 4. The stability of the situation. If we can assume basic patterns that held in the past will continue to hold in the future, we can use a different approach than if we are attempting to deal with a great deal of change.
2.2.2 Forecasting Model Types

We can categorize forecasting models in two general ways: quantitative versus qualitative time series versus causal Quantitative models use one or more equations to turn a set of numerical or categorical inputs into a forecast of a value or set of values for one or more variables. Qualitative models are subjective. They are based on the subjective assessments of individuals, working separately or in groups, rather than on formal equations. Probably the best-known of the qualitative methods is the Delphi technique (approach to generating forecasts from expert opinion in which the forecaster uses a series of surveys to develop a consensus on a subject). Given the amount of time and the cost required to use the Delphi technique, it is most often used for long-range decisions with significant implications for capital expenditures or the organization's future direction. At the other extreme, a qualitative method sometimes used for annual demand forecasting is the grass-roots method, in which individual salespeople
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estimate next year's sales for their territories and the results are added up (with or without adjustment for perceived bias) to get sales for the district, the region, and the company. Time series models are based on extrapolating the historical pattern for the variable of interest into the future. The model's inputs may include all or selected past values of the variable and, possibly, the forecast errors for all or selected past periods. Time series models are most often used for short time frames; they will be our primary focus. Causal models estimate the value of the variable of interest, called the dependent variable, on the basis of a second set of variables, called the independent variables, that are believed to determine the value of the dependent variable. For example, a quarry can do a very good (but not perfect) job of forecasting its potential sales by looking at the number of major construction projects that are in the bidding process. (Why might this approach not give a perfect forecast?) Two popular modeling techniques for causal models are regression and simulation.
2.2.3 Time Series Components

A time series is a time-ordered series of values of some variable. Examples are the monthly, quarterly, or yearly sales of a product. The variable's value in any specific time period is a function of four factors: (1) trend, (2) cyclic effects, (3) seasonality, and (4) randomness. 2.2.3.1 Trend Trend refers to a general pattern of change over time. A few of the many possible basic trend patterns are shown in Figure 2-8. The most basic pattern is level or horizontal, shown in Figure 2-8a. This pattern implies that there is no basic change expected over time. Figure 2-8b and c show increasing and decreasing linear trends. A linear trend implies a constant amount of change from one period to the next. Figure 2-8f is an S-shaped growth curve. Typical of the cumulative demand for a product over its lifetime, it shows a pattern of slow growth, followed by a period of rapid growth, and, finally, slow growth again as the product nears the end of its life cycle (this is also often the shape of a learning curves).
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Figure 2-8: Trend Patterns
2.2.3.2 Cyclic Effects Cyclic effects arise from changes in the economy as it moves through the phases of growth and decline in the business cycle, a process that generally takes several years. For any particular item, cyclic effects may be very important or not important at all, depending on whether the item is or is not influenced by the phases of the business cycle. Incorporating cyclic effects into a forecasting model is extremely difficult because it requires the ability to forecast the timing of the turns in the business cycle and the rates of growth and decline between those turns. Experience has shown that doing so is extremely difficult, if not impossible, in spite of the enormous amounts of money that have been spent on the development of macroeconomic forecasting models. For this reason, cyclic effects are often ignored, at least in those models that forecast only a few months or quarters ahead. 2.2.3.3 Seasonality Seasonality refers to any regular pattern recurring within a time period of no more than one year. Seasonality effects are often related to the seasons of the year (hence the name), as, for example, the increase in demand for construction aggregates or coal (for the increased use of air conditioners) in summer and potash/salt in winter (used to melt ice on roads). Regardless of the nature or cause of the pattern, its recognition can make a forecasting model considerably more accurate. 2.2.3.4 Randomness Randomness refers to all other factors that cause the actual observed value of a variable to differ from that predicted by the trend, cyclic, and seasonal effects.
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2.2.4 Short-Term Forecasting

When there is no trend in a time series, a naive (but sometimes useful) short-term forecasting approach is to assume that the value of the variable will be the same next period as it is this period. Of course, this approach ignores the effect of seasonality, if it is relevant, but it also causes the forecasts to jump around from period to period in response to the randomness. One way to compensate for this jumpiness in the forecasts is to use averaging. Two popular time series models for averaging when there is no seasonality are the simple moving average (SMA - forecasts the value for the next period simply by estimating the height or level of the horizontal line around which the actual values are randomly scattered) and simple exponential smoothing (SES - A popular item series model for averaging when there is no seasonality by forecasting the value for next period simply by estimating the height of the horizontal line around which the actual values are randomly scattered). Both forecast the value for next period simply by estimating the height or level of the horizontal line around which the actual values are randomly scattered. 2.2.4.1 Simple Moving Average If we could assume that the height of the line around which the actual values are randomly scattered has always been the same, then the simplest way to estimate it and forecast the value for the next period would be to average all past values of the variable. Since we cannot always make this assumption, a reasonable compromise is to use the average of the last few periods. This approach is called the simple moving average model. Letting Ft be the forecast for period t and Yt be the actual value, the n-period SMA forecast for period t+1 is:
Example 2-1: SMA Luis's quartz powders
The demand for a particular grade of quartz at Luis's quartz powders has been fairly stable. The actual numbers of chairs ordered for the past 18 months are given in Figure 2-9. A comparison of the two equations in this example shows why this model is called a simple moving average. As the period to be forecasted moves up by one, the periods for which the actual values are averaged also move up by one; the oldest data value is dropped and replaced by the new one.
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This simple model is easy to automate with a spreadsheet, either by building the equation into the sheet directly or by using the spreadsheet's built-in procedure. Figure 2-9 also shows the results of applying the moving average procedure from data analysis in Excel. Notice that there are no forecasts for the first six months, since we can't get an average until we have six months of data. Also notice that, because of the averaging, the line for the forecast does not bounce around as much as the line for the actual data. If we used more periods in the average, the forecast line would fluctuate even less.
2.2.4.2 Simple Exponential Smoothing
While the simple moving average forecast is easy to compute and the concept is easy to understand, it has two possible drawbacks: (1) it treats all values used equally, regardless of their age, and 2) it requires a fair amount of storage (although this drawback becomes less of a problem as computer storage gets cheaper). An alternative to the SMA model is simple exponential smoothing (SES), which differs from SMA in three important respects: The model implicitly uses the entire past history of the time series, not just the most recent periods. The weights assigned to the values decrease with the age of the data, rather than being 1/n for each. Less storage is required: Only the value of the smoothing constant ( in the equations to follow) and the most recent forecast are needed. There are two alternative, but equivalent, forms of the SES model. The first, Ft+1 = Yt + (1- )Ft, says that the new forecast is simply a weighted average of the most recent actual value, Yt, and the old forecast, Ft. The smoothing constant, , is a number between 0 and 1. A value close to 0 produces a lot of smoothing (similar to a large value for n in an SMA model), while a value close to 1 yields a forecast that responds quickly to changes in the data pattern. By doing a little algebra on the equation above, we get the second form of the equation: Ft+1 = Ft + (Yt Ft). This equation shows that the new forecast is simply the old forecast corrected by a percentage of the amount by which that forecast was in error (Yt Ft). Just as the n-period SMA model could not produce a forecast before period n+1, so the SES model cannot give a forecast for period 1 unless, for some reason, there are values for F0 and Y0. Common practice, then, is to let F1 = Y1 and start the forecasts with t = 2.
Example 2-2: SES Luis's quartz powders
From Find the SES forecasts for months 2 and 3. Use
= .3.
Solution: Letting F1 = Y1 = 122 (from Figure 2-9), the SES forecast for quartz in period 2 with = .3 is:
F2 = Y1 + (1 )F1 = (.3)(122) + (.7)(122) = 122
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The forecast for period 3 is: F3 = Y2 + (1 )F2 = (.3)(90) + (.7)(122) = 112.4 As with the SMA model, the simple form of the SES model is easy to automate with a spreadsheet, either by building the equation into the sheet directly or by using the spreadsheet's built-in procedure. Figure 2-9shows the results of applying the exponential smoothing procedure from data analysis in Excel to the data. As with the graph for the SMA model, note that the SES forecasts are much less variable than the actual data. With a smaller value , there would be even less variability. (note: Excel's Exponential for Smoothing dialog box asks for the value of the damping factor, which is 1-, rather than the smoothing constant.)
Month Demand
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 122 90 131 87 123 127 105 105 118 135 108 91 99 107 114 139 80 119 SMA SES 122.0 122.0 112.4 118.0 108.7 113.0 117.2 113.5 111.0 113.1 119.7 116.2 108.6 105.7 106.1 108.5 117.6 106.3
160 140 120 Demand 100 80 60 40 20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Month Demand SMA SES
113.333 110.500 113.000 110.833 118.833 116.333 110.333 109.333 109.667 109.000 109.667 105.000
Figure 2-9: Example for SMA and SES
2.2.4.3 Forecasting More Than One Period Ahead Since the basic data pattern assumed for the SMA and SES models is random scatter around a horizontal line, the forecast is simply the estimated height of that line. Although the equations given above for these models assume that we are forecasting only one period ahead (Ft+1), we can just as easily use them to forecast two, three, or as many periods ahead as desired by using the same value. Of course, as with any model, the further into the future we attempt to forecast, the larger our forecast error is likely to be. 2.2.4.4 Other Short-Term Forecasting Models The two short-term forecasting models discussed are both designed for situations where the basic data pattern is random scatter around a horizontal line. Of course, in many cases we will have either trend or seasonality (or both). How to incorporate seasonality into these models will be discussed 31
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later, after we have shown how seasonal factors can be estimated. There are also moving average and exponential smoothing models that build the estimation and use of trend effects directly into short-term forecasts. These models are beyond the scope of this subject matter, but the models are available in many software packages. In particular, exponential smoothing with trend is available in the Excelpom package.
2.2.5 Measuring Forecast Accuracy

An important consideration in the selection and use of a forecasting model is how well it will perform, i.e., how close the forecasts come to the actual values of the variable of interest. Three popular measures of forecast accuracy are the mean squared error (MSE), which is analogous to a sample variance in basic statistics, the mean absolute deviation (MAD), and the mean absolute percentage error (MAPE). All three start with the same basic forecasting error measurement: et = Yt Ft The MSE, MAPE, and MAD actually tell us about the average magnitude of error terms. Any of these three accuracy measures can be used as the basis for comparing forecasting models or as the basis for selecting parameter values for a given model type. Either the MSE or MAD, with appropriate adjustments, can be used for finding forecast intervals (similar to confidence intervals in basic statistics). The average error term, also called the mean forecast error (MFE), doesn't tell us how accurate our forecast is. The MFE can, however, tell us if our forecast consistently over or under estimates demand. (For this reason the MFE is also called the forecast bias.) Forecast bias is considered large when its magnitude is a significant percentage of the MAD. Large negative values for the MFE indicate that our forecasts are consistently higher than demand. By contrast, large positive values suggest that our forecasts are consistently low. The presence of bias is an indicator of at least three possibilities. First, a large bias indicates that the forecasting technique can be improved; any consistent pattern in the forecast error terms can be analyzed and exploited to improve the forecast. Second, if a forecasting technique becomes biased over time but was not biased to start with, the underlying demand pattern must have changed. (For example, there could have been a turning point in a product life cycle, a new seasonal effect could have developed, and so on.) Third, bias may result from deliberate attempts to manipulate forecasts. For example, marketing personnel or valued customers might attempt to inflate demand forecasts to guarantee the availability of supply (example: construction companies ordering aggregate prior to winning the bid). In reality, such attempts are counterproductive because they foster uncertainty, undermine trust, and hinder integrated cross-functional decision making. Decision makers in all functions rely on forecasts to make their decisions. They should all be using the best information available. Rather than
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manipulating forecasts to influence decisions, managers should get the best forecast possible, then consider their range of options to make the most effective decision. There is ample opportunity for cross-functional influence on decisions once an unbiased forecast has been developed. 2.2.5.1 Mean Squared Error (MSE) Similar to the procedure for measuring variation in a sample in basic statistics, the mean squared error compensates for the problem of positive/negative error cancellation by squaring the forecast errors, summing them, and then taking their average.
Just as we take the square root of a sample variance to get the standard deviation, which is used in finding a confidence interval in statistics, we can take the square root of the MSE, called the root mean squared error, and use it as the basis for a forecast interval:
Following the basic approach for finding a confidence interval in statistics, a forecast interval for any particular level of confidence can be found as: Forecast Z(standard error of forecast)
Example 2-3: MSE for Quartz Powder example
Use Excel to compute the mean squared error and root mean squared error for the simple exponential smoothing forecasts with = .3 for the quartz powder demand data found in Example 2-2. Use the results to find an approximate 95% forecast interval for quartz powder demand in month 19. Solution: The spreadsheet in Figure 2-10 shows the use of Excel to compute the MSE and RMSE for the quartz powder demand data in Figure 2-9. (The forecast values from using SES with = .3 come from Figure 2-9). We see that the MSE is 6915.58/17 = 406.80 and the RMSE is 20.17. Using this value for the RMSE and, from the spreadsheet, the forecast value of 110.1 for t = 19, we can get an approximate 95% (2 standard deviations) forecast interval of:
F19 2(RMSE) = 110.1 2(20.17) = 110.1 40.34 = (69.76, 150.44) We could say that we are roughly 95% sure that the demand for quartz powder in month 19 will be between 70 and 150.
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Figure 2-10: MSE, MAD Example
2.2.5.2 Mean Absolute Deviation (MAD) An alternative approach to compensating for the positive/negative error compensation problem is to take the absolute values of the errors and average them to obtain the mean absolute deviation:
As we can see by comparing the values of MAD and RMSE in Exhibit D.4, the mean absolute deviation is generally smaller than the root mean square error. However, it has been found that, for a normal probability distribution, MAD tends to be just about 80% of the standard deviation, so we can get a good estimate of the standard deviation of forecast errors by using 1.25MAD.
Example 2-4: MAD for Quartz Powder example
Use Excel to compute the mean absolute deviation for simple exponential smoothing forecasts with = .3 for the quartz powder demand data found in
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Figure 2-10. Use the results to find an approximate 95% forecast interval for quartz powder demand in month 19. Solution: Figure 2-10 also shows the computation of the value of the MAD for the quartz powder demand data, using SES with = .3. From the spreadsheet, we see that the sum of the absolute values of the forecast errors = 295.98 and MAD = 295.98/17 = 17.41. Using this value for MAD and, from the spreadsheet, the forecast value of 110.1 for t = 19, we can get an approximate 95% forecast interval of: F19 2(1.25MAD) = 110.1 2.5(17.41) = 110.1 43.525 = (66.575, 153.625) We could say that we are roughly 95% sure that the demand for quartz powder in month 19 will be between 67 and 154. This interval is, of course, not exactly the same as the one found above using RMSE, but that is to be expected since neither RMSE nor 1.25MAD is exactly equal to the true standard deviation of forecast errors. 2.2 Mean Absolute Percentage Error (MAPE) A large forecast error is less of a problem when the value being forecasted is large than when it is small. An alternative to using the actual error is to use the relative or percentage error, which is found by dividing the error by the value being forecasted and, if desired, multiplying the ratio by 100. The absolute percentage errors can then be averaged to get the mean absolute percentage error or MAPE:
While useful as a way of comparing alternative forecasting methods or comparing different parameter values for a particular forecasting method, MAPE does not lend itself to serving as the basis for constructing forecast intervals.
Example 2-5: MAD for Quartz Powder example
Use Excel to compute the mean absolute deviation for simple exponential smoothing forecasts with = .3 for the quartz powder demand data found in the previous example. Solution: Figure 2-10 also shows the computation of the value of the MAPE for the = .3. From the spreadsheet, quartz powder demand data, using SES with we see that the sum of the absolute percentage forecast errors is 285.86 and MAPE = 285.86/17 = 16.82. That is, the forecast is, on average, in error by 16.82% of the demand value. 35
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2.2.6 Estimating and Using Seasonal Indexes

As discussed earlier, seasonality refers to any regular pattern recurring within a time frame of no more than a year. Although seasonal indexes may be either additive or multiplicative, we shall focus here on the more commonly used multiplicative type.
A multiplicative seasonal index is the expected ratio of the value of a time series in the period for which the index applies to the value as called for by any trend and cyclic components. For example, if the seasonal index in a period is 1.0, the value of the time series in that period is expected to be exactly what the trend and cyclic components call for. If the seasonal index is 1.25, the value is expected to be 25% larger than what trend and cycle call for. If the seasonal index is .90, the value is expected to be only 90% of (10% lower than) what the trend and cycle call for. Since seasonal indexes show how to adjust the values of individual periods up or down from "normal," they must average 1.0 across a full set of seasons. 2.2.6.1 Estimating Seasonal Indexes The basic multiplicative time series model says that the value of the variable is the product of its four component parts: trend, cycle, seasonality, and randomness. That is:
Y = TCSR
This leads to a four-step process for estimating multiplicative seasonal indexes: 1. Estimate the value of TC in each period. 2. Divide the value of Y by the estimate of TC in each period, giving an estimate of SR for that period. 3. Average the SR values for all periods of the same type or season to get raw seasonal indexes. 4. Average the raw seasonal indexes. If the average is not 1.0, divide the raw indexes by the actual average to get adjusted seasonal indexes. There are a number of ways to implement this process. They differ in the way in which the TC estimates are obtained (step 1). We will consider two approaches, one for basically horizontal data patterns and one for trend. Both approaches assume that cyclic effects are negligible and can be ignored. 2.2.6.2 Horizontal Data Patterns If the basic data pattern is horizontal, then its level can be estimated simply by averaging the values for all time periods (step 1 of the process described above). To make this estimate as valid as possible, the same number of each type of season should be included in the average. For quarterly indexes, the
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average should be based on 4, 8, 12, etc. periods. For monthly indexes, the average should be based on 12, 24, 36, etc. periods.
Example 2-6: Horizontal Data Pattern Indexing
Figure 2-11 shows a quarry's quarterly sales of materials over a period of three years. The graph shows that the basic pattern is horizontal, but with a pronounced up and down quarterly pattern. Use Excel to estimate the quarterly multiplicative seasonal indexes.
Figure 2-11: Aggregate Sales
Solution: Figure 2-12 shows an Excel spreadsheet for calculating the seasonal indexes. The actual sales values in column C are divided by their average (in C15) to obtain the quarterly ratios in column D. These ratios are grouped by year in columns GI; the quarterly averages are shown in column J. Since these raw indexes average 1.0, they can be used as seasonal indexes.
Figure 2-12: Spreadsheet solution for seasonal indexes
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2.2.6.3 Trend Data Patterns If the basic data pattern exhibits a trend, then the basic trend value for a period can be estimated from the appropriate trend equation (step 1 of the process described above). The seasonality ratio for each period is then found by dividing Yt, the actual value for that period, by Tt, the trend estimate (step 2 of the process).
Example 2-7: Trend Data Patterns
Figure 2-13 shows the quarterly demand for Jimbob's company over the past two years. The basic data pattern exhibits both upward trend and quarterly seasonality. Estimate the linear trend equation and quarterly multiplicative seasonal indexes.
Figure 2-13: Quarterly Demand
Solution: The results from Excel's regression analysis procedure in data analysis are shown in Figure 2-14, along with the computed trend values for each period and the ratios of actual to trend values. The seasonal indexes are computed as follows: Quarter Quarterly Seasonal Index
1 2 3 4 S1 S2 S3 S4 = = = = (0.909 (1.014 (1.225 (0.715 + + + + 0.966)/2 1.149)/2 1.281)/2 0.737)/2 = = = = 0.938 1.092 1.253 0.726
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Figure 2-14: Results of Regression
2.2.6.4 Using Seasonal Indexes Seasonal indexes are used for two purposes: 1. To deseasonalize raw data, in order to compare values from different seasons or to use them in a basic forecasting model 2. To incorporate seasonality into a forecast made by a basic model that does not include seasonal effects Since the multiplicative model incorporates the seasonal effect by multiplying by the seasonal index, seasonality is removed by the reverse process, dividing. That is, you can deseasonalize a data value by dividing the actual value by the appropriate seasonal index. Note that in production environments, a type of seasonality occurs during the winter holiday season and during summer, when fewer workers are available and production may decrease. Scheduled maintenance on processing facilities such as re-tileing the smelter typically occurs on an annual basis and may result in a vertical shutdown of all facilities. Comparing monthly production rates over these time periods can significantly skew data and performance measures. Deseasonalization can eliminate this problem, or comparatives can be seasonlized.
Example 2-8: Deseasonalization
Suppose the sales of product XYZ construction material during the four quarters of the next (fourth) year are:
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Quarter 1 2 3 4
Sales 95 116 89 73
Use simple exponential smoothing with = .2 to find the base level forecast for the first quarter of year 5. Assume the base level forecast for the first quarter of year 4 was 99.1. Solution First use the seasonal indexes found in the previous example (Figure 2-12) to deseasonalize the raw data for year 4. Then use these deseasonalized values in an SES model with = .2 to obtain a base-level forecast for quarter 1 of year 5. These operations have been carried out in the spreadsheet in Figure 2-15, which shows that the base level forecast is 96.75 units. Note that, since the exponential smoothing procedure in Excel assumes that F1 = Y1, we had to trick it into using a different value for F1. This was done by inserting a period 0, with Y0 = 99.1, the value we want to use for F1.
Figure 2-15: Deseasonlization
2.2.6.5 Incorporating Seasonality To use multiplicative seasonal indexes to incorporate seasonality into a forecast made with an unseasonalized model, multiply the basic value by the appropriate seasonal index.
Example 2-9: Seasonalization
Forecast the demand for in-house continuing education classes at Jimbobs company (Figure 2-14) for the four quarters of next year. Solution: Use the trend equation found in Figure 2-14, Tt = 331.464 + 17.119t, to determine the trend value for each of the four quarters. Then multiply the trend values by the seasonal indexes found in the solution above Figure 2-14, to get the forecasts, as follows:
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Quarter 1 2 3 4
T 9 10 11 12
Trend 331.464 331.464 331.464 331.464 + + + + 17.119(9) = 485.535 17.119(10) = 502.654 17.119(11) = 519.773 17.119(12) = 536.892
x Index = Forecast 0.938 1.092 1.253 0.726 455.4 543.9 651.3 389.8
2.2.7 Conclusions
The forecasting techniques discussed in the preceding section are used for forecasting not only customer demands but predicting or setting other values for which trends or patterns exist. For example, performance measures that expectedly vary over time can be forecasted so that seasonal effects do not unduly alter evaluating true performance. Forecasting and trend analysis are becoming increasingly important in data mining fields where trend and patterns need to be mathematically identified and characterized.
ADDITIONAL RESOURCES III
The information in the above notes is additionally complimented by: Lecture Module 2.2 Forecasting
2.3 Master Scheduling and Inventory Management

Master scheduling decisions have a shorter planning horizon than aggregate planning. The aggregate plan is typically revised monthly based on a 6- to 18-month planning horizon. Typically, a freeze window will be established on the master schedule (known as weekly plan in mining). This is a fixed period of time at the beginning of the schedule for which the master schedule is final and not subject to revision. Master schedules are typically revised at least once a week, and though they may look forward six months or more, the emphasis is on agreement about satisfaction of near-term customer requirements. Master scheduling decisions are constrained by capacity decisions that are made in the aggregate planning process. As a result, master schedulers should not commit to accomplishing work for which they do not have sufficient capacity. Part of master scheduling involves attempts to keep capacity requirements as level as possible from week to week. Heavy use of capacity can lead to problems with worker morale, equipment failure, quality, and customer service. It can also reduce efficiency. Low use of capacity leads to low levels of productivity and can have an influence on worker morale, customer service, and quality. Master scheduling requires dis-aggregation of the aggregate plan. Aggregate plans set the stage for the execution of a master schedule by making funds available for overtime, subcontracting, changes in workforce size, and the accumulation of inventory to meet periodic surges in demand. Thus, the level
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of demand accommodated in the master schedule needs to match the level of demand anticipated in the aggregate plan. For example, the aggregate plan calls for 2000 man-hours on LHD machines, the master schedule would then specify the stopes that would be mucked with that capacity. Across the board, material planning decisions and capacity planning decisions have to be synchronized with each other and with demand projections. You cannot schedule operations without available capacity at the required resources. Therefore, master scheduling relies on capacity planning decisions, ranging from aggregate resource planning to detailed capacity plans. A few important terms that should be understood include: Loading decisions: assign work to resources Dispatching decisions: the sequence in which that work will be completed. Make-to-order: (MTO) type of business whose customers order in the short-term, an example are aggregate companies catering to drop-in consumers Make-to-stock: (MTS) type of business who can accurately forecast future orders, most mining operations are on long-term contracts with smelters or metal consumers. rough-cut capacity planning: A planning method where the feasibility of master schedules must be verified. closed loop planning: a process in which information from detailed capacity planning is used to level (and ensure the feasibility of) the master schedule. forward scheduling: when customers are particularly time sensitive, the master scheduler will usually attempt to add the order as early as possible in the hope that it can be completed within a satisfactory period. backward scheduling: a process where companies determine when a stock of outputs will be needed, then place orders on the master schedule so as to ensure the availability of outputs by that time. In MTS companies, planners typically use this to develop the master schedule.
Figure 2-16: Master scheduling and inventory management.
Because of the link between scheduling and inventory, discussion on master scheduling would not be complete without some discussion of inventory
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decisions. This subsection will address competitive considerations in inventory management, describe several of the most common inventory models, and highlight some recent trends in inventory management. 2.3.1.1 Negative Aspects of Inventory There are several negative consequences of an over-reliance on inventory, these include: Over depending on inventory as a buffer to poor forecasts (or any other reason) can prohibit meaningful feedback on the quality of the productservice bundle. With large inventories, there is usually a long delay between the creation of an item and its use. Thus, when problems are discovered, it is usually too late to investigate and remedy the causes. Large inventories hide operational problems that might be solved if they were discovered. When a worker finds a nonconforming item and inventory provides an immediate replacement, the worker has very little incentive to communicate the fact that a defective item was created. Poor quality powder is a common occurrence in mining and usually goes unreported. There is a financial cost to carrying excess inventory. It includes the lost opportunity to invest the money tied up in the inventory, as well as the rental cost for the space used to house the inventory (including utilities, security, and insurance on the structure and the inventory itself). There is some risk of damage to goods held in inventory. There is a cost to tracking and accounting for inventory. Inventory records are often quite inaccurate; thus, accountants and auditors frequently must spend days locating and counting specific items. Much productivity is lost because of time wasted searching for inventory that has been moved without updating warehouse records. Large inventories are associated with a risk of product obsolescence and losses due to depreciation. (common for equipment parts in mining) 2.3.1.2 Positive Aspects of Inventory Clearly, carrying more inventory than is needed is not advisable. On the other hand, inventory is listed on the balance sheet as an asset, and it does have a positive impact on operations when used in moderation. Sometimes managers find it hard to draw the line between inventory that adds value (or facilitates the adding of value) and inventory that is needed only to cover some solvable problem in the value-adding system. Following are some of the potential benefits of inventory: Inventory allows managers to decouple operations. That is, placing inventory between as a planned, controlled buffer between two processes (Ore pass/storage bin) or a customer and supplier (stockpiles), allows them to operate independently. Inventory protects one part of an operating system from disruptions in other parts of the system.
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Inventory allows firms to take advantage of quantity discounts from suppliers. Inventory allows firms to meet unexpected demand.
2.3.1.3 Finding the Right Inventory Level Just as carrying excess inventory is not wise, holding inadequate inventory is also inadvisable. Operations are much easier to run when some inventory is available. The right inventory level depends on the level of uncertainty surrounding demand, the potential for system disruptions, and the characteristics of the operating system. The greater the degree of uncertainty surrounding demand and the greater the potential for system disruptions, the more inventory is required to effectively operate. Fortunately, at least as far as the short term is concerned, the uncertainty surrounding demand can be estimated. One way to do so is to use the error statistics from demand forecasts, such as the mean absolute deviation (MAD), mean forecast error (MFE), or mean squared error (MSE). A similar approach is to simply compute the standard deviation of periodic demand. The potential for system disruptions can also be estimated using measures such as the variability of the time required to complete orders or the variability of the time required for suppliers to fill orders.
ADDITIONAL RESOURCES IV
The majority of the theory and mathematical tools used in inventory management are provided by the following resources: Lecture 2.3 Inventory Management Readings from: Winston, Wayne and Christian S. Albright, Practical Management Science: Spreadsheet Modeling and Applications., Belmont CA: Duxburry Press, 1997, selections from chapter 9 and 10 (Mandatory)
2.4 Just-In-Time and Synchronous Systems

JIT system is a way of planning operations that reduces variability of demand, enhances responsiveness of operational resources, and attempts to conduct value-adding operations as close as possible to the time that value is consumed. Due to the limited size of underground warehouses and deterioration of raw materials underground, mineral companies are increasingly focusing on reducing inventory stored through JIT type planning systems. The benefits of a JIT system include: cycle time reductions inventory reductions of raw materials, work-in-process, and finished goods direct and indirect labor cost reductions space requirement reductions quality cost reductions
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material costs reductions
Despite the benefits of JIT, it is not an appropriate planning and control system for all companies and business environments. Figure 2-17 summarizes the system characteristics for which use of a JIT planning and control system would make sense. If these characteristics aren't present, some different planning and control system (discussed in a later chapter) might be a more logical choice. Typically, JIT systems are a good fit when demand is reasonably stable and high-volume repetitive value-adding systems can be used to make standardized product-service bundles. Effective use of JIT also requires the cooperation and coordination of employees and suppliers. Continuous improvement and employee involvement are core aspects of the JIT system: Every worker is responsible for making sure that things are working right and finding ways to make things work better. JIT planning and control relies on a level master schedule, prefers excess capacity to excess inventory, and works with suppliers and customers to reduce complexity and uncertainty while simultaneously improving the system's responsiveness to customer requirements.
Figure 2-17: System Characteristics of JIT Planning and Control
2.4.1 JIT Perspectives on Inventory

JIT is focuses on managing the system so as to minimize inventory. Inventory is seen as a buffer that will keep the manager from noticing and addressing core problems with the processes within the system. If a machine breaks down, a worker is absent, a supplier fails to come through, a truck gets delayed in transit, a process is idle for a long time, or a capacity imbalance develops, inventory can save the day. If, on the other hand, we don't have inventory, we expose the problems in our value-adding system
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and develop a strong incentive to eliminate them. The problems listed previously. Without inventory to hide these problems, firms experience the problems, but they also gain an understanding of the weaknesses of their system. Thus, JIT is a philosophy that not only helps managers to find their problems but motivates them to find remedies. With inventory to cover up the problems, managers may never even notice, much less address them. Figure 2-18 shows reasons a manager would want excess inventory and strategies to wean them from that dependence.
Figure 2-18: Inventory margin of safety
2.4.2 Supply Chain and E-Commerce Considerations in JIT

Since decisions at one point in the value-adding system influence decisions elsewhere, it is worth considering the impact on customers and suppliers of a company's use of JIT planning and control. Companies that choose to use JIT systems will attempt to work with their suppliers to effect both structural and infrastructural improvements. On the structural side, suppliers will be encouraged to improve their responsiveness and efficiency via group technology. Reduced inventory at suppliers should result in lower space requirements and therefore lower fixed costs. On the infrastructural side, the emphasis will be placed on maintaining a relationship that is beneficial to both parties. Communication lines need to remain open at all times: Information regarding costs, quality, and process capability needs to be shared without reservation. Along with relationship management, the 46
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suppliers of JIT companies will need to be capable of providing productservice bundles in small quantities with frequent deliveries. They will have smoother master schedules and will need to provide short lead-times. When improvements are made, all parties in the supply chain, as well as the customer, should share the benefit of these improvements through higher profit margins and lower costs.
2.4.3 Synchronous value-adding systems

This chapter covers planning and control issues in synchronous value-adding systemssystems whose effective management, because of the presence of a bottleneck, requires that the timing of value-adding activities be coordinated (or synchronized) throughout the system. From an operational point of view, a bottleneck is any resource that has insufficient capacity to satisfy requirements. It's usually easy to find a bottleneck, because of the large number of customers or jobs waiting for service. For example, a mine is running its shaft at near 100% utilization, and the mucking must occasionally stop so that the hoist can reduce bin levels. When a value-adding system has a bottleneck and other activities aren't coordinated with that resource, the bottleneck's capacity might be wasted, unnecessary inventories might be created, and customer service may suffer. Regardless of where a bottleneck is located, decision makers in other functions can do their company harm if they aren't aware of the bottleneck and its implications. The key to effective management of such systems is to recognize and exploit a system bottleneck wherever it exists. General guidelines for the various functions might be stated as follows: Operations should make whatever is most profitable for the firm, not what generates the best local performance results or piece rate bonuses. Finance should support efforts to improve performance at the bottleneck. When traditional capital justification techniques are used, the system return on improvements to bottleneck performance is usually understated, because those techniques look at resources in isolation. On the other hand, one must be careful about expecting a return on an investment in a non-bottleneck work center; there is no financial benefit to improving performance at an underutilized resource. Engineering, operational, financial, and marketing personnel who serve on design teams need to design (or redesign) product-service bundles for manufacturability. That means they need to be aware of existing and potential bottlenecks and create designs that can bypass these system constraints. Accounting must approach cost and performance measurement in nontraditional ways. Activity-based costing, the balanced scorecard, and other recently developed performance measurement methods that focus on system-wide rather than local performance are necessary if cost information is to adequately support managerial decision making in a synchronous value-adding system.
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Management information systems personnel need to clearly understand the information requirements of managers. Particularly in complex valueadding systems, synchronizing operational, marketing, purchasing, and financial decisions frequently requires the use of decision support systems. Figure 2-19 summarizes the place of synchronous systems for manufacturing systems.
Figure 2-19: Manufacturing Systems.
2.4.4 Overview of Synchronous Systems

In the 1980s, Eliyahu Goldratt published a book called The Goal, which popularized the principles underlying a software package he had developed called Optimized Production Technology (OPT). This management system has been popularly known as the Theory of Constraints. The book dealt primarily with the importance of bottlenecks in a value-adding system. For example, the lead character in the book, Alex Rogo, learns that an hour lost at a bottleneck is an hour lost for the entire system, while an hour lost at a non-bottleneck is inconsequential. He also learns that it helps not to begin work on jobs that cannot be accommodated at a bottleneck. Similarly, if a customer's order must wait, it's better for it to wait as an un-started job, with no investment in materials, than as a partially completed order representing a partial investment in materials and processing time. Not only is money tied up when an order waits as work in process, but scheduling flexibility is lost. The following lists the principles of the theory of constraint:
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Balance the flow of materials through the system, not the capacity of resources. Utilization levels for non-bottleneck resources are not determined based on their own capacity, but by the capacity of the system bottleneck. Utilization and activation of a resource aren't the same thing. You can create useless WIP by activating a resource. Only useful WIP counts toward utilization. Any time lost at the bottleneck is lost to the system and cannot be recovered. Any time saved at a non-bottleneck is irrelevant since it already has time to spare. The bottleneck is the key to improving throughput or lowering system inventory. You don't have to complete an order at one work center before you transfer WIP forward allowing the next work center to begin. Batch sizes aren't set in stone; their size can affect rates of throughput and inventory levels. Schedules for each resource should simultaneously consider all system constraints. Since the system and its constraints can change over time, schedules change over time and lead-times will also vary.
2.4.5 Performance Measures and Capacity Issues in TOC

One issue that comes up in attempting to synchronize the schedule of resources across an entire facility is the question of how performance will be measured. The traditional approach to operational performance measurement relies on local performance measures, in which worker performance and resource utilization are measured against a work standard and resource capacity. In other words, workers are considered to be performing to expectations if they are doing their jobs as fast as we believe they can. Resources are considered to be well managed if the operation is producing the volume of output it is capable of generating. Output is measured in units completed at the individual resource. Similarly, work-inprocess inventory is accounted for as an asset whose value increases with each additional operation it passes through. Capacity and, therefore, operating expenses are essentially fixed at the output level individual resources are able to provide. In synchronous systems, relying too heavily on local performance measures can lead to a frustrating phenomenon called the hockey stick syndrome, in which daily output resembles the pattern shown in Figure 2-20. Note the high levels of output at the end of reporting periods, followed by low levels of output for the majority of the reporting period
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Figure 2-20: Hockey Stick Syndrome
Why do companies experience the hockey stick syndrome? When accountants compute local performance measures, they generate information that managers use to make decisions about worker performance, resource utilization, and asset allocation. These decisions ultimately influence workers' pay and the quality of their jobs. As a result, workers and managers are motivated to look good on local performance. But their goal-directed behavior creates problems for anyone who is trying to synchronize operations across an entire system. When decisions are made based on local performance, operations are not synchronized and customers' orders get bottled up in the value-adding system. At the end of the month, when financial performance has to be reported to key stakeholders, managers become very interested in performance measures such as net profit, return on assets (ROA), and cash flow. Unlike the local performance measures that influence employees' behavior for most of the month, these financial measures are global performance measures: They indicate the effectiveness of the entire value-adding system, not just one resource. So toward the end of the month, decisions are made with system performance in mind, and the system generates rapid output. To synchronize operations, local operational performance measures must be replaced with global measures. These broader operational measures should help decision makers and workers to coordinate their activities for the customer's benefit every day of the month, not just when financial results must be reported. Goldratt has suggested that the following three operational performance measures replace traditional local measures: Throughput, which is the rate at which the system generates money through sales. It is desirable to increase throughput. Inventory, which is all the money invested in purchasing items the system intends to sell. It is generally desirable to reduce inventory. Operating expense, which is the money the system spends in converting inventory to throughput. It is generally desirable to reduce operating expense. The opposite view is also understandable as workers have difficulty with motivation by goals that are not directly visible from their work-view. Measures that are un-applicable to the work being done are popularly seen as useless.
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2.4.6 Cost Accounting

With the advent of synchronous value-adding systems, cost accountants have had to develop new approaches that provide more useful information for decision makers. Two of the better-known approaches currently in use are activity-based costing and the balanced scorecard. Activity-based costing (ABC) is a managerial accounting approach that rests on the principle that activities cost money and operations consume activities. ABC seeks to provide greater accuracy in allocating overhead costs to the direct value-adding activities than is possible using the historical percentage allocation method. In this approach, the accountant first enumerates all the overhead activities and their costs. Next, the accountant determines the product-service bundles whose creation consumes these overhead activities. The overhead cost for each product-service bundle is the sum of the costs of the activities consumed in its creation. Though this approach is not conceptually difficult, the level of detail required was prohibitive prior to the advent of modern information systems. If ABC leads to more accurate estimates of the indirect costs that go along with the creation of each product-service bundle, then it is particularly useful to managers of value-adding systems that contain a bottleneck. These managers have to decide how to ration bottleneck capacity among various product-service bundles. If their indirect cost estimates are not accurate, they might well think they are allocating bottleneck capacity to the most profitable product-service bundles, when they are actually wasting critical capacity on unprofitable items. Robert Kaplan of the Harvard Business School suggested another managerial accounting approach, the balanced scorecard, which includes information about performance in key nonfinancial categories. Part of the idea behind the balanced scorecard is that often the very decisions that optimize short-term financial performance ultimately lead to disappointments in long-term performance. Kaplan's approach suggests that a company should consider its strategic goals in establishing its cost measurement system. The balanced scorecard might include measures representing the customer perspective, the internal business process, and innovation and learning. For instance, the customer perspective might be measured by customer retention ratios, on-time deliveries, and customer satisfaction surveys. The internal business process perspective might be represented by cycle time, throughput, yield, and quality defect rates. Innovation and learning could be measured by product development lead-time, new product introduction rates, number of employees cross trained, and percentage of sales from new products. Measuring performance from each of these perspectives, in addition to the financial perspective, should help managers to balance various stakeholder concerns.
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2.4.7 The Management Process

The theory of constraints suggests that managers use a five-step process to manage their value-adding system. The five steps are: Identify the system constraints. Determine how to exploit the system constraints. Subordinate every other decision to the decision made in step 2. Elevate the system constraint. If the constraint has changed with the passage of time or the process of moving through steps 1 through 4, go back to step 1.
2.4.8 Detailed Scheduling: The Drum-Buffer-Rope System

At the most detailed level of scheduling, in which managers must decide who should do what and with which resource, the drum-buffer-rope system (DBR) is often used. This is a detailed scheduling approach most useful in valueadding systems that contain a bottleneck. The term drum refers to the bottleneck; like a marching band, its rate of throughput sets the pace for all other work centers. The buffer is time that is maintained in front of the bottleneck or other strategic points in the system, to make certain the bottleneck never sits idle for lack of work. (This extra time results in an inventory of materials that will accumulate in front of the bottleneck.) Finally, the rope refers to communication links between the buffers and the gateway work centers. These communication links keep workers from starting jobs for which there is no room in the buffer. The purpose of the drum-buffer-rope system is to ensure that bottleneck resources are fully utilized and that all other resources work at the pace of the bottleneck.
ADDITIONAL RESOURCES V
The majority of the theory and mathematical tools used in inventory management are provided by the following resources: Lecture 2.4 JIT and TOC
2.5 Project Management

Project management is a complex and involved process of forecasting, planning, implementation, and tracking. It is heavily used in mining in the execution of virtually every mining stage. Mining is an ongoing construction project where access is developed to ore bearing areas through a series of time-linked activities. The processes used to construct access and extract the ore use repetitive processes that would be found in manufacturing. However, the importance of the process sequence and location-induced variability also creates a construction process with highly variable demand. All these repetitive tasks and scheduled processes operate within a budget. Other measurement techniques are used to measure the repetitive tasks. Project management tools can be used to measure the fulfillment of the schedule for development and production on a process-level. The technical
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tools used in project management are described in this module, however, project management tools are expected to be used throughout this course.
ADDITIONAL RESOURCES VI
The information in the above notes is additionally complimented by: Lecture Module 2.5 Project Management. (mandatory) Readings Chapter 16 from Shaffer, Scott M and Jack R. Meredith. Operations Management: A process approach with spreadsheets. New York: John Wiley & Sons. 1998. Assignment 2: Project Management (mandatory)
2.6 Appendix: The Chronological Development of Operations Management (optional readings)

While operations have been managed from the beginning of time, we trace the roots of what we call "operations management" back to the birth of mass production during the Industrial Revolution. In this section, we trace chronological development of the field up to the present. We show OM to be a field that has been influenced by many disciplines, including industrial engineering, industrial psychology and sociology, statistics, management science, management information systems, and others.
2.6.1 The Industrial Revolution: The Birth of Mass Production

Adam Smith popularized the concept of division of labor in England in the late 1700s. He illustrated this concept with the example of pin makers. Working alone, a worker could produce 20 pins a day. When repeatedly performing a limited portion of the work involved in making a pin, a small group of workers could produce 48,000 pins a day. Along with specialization of labor came the concerns of industrialization, including worker motivation and development, worker welfare, the organization of work, tracking of inventory, product design for mass production, and questions regarding the limits of economies of scale (including how many units should be produced at a given time and appropriate rationale for the mechanization of human work). In The Evolution of Management Thought, Daniel Wren states, "Historically, industrialization is a relatively recent phenomenon. Humankind existed for eons before the great advances in power, transportation, communication, and technology that came to be known as the Industrial Revolution. . . . Some people engaged in economic undertakings, but not on a scale to compare with what would emerge as a result of the Industrial Revolution" (Wren 1994). Modern systems for the management of operations have roots in that period. It was the Industrial Revolution that made common the mass production of standardized products. At that time, a host of operational complexities and problems were encountered for the first time. As a result, a
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number of individuals attempted to solve problems related to the methods used and the organization of work, while others focused on the human problems associated with mass production in factories. It soon became clear that piecemeal organization, varied approaches to communication, and nonstandardized information handling were not adequate to meet the needs of business; rather a structured system of management was needed in order to effectively administer large-scale enterprises.
2.6.2 Scientific Management: Developing a Technical Understanding of Work

The term scientific management refers to the system of management introduced by Frederick W. Taylor in the late 1800s. In fact, scientific management has also been called the Taylor System. Time study, a technique used to precisely define an activity or job as a detailed set of repeatable tasks and determine the time in which these are to be done, was the foundation of the Taylor System. By using time study, management could set work standards "scientifically," rather than relying on the past performance of workers to set work standards. Given the ability to independently analyze work, management then gained the opportunity to use a piece-rate incentive plan, to select workers who were best suited to particular jobs, to train workers in the ideal way to complete a task, and to track production costs according to particular classifications for reporting based on the deviations from those standards. In essence, the Taylor System allowed for a separation of the planning of work from the performance of work. Scientific management has been praised due to the increases in worker productivity that it generated. On the other hand, scientific management may have been more suited to a time when a great deal of physical labor was not automated and the level of education of the workforce was extremely limited. Scientific management has been criticized for developing work settings that weren't fulfilling from a human perspective. As a result of Taylor and others who worked to promote scientific management, this system became widely used in the United States and elsewhere. Since Taylor and many of his disciples were engineers, the ongoing development of scientific management led to a field of engineering now known as industrial engineering. In industrial engineering curricula, much of the influence of scientific management remains. Also, many Japanese authors and managers credit scientific management for providing techniques that they have used to establish their highly effective operational systems. Today, as we are beginning to place greater stress on workplace ergonomics and learn more about the management practices of the Japanese, there is renewed interest in scientific management.
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2.6.3 Industrial Psychology and Industrial Sociology: Developing a Human Understanding of Work
The rise in unionization of the American workforce resulted from labor's dissatisfaction with scientific management. Given the criticisms of the Taylor System, many of the developments between 1910 and 1940 were related to the psychology of workers. In 1913, Hugo Mnsterberg laid the foundation for the field of industrial psychology with the publication of his work Psychology and Industrial Efficiency. In 1912, Lillian Gilbreth completed a dissertation that was later published as The Psychology of Management: The Function of Mind in Determining, Teaching and Installing Methods of Least Waste. To be sure, these efforts were presented in the context of the Taylor System and were used to point out the value of understanding human mental processes in the design of work. It was suggested that by considering human factors in the design of work, systems would be developed where workers were both better off and more productive. As a result of interest in the human behavioral dimensions of work, a series of experiments were performed by Elton Mayo at the Hawthorne plant of the Western Electric Company in the late 1920s and early 1930s. Initially designed to identify optimal environmental conditions for maximized productivity, these well-known experiments led to greater understanding of the implications of social factors for worker productivity. In fact, the very understanding that work systems are also social systems (and that social factors profoundly influence individual work behavior) can be attributed to the Hawthorne Studies. The Hawthorne Studies are frequently credited as providing a foundation for the study of human behavior in organizations, which continues today in the field of organizational behavior.
2.6.4 Statistical Control of Quality

Walter Shewhart, a manager at the Hawthorne plant of the Bell Telephone Laboratories in the early 1900s, was the first to develop and use statistical methods to control quality. As early as 1924, he was promoting the use of control charts. (A control chart plots the behavior of some system variable of interest to determine whether there are any unusual circumstances in the system.) By 1931 Shewhart had published Economic Control of Quality of Manufactured Product. Following this, in the 1930s and 1940s, there were a number of statisticians who contributed methods of sampling, analysis, and control techniques that were useful to managers interested in quality. Statistical quality control techniques provide an interesting counterpoint to the job design techniques of the Taylor System. The time study, job assignment, and training techniques of scientific management were used to design variability out of a job. They allowed managers to set a standard production rate, or quota, for workers. By contrast, statistical quality control techniques recognize that there is inherent variation in any system. A worker cannot reasonably be expected to produce the very same amount of quality
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product as every other workerworkers are different. Similarly, a worker will not produce the very same amount of quality product every hourthere are good days and bad days. Based on the ability to estimate the natural variation in the system, quality control techniques are designed to alert managers to unusual variation from system standards.
2.6.5 Management Science: Optimizing the Use of Limited Resources

During World War II, the U.S. industrial sector was faced with the challenge of supplying geographically distant troops with food, clothing, armor, munitions, and other supplies that were available in only limited amounts. In short, the demand for products from the industrial sector exceeded the production capacity, transportation capacity, and capacity of the resource supply base. Coordinated decisions had to be made about the use of resources, production capacity, and transportation capacity. At this time, the military relied on mathematicians to develop solutions to their resource allocation problems, and the field of mathematics referred to as operations research (OR) was developed. Much of the early development of OR involved refining the operation of radar, estimating war losses, and forecasting enemy strength. [Today, operations research is also known as management science (MS).] The mathematical tools developed for wartime applications were first applied in business during the 1950s. The tools were particularly useful at that time because of the large backlog of demand for household products that resulted from wartime austerity and postwar economic prosperity. In general, these mathematical decision modeling tools are useful whenever there are some constraints and there is a clear objective influenced by those constraints. This is certainly the case in business where organizations seek to maximize profits or minimize costs in the context of such limitations as budgets, plant capacity, market size, and supply of raw materials.
2.6.6 Functionalization of OM: Bringing It All Together in One Function

In the late 1950s, it became clear that factory managers were applying knowledge of the technical aspects of work design, statistical control of quality, human aspects of work, and tools for the optimization of resource allocation. These managers were referred to as production managers, and the field of production management was recognized as a discipline within business schools. Production management was only then recognized as a function within businesses that required understanding work from a variety of perspectives. In the 1970s, many of the tools of production management were applied in the service sector, and the field came to be referred to as production/operations management (POM). Today, the field is simply referred
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to as operations management (OM). OM is widely recognized as a business function that is critical to the success of any organization.
2.6.7 The MRP Crusades: Computerizing Operational Decision Making

In many ways, the field of operations management in the United States was stagnant during the 1950s, 1960s, and early 1970s. This was a time in which U.S. business, which had not been faced with the difficulty of rebuilding infrastructure after World War II, faced seemingly unlimited global demand for its seemingly superior products. U.S. business was able to sell anything that was produced with a "made in the USA" label on it. As production management had been only recently recognized as a business function, production managers were given liberty to apply the tools of their trade. With operations managers to take care of the details, other managers seemed to feel that all of the problems of production had been solved. In the United States, OM was not seen as a potential source of competitive advantage. Instead, U.S. businesses built and entrenched bureaucracies that sustained a status quo brought about by prosperity and a false sense of superiority. Some would argue that inertia ruled the day and the concept "if it ain't broke, don't fix it" became a guiding light. Any change that might have occurred in such a setting would be primarily reactive to immediate problems, challenges in the marketplace, or innovations. Proactive change, or improvement, was rare. The 1960s and 1970s did represent a period of significant progress in the application of computing technologies in industry. Processes were further automated, and since the decision-making tools of production management were widely known, some of them could also be programmed into computer systems to make the production manager's job easier. In fact, the most widely applied computerized production management planning tool was material requirements planning (MRP). The drive to promote MRP in America has been referred to as the MRP crusades. As a result of the MRP crusades, widespread application of automation technologies, and subsequent developments in information technologies, the management of operations now relies heavily on up-to-date information systems.
2.6.8 JIT, the Quality Revolution, and Operations Strategy

While American business was ignoring production management in the postwar decades, the Toyota production system was being developed in Japan. The Toyota system was a result of a variety of efforts designed to catch up with Western automotive manufacturers without the benefit of massive funds or new production facilities. This system, now referred to as just-in-time (JIT), was largely developed to enhance productivity and reduce cost by removing waste from production. Taiichi Ohno, the Toyota executive largely responsible for the development of the JIT system emphasizes that because
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the Toyota production system was created from actual practices in the factories of Toyota, it is a very practical approachnot just a theory. It's very applicable to actual business operations and well suited for implementation. Poor quality is a major source of waste targeted by the JIT system. During the 1950s and 1960s, the worker-inspired Japanese industry was able to develop operational systems that were more productive than their American counterparts. In fact, they were able to produce material goods of superior quality at a lower cost. Although Americans such as Armand Fiegenbaum, W. Edwards Deming, and Joseph Juran had provided U.S. business with the insights required for a quality revolution in the 1950s, America experienced the quality revolution out of painful necessity in the 1980s with widespread adoption of total quality management. The strong business orientation toward creation and enhancement of customer satisfaction that this text reflects is a result of this quality revolution. Observing the practices of Japanese managers, many of which originated in the United States, has led to an American rediscovery of many of the roots of OM. As a consequence of the threat posed by international competition, and more particularly the lessons learned from the Japanese, OM has gained worldwide recognition as a key to competitiveness for organizations in the 21st century. In fact, rather than leaving operations professionals to their own functional devices, modern organizations rely on operations professionals to integrate their decision-making processes with organizational objectives and competitive realities. This calls for an operations strategy that can guide decision making throughout the operations function. Today's progressive organizations are developing operations strategies that effectively leverage operational excellence into global competitive advantages. Figure 2-21 summarizes the development of OM as we have described it in the above paragraphs.
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Figure 2-21: Operations Management Timeline.
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Module 3:
Management Science 3
Management science is a field of mathematical modeling focused on solving business problems. Management science uses linear and other programming techniques to find optimal results of business models. General areas include multi-objective and uncertainty decision making, simulation, network models, and a host of others. This module is organized into the general areas that would impact engineers most: network modeling (a process of representing flows) and justification of business investment. In engineering, justification would usually consider the risk of various outcomes.
3.1 Network Models 4

A network is a system of lines or channels connecting different points. Some Network models were first seen in project management as CPM and PERT models. Other models include transportation and assignment. Transportation models are used to minimize transportation cost or time to transport material. The assignment network model maximizes the efficiency of a batch of jobs to a limited number of machines. The assignment and transportation models are variations of the minimum cost network flow model (MCNFM).
3.1.1 Transportation Model

In many situations a company produces products at locations called supply points and ships these products to customer locations called demand points. Typically, each supply point has a limited amount that it can ship, and each customer must receive a required quantity of the product. Spreadsheet solvers can be used to determine the minimum-cost shipping method for satisfying customer demands. For now we assume that the only possible shipments are those directly from a supply point to a demand point. That is, no shipments between supply points or between demand points are possible. Such a problem is called a transportation problem. Consider the example of an aggregate company owning several aggregate pits in a municipal region. The supply (aggregate plant), demand (construction site, CS), and costs between each supply and each demand site are given in the tables below.
3
Some of the text for this module is taken directly from Dessureault, Sean. Capital Investment Appraisal for Advanced Mining Technology: Case Studies in GPS and Information Based Surface Mining Technology. University of British Columbia, Masters Thesis, 1999. Some of the text for this sub- module is taken directly from Winston, Wayne L., Albright, Christian S., Practical Management Science., Duxbury., Belmont. 1997. It has been edited for content and applicability.
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Table 3-1: A) Capacities
B)Demands
Plant 1 Plant 2 Plant 3
Capacity 35 50 40
CS CS CS CS
1 2 3 4
Demand 45 20 30 30
Table 3-2: Shipping Costs
Plant 1 Plant 2 Plant 3
CS 1 8 9 14
CS 2 6 12 9
CS 3 10 13 16
CS 4 9 7 5
To set up a spreadsheet model we need to keep track of the following: the units shipped from each plant to each construction site the total units shipped out of each plant the total units received by each city the total shipping cost incurred
Figure 3-1: Transportation Problem.
The spreadsheet model is shown in Figure 3-1. To develop this model, perform the following steps. Inputs. Enter the unit shipping costs for each plant to each city in the range C6:F8. Amounts shipped. Enter any trial values for the shipments from each plant to each city in the range C13:F15. These are the changing cells.
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Amounts shipped out of plants. To ensure that a plant does not ship more than its available supply, we need to compute the amount shipped out of each plant. In cell G13 compute the amount shipped out of plant 1 with the formula =SUM(C13:F13) Copy this formula to the range G14:G15 to compute the amounts shipped out of the other plants. Then enter the supply capacity of each plant in the range 113:115. Amounts received by construction sites. To ensure that each city receives the needed units, we keep track of the power received by each city in the range C16:F16. In cell C16 compute the units received by construction site with the formula =SUM(C13:C15) Copy this formula to the range D16:F16 to compute the units received by the other construction sites. Then enter the needed units of each construction site in the range C18:F18. Total shipping cost. Compute the total cost of shipping units from the plants to the construction cites cities in cell I9 with the formula =SUMPRODUCT(C6:F8,C13:F15) This formula simply sums all units' shipping costs multiplied by amounts shipped. Using the Solver Objective. Select cell 19 (total cost) as the objective to minimize. Changing cells. Select the range C13:F15 as the changing cells and constrain these to be nonnegative. These cells correspond to the amounts shipped from each plant to each city. Supply constraints. Add the constraints G13:G15<=I13:I15. These constraints (called supply constraints) ensure that no plant ships an amount of units exceeding its capacity. Demand constraints. Add the constraints C16:F16>=C18:F18. These constraints (called demand constraints) ensure that each construction site receives enough aggregate units. Linear model and optimize. Check the Assume Linear Model box and Solve. The Solver solution is shown in Figure 3-1 and is illustrated graphically in Figure 3-2.
Supplies Plants Const. Sites Demand
Figure 3-2: Transportation solution
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3.1.2 Transshipment model

Consider a metallurgical coal mining company in Australia shipping its products from various mines customers throughout the country. The material can be shipped directly by rail, or by a combination of rail to a port then onto an ocean vessel. This is not a transportation problem because shipments do not occur directly from the supply points (production plants) to the customers (steel foundries). Figure 3-3 represents a potential network. The network flow model of this situation requires the following elements: There must be a changing cell that represents the possible flow through each arc in the network. Each arc must have a unit shipping cost (or unit shipping profit) which is the cost (or profit) received per unit shipped along the arc. Each arc in the network must have a lower bound (usually 0 and an upper bound (often infinity) on the flow through the arc. These upper bounds are called arc capacities. Each node in the network must have a net supply. For each node i in the network, flows through the arcs must satisfy the following flow constraint: o (Flow out of node i)-(Flow into node i) = (Net supply at node i) Any node with a positive net supply is called a supply point; it is a net shipper of goods. Any node with a negative net supply is called a demand point; it is a net receiver of goods. A node with a net supply of zero is called a transshipment point; goods neither originate nor end up there. To formulate a problem as a MCNFM, it is necessary that the sum of all the net supplies in the network equal zero. If this is not the case, we simply add a dummy node with a net supply equal to the negative of the sum of the net supplies for all other nodes: (Net supply for dummy node) = - (Sum of net supplies for all other nodes) There are two cases where a dummy node is necessary: when the net supply for the dummy node is negative and when it is positive. The first case is when there is more capacity than demand; the second is when demand exceeds capacity. In the first case, no shipments out of the dummy node are allowed. To model this, we make the arc capacity for any shipment out of the dummy node equal to 0, and we insert an arc from each "real" node to the dummy node. The unit shipping cost for each of these arcs equals 0, and the capacity of each of these arcs equals the negative of the net supply of the dummy node.
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Figure 3-3: Transshipment example
As an example, consider Figure 3-3, where the three plants have capacities of 200, 300, and 100 units, and the two customers have demands of 400 and 180 units and the shipping capacities between nodes is 200 per arc. Then the net supplies for nodes 1, 2, and 3 are 200, 300, and 100, the net supplies for nodes 4 and 5 are 0, and the net supplies for nodes 6 and 7 are -400 and 180. Since the sum of these is 20, the net supply for the dummy node is -20. There would then be an arc from each of nodes 1-7 to the dummy node. These would each have unit shipping cost 0 and capacity 20. A "shipment" from node 1, say, to the dummy node would correspond to unused capacity at the first plant. In the second case, where the net supply of the dummy node is positive, no shipments into the dummy node are allowed. To model this, we make the arc capacity for any shipment into the dummy node equal to 0, and we insert an arc from the dummy node to each "real" node. The unit shipping cost for each of these arcs equals 0, and the capacity of each of these arcs equals the net supply of the dummy node. As an example, consider changing Figure 3-3 slightly so that the second customer's demand increases to 250. Then nodes 1,2, and 3 have net supplies of 200, 300, and 100, nodes 4 and 5 have net supplies of 0, and nodes 6 and 7 have net supplies of -400 and -250. Since the sum of these is -50, the net supply for the dummy node is 50. There would then be an arc from the dummy node to each of nodes 1-7. These arcs would each have unit shipping cost 0 and capacity 50. A "shipment" from the dummy node to node 6, say, would correspond to unsatisfied demand for the first customer. We are now ready to set up and solve a network flow problem. The changing cells will represent the flows through the arcs in the network. The constraints will consist of arc capacity constraints and the conservation of flow.
Plant 1 $0.00 $9.00 $0.40 $1.00 $2.00 $2.00 $7.00 $0.00 Plant 2 $5.00 $0.00 $8.00 $1.00 $1.00 $9.00 $3.00 $0.00 Plant 3 $3.00 $9.00 $0.00 $0.50 $0.60 $1.00 $6.00 $0.00 Wareh. 1 $2.00 $1.00 $1.00 $0.00 $0.80 $0.60 $1.00 $0.00 Wareh. 2 $1.00 $1.00 $0.50 $1.20 $0.00 $0.70 $0.30 $0.00 Cust. 1 $2.00 $8.00 $10.00 $5.00 $2.00 $0.00 $7.00 $0.00 Cust. 2 $4.00 $9.00 $8.00 $1.00 $7.00 $3.00 $0.00 $0.00 Dummy $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
Plant 1 Plant 2 Plant 3 Wareh. 1 Wareh. 2 Cust. 1 Cust. 2 Dummy
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It can be seen that nodes 1-3 are supply nodes, 4-5 are transshipment nodes, and 6-7 are customer nodes. A dummy node (8) will need to be added so that it will accept 20 nodes of excess production but it will not be physically shipped. Figure 3-4 shows how the problem can be set-up in excel.
Figure 3-4: Transshipment solution
Note that total outflows are calculated in cell K18 by summing C18 to J18. Similarly, all inflows into cell are calculated by summing To set up the spreadsheet model, proceed as follows. Unit shipping costs. Enter the unit shipping costs (in thousands of dollars) in the range C6:J13. Note that the cost of shipping along any node leading to or from the dummy node is zero. Arc capacities. Enter the arc capacities in the range C35:J42. Note that the zero entries in the range C42:J42 prohibit shipments out of the dummy node. Also note that zero arc capacities are used to rule out shipments from any node to itself. Amounts shipped. Enter any trial values for the shipments between points in the range C18:J25.
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Flows out of nodes. In preparation for creating the conservation of flow constraints for each node, we need to compute the flow out of and the flow into each node. In the range K18:K25 compute the flow out of each node. For example, to compute the flow out of node 1, we add all the flows out of node 1. To do this, enter the formula =SUM(C18:J18) in cell K18. Then copy this formula to the range K19:K25 to compute the flow out of the other nodes. Flows into nodes. Compute the flow into each node in the range C26:J26. First, compute the total flow into node 1 by adding the flow into node 1 from all other nodes. To do this, enter the formula =SUM(C18:C25) in cell C26. Then copy this formula to the range D26:J26 to compute the flow into the other nodes. Transpose flows out of nodes. It is convenient to "copy" the flows out of the nodes to the horizontal range C27:J27. To do this, enter the flow out of node 1 in cell C27 with the formula =K18 Then continue in this fashion to "copy" the flow out of nodes 2 through 8 to the range D27:J27. Note: An easy way to "copy" or transpose in one step in Excel is to highlight the range C27:J27 and then enter in cell C27 the array formula = TRANSPOSE(K18:K25) To enter this formula you must press Control, Shift, and then Enter, not just Enter. You will notice that the numbers in the vertical range K18:K25 have been transposed to the horizontal range C27:J27. Net outflows. Now prepare for the creation of the flow constraints by computing the actual net outflow for each node in the range C28:J28. Begin by entering the formula =C27-C26 in cell C28. Then copy this formula to the range 028:J28 to compute the flow out of the other nodes. Net supplies (inputs). Enter the net supply for each node in the range C30:J30. (These are labeled "Given net outflow" in the spreadsheet.) Total shipping cost. In cell K15 compute the total shipping cost (in hundreds of dollars) with the formula =SUMPRODUCT( C6:J13, C18:J25) Using the Solver Objective. Choose cell K15 (total shipping cost) as the objective to minimize. Changing cells. Choose the range C18:J25 (the possible shipments) as the changing cells and constrain these to be nonnegative. Flow balance constraints. Add the constraints C28:J28=C30:J30. Arc capacity constraints. Add the constraints CI8:J25<=C35:J42. These ensure that the flow through each arc does not exceed the arc's capacity. Linear model and optimize. Check the Assume Linear Model box and Solve.
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Figure 3-5: Solution to transshipment problem
3.1.3 Maximum Flow Model

Many situations can be modeled by a network in which each arc has a capacity that limits the quantity of a product that can be shipped through that arc. In these situations it is often desired to transport the maximum amount of flow from a starting point (called the source) to a terminal point (called the sink). Such problems represent a special case of the network flow model known as the maximum flow model. The following is an example of the maximum flow model. Consider the situation where Sunco Oil wants to ship the maximum amount of oil (per hour) via pipeline from a source (an Alaskan well) to a sink (a California refinery), as depicted in Figure 3-6. On its way from the source to the sink, the oil must pass through some or all of the three stations:1, 2, and 3. The various arcs represent pipelines of different diameters. The maximum number of barrels of oil (millions of barrels per hour) that can be pumped through each arc is shown in Figure 3-6. Sunco wants to determine the maximum number of barrels per hour that can be sent from the source to the sink. (In this figure, the source and sink are abbreviated as so and si.)
Figure 3-6: Maximum Flow problem.
To represent a maximum flow problem as a network flow model, we add a dummy arc flowing from the sink to the source. We set the net outflow for
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each node in the network equal to zero. Then ensure that the flow through the dummy arc will equal the flow into the sink. Therefore, we need only maximize the flow through the dummy arc, that is, the arc from the sink to the source. Since we do not know what the flow through the dummy arc will be, we make the capacity of the dummy arc equal to the sum of the arc capacities leading out of the source. In this case the total flow out of the source cannot exceed 2 + 3 = 5, so we make the capacity of the dummy arc equal to 5. Developing the Spreadsheet Model In setting up a spreadsheet for the maximum flow model, we must keep track of the arc capacities, the flow through each arc, and the net outflow for each node (which should be zero). The spreadsheet solution appears in Figure 3-7. To develop it, proceed as follows: Arc capacities. Enter the arc capacities in the range C20:G24. Observe that the arc capacity of 5 for the dummy arc from the sink to the source is entered in cell C24 (or add the capacities of the source to the nodes, =SUM(D20:F20). For arcs that do not exist, enter an arc capacity of zero. Net supplies. Enter the net supply (zero) for each node in the range C15:G15. Flows. Enter any trial values of the flow through each arc in the network in the range C6:G1O. Outflows from nodes. Compute the outflow from each node in the range H6:H1O: Specifically, compute the outflow from the source in cell H6 with the formula =SUM(C6:G6) Then copy this formula to the range H7:HIO to compute the outflow from the other nodes. Inflows to nodes. Compute the inflow to each node in the range C11:G11 Specifically, compute the inflow to the source in cell C11 with the formula =SUM(C6:C10) Then copy this formula to the range D11:G11 to compute the inflow for the other nodes. Transpose outflows from nodes. To compute the net outflow for each node, "copy" the outflow from each node to the range C12:G12. Net outflows from nodes. In the range C13:G13 compute the net outflow from each node. Specifically, compute the net outflow from the source in cell C13 with the formula =C12-C11 Then copy this formula to the range D13:G13 to compute the net outflow for the other nodes. Total flow from source to sink. In cell J6 compute the total flow from the source to the sink, which equals the flow through the arc from the sink to the source, with the formula =C10
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Figure 3-7: Maximum Flow spreadsheet
Using the Solver Objective. Choose cell J6 as the objective to maximize. This maximizes the flow through the artificial arc. As previously explained, this maximizes the flow from the source to the sink. Changing cells. Select the range C6:G1O as the changing cells and constrain these to be nonnegative. Flow balance constraints. Add the constraints C13:G13=C15:G15. These are the conservation of flow equations. Arc capacity constraints. Add the constraints C6:G1O<=C20:G24. These are the arc capacity constraints. Linear model and optimize. Check the Assume Linear Model box and Solve. Note: The solution is fairly obvious for such a small problem. The arc capacities of the arcs leading into the sink limit the total flow to 3, and it is easy to find a feasible solution with total flow 3. But in large networks the solution is usually far from obvious.
Figure 3-8: Maximum Flow Solution.
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MGE 409 Management Operations Technology ADDITIONAL RESOURCES VII
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The notes are additionally supplemented by: Lecture module 3.1 Network Models. Assignment 3
3.2 Justification 5
Capital investment assessment (CIA) is a key function for most engineering professions. Engineers are typically responsible for developing studies to identify the costs and benefits of investments. This is a field of management science in which many models have been developed to quantify the benefits, costs, and risks of investing in one or more alternative. The discussion of these tools is organized into 4 main level. Each corresponds to a level of complexity. Justification approaches can be classified as illustrated in Figure 3-9.
Justification Approaches Economic - Payback Value Analysis - ROI - IRR - MAPI - NPV Non-numeric - sacred cow - operating necessity Scoring - unweighted 0-1 - unweighted - weighted - AHP Programming - linear - integer - goal - business objectives - competitive advantage Portfolio analysis Risk Analysis Analytic Strategic - technical importance
Figure 3-9: Classification Scheme for justification approaches
As the complexity of the issues involved in a capital expenditure increase, so does the complexity and number of justification approaches used. Figure 3-10 illustrates a technique selection mechanism that can be used to identify the most appropriate techniques. For example, the vertical dotted line represents the situation where a level 2 technology is under investigation. It should be seen that the most intensely shaded areas (region closest to the shaded-white border) are opposite the 'analytic methods. Therefore at level 2, the most appropriate CIA methods are the analytic methods. The financial methods remain in the shaded area, therefore they are still useful in the evaluation, but alone would not accurately reflect an accurate appraisal. Therefore all justification schemes still in the region above the horizontal dotted line are appropriate
Some of the text for this sub- module is developed from Winston, Wayne L., Financial Models Using Simulation and Optimization. Newfield NY: Pallisade. 1998, 499p. 1/11/2006
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Level 1 Production Units

- Single unit equipment - Labor (incl. Eng. & Supp.)
Level 2 Integrated Process

- Integrated activities - Operator enhancement
Level 3 Operation Integr.

- Integrated Processes - Real-time Optimization
Level 4 Entreprise-wide
Integration - Integrated System
Economic
Useful
Analytic - Mathematical - Value Analysis
Most Appropriate
- Risk
Strategic
Largely Unnecessary
Figure 3-10: Selecting the appropriate justification technique
There are numerous formulae and approaches that firms use to evaluate the potential economic performance of a proposed project. The techniques most common in the mining industry include the payback method, incremental rate of return (IRR, also known as internal rate of return) or return on investment (ROI, referred to also as discounted cash flow rate of return Manufacturing statistics indicate that the (DCF-ROR) or simply DCF 6 ). overwhelming majority (91%) of firms in manufacturing use the payback method and ROI methods. These figures may also reflect some habits of mining management. This section will begin by presenting some of the techniques currently used in industry for economically justifying new projects. Criticisms of the various methods are also provided. The basic economic methods include payback, discounted cash flows (DCF) and internal rate of return (IRR). Analytic techniques are organized by scoring and portfolio models.
3.2.1 Economic Justification

3.2.1.1 Payback One of the most common evaluation criteria used by mining companies is the payback method. 7 The payback period is relatively simple: it is the amount
6
Gentry, D.W., ONeil, T.J., Mine Investment Analysis, American Institute of Mining, Metallurgical and Petroleum Engineers, Inc., 1984, p. 267 7 Gentry, Ibid., p.256 Dessureault 1/11/2006
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of time for the initial investment of the project to be paid-back from the cost reductions or amount of income it creates. 3.2.1.1.1 Analytical Example of the Payback Method Given the following example: A mining company is considering improving its grade distribution to the mill. There are several options available: Project 1: A GPS based shovel-monitoring system that has many other options; however, the estimates only reflect the improved grade distribution and avoidance of load misdirection. Project 2: Automated trip selector that the shovel operator can activate via radio link to indicate to the truck driver where the load should go. Project 3: re-training the truck drivers and buying an electronic trip counter to keep track of operator performance The table below summarizes all the economic variables involved in the calculation of the payback period.
Table 3-3: Economic variables for Payback Example
Project 1 Project 2 High Tech Tech Initial capital input $ 220,000 $ 100,000 Operating costs $ 2,000 $ 3,000 Revenue $ 50,000 $ 30,000 Risk Adjusted Int. ra 15% 10% Project life 7 6 Project 3 Retraining $ 18,000 $ 15,000 $ 20,000 5% 5
The table below calculates the payback periods of each of the projects. Analysis of the results is discussed following the table.
Table 3-4: Payback Example Results
Project year
investment --> 1 2 3 4 5 6 7 8 Payback (yrs.) Total profit $ $ $ $ $ $ $ $ $ $
Annual Net Cash Flows HT T R 220,000 $ 100,000 $ 18,000 48,000 $ 27,000 $ 5,000 48,000 $ 27,000 $ 5,000 48,000 $ 27,000 $ 5,000 48,000 $ 27,000 $ 5,000 48,000 $ 27,000 $ 5,000 48,000 $ 27,000 $ 48,000 $ $ $ $ 4 3 3 116,000 $ 62,000 $ 7,000
According to this method, if a manager were selecting a project based on payback period, projects 2 or 3 would be selected instead of the most profitable project 1. This method can increase in complexity when
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considering added variables. Added complexity may add accuracy, or more realistic estimates. However, if the proposed project has not yet been implemented (there is no historical data on which to base estimates), accuracy decreases. 3.2.1.1.2 Analysis of the Validity of the Payback Method When analyzing this method, several disadvantages can be seen. Primarily, the payback period is much too simple to model a complex system. In a complex system, some variables may not be easily accounted for, such as flexibility or improved engineering plans. For example, if a new engineering planning software package is being evaluated, the increased compatibility of the new system with other software may not be easily accounted for. This disadvantage is shared with most economic evaluation methods A second disadvantage of the payback period is that it fails to consider the timing of cash flows, therefore it cannot be used to assess profitability. For example, consider the example used above. Proposal 2 has the lowest payback period yet it has the lowest overall profit. A third disadvantage of the payback period is that the timing of payments is disregarded. A further disadvantage is some projects are more risky than others. In the example used above, the cost of capital and risk is ignored. These drawbacks are easily accounted for by utilizing a risk adjusted discounted payback period, as seen in the table below.
Table 3-5: Payback Example Results using Discount factor
Annual Net Cash Flows HT T R 220,000 $ 100,000 $ 18,000 41,739 $ 24,545 $ 4,762 36,295 $ 22,314 $ 4,535 31,561 $ 20,285 $ 4,319 27,444 $ 18,441 $ 4,114 23,864 $ 16,765 $ 3,918 20,752 $ 15,241 $ 18,045 $ $ $ $ 8 4 4 (20,300) $ 17,592 $ 3,647
Project year
investment --> 1 2 3 4 5 6 7 8 Payback (yrs.) Total profit $ $ $ $ $ $ $ $ $ $
From the results of the example, it can be seen that the first project is no longer the most profitable, furthermore, project 2 has a longer payback period than project 3.
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3.2.1.1.3 Reasoning for Selecting the Payback method Despite the numerous shortcomings of the payback method, it is still highly utilized in the mining industry 8 . The following is a list that provides some of the reasons, given by management, why this method is so popular. The main reason the payback method was selected to be used in this case study is due to its popularity. However, this method is considered to be inadequate due to its numerous deficiencies. Simplicity: The payback period is very simple. Managers can easily calculate the figure and understand the reasoning. Furthermore, it is much simpler to have an index, or common figure, that can be used as a comparison between competing projects. A further simplifying factor is that the break-even point is very obvious. Lack of interest in new techniques: Managers are well familiar with this technique, which has been used in the industry for decades. A sense of traditionalism has evolved around certain techniques, to the exclusion of new techniques. This is an important problem but a social-managerial issue and will therefore not be covered in this study. Established techniques may still be applicable but not in all cases. Risk reduction: A shorter payback period is considered to prevent management from being exposed to risk. For example, if a risky project were being considered, a shorter payback period would leave the company exposed to risk for a shorter period of time. The validity of this argument was discussed in a previous section. The manager must decide what the appropriate payback period should be. This value is often very subjective. Also, selection of appropriate discount rates is an issue that will be raised for every economic evaluation method. Discounted Cash Flow Techniques (DCF) 3.2.1.2 Discounted cash flow (DCF) techniques use a discount rate, usually in terms of a percentage, to represent risk. The discount rate is usually either a hurdle rate or the true cost of capital. Several versions of discounted cash flows are used in the following economic evaluation methods: NPV, ROI and IRR. Other DCF methods will not be explained. 3.2.1.2.1 Net Present Value This method is highly valued as one of industrys favorites. The net present value represents the amount of money the project is worth at the present time (t=0). The number is calculated by summing the inflows and outflows of cash, discounted at the selected discount rate. The choice of the discount rate is an important issue. The discount rate can be the true cost of capital or a value set by the corporation that can be adjusted to take risk into account. The general equation that best represents the NVP is presented
8
Gentry, Ibid., p.259 1/11/2006
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below. Typically, if the net present value is a negative value, the project should be rejected.
Net present value = present value of cash benefits - present value of cash costs
Equation 3-1: Net Present Value
3.2.1.2.1.1 Numerical Example of the NPV method Consider the following example:
Table 3-6: Data to be used in NPV example
initial investment Operating cost increasing at Revenue
$ $ $ $
4,000 3,000 450 0.75% 4,000
year 1 year 2 per year per year per year
Table 3-7: NPV example

1 (4,000) (450) 4,000 (450) (450) 7,308 2 (3,000) (453) 4,000 547 481 3 $ $ $ $ (457) 4,000 3,543 2,744 $ $ $ $ 4 (460) 4,000 3,540 2,412 $ $ $ $ 5 (464) 4,000 3,536 2,121
Net investment Operating Cost Revenue Income Income (DCF@12%) NPV@12%
$ $ $ $ $ $
$ $ $ $ $
3.2.1.2.1.2 Validity of the NPV method Two characteristics make this technique popular and more accurate than the payback period. Using a discount rate takes into account the time value of money. However, determining the appropriate discount rate is one of the difficulties of this method. The number is very subjective and sometimes set by corporate objectives. Some discount rates are set excessively high as a hedge against risk. This is very common when managers are considering new technology that has not yet been widely accepted. Similar to the payback method, NPV provides a single number upon which comparisons can be made between two projects with similar goals; however, one of the main problems with this method is that it does not measure profitability. For example, consider two projects with different capital input but identical NPVs. The project that is more capital intensive yet still profitable may be selected over a project that requires less capital but is more profitable. These deficiencies can be overcome by using a version of this method called the profitability index (PI) or the benefit/cost ratio (B/C).
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B/C ratio (PI) =
PV of net cash inflows PV of net cash outflows
Equation 3-2: Benefit/Cost ratio
3.2.1.2.2 Internal Rate of Return (IRR) Variations of the IRR method include rate of return (ROR) and return on investment (ROI). This economic justification method is used by the mineral industry more than any other technique 9 . The internal rate of return can be defined as the interest rate (discount rate) that allows the sum of the present value of all the inflows and outflows of cash to equal zero. This definition satisfies the equation below.
PV cash inflows PV cash outflows = NPV = 0

Equation 3-3: Internal Rate of Return
3.2.1.2.2.1 Numerical Example Illustrating the IRR method Using spreadsheet solvers, the IRR can be easily found. Prior to the introduction of spreadsheets, this calculation was done by trial and error. The example below was solved using the solver in Excel.
Table 3-8: IRR example data
yr 1 yr 2 total Operating costs Revenue Project life
Initial capital
Project 1 $ 110,000 $ 110,000 $ 220,000 $ 1,000 $ 40,000 7
Project 2 $ 80,000 $ 30,000 $ 110,000 $ 3,000 $ 30,000 6
$ $ $ $ $
Project 3 6,000 8,000 14,000 15,000 20,000 3
Table 3-9: IRR example results

Annual Net Cash Flows Project 1 Project 2 Project 3 $ (110,000) $ (80,000) $ (6,000) $ (71,000) $ (3,000) $ (3,000) $ 36,154 $ 22,735 $ 4,659 $ 33,516 $ 19,144 $ 4,341 $ 31,071 $ 16,119 $ $ 28,804 $ 13,573 $ $ 26,702 $ 11,429 $ $ 24,753 $ $ $ $ $ 7.87% 18.76% 7.32%
Year
investment --> 1 2 3 4 5 6 7 8 IRR
Gentry, Ibid., p.267 1/11/2006
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As can be seen in the results above, project 2 has the highest IRR. The acceptance or rejection of a single project using the IRR method depends on the hurdle rate set, usually by the corporation or manager. Most corporation use a hurdle rate of 15%, however, extreme cases exist, such as entertainment where a 300% hurdle rate is usually expected. 3.2.1.2.3 Validity of the IRR method There are several reasons for IRRs widespread popularity as a financial evaluation tool. The primary advantage is that it provides a single value that can be used to judge the project. A further advantage is that the result is presented as a percentage. According to Gentry (1984) engineers prefer percentages to absolute values such as NPV. A third advantage is that this method takes into account the timing of the payments. Another advantage is that it does not require a subjective input in the form of a pre-established discount rate.
3.2.2 Portfolio & Scoring models

Analytic justification approaches include programming models, scoring models, non-numeric arguments and growth options. Programming models include linear, integer and goal programming. Programming models and growth options are considered to be portfolio models since the securities industry uses them to optimize investment portfolios. Scoring models include weighted scoring and the analytical hierarchy process (AHP). Non-numeric models are the sacred cow and operating necessity arguments. Descriptions and examples of most of these methods will be provided. Programming models 3.2.2.1 The following subsections include examples of integer programming and goal programming in justification. It should be noted that all examples given in this text are illustrative, not exhaustive. 3.2.2.1.1 Integer Programming Optimization models where some or all of the variables must be integers are called integer programming (IP) models. 10 An example of how to build and execute a model on a modern spreadsheet tool is provided. Example: Minecomp, a fictitious underground base metal mine, is considering investing in one of several different technologies. Minecomp is considering upgrading its communications system to provide possible automation. The monetary values of both the investment and estimated return are provided in the table below. Some restrictions are imposed on the
10
Winston, Ibid. p.214 1/11/2006
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model due to technology incompatibilities. presented below.

Table 3-10: Data for Minecomp Example
Investment 1 2 3 4 5 6 Description Leaky feeder (low capacity) Leaky feeder (high capacity) Distributed antenna system Radio tech 1 Radio tech 2 Both Radio techs Abreviation LFL LFH DAS R1 R2 RR
These restrictions are also
Cash Required NPV (in thousands) $150 $200 $250 $400 $400 $600 $150 $500 $100 $1,750 $250 $3,500
Table 3-11: Restrictions for Minecomp Example
Restrictions: Radio tech 1 cannot function with LFL DAS cannot function with LFL Total Budget of $730,000
The main components of this assessment are: The investments chosen The cash required for the investments Total NPV of the chosen investments The data was entered into the spreadsheet as seen in the figure below. The changing cells were in the investment decision row. The goal of the algorithm was to maximize the NPV subject to the constraints. The solver was invoked and constraints applied. The solver changed the cell in array B2:G2 to reflect the maximized NPV given the constraints.
Figure 3-11: Optimal Solution for Minecomp Example
As can be seen from the figure above, the solution to the problem would be to invest in a DAS, while using radio technologies 1 and 2. This example may appear trivial, but real situations may require many more variables and constraints.
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3.2.2.1.2 Goal Programming Goal programming is ideal for situations where a company wants to achieve several objectives, given limited resources. Sometimes it is impossible to realize all the objectives simultaneously 11 , but in the solution process, an If the company cares to prioritize its optimum is usually achieved 12 . objectives, goal programming can still be used. This method of prioritizing objectives is called a preemptive goal programming approach 13 . A fictional open pit mining company, OPMC, would like to improve its drilling operations. Management has identified three key variables that measure drill performance. The mill would like a specific size distribution, making fragmentation a key variable. Due to the geological conditions, accurate drill position is another important variable. Finally, the drilling operation is taking too much time to set-up the drill and begin drilling, therefore set-up time is another variable. Management has identified two possible solutions. The first is to undertake an intensive operator-training program. There is an incremental improvement in the three key variables governing drill performance, as seen in the table below. The second solution is the purchase of a drill navigation package offered by Aqmod, a fictitious mining technology provider. Each navigation package purchased provides an incremental improvement in the three drill improvement variables. A total budget of $170 000 has been budgeted for this project. This data is summarized in the tables below.
Table 3-12: Goals for OPMC Example
Description Abbreviation goal 1: improve fragmentation by Frag 31% goal 2: improve blast hole positionPos 20% goal 3: decrease set-up time S-t 30%
Table 3-13: Improvement Methods for OPMC Example
% improvement/unit Description Abbreviation Frag Pos S-t Cost/unit method 1 Higher level of train Training 1% 2% 3% $ 3,300 method 2 Aqmod drill platform Aqmod 17% 8% 11% $ 80,000
A spreadsheet model, similar to the integer programming model above, will be formulated. The main components of this model are listed below: Number of improvement method units purchased Cost of the methods Overall improvement
11 12
Winston, Ibid. p. 338 Camm, Jeffery D., Evans, James R., Management Science; Modeling, Analysis and Interpretation., South-Western College Publishing., 1996., p. 328-329 13 will not be explained here but readers are encouraged to review the Winston (1997) Dessureault 1/11/2006
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The spreadsheet model was formulated as shown in the figure below. The solver determined the values in cells B8 and C8; they represent the optimized solution. The optimal solution is to train three operators, while purchasing two Aqmod drill packages. Changing the estimated improvement values incurred from the two methods can alter the solution. Increasing or decreasing the percentage values of the goals can alter their importance. For example, if the management considers that decreasing the set-up time is of prime importance, the goal value may be changed from 30 to perhaps 40. Therefore this solution is only as valid as the estimated improvements or management goals.
Figure 3-12: Optimal Solution for the OPMC Example
3.2.2.2 Scoring Models The two scoring models explained in this section are the weighted average and analytical hierarchy process. The weighted average method is relatively simple and is used in many industries. The analytical hierarchy process (AHP) is a multi-objective decision making tool that is accepted as one of the best multi-criteria assessment tool that can simultaneously evaluate quantitative and qualitative data. 3.2.2.2.1 Weighted Average Method The weighted average method is simple and easy to use, but it is very subjective. The method can be used to decide between different projects, or to ensure that the project conforms to certain pre-established criteria. This method consists of quantifying the importance of different objectives, then estimating the importance of each factor. To obtain a solution, the hierarchy of the objectives is multiplied by the rating of the factors to yield a comparative score. Consider the following example: An underground mining company, UMC, which uses a vertical retreat mining method, is contemplating three different technologies for mucking out the open stopes. There are eight variables
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(objectives) that management considers to be of top importance for the mucking cycle: capital cost, operating cost, productivity, operator acceptance, maintenance cost, infrastructure requirements, unfamiliarity of the technology, and safety. Each technology being evaluated has a different rating on these factors on a scale of 1 to 10; here a higher number signifies a more attractive outcome. For example, if technology A has a lower capital cost, it receives either an 8 or a 10. A weight is also given to each objective, depending on the importance of the objective to the mine management. The three technologies under consideration are described below: Option 1: line of sight tele-operated system. This system is well accepted by miners due to its long widespread use in mines. However, many operators are accidentally killed or injured due to operator error (controlling the machine from an unprotected area). Option 2: Controlling the LHD from a control room on the same level. This technology is relatively straightforward, but communications infrastructure is required. Productivity is slightly higher since higher speeds can be used. Option 3: Controlling LHD from surface. This technology is state-of-the-art. The miner is not exposed to danger, and less ventilation is required in the area. Increased productivity can be achieved since the LHD can operate at higher speeds and since work can begin as soon as the miner arrives at the surface workstation. However, no mines currently use such systems in a production capacity. A further drawback would be the operator resistance to the technology since more intense work hours are possible and the technology is unfamiliar. A final drawback is the considerable extension of communications infrastructure that would be required beyond option 2. A manager can then rate the projects according to the table below. The scoring is subjective. For example, the opinion of the importance of safety may be increased or decreased depending on the manager, or the corporate policies.
Table 3-14: Weighted Scores for UMC Example
1 2 3 4 5 6 7 8
Projects Factor LSTR TRL TRS Weight Capital Cost 8 6 3 7 Operating Cost 9 6 6 8 Productivity 6 8 10 10 Legend: Operator acceptance 8 7 5 6 Line of Sight tele-remoteLSTR Maintenance Costs 7 6 5 7 Tele-remote from level TRL infrastructure requireme 10 7 5 3 Tele-remote from surfacTRS Unfamiliarity 10 7 6 4 Least desireable impact 1 Safety 4 7 10 2 Most desireable impact 10
The final results are presented in the table below. This result was achieved by multiplying the weight of each project objective by the rating each project receives. The weights are summed, then normalized for ease of comparison. According to the manager at this mine, the line-of-sight remote control LHD
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is the best decision in this case. The power of this CIA method lies in the ability to quantify qualitative factors such as safety or operator acceptance.
Table 3-15: Results of Weighted Average Method for UMC Example
Factor LSTR TRL TRS Capital Cost 56 42 21 Operating Cost 72 48 48 Productivity 60 80 100 Operator acceptance 48 42 30 Maintenance Costs 49 42 35 infrastructure requireme 30 21 15 Unfamiliarity 40 28 24 Safety 8 14 20 363 317 293 Sum: 1.00 0.87 0.81 Normalized
3.2.2.2.2 The Analytical Hierarchy Process (AHP) The analytical hierarchy process (AHP) is another multi-objective decision making tool. Tomas Saaty 14 developed the technique to overcome inconsistency in human judgment. This powerful decision tool is used by many disciplines including accounting, finance, marketing, energy resource planning, microcomputer selection, sociology, history, architecture and political science 15 . The power of this decision process is that it quantifies qualitative values so that they can be evaluated with the naturally quantitative values. For example, qualitative benefits can be considered with financial values. This method is similar to the weighted average evaluation technique where objectives or factors are assessed. The power of this method is the ability to compare the importance of two different factors through a method called the Pairwise Comparison Matrix. An example is given along with a pragmatic explanation of the mathematics involved. To obtain the weights the Pairwise Comparison Matrix is formed. The entry rows are labeled i and entry columns j. Priority or importance is measured on an integer 1-9 scale, according to the definitions provided in the table below. The phrases in the table are comparative phrases, to help the evaluator compare two variables. The values may seem discrete, however, more experienced evaluators may use a continuous scale.
14 15
Saaty, Thomas. The Analytical Hierarchy Process. New York: McGraw-Hill, 1988 Winston, Ibid. p.371
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MGE 409 Management Operations Technology Table 3-16: Interpretation of Values in Pairwise Comparison Matrix 16
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Value of aij 1 3 5 7 9
Interpretation Objectives i and j are equally important Objective i is slightly more important than j Objective i is strongly more important than j Objective i is very strongly more important than j Objective i is absolutely more important than j
The following is an example of how pairwise comparisons are made. If an evaluator were judging a situation where there are three objectives, the matrix would contain a 3x3pattern.
a11 A = a12 a 13
a21 a22 a23
a31 1 a32 = 1 a 21 a33 1 a31
a21 1 1 a32
a31 a32 1
Equation 3-4: Pairwise Comparison Matrix for 3 objectives
Equations above represent a situation where there are three objectives. To illustrate, if objective 1 is strongly more important than objective 2, then a12 =5 and a21 = 1/5. Correspondingly, if objective 3 is very strongly more important than objective 1, then a31=7 and a13=1/7. Finally, if objective 2 is slightly more important than objective 3, then a23=3 and a32=1/3. The matrix below is obtained using these values.
1 A = 5 1 7
5 1 3
7 1 3 1
Figure 3-13: Pairwise Comparison Matrix solution for 3x3 example
An open pit iron ore mine, IOM, is trying to determine what technology, if any, should be implemented. IOM has a large mill throughput therefore fragmentation is very important for the mill recovery. A further difficulty is that the complicated geology makes the large blast patterns difficult to design. Grade control is also important in iron ore mines. At IOM, it is difficult for shovel operators to distinguish between low and high grade. Management has several objectives that resulted in the decision to invest in technology: Objective 1: Fragmentation Objective 2: Lead-time for blast pattern design changes from geological updates Objective 3: Cost of equipment
16
Winston, Ibid. p.364 1/11/2006
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Objective 4: Grade control
Several technologies might help the manager achieve the objectives mentioned above. One suggestion is to continue using the same tools so that costs do not increase, another is to implement drill monitoring technology, a third is to implement shovel monitoring technology while a fourth, is to implement both the drill and shovel monitoring technology. The figure below summarizes the objectives and solutions:
Table 3-17: Objectives and solution options for IOM example
Description Objective 1 Ideal fragmentation for Mill Objective 2 Flexibility of design changes Objective 5 Cost of equipment Objective 6 Better grade control Option 1: Option 2: Option 3: Option 4: Without drill technology Drill tech Shovel tech Both shovel & drill tech
Abbreviation Fragment Flexibility Cost Grade No tech Drill Shovel All techs
Solution to IOM problem: Step 1: Determine the Pairwise Comparison matrix. The manager, after careful contemplation, forms the following pairwise comparison matrix, on a spreadsheet:
Fragment Flexibility Cost Grade Fragment 1 5 3 2 Flexibility 1/5 1 1/4 1/2 Cost 1/3 4 1 1 Grade 1/2 2 1 1
Figure 3-14: Pairwise Comparison Matrix for Objectives for IOM example
From the matrix above, it can be seen that the manager considers fragmentation strongly more important than flexibility. Step 2: determine the weights. Take the sum of each of the columns, and divide each value in the column the sum of the column. (This normalizes the column.) The values obtained for the normalized matrix are:
Fragment Flexibility Cost Grade Fragment 0.4918 0.4167 0.5714 0.4444 Flexibility 0.0984 0.0833 0.0476 0.1111 Cost 0.1639 0.3333 0.1905 0.2222 Grade 0.2459 0.1667 0.1905 0.2222
Figure 3-15: Normalized Pairwise Comparative Matrix
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An example of the calculation used for the above matrix is:
a11 (normalized ) =
a11 1 = = 0.4918 a11 + a12 + a13 + a14 1 + 1 + 1 + 1 5 3 2
Step 3: Determine the weights of the objectives. The weight of each objective is calculated by taking the average value of each row. From the matrix above, the resulting 1x4 vector is found to be:
0.4811 0.0851 w= 0.2275 0.2063

From this vector, it can be seen that the manager considers fragmentation to be the most important objective, while cost and grade are relatively the same. Flexibility is not a great concern according to this evaluation. Comparisons can be inconsistent due to human discrepancies. A method was devised to check for inconsistencies. The solution consists of multiplying the pairwise comparison matrix by the score of the objectives. Therefore, from the example above, the following multiplication is made:
wconsistency
1 15 =1 3 1 2
5 1 4 1 2
3 2 0.4811 2.0017 1 2 0.0851 0.3414 4 = 1 1 0.2275 0.9346 0.8446 0.2063 1 1
Using the numbers from the vector wconsistency, the following single value is calculated using the weighted objective values.
2.0017 0.3414 0.9346 0.8446 + + + 0.4811 0.0851 0.2275 0.2063 = 4.0934 4

Using the value above, the consistency index (CI) is calculated using the equation below. The n variable is the number of objectives.
CI =
4.0934 n 4.0934 4 = = 0.0311 n 1 3
The CI is then compared to an index value, obtained from the table below. Saaty derived the table.
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MGE 409 Management Operations Technology Table 3-18:Random Indices for Consistency Check 17
2006
n RI
2 0
3 0.58
4 0.9
5 1.12
6 1.24
7 1.32
8 1.41
9 1.45
10 1.51
if CI = 0, perfectly consistent if CI/RI < .10 then satisfactory consistency if CI/RI > .10 then serious inconsistencies exist The solution is still not complete. All the steps above must be repeated for every option. Options 1 through 4 (No Tech, Drill, Shovel and All Techs) must be compared with each other, rated on the performance of each objective. Figure 3-16, represents the pairwise comparison matrix for comparing the options according to the fragmentation objective (on an Excel spreadsheet). The evaluator considers the Drill option to be moderately more important than the No Tech option for improving fragmentation (cell C13). Furthermore, according to the final scores, the Drill option is the best solution for fragmentation. Finally, it can be seen that the matrix has satisfactory consistency.
Figure 3-16: Pairwise Comparison Matrix of Options for Fragementation for IOM Example
Once all score matrices have been completed, and they all have satisfactory consistency, the score matrix is multiplied by the weight matrix to obtain the final overall score matrix. The result is shown in the figure below. From the solution in Figure 3-17, both the Drill and All Techs options satisfy the management at the iron ore mine.
Matrix of scores Fragment Flexibility Cost Grade 0.1943 0.1612 0.6349 0.1564 0.7587 0.5880 0.3214 0.3011 0.1943 0.3421 0.2410 0.6297 0.5881 0.9302 0.1051 0.8280
No tech Drill Shovel All techs
Weights 0.4811 0.0851 0.2275 0.2063
Overall Scores 0.283884 0.550276 0.307343 0.55683
Figure 3-17: Final Solution for IOM Example
17
Winston, et. al., Ibid., pp.368 1/11/2006
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3.2.3 Options Pricing

Note: Undergraduate students are not responsible for learning the following introductory section The options pricing section is intended for graduate students only. Interested undergraduates are welcome to read and ask questions regarding this material, however, no lectures or undergraduate assignments will be provided. The options pricing technique was originally intended to formulate a fair, non-subjective price for stock options. Manufacturing has used this price model to determine the value of flexibility in manufacturing systems. The economic model has also been used in the mining industry for valuing the flexibility of design. 18 This methods power lies in its ability to quantify the flexibility of the technologies. In this section, the origin and mechanics of option pricing, as a justification method, will be given, with an example of its application as a justification tool. The technique can be applied to technologies that are level 2 or 3 since flexibility can be tactical or strategic in nature. An example of tactical flexibility in mining is the ability to mine a back-up stope in case the planned stope becomes unavailable (for example, due to a catastrophic cave-in of the planned stope). This flexibility can be purchased by undertaking advanced development 19 ; however, the extra capital costs of undertaking advanced development must be larger than the cost of the loss of production that would be incurred in the event of losing a stope. Option pricing is considered to be an important method for future capital investment appraisal of new technologies. An option is defined as the right, but not the obligation to buy (or sell) an asset under specified terms. A put option is the right to sell an asset at a given price, whereas a call option is the right to buy at a certain price. Options that are associated with investment opportunities are usually referred to as real options. The term real is emphasized since they involve real activities and real commodities. A summary is now given of the history of options and the development of tools that are used to price options. Different types of options are listed and finally, mining examples are provided. According to Copeland and Keenan 20 , the first account of a real option is found in the writings of Aristotle. It tells of how Thales the Melesian divined from tea leaves that the olive harvest, six months away, would be bountiful. He approached the olive press owners and bought the right to rent the
18
Samis, Mike, Project evaluation using contingent claims analysis an overview, Masters Thesis, University of the Witwatersrand, Johannesburg, 1994 19 Dunbar, W Scott; Sean Dessureault and Malcolm Scoble. Analysis of Flexible Mining Systems. CIM 98 CD-ROM, 1998 20 Copeland, T. and P. Keenan. Making real options real. McKinsey Quarterly, no.3, 1998. Dessureault 1/11/2006
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presses at the usual rate during the harvest season. As Thales had predicted, the harvest was plentiful so farmers were desperate for presses. Thales rented the presses at the usual rate and rented them out himself at a much higher rate, thereby making profit on the difference minus the original cost to buy the rights. Had the harvest been bad, then Thales would have simply not exercised his right to purchase the presses and would have only lost the money he had paid for the right to rent the presses. Developing a methodology of determining an arbitrage free price of a European option, won Fischer Black, Myron Scholes, and Robert Merton the 1997 Nobel Prize for economics. The term arbitrage free means that stocks with exactly the same risk/return profiles should be identically priced. Most investors recognize that investment with higher risk should have the potential to make more money. A European option is the right to buy a certain asset for a specified price at a specific time. This differs from an American option which allows the option owner to buy at any time before a specified expiry date. Several securities options are available throughout the world. The equation below provides the Black-Scholes formula for an option price. The SP variable is the current price of the stock. EP is the exercise price (the price at which the option owner has the right to buy), while DUR is the duration of the option (the time from the present at which the option may be exercised). IR is the markets current risk-free rate of return and VOL is the volatility of the stock. All values, except for VOL, are known; however, the volatility can be estimated using the capital asset pricing model or through market histories, for example, from the London Metal Exchange.
Black - Scholes option price = SP N (d1 ) EP e DUR IR N (d 2 )

2 SP ln + IR + VOL 2 (DUR ) EP d1 = VOL DUR
(1)
where and
(2) (3)
d 2 = d1 VOL DUR
N(x) is the cumulative normal distribution at value X, where the distribution has a mean of 0 and a standard deviation of 1. Real options differ from securities options since they deal with real assets or activities. These investment opportunity options use the pricing models developed for the securities sector. The first important step in investment appraisal is to identify the real option. There is no official convention on the identification of the types of options. Copeland and Keenan27 provided a classification of options as growth, deferral and abandonment options. Growth options are available when a company has the option to invest in opportunities that will lead to growth of the company. Scale-up options are investments in infrastructure that would allow the option for future growth as the market grows. A switch option would be the purchase in infrastructure
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or technology that would allow a company to change the type of product to produce the highest return, depending on market conditions, or to switch to the next generation of a product easily. Deferral options are sometimes referred to as natural resource development options. This options value depends on the value of delaying investment in an opportunity. It is common in the mining industry, where companies sometimes wait for appropriate market conditions (commodity of the proposed mine) before investment. Copeland and Keenan also considered a learning option, as a form of deferral option.27 This type of option has also been referred to as a Pioneer option, R&D option, or natural resource exploration development option. Learning options arise when companies have the choice to spend money to speed up the acquisition of important information and to use what it has learned to modify its future decisions. For example, a mining company may decide to spend money to further define an orebody so that the extent of the reserves are estimated with greater precision and an optimum mine design formulated. An abandonment option is the ability to choose to dis-invest or sell assets, given market conditions. A company may chose to abandon a particular operation if there is no further potential for significant payback. For example, a mining company may choose to abandon a particular mine if the market conditions are no longer favorable, or if there are undue political developments. Real options that calculate the value of a new technology could pertain to more than one of these types of option. They relate to the choices that a manager could make, given certain information. Those choices represent flexibility. Information and communications based technology provide both information and flexibility, therefore options pricing should be considered an important tool in the valuation of this type of technology. Several models have been developed to determine the value of various options, most tend to be based on the Black-Scholes equation. Considering once again the GPS based drill monitoring technology example discussed previously. One of the many benefits of its integration would be the value of the experience gained from implementing, utilizing, and maintaining the GPS and machine monitoring technology. This experience value is exploited when other applications of this type of technology are made available. These can then be more readily integrated into operational systems. GPS based shovel monitoring equipment is also available that could similarly impact a mining operation. Learning how to implement and fully utilize GPS based drilling technology would provide information and experience on how to appraise and fully utilize GPS based shovel technology. This learning benefit could be considered to be a learning option. Another benefit that could be construed as a type of option is the ability to use the information provided by the GPS based drill technology in a blending process to interface the mine and mill more effectively. With further
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investment, a computer aided methodology could be developed that would enable production planners to blend ore according to grade and ore hardness (a parameter sensed by the drill monitoring system), thereby improving the throughput or recovery. Once the drill monitoring technology is purchased, then the mine has the option, but not the obligation, to invest in the blending project. From another perspective, the mine may wait to see how well the technology is utilized by the operations and how well it fits with the corporate culture. This investment could be considered as a growth option, since the mine could choose to take the opportunity to expand its assets value, given appropriate market conditions. As discussed previously, several methods exist which calculate the value of a growth option. Numerical examples using the Black Scholes model are presented below. Other models include Azzone 21 , American options, and binomial models. 22 3.2.3.1 Binomial Options Theory Binomial option pricing is a generalization of Black-Scholes (covered next). This method of calculating the value of an option is based on a binomial model of metal price fluctuations 23 . For example, over a certain period the price of a metal can either increase or decrease from its value at the beginning of the period.
P-up
P P-down
Figure 3-18: Binomial Fluctuations
Increasing the production from a mine is analogous to a call option (i.e., the mine operator has the right, but not the obligation to produce more metal at any time). The option to increase production will only be exercised if P>X given that P is the price per unit and X is the cost of production per unit. The figure below simplifies this concept, where the payoff (option value) is governed by metal price.
Azzone, Giovanni and Bertele, Simulation vs. Analytical Models for the Economic Evaluation of Flexible Manufacturing Systems: An Option-Based Approach, Economics of Advanced Manufacturing Systems, Edited by Parsaei et. al., Chapman & Hall, London, 1992. 22 Dessureault, S., Scoble, M., and Dunbar, S. Analytical management tools for continuous improvement in mining operations. Proceedings of the 28th APCOM conference, Golden CO., Oct. 20-22, 1999. p.719-726.
23
21
Luenberger, D. G., Investment Science. Oxford University Press, 1998, p. 341-342
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Payoff
Option Payoff = max( P X ,0)

X Metal Price, P
Figure 3-19: Option Payoff
An example of the application of valuation of strategic flexibility is presented below. The example calculates the value of two flexibility options. The first is to be able to open or close the mine when gold price fall below a particular level. The second calculates the value of a technology/methodology that can allow a gold mine to increase capacity in the event of a price increase. The following variables are used in the example: Mine life Production rate, Mt Production cost, X Risk-free discount rate r Price P = Upward u = Downward d = 10 years 10,000 oz/year $200/oz 5% $300/oz 1.1 0.9
The lattice of gold prices below is calculated using binomials. For example, over the 10 year life of the mine, the price can either increase by 10% (u=1.1) or decrease at a rate of 10% (d=.9) every year. Hence, if in the first year the price of gold increases, from 300 to 330, then decreases in the following year, the price would fall to 297. There are two elements of flexibility in this problem. First, the mine can shut down when the price of gold is above production cost. The first exercise will determine the value of the project if the option to shut down the mine is exercised. The second is the option to invest in additional technology that would extend the production rate to 12,000 oz/year at a capital cost of $1.0 million and an increased production cost of $215/oz (the cut-off will similarly be reduced).
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MGE 409 Management Operations Technology Table 3-19: Binomial price lattice for gold over a 10 year period
2006
Year
0 300
1
330 273
2 363 300 248
3
399 330 273 225
4 439 363 300 248 205
5
483 399 330 273 225 186
6 531 439 363 300 248 205 169
7
585 483 399 330 273 225 186 154
8 643 531 439 363 300 248 205 169 140
9
707 585 483 399 330 273 225 186 154 127
10 778 643 531 439 363 300 248 205 169 140 116
Calculating the present value of the gold mine considering the fluctuations is explained in 4 steps. Step 1: Finding the probabilities of arbitrage-free option probability. Remember that options are designed to provide the value of an arbitragefree investment. Therefore, the probability of the gold price to move up or down must be risk free, therefore: (prob. of increase)(increase)+(prob. of decrease)(decrease) = risk-free investment, or p(u)+(1-p)(d) = (1+r), we want to solve for probability, p, therefore:
p=
(1 + r ) d 1.05 0.9 = = .75 ud 1.1 0.9
Step 2: At the end of year 10, the revenue from operating the mine is calculated. Therefore, the value of the years production is the gold price of that year, subtracted by the costs, multiplied by the number of ounces produced. Note that for option 1, the mine would operate only if the gold price was above the cut-off, being the costs. The value for to highest price in year 10 was (778-200)*10,000=$5.78 million dollars. Note however, that the value at the beginning of year 10 was 1/(1+r)*5.78= $5.51 million. The value of the revenue for each possible gold price is calculated for year 10. Remember for option 1 that when the gold price is below 200, no revenue is incurred because the mine temporarily shuts down. Table 3-20 shows the value of gold production in year 10 and Table 3-21 shows the values for option 1. In excel, this can be calculated using the MAX(0,((price-cost)*ounces*(1/(1+r) function, as seen in Figure 3-20.
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Table 3-20: Value of gold production ($million) using gold price fluctuations and mine model for base case
Year
0 14.82
1
15.99 10.53
2 16.90 11.50 7.04
3
17.50 12.22 7.85 4.25
4 17.71 12.63 8.43 4.96 2.09
5
17.46 12.67 8.71 5.43 2.73 0.49
6 16.65 12.26 8.63 5.63 3.15 1.10 -0.60
7
15.18 11.31 8.12 5.48 3.30 1.49 0.00 -1.23
8 12.93 9.74 7.10 4.92 3.12 1.64 0.41 -0.61 -1.45
9
9.76 7.42 5.48 3.89 2.57 1.48 0.57 -0.17 -0.79 -1.30
10 5.51 4.22 3.16 2.28 1.55 0.95 0.46 0.05 -0.29 -0.57 -0.80
Table 3-21: Value of gold production ($million) using gold price fluctuations and mine model for Option 1
Year
0 14.82
1
15.99 10.53
2 16.90 11.50 7.05
3
17.50 12.22 7.85 4.28
4 17.71 12.63 8.43 4.96 2.20
5
17.46 12.67 8.71 5.43 2.75 0.89
6 16.65 12.26 8.63 5.63 3.15 1.19 0.23
7
15.18 11.31 8.12 5.48 3.30 1.51 0.33 0.02
8 12.93 9.74 7.10 4.92 3.12 1.64 0.46 0.02 0.00
9
9.76 7.42 5.48 3.89 2.57 1.48 0.57 0.03 0.00 0.00
10 5.51 4.22 3.16 2.28 1.55 0.95 0.46 0.05 0.00 0.00 0.00
Step 3: Calculate the overall value of the mine at present. Note that the value of the operation is the cumulative addition of all of the previous years values based on their respective probabilities and the present years production values. Therefore in year 9, the value of its end-of-year revenue is = MAX(0,((price-cost)*ounces*(1/(1+r) = (MAX(0,((707.4-200)*10,000*1/(1+0.05)=$4.83 million. The future value of the production in year 10 would also need to be included in order the derive the full value of the operation from the viewpoint of year 9. Therefore the value of year 10s values in year 9 would be calculated by: =(1/(1+r)) * ((probability of increase)*(value higher-priced production in year 10) + (probability of decrease)*(value of decreased-priced production in year 10)). =(1/(1+r)) * (p*(high-rev of next year) + (1-p)(low-rev of next year) 93
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=(1/(1+0.05) * (0.75*5.51 + (1-0.75)(4.16) = 4.922 Hence, the total value of the mine from the high-value of year 9 is calculated to be 4.83+4.922=$9.76 million The equation to calculate the above in excel is shown in Figure 3-21. This equation is copied to all previous cells below and to the left. The final present value of the project given the current price fluctuations can be seen in Table 3-24. As can be seen, at the present time, the value of this investment is $14.82 million. This model can be used to determine the value of an investment or business that can be stopped when price falls below cost. However, in situations where one is trying to determine the VALUE of the option to turn investments on or off, a comparison would have to be made between the base case and where the option is not invoked.
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Figure 3-20 Spreadsheet model showing equation in cell L32.
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Figure 3-21: Spreadsheet model showing equation in cell K33
Step 4: Comparing the values. A comparison is made between the option to shut down the operation when gold falls below a particular price and when the mine continues to produce regardless of price. In this case, the MAX(0, function), is removed so that only the function remains (allowing negative values to occur). This results in the table of values seen below in Table 3-20. The difference is relatively minor (the difference of $781.9, does not even scratch the $14.82 overall value of the operation). Therefore the option to shut down or start-up given gold price fluctuations is not worthy. However, when undertaking a sensitivity analysis, using data tables (covered in
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lectures), a sensitivity analysis is undertaken to evaluate the effect of production cost. The results are shown in Table 3-23. As can be seen, at a production cost of $375/oz, the value of the option becomes much more attractive
Table 3-22: Table of Values when not exercising the option to shut down.
Year
0 14.82
1
15.99 10.53
2 16.90 11.50 7.04
3
17.50 12.22 7.85 4.25
4 17.71 12.63 8.43 4.96 2.09
5
17.46 12.67 8.71 5.43 2.73 0.49
6 16.65 12.26 8.63 5.63 3.15 1.10 -0.60
7
15.18 11.31 8.12 5.48 3.30 1.49 0.00 -1.23
8 12.93 9.74 7.10 4.92 3.12 1.64 0.41 -0.61 -1.45
9
9.76 7.42 5.48 3.89 2.57 1.48 0.57 -0.17 -0.79 -1.30
10 5.51 4.22 3.16 2.28 1.55 0.95 0.46 0.05 -0.29 -0.57 -0.80
Table 3-23: Sensitivity Analysis
Production cost $ $ $ $ $ $ $ $ $ $
175 200 225 250 275 300 325 350 375 400
Value of option 1 $ 96 $ 782 $ 4,451 $ 22,842 $ 89,154 $ 271,070 $ 869,860 $ 1,755,348 $ 2,862,888 $ 4,140,228
Step 4 for Option 2: Consider a technology or modification that allows a capacity expansion or contraction at any time. The cost of the technology is $1.2 million, with potential production rate increase to 12 000 oz/year and production costs increase to $215/oz (7.5% increase), at any time. Therefore, when the price dips below $215/oz, the annual production rate can be dropped to 10,000oz and production cost of $200. Assuming that the modification was in place, the previous table is re-calculated and presented below. Note that an IF statement is inserted where the production rate and cost is adjusted depending on price. The option to stop mining even if the price is below $200 is not enabled. Figure 3-23 shows the spreadsheet model and equation.
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Figure 3-22: Spreadsheet model and equation for technology option.
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MGE 409 Management Operations Technology Table 3-24: Present Value of gold production with design modification
2006
Year
0 19.71
1
21.19 14.06
2 22.32 15.26 9.44
3
23.03 16.14 10.45 5.78
4 23.22 16.60 11.13 6.62 3.00
5
22.80 16.57 11.42 7.17 3.69 1.15
6 21.63 15.94 11.23 7.34 4.14 1.59 -0.06
7
19.58 14.59 10.47 7.07 4.26 1.96 0.38 -0.79
8 16.49 12.41 9.04 6.25 3.95 2.05 0.58 -0.29 -1.18
9
12.18 9.23 6.80 4.79 3.12 1.75 0.65 0.01 -0.64 -1.17
10 6.44 4.89 3.62 2.56 1.69 0.97 0.38 0.05 -0.29 -0.57 -0.80 -1.90
The value of the design modification is given by subtracting base case from the enhanced version, therefore: $19.71-$14.82=$4.90 million. This technology may be purchased since the overall benefit after the $1.2 million capital investment is $3,700,000. Black Scholes - appraisal of a technology option: 3.2.3.2 Consider that, for example the drill monitoring technologys NPV is $500,000, including implementation and training. The mine is aware that the option to extend beyond the technologys information to benefit blending is valuable, and decides to determine the value and add it to the NPV of the technology alone. The company expects the technologys potential to be fully understood and the implementation plan for the blending project to be ready two years from the purchase of the drill technology. The cost of implementation, other technologies and training required for the blending project is estimated to be $ 2,250,000. The present value of the returns expected from the project is $2,000,000. The hypothetical mines historical data shows that these types of predictions are usually accurate to within 15%. The present value of the technology is also subject to the variability of the price of the commodity being mined, which has a historical volatility of 30%. Therefore the total expected volatility is 45%. The current risk-free rate of return is 9%. Given this information, all the variables in the Black Scholes model are known:
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MGE 409 Management Operations Technology Table 3-25: Variables for the Black-Scholes mining example
2006
Variable Symbol SP EP VOL T IR
Black-Scholes Name Stock price Exercise price Volatility Expiry date Risk-free interest rate
Example Value Present value of the projects $2,000,000 returns Present value of expenditures $2,250,000 Expected volatility 45 %/year Implementation date 2 years Risk-free interest rate 9 %/year
Mining Example Label
At first glance, it would appear that the option to expand on the technology is not valuable, since its NPV is a loss of $250,000. Using traditional economic methods, this option would therefore be ignored; however, as will be shown in the example below, this option does have significant value. Note that the volatility of the project is high, at 45%. Therefore, after only one year, the project may make $0.65 million (2*(1.45)-2.25) or lose $1.15 million (2(10.45)-2.25), however, if it appears as though the project will loose money after two years, the company has the option not to initiate the project. Consider the option value as calculated from the Black Scholes model:
2 (0.45) 2 ln 0 . 09 + + 2 2.25 d1 = 0.45 2 and
(2 ) = 0.416
N (d1 ) = 0.661 N (d 2 ) = 0.413
d 2 = 0.416 0.45 2 = 0.220
Black - Sholes option price = 2 0.661 2.25 e 20.09 0.413 = 0.546

Therefore the value of the option is $ 546,000. The company should add this option value to the present value of the base system, therefore the NPV of the new drill technology should be $1,047,000 (i.e. $500,000 +$547,000). The company may decide, before the two years are up, that it would like to integrate the new technology immediately. This would then become an American option, that is, an option that can be exercised at any time. This would increase the value of the option, although greatly complicate the mathematical model. Azzones option-based model for Manufacturing systems 3.2.3.3 24 Azzone , developed a model that aims at evaluating the value of flexibility for manufacturing systems, based on the ability to mix or produce variable
Azzone, Giovanni and Bertele, Simulation vs. Analytical Models for the Economic Evaluation of Flexible Manufacturing Systems: An Option-Based Approach, Economics of Advanced Manufacturing Systems, Edited by Parsaei et. al., Chapman & Hall, London, 1992 Dessureault 1/11/2006
24
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products. An example of this type of flexibility in mining is the blending that occasionally occurs in coal mines. Customers specify the various grades of coal according to their needs. If a coal mine has the ability to change its sequencing and dispatch to achieve this specific grade (product) from varying ore benches throughout the mine, it may be able to take advantage of price fluctuation for certain products. In order to change from producing one product to another, a change or adaptation cost (AC) is incurred. This change cost may include removing waste rock to expose a specific grade of ore or building a haul road to access a specific grade of ore. If planned correctly, this product mix change will create a cash flow (CF). The product mix changes will be introduced (the option will be exercised) only if the cash flows are higher than the adaptation costs (CF>AC), creating a payoff CF-AC. This flexibility can affect a system, according to this model, in two ways. First, by reducing the AC, the company can afford to undertake more product mix changes that can potentially increase cash flow. For example, consider a technology such as an algorithm that is connected to the truck dispatch and geological database that can automatically allocate trucks so that the new blends are formed, optimizing profitability (a relatively simple problem that can be solved using linear programming). This increases the probability, p(CF) that these products will be the ideal product mix (Knowledge of the market place may be an unknown factor. In manufacturing this uncertainty is minimized by market research to determine which product is demanded by consumers). Second, the net value of each acceptable product mix change increases the payoff (payoff is CF-AC, therefore if AC decreases, payoff increases). According to these assumptions, the value of flexibility can be calculated using the equation below:
+
V =
AC
(CF AC ) p(CF )dCF
Equation 3-5: Value of flexibility
The model may assume that the CF has a normal distribution, N(a;s) (the probability of a certain cash flow will vary according to a normal curve, according to mean a and a standard deviation of s), as seen in the figure below. Using this assumption, the following equation can be derived by evaluation of the integral in Equation 3-5
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Figure 3-23: Normal Curve distribution p(CF) vs. CF 25
V =
s 2
( a AC ) 2
2s2
AC a + (a AC ) 1 F s
Equation 3-6: Value of flexibility assuming a normal distribution
a = mean s = variance V = value - And where F(X) is the cumulative probability at x of a normal distribution having a mean of a and a variance of s. (X= (AC-a)/s) A numerical example using the coal mine analogy, described above (with products that vary in grade), is demonstrated below. The increase in product flexibility could lead to a reduction in product change cost from $100 000 to $25 000. Preliminary discussions with metallurgical coal buyers show that the probability of annual demand of the new product mixes is 0.6 (the product may change 0.6 times per year). Based on records and expert market analysis by the marketing department, the company estimates that the cash flow from each new coal-mix opportunity can be described by a normal distribution N(175 000; 70 000). Using the equation above, and a spread-sheet, the value for the base case (operating as usual), was found to be:
150000 + (150000) 1 F = $151,880 2 70000 and the value of changing the product mix using the technology, V= 70000
70000 V= e 2
25
(175000 100000 ) 2 270000 2
(175000 25000 ) 2 270000 2 e
75000 + (75000) 1 F = $90264 70000
Azzone, Ibid, p.136 1/11/2006
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Therefore, the difference between the base case and technological methods of changing the product mix is $151,880-$90,264=$61,615. Considering an estimated probable annual demand of 0.6, the value of the technologys flexibility is $36,969 or roughly $37 000 per year. This value should be added to the cash flow analysis (the economic evaluation). The assumptions made for the example above can be changed, as new or more precise information becomes available. For example, if the cash flow from new product mixes is not truly a normal distribution, its cumulative probability function, F(X) would be changed.
ADDITIONAL RESOURCES VIII
The notes are additionally supplemented by: Lecture module 3.2 Justification. Assignment 4
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Module 4:
Accounting26
Accounting is a relatively old technology yet central to most planning, valuation, and control strategies in earthmoving operations. Accounting is used to control management through their budgets. Accounting information is used by mine planners to determine the budgets and the feasibility of a planning option. Accountants are specially trained to understand the taxation and formal standardized accounting rules called the General Agreement on Account Practices (GAAP) and therefore are rarely expected to provide engineers with the data for design. Engineers are typically responsible for understanding the accounting information and derive the information needed. This module is intended to provide engineers with some background knowledge of accounting practice, nomenclature, and the management accounting activities expected of tactical-level costing and cost control. (note: strategic accounting is expectedly covered in the mine valuation course).
4.1 Basic Nomenclature

Accounting is the information system that measures business activities, processes that information into reports, and communicates the results to decision makers. Accounting is not the same as bookkeeping. Bookkeeping is a procedure in accounting, just as arithmetic is a procedure in mathematics. A key product of an accounting system is a set of financial statements. Financial statements report on a business in monetary terms. Today people use computers to do detailed bookkeeping. The process of accounting starts and ends with people making decisions: people make decisions financial transactions occur businesses prepare reports to show the results of their previous decisions people again make decisions. In the context of operations, various groups need the accounting information: Businesses: use accounting information to set goals for their organizations, to evaluate progress toward those goals, and to take corrective action if necessary. Decisions based on accounting information may include which building to purchase, how much merchandise to keep on hand, and how much cash to borrow. Investors: Investors provide the money a business needs to begin operations. To decide whether to invest in a company, potential investors evaluate what income they can expect from their investment. This means analyzing the financial statements of the business and keeping up with developments in the business press.
26
Some of the text for this module is taken directly from Horngren, Charles T., Walter T. Harrison, and Linda S. Bamber. Accounting. Upper Saddle River, New Jersey: Prentice Hall. 2002. activebook. It has been edited for content and application.
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Creditors: before making a loan, creditors (lenders) such as banks determine the borrower's ability to meet scheduled payments. This evaluation includes a report on the borrower's financial position and a prediction of future operations, both of which are based on accounting information. To borrow from a bank before striking it rich, Harold Nix probably had to document his income and financial position. Government Regulatory and Taxation Agencies: Most organizations face government regulation. Geological metal inventories are a key factor in taxation, depreciation, and asset appraisal. The rules for metal accounting are usually fixed by government. Local, state, and federal governments levy taxes on individuals and businesses. Note that individuals, non-governmental political organizations, and others also use accounting data. Users of accounting information may be categorized as external users or internal users. This distinction allows us to classify accounting into two fieldsfinancial accounting and management accounting. Financial accounting focuses on information for people outside the firm. Creditors and outside investors, for example, are not part of the day-to-day management of the company. Government agencies and the general public are external users of a firm's accounting information. Note that the method an engineer would use to cost-out a project may have significant effects on the external financial view of a company (for example, capitalizing certain actions such as stripping). Strategic-management are also typically closely involved with accounting issues. Management accounting focuses on information for internal decision makers. This is the area of accounting which engineers most commonly interact.
4.1.1 The Authority Underlying Accounting

In the United States, a private organization called the Financial Accounting Standards Board (FASB) determines how accounting is practiced. The FASB works with a governmental agency, the Securities and Exchange Commission (SEC), the American Institute of Certified Public Accountants (AICPA), and the Institute of Management Accountants (IMA), two large professional organizations of accountants. Certified public accountants, or CPAs, are accountants who are licensed to serve the general public rather than one particular company. Certified management accountants, or CMAs, are licensed accountants who work for a single company. The rules that govern public accounting information are called generally accepted accounting principles (GAAP). Exhibit 1-2 diagrams the relationships among the various accounting organizations.
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Figure 4-1: Key Accounting Organizations
4.1.2 The Corporation

A business takes one of three forms of organization. In some cases, accounting procedures depend on which form the organization takes. A corporation is a business owned by stockholders, or shareholders, people who own stock (shares of ownership) in the business. A business becomes a corporation when the state approves its articles of incorporation. A corporation is a legal entity, an "artificial person" that conducts its business in its own name. Like the proprietorship and the partnership, the corporation is an organization with an existence separate from its owners. Corporations differ significantly from proprietorships and partnerships in one very important way. If a proprietorship or a partnership cannot pay its debts, lenders can take the owners' personal assetscash and belongingsto satisfy the business's obligations. But if a corporation goes bankrupt, lenders cannot take the personal assets of the stockholders. This limited personal liability of stockholders for corporate debts partly explains why corporations are the dominant form of business organization: People can invest in corporations with limited personal risk. Another factor in corporate growth is the division of ownership into individual shares.
4.1.3 Accounting Concepts

The most basic concept in accounting is that of the entity. An accounting entity is an organization or a section of an organization that stands apart as a separate economic unit. In accounting, boundaries are drawn around each entity so as not to confuse its affairs with those of other entities. Consider Kiewit, a huge organization with several divisions. Kiewit management evaluates each division as a separate accounting entity. If sales in the Mining division are dropping, Toyota can find out why. If sales figures from all divisions of the company are combined, management will not know that Coal sales are going down. Thus, the entity concept also applies to the parts of a large organizationin fact, to any economic unit that needs to be evaluated separately.
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Accounting records and statements are based on the most reliable data available so that they will be accurate and useful. This guideline is the reliability (independent) principle, also called the objectivity principle. Reliable data are verifiable. If you believe the value of a mining shovel transferred from another division is worth 8 million, and you hire professional independent appraisers who tell you it is worth 5 million, the business should record the acquisition as 5 million because the opinion was independent. The cost principle states that acquired assets and services should be recorded at their actual cost (also called historical cost). Even though the purchaser may believe the price is a bargain, the item is recorded at the price paid in the transaction and not at the "expected" cost. Suppose your mine purchases equipment from a supplier who is going out of business. Assume that you get a good deal and pay only $1 million for an LHD that would have cost you $2 million elsewhere. The cost principle requires you to record the equipment at its actual cost of $1, not the $2 that you believe the equipment is worth. Another reason for measuring assets at historical cost is the going-concern concept, which holds that the entity will remain in operation for the foreseeable future. Most firm resourcessuch as supplies, land, buildings, and equipmentare acquired to use rather than to sell. Under the goingconcern concept, accountants assume that the business will remain in operation long enough to use existing resources for their intended purpose.
4.1.4 Accounting Equation

Financial statements tell how a business is performing and where it stands. They are the final product of the accounting process. But how do we produce the financial statements? The basic tool of accounting is the accounting equation. It presents the resources of the business and the claims to those resources. Assets are the economic resources of a business that are expected to be of benefit in the future. Cash, office supplies, merchandise, equipment, mineral claims, furniture, land, and buildings are assets. Claims (an accounting term meaning a declaration of possession) to those assets come from two sources. Liabilities are outsider claims, which are economic obligationsdebtspayable to outsiders. These outside parties are called creditors. For example, a creditor who has loaned money to a business has a claima legal rightto a part of the assets until the business pays the debt. Insider claims to the business's assets are called owner's equity, or capital. These are the claims held by the owners of the business. Owners have a claim to the entity's assets because they have invested in the business.
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The accounting equation shows the relationship among assets, liabilities, and owner's equity. Assets appear on the left-hand side of the equation. The legal and economic claims against the assetsthe liabilities and owner's equity appear on the right-hand side of the equation. (Economic Resources) ASSETS = (Claims to Economic Resources) LIABILITIES + OWNER'S EQUITY
Let's take a closer look at the elements that make up the accounting equation. Suppose you run Apache Nitro (AN), which supplies explosives to Sierrita Copper mine (SCM) and other mines. Some customers pay you in cash when you deliver the explosives. Cash is an asset. Other customers buy on credit and promise to pay you within a certain time after delivery. This promise is also an asset because it is an economic resource that will benefit you in the future, when you receive the cash. To AN, this promise is an account receivable. A written promise for future collection is called a note receivable. SCMs promise to pay you for the explosives it purchases on credit creates a debt for SCM. This liability is an account payable of SCM the debt is not written. Instead, it is backed by the reputation and the credit standing of Sierrita Copper mine. A written promise of future payment is called a note payable. All receivables are assets. All payables are liabilities. Owner's equity is the amount of an entity's assets that remain after the liabilities are subtracted. The purpose of business is to increase owner's equity through revenues, which are increases in owner's equity earned by delivering goods or services to customers. Revenues increase owner's equity because they increase the business's assets or decrease its liabilities. As a result, the owner's share of business assets increases.
Figure 4-2 That Increase or Decrease Owner's Equity
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In accounting terms, a transaction is any event that both affects the financial position of the business entity and can be recorded reliably. This can include: Equity transaction: Selling stock or privately investing. Another type of equity transactions is the purchase of an asset (moving, for example, a cash asset to a land asset, the assets and equity remain the same but the type of assets change). Account payable: transactions such as purchasing supplies on credit. Sales revenue: when you sell goods such as coal or concentrate, is a sales revenue transaction. This transaction increases the assets of the company because someone pays cash for the transaction. Note that when a company promises another company to pay for a good or service at a later date, the transaction is on account. Service revenue: when you sell services such as accounting expertise is an example of a service revenue transaction Payment of expenses: are when you de-value the company by moving assets to pay the expenses of running the business. Payment on account: are when you move assets to pay for a prerecorded liability, therefore you decrease both the cash (assets) side of the equation and the liabilities (account payable) side of the accounting equation. After analyzing transactions, we need a way to present the results. We look now at the financial statements, the formal reports of an entity's financial information. The primary financial statements are the: income statement statement of owner's equity balance sheet statement of cash flows
ADDITIONAL RESOURCES IX
This module is additionally supplemented by: Lecture for Module 4.1
4.2 Financial Statements 27

Financial statements are important from an investors perspective. Understanding the financials of a company and how they are calculated allow an engineer to determine how to cost a particular project so as to conform to the companys financial mission. Therefore this module is primarily focused on strategic management issues, for investors, and for engineers interested in understanding how their actions can affect the external viewpoint of their
27
Some of the text for this module is taken directly from Keown, Arthur J. J., William Petty, David F. Scott, Jr., and John D. Martin. Foundations of Finance. Upper Saddle River, New Jersey: Prentice Hall, Inc. 2002. It has been edited for content and application. 1/11/2006
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operation. reviewed.
The key financial statements and how they are analyzed are
4.2.1 Income Statement

An income statement, or profit and loss statement, indicates the amount of profits generated by a firm over a given time period, often a year. The income statement answers the question, How profitable is the business? In providing this answer, the income statement reports financial information related to five broad areas of business activity: Revenue (sales)money derived from selling the company's product or service Cost of goods soldthe cost of producing or acquiring the goods or services to be sold Operating expensesexpenses related to (1) marketing and distributing the product or service to the customer and (2) administering the business Financing costs of doing businessthe interest paid to the firm's creditors and the dividends paid to preferred stockholders (but not dividends paid to common stockholders) Tax expensesamount of taxes owed based on a firm's taxable income Thus, we would expect that: The higher (lower) a firm's revenues or sales, the higher (lower) its profits will be. The lower (higher) the costs of producing a product, the higher (lower) its profits will be. The lower (higher) a company's operating expenses (which consist of marketing expenses, administration expenses, and depreciation expenses), the higher (lower) its profits will be. The less (more) interest and preferred stock dividends a company pays, the higher (lower) its profits will be. The less (more) taxes a company pays, the higher (lower) its profits will be. In short, combining higher (lower) sales with lower (higher) costs and expenses yields a firm higher (lower) profits. All of these "income statement activities" are presented graphically in Figure 4-3. We observe that the top portion of Figure 4-3, beginning with sales and continuing down through the operating income or earnings before interest and taxes, is affected solely by the first three activities listedsales, cost of acquiring the firm's product or service, and operating expenses. To this point, no financing costs are included. In other words, the operating profits are unaffected by how the company is being financed. The firm may be financed entirely by its owners (shareholders) without incurring any debt, or it may be financed in part by the owners (shareholders) and in part by
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borrowing money (incurring debt). In either case, operating profits are the same. In other words, operating profits (earnings before interest and taxes) represent the firm's profits that are available to all the firm's investors, both debt holders and shareholders.
Figure 4-3: The Income Statement: An Overview
Below the line reporting operating income in Figure 4-3, we see the results of the firm's financing decisions, along with the taxes that are due on the company's income. Here the company's financing costs are shown, first in the form of interest expenses and then preferred dividends. The tax rates imposed on the company's earnings before taxes determine the amount of the tax liability, or the tax expenses. The final number, net income available to common stockholders (commonly called net income), is the income that may be distributed to the company's owners or reinvested in the company, provided of course there is cash available to do so. As we shall see later, however, the fact that a firm has a positive net income does not necessarily mean it has any cashpossibly a surprising result to us, but one we shall come to understand. An example of an income statement is provided in Figure 4-4 for the ABC Corporation. As shown in the table, ABC had sales of $11,509 million for the 12-month period ending December 31, 1997, and the cost of goods sold was $6,537 million. (The numbers for ABC are expressed in millions, so ABC sales were actually about $11.5 billion, with cost of goods sold over $6.5 billion.) The result is a gross profit of $4,971 million ($4.97 billion). The firm then had $2,177 million in operating expenses, which included marketing
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expenses, general and administrative expenses, and depreciation expenses. After deducting operating expenses, the firm's operating profits (earnings before interest and taxes) amounted to $2,794 million ($2.8 billion). This amount represents the before-tax profits generated as if the ABC Corporation were an all-equity company. To this point, we have calculated the profits resulting only from operating activities, as opposed to financing decisions such as how much debt or equity is used to finance the company's operations.
Figure 4-4: Income statement for ABC Corporation.
4.2.2 Balance Sheet

Whereas the income statement reports the results from operating the business for a period of time, such as a year, the balance sheet provides a snapshot of the firm's financial position at a specific point in time, presenting its asset holdings, liabilities, and owner-supplied capital. In its simplest form, a balance sheet follows this formula: Assets represent the resources owned by the firm, whereas the liabilities and shareholders' equity indicate how those resources are financed. The difference between the timing of an income statement and a balance sheet may be represented graphically as follows.
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Figure 4-5: Comparing Balance Sheets and Income statements.
Figure 4-6 gives us the basic components of a balance sheet. On the left side of Figure 4-6, the firm's assets are listed according to their type; on the right side, we see a listing of the different sources of financing a company could use to finance its assets.
Figure 4-6: The Balance Sheet: An Overview
Types of Assets 4.2.2.1 As shown in Figure 4-6, a company's assets fall into three categories: (1) current assets, (2) fixed assets, and (3) other assets. 113
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4.2.2.1.1 Current Assets Current assets, or gross working capital, as it is sometimes called, comprise those assets that are relatively liquid, that is, those that are expected to be converted into cash within a year. Current assets primarily include cash, accounts receivable, inventories, and prepaid expenses. Cash. Every firm must have cash for current business operations. A reservoir of cash is needed because of the unequal flow of funds into (cash receipts) and out of (cash expenditures) the business. The amount of the cash balance is determined not only by the volume of sales, but also by the predictability of cash receipts and cash payments. Accounts receivable. The firm's accounts receivable consists of payments due from its customers who buy on credit. Inventories. Inventory consists of the raw materials, work in process, and the final products held by a firm for eventual sale. Prepaid expenses. A company often needs to prepay some of its expenses. For example, insurance premiums may be due before coverage begins, or rent may have to be paid in advance. Thus, prepaid expenses are those cash payments recorded on the balance sheet as current assets and then shown as an expense in the income statement as they are used. 4.2.2.1.2 Types of Financing We now turn to the right side of the balance sheet in Figure 4-6, labeled "Liabilities (Debt) and Equity," which indicates how the firm finances its assets. Financing comes from two main sources: debt (liabilities) and equity. Debt is money that has been borrowed and must be repaid at some predetermined date. Equity, on the other hand, represents the shareholders' investment in the company. Debt capital is financing provided by a creditor. As shown in Figure 4-6, it is divided into (1) current, or short-term, debt and (2) long-term debt. Current debt, or short-term liabilities, includes borrowed money that must be repaid within the next 12 months. Sources of current debt include the following: Accounts payable represents credit extended by suppliers to a firm when it purchases inventories. The purchasing firm may have 30 or 60 days before paying for inventory that has been purchased. This form of credit extension is also called trade credit. Other payables include interest payable and income taxes payable that are owed and will come due within the year. Accrued expenses are short-term liabilities that have been incurred in the firm's operations, but not yet paid. For example, employees perform work that may not be paid for until the following week or month, which are recorded as accrued wages. Short-term notes represent amounts borrowed from a bank or other lending source that are due and payable within 12 months.
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Long-Term Debt includes loans from banks or other sources that lend money for longer than 12 months. For example, a firm might borrow money for 5 years to buy equipment, or for as long as 25 to 30 years to purchase real estate, such as a warehouse or office building. Equity includes the shareholders' investmentboth preferred stockholders and common stockholdersin the firm. Preferred stockholders receive a dividend that is fixed in amount. In the event of liquidation of the firm, these stockholders are paid after the firm's creditors, but before the common stockholders. Common stockholders are the residual owners of a business. They receive whatever is left overgood or badafter the creditors and preferred stockholders are paid. The amount of a firm's common equity as reported in the balance sheet is equal to (1) the amount the company received from selling stock to investors plus (2) the firm's retained earnings. The amount the firm receives from selling stock is recorded in the common equity section in the accounts of par value and paid-in capital. These amounts may be offset by any stock that has been repurchased by the company, which is typically shown as treasury stock. Retained earnings is the cumulative total of all the net income over the firm's life less the common stock dividends that have been paid over the years.
4.2.3 Statement of Owner's Equity

The statement of owner's equity presents a summary of the changes that occurred in the entity's owner's equity during a specific time period, such as a month or a year. Increases in owner's equity arise from investments by the owner and from net income earned during the period. Decreases result from owner withdrawals and from a net loss for the period. Net income or net loss come directly from the income statement. Owner investments and withdrawals are capital transactions between the business and its owner, so they do not affect the income statement.
4.2.4 Statement of Cash Flows

The statement of cash flows reports the amount of cash coming in (cash receipts) and the amount of cash going out (cash payments or disbursements) during a period. Business activities result in a net cash inflow (receipts greater than payments) or a net cash outflow (payments greater than receipts). The statement of cash flows shows the net increase or net decrease in cash during the period and the cash balance at the end of the
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period.
4.2.5 Financial Statement Headings

Each financial statement has a heading giving the name of the business (in our discussion, AN Explosives), the name of the particular statement, and the date or time period covered by the statement. A balance sheet taken at the end of year 2002 would be dated December 31, 2002. A balance sheet prepared at the end of March 2003 is dated March 31, 2003. Software programs have streamlined the preparation of the financial statements. These statements can now be produced instantaneously after the financial records are entered into the computer. Of course, any errors in the financial records will show up in the financial statements. So the person who analyzes the data controls the accuracy of the financial statements. Figure 4-7 demonstrates the relationships between the statements.
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Figure 4-7: Relationships between financial statements.
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Financial statements are analyzed to understand the financial health of a company. Many investors use the annual reports to evaluate and benchmark companies.
4.2.6 Analyzing Financial Statements

Investors who purchase a company's stock expect to receive dividends and hope the stock's value will increase. Creditors make loans to receive cash for the interest and principal. They use financial statement analysis to (1) predict the amount of expected returns, and (2) assess the risks associated with those returns. The analysis of financial statements applies some specific techniques to the data contained in the annual report. In addition to the financial statements, annual reports usually contain: Notes to the financial statements, including a summary of the accounting methods used Management's discussion and analysis of the financial results The auditor's report Comparative financial data for 510 years Management's discussion and analysis (MD&A) of financial results is especially important because top managers are in the best position to know how well or how poorly their company is performing. The SEC requires the MD&A from public corporations. The tools and techniques the business community uses in evaluating financial statement information can be divided into several broad categories: horizontal analysis, vertical analysis, benchmarking, and ratio analysis. Horizontal Analysis 4.2.6.1 Many managerial decisions hinge on whether the dollar amountsof sales, income, expenses, and so onare increasing or decreasing over time. Have sales risen from last year? From two years ago? By how much? Sales may have risen by $200,000. This fact may be interesting, but considered alone it is not very useful. The percentage change in the net sales over time offers a more useful perspective. It is better to know that sales have increased by 20% than to know that sales rose by $200,000. The study of percentage changes in comparative statements is called horizontal analysis. Computing a percentage change in comparative statements requires two steps: 1. Compute the dollar amount of the change from the base (earlier) period to the later period. 2. Divide the dollar amount of change by the base-period amount.
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In looking at the Phelps Dodge annual report (for download on 409 or on Phelps Dodge website) for 2001, it can be seen that the previous accounting years revenue was 4.525 billion.
Step 1: Compute the dollar amount of change 2001 (297,500) 2000 72,300 = (Decrease) (369,800)
Step 2: Divide the dollar amount of change by the base-period amount to compute the percentage change during the later period:
=
4.2.6.2 Benchmarking
(369,800) = 511.5% 72,300
Benchmarking is the practice of comparing a company to a standard set by other companies, with a view toward improvement. A company's financial statements show past results and help investors predict future performance. Still, that knowledge is limited to that one company. We may learn that exploration (or R&D) decreased and that net income increased last year. This information is helpful, but it does not consider how businesses in the same industry have fared over the same time period. Have other companies in the same line of business also decreased exploration? Is there an industry-wide increase in net income? Managers, investors, creditors, and other interested parties need to know how one company compares with other companies in the same line of business. Ratios 4.2.6.3 Ratios play an important part in financial analysis. A ratio is a useful way to show the relationship of one number to another number. For example, if the balance sheet shows current assets of $100,000 and current liabilities of $50,000, the ratio of current assets to current liabilities is $100,000 to $50,000. We simplify this numerical expression to 2 to 1, which may also be written 2:1 and 2/1. The ratios discussed below may be classified as follows: Ratios that measure the company's ability to pay current liabilities
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Ratios that measure the company's ability to sell inventory and collect receivables Ratios that measure the company's ability to pay short-term and longterm debt Ratios that measure the company's profitability Ratios used to analyze the company's stock as an investment
Measuring Ability to Pay Current Liabilities Working capital is defined as follows: Working capital = Current assets Current liabilities. Working capital is widely used to measure ability to pay current liabilities with current assets. In general, the larger the working capital, the better able the business is to pay its debt. Current Ratio: The most common ratio using current-asset and currentliability data is the current ratio, which is total current assets divided by total current liabilities. What is an acceptable current ratio? The norm for companies in most industries is between 1.40 and 1.70. A current ratio of 2.0 is considered very strong. Acid-Test (or quick) ratio tells us whether the entity could pay all its current liabilities if they came due immediately. To compute the acid-test ratio, we add cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) and divide by total current liabilities. Inventory and prepaid expenses are not included because a business cannot convert these assets to cash immediately to pay current liabilities. An acid-test ratio of 0.90 to 1.00 is safe in most industries. Measuring Ability to Sell Inventory and Collect Receivables Inventory turnover is a measure of the number of times a company sells its average level of inventory during a year. In general, companies prefer a high rate of inventory turnover. An inventory turnover of 6 means that the company sells its average level of inventory six times during the year. This is generally better than a turnover of 3 or 4. But a high value can mean the business is not keeping enough inventory on hand, and that can result in lost sales if the company cannot meet a customer's need. Therefore, a business strives for the most profitable rate of inventory turnover, not necessarily the highest rate. To compute the inventory turnover ratio, we divide cost of goods sold by the value of the average inventory for the period. Accounts receivable turnover measures a company's ability to collect cash from customers. In general, the higher the ratio, the more successfully the business collects cash. Measuring Ability to Pay Short-Term and Long-Term Debt Debt Ratio - the ratio of total liabilities to total assets, plus the proportion of the company's assets financed with debt. Creditors view a high debt ratio with caution. If a business trying to borrow already has large liabilities, then additional debt payments may be too much for it to
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handle. Creditors generally charge higher interest rates on new borrowing to companies with an already high debt ratio. Measuring Profitability Rate of Return on Net Sales - In business, the term return is used broadly and loosely as an evaluation of profitability. Consider a ratio called the rate of return on net sales, or simply return on sales. This ratio shows the percentage of each sales dollar earned as net income.
Earnings per share of common stock, or simply earnings per share (EPS), is perhaps the most widely quoted of all financial statistics. EPS is the only ratio that must appear on the face of the income statement. EPS is the amount of income earned for each share of the company's outstanding common stock. Earnings per share is computed by dividing net income available to common stockholders by the number of common shares outstanding during the year.
New Analytical Method: Economic Value Added (EVA) The top managers of many leading companies use economic value added (EVA) to evaluate a company's operating performance. EVA combines accounting and finance to measure whether the company's operations have increased stockholder wealth. EVA can be computed as follows: EVA = Net income + Interest expense Capital charge where
All amounts for the EVA computation, except the cost of capital, are taken from the financial statements. The cost of capital is a weighted average of the returns demanded by the company's stockholders and lenders. The cost of capital varies with the company's level of risk. The idea behind EVA is that the returns to the company's stockholders (net income) and to its creditors (interest expense) should exceed the company's capital charge. The capital charge is the amount that stockholders and lenders charge a company for the use of their money. A positive EVA amount indicates an increase in stockholder wealth, and the company's stock price should rise. If the EVA measure is negative, the stockholders will probably be unhappy with the company's progress and sell its stock
ADDITIONAL RESOURCES X
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4.3 Plant Assets

Heavy industry is by nature heavily dependant on equipment. When planning a budget or project, the perspectives of how the asset is utilized can result in dramatic accounting results. A discussion of how plant assets are accounted and manipulated financially will provide insight on how projects feasibility and profitability can be improved. Plant assets, or fixed assets, are long-lived tangible assetsfor instance, land, buildings, and equipmentused to operate a business and not held for sale. Their physical form provides their usefulness. The expense associated with plant assets is called depreciation. Ore bodies are considered assets in many nations and the acquisition and characterization costs can be depreciated. Of the plant assets, land is unique. Its cost is not depreciated expensed over timebecause its usefulness does not decrease. Most companies report plant assets under the heading Property, plant, and equipment on the balance sheet. Intangible assets do not have a physical form. We cannot see or touch them. They are useful only because of the special rights they carry. Patents, copyrights, and trademarks are intangible assets, and their accounting is similar to that for plant assets. Accounting for intangibles has its own terminology. Figure 4-8 shows that we refer to the using up of intangibles as amortization, which is the same concept as depreciation.
Figure 4-8: Terminology Used in Accounting for Plant Assets and Intangibles
The cost principle directs a business to carry an asset on the balance sheet at its costthe amount paid for the asset. The general rule for measuring cost is: The cost of an asset = The sum of all the costs incurred to bring the asset to its intended purpose, net of all discounts The cost of a plant asset is its purchase price plus applicable taxes, purchase commissions, and all other amounts paid to acquire the asset and make it
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ready for its intended use. Note that this is also applied to inventory. The types of costs differ for the various plant assets, so we discuss each asset individually.
4.3.1 Costs Associated to Types of Assets

4.3.1.1 Land and Land Improvements The cost of land includes its purchase price, brokerage commission, survey and legal fees, and any back property taxes that the purchaser pays. Land cost also includes the cost of clearing the land and removing any unwanted buildings. The cost of land is not depreciated. The cost of land does not include fencing, paving, sprinkler systems, and lighting. These separate plant assetscalled land improvementsare subject to depreciation. Buildings 4.3.1.2 The cost of constructing a building includes architectural fees, building permits, contractors' charges, and payments for material, labor, and overhead. The time to complete a building can be months, even years. If the company constructs its own assets, the cost of the building may include the cost of interest on borrowed money. (We discuss this topic in the next section of the chapter.) When an existing building is purchased, its cost includes all the usual items, plus the cost to repair and renovate the building. Machinery and Equipment 4.3.1.3 The cost of machinery and equipment includes its purchase price (less any discounts), plus transportation charges, insurance while in transit, sales and other taxes, purchase commission, installation costs, and the cost of testing the asset before it is used. After the asset is up and running, we cease capitalizing these costs to the Equipment account. Thereafter, insurance, taxes, and maintenance costs are recorded as expenses (unless a major overhaul occurs which can be capitalized). Leasehold Improvements 4.3.1.4 Leasehold improvements are similar to land improvements. Leasehold improvements are alterations to assets the company is leasing. For example, a mining company may lease haul trucks but decide to replace their steel boxes with ultra-lights. These improvements are assets of mining company even though the company does not own the truck. Leasehold improvements appear on the company's balance. Leasehold improvements should be amortized (depreciated) over the term of the lease. (Overhauls on leased equipment is therefore amortized if the costs are capitalized).
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Construction in Progress 4.3.1.5 Construction in progress is an asset, such as a warehouse, that the company is constructing for its own use. The construction is incomplete and the warehouse is not ready for use. However, the construction costs are assets because the warehouse, when completed, will render future benefits for the company. Capitalizing the Cost of Interest 4.3.1.6 A mining company builds a new mine with borrowed money. The mining company pays interest that it includes as part of the cost of a selfconstructed asset. Including interest in the asset's total cost is called capitalizing interest. To capitalize a cost means to debit an asset (versus an expense) account. Suppose on July 2, 2002, a mining company borrows $10,000,000 on a twoyear, 10% note payable to build new concentrator. The interest cost for 2002 on this note payable is $500,000 ($1,000,000 .10 6/12). Assume all of this interest cost should be capitalized as part of the cost of the building.
4.3.2 Capital Expenditures

When a company makes a plant asset expenditure, it must decide whether to debit an asset account or an expense account. In this context, expenditure refers to a cash or a credit purchase of goods or services related to the asset. Examples of such expenditures range from a mines purchase of robots rock bolts to a motorist's replacing the windshield on a Chevrolet. Expenditures that increase the asset's capacity or efficiency or extend its useful life are called capital expenditures. For example, the cost of a major overhaul that extends a Jumbos useful life is a capital expenditure. Repair work that generates a capital expenditure is called a major repair, or an extraordinary repair. The amount of the capital expenditure, said to be capitalized, is debited to an asset account. Other expenditures that do not extend the asset's capacity, which merely maintain the asset or restore it to working order, are called expenses. These costs are matched against revenue. Examples include the costs of hoses, repairing an engine, and replacing tires. These costs are debited to an expense account. The distinction between capital and maintenance expenditures is often a matter of opinion. Does the cost extend the life of the asset (a capital expenditure), or does it only maintain the asset in good order (an expense)? When in doubt, companies tend to debit an expense, for two reasons. First,
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many expenditures are minor and most companies have a policy of debiting expense for all expenditures below a specific minimum, such as $1,000. Second, the income tax motive favors debiting all borderline expenditures to expense in order to create an immediate tax deduction. Treating a capital expenditure as an expense, or vice versa, creates errors in the financial statements. Suppose a company makes a capital expenditure and erroneously expenses this cost. A capital expenditure should have been debited to an asset account. This accounting error overstates expenses and understates net income on the income statement. On the balance sheet, the Equipment account is understated, and so is owner's equity, as follows:
Figure 4-9: Understating net income by expensing a capital expenditure.
Capitalizing the cost of an ordinary repair creates the opposite error. Expenses are then understated, and net income is overstated. The balance sheet overstates assets and owner's equity. Plant Depreciation 4.3.2.1 The allocation of a plant asset's cost to expense over the asset's useful life is called depreciation. Depreciation accounting matches the asset's cost (expense) against the revenue earned by the asset, as the matching principle directs. Let's contrast what depreciation accounting is with what it is not: Depreciation is not a process of valuation. Businesses do not record depreciation based on the market (sales) value of their plant assets at the end of each year. Instead, businesses allocate an asset's cost to expense during the period of its use. Depreciation does not mean that the business sets aside cash to replace an asset when it is used up. Establishing a cash fund is entirely separate from depreciation, and depreciation does not represent cash.
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Causes of Depreciation 4.3.2.2 All assets but land wear out. For some plant assets, physical wear and tear and the elements cause depreciation. For example, physical deterioration wears out the haul trucks and even the shaft will eventually wear-out. Assets such as computers, software, and equipment may be obsolete before they deteriorate. An asset is obsolete when another asset can do the job better or more efficiently. Thus, an asset's useful life may be much shorter than its physical life. Accountants usually depreciate computers over a short periodperhaps two to four yearseven though the computers will continue working much longer. Whether wear and tear or obsolescence causes depreciation, the asset's cost is depreciated over its expected useful life. Measuring Depreciation 4.3.2.3 Depreciation of a plant asset is based upon the asset's cost, estimated usefully life, and estimated residual value. Cost is the only known amount. Estimated useful life is the length of the service period expected from the asset. Useful life may be expressed in years, units of output, miles, or another measure. For example, the useful life of a building is stated in years. The useful life of a rock drill is the number of meters the machine can drill (its expected units of output). Companies make such estimates from past experience, industry information, and government publications. Estimated residual valuealso called scrap value or salvage valueis the expected cash value of an asset at the end of its useful life. For example, a machine's useful life may be seven years. After seven years, the company expects to sell the machine as scrap metal or to refurbishing companies. The cash the business thinks it can sell the machine for is its estimated residual value. Estimated residual value is not depreciated because the business expects to receive this amount from disposing of the asset. If there's no residual value, then it depreciates the full cost of the asset. Cost minus residual value is called the depreciable cost of the asset. Depreciation Methods 4.3.2.4 Three major methods exist for computing depreciation: straight-line, unitsof-production, and declining-balance. These methods allocate different amounts of depreciation to each period. However, they all result in the same total amount of depreciation over the life of the asset. Figure 4-10 gives the data we will use to illustrate the depreciation computations for small utility truck. We cover the three most widely used methods.
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Figure 4-10: Data for depreciation examples.
4.3.2.4.1 Straight-Line Method In the straight-line (SL) method, an equal amount of depreciation is assigned to each year of asset use. Depreciable cost is divided by useful life in years to determine the annual amount of depreciation. The entry to record one years expense is $8,000. This truck was purchased on January 1, 20X1, and let's assume the companys fiscal year ends on December 31. A straight-line depreciation schedule is given in Figure 4-11. The final column in the exhibit shows the asset's book value, which is its cost less accumulated depreciation. Book value is also called carrying amount or carrying value. At the end of its useful life, the asset is said to be fully depreciated or have zero book value.
Figure 4-11: Straight-Line Depreciation Schedule
4.3.2.4.2 Units-of-Production (UOP) Method In the units-of-production (UOP) method, a fixed amount of depreciation goes with each unit of output produced by the asset. Depreciable cost is divided by useful life, in units of production. This per-unit expense is then multiplied by the number of units produced each period to compute
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depreciation for that period. The amount of UOP depreciation each period varies with the number of units the asset produces.
4.3.2.4.3 Double-Declining Balance Method An accelerated depreciation method writes off more of the asset's cost near the start of its useful life than the straight-line method does. The main accelerated depreciation method, double-declining-balance (DDB), multiplies the asset's decreasing book value by a constant percentage that is 2 times the straight-line depreciation rate. DDB amounts can be computed in four steps: 1. Compute the straight-line depreciation rate per year. A five-year truck has a straight-line depreciation rate of 1/5, or 20% per year. A tenyear asset has a straight-line rate of 1/10, or 10% per year, and so on. 2. Compute the DDB rate: Multiply the straight-line rate by 2. The DDB rate for a ten-year asset is 20% per year (10% 2 = 20%). For a five-year asset, such as example truck, the DDB rate is 40% (20% 2 = 40%). 3. Compute DDB depreciation for each year. Multiply the asset's book value (cost less accumulated depreciation) at the beginning of each year by the DDB rate. You should ignore the asset's residual value in computing depreciation, except for the last year. The first-year depreciation for the truck is $16,400 (41,000 x 0.40). For the second year, it would be calculated as 9,840 ( (41,000-16,400) x 0.4). 4. Determine the final year's depreciation, the amount needed to reduce the asset's carrying amount to its residual value. In the DDB depreciation schedule in Exhibit 10-8, the last year's depreciation is $4,314book value of $5,314 less the $1,000 residual value
Figure 4-12: Double-Declining-Balance Depreciation Schedule
The DDB method differs from the other methods in two ways: 128
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The asset's residual value is ignored at the start. In the first year, depreciation is computed on the asset's full cost. The final year's depreciation is the amount needed to bring the asset's carrying amount to residual value. The final-year depreciation amount is like a "plug" figure.
4.3.2.4.4 Depreciation for Partial Years Companies purchase plant assets whenever they need them. They don't wait until the beginning of a period. Therefore, companies must develop policies to compute depreciation for partial years. For example, if the truck was purchased on October 4th and the companys policy is to use SL depreciation, the first years annual depreciation would be calculated by, 41,000/5 x 10/12. However, note that many companies develop monthly cost reports which automatically divide the annual depreciation costs into monthly amounts. 4.3.2.4.5 Comparisons of Depreciation Straight-Line: A business should match an asset's expense against the revenue that asset produces. For an asset that generates revenue evenly over time, the straight-line method follows the matching principle. Each period the asset is used, an equal amount of depreciation is recorded. Units-of-Production: The units-of-production method best fits an asset that wears out because of physical use rather than obsolescence. Depreciation is expensed only when the asset is used, and more asset use causes greater depreciation. Double-Declining-Balance: The accelerated method (DDB) works best for assets that produce more revenue in their early years. The greater expense in the earlier periods is matched against those periods' greater revenue. This is the mark of an accelerated depreciation method. Note that depreciation is considered as leasing cost of equipment when equipment is purchased rather than leased. It can be added to the cost of doing business of a particular process. Large operations are increasingly considering depreciation in their cost management as leased equipment is considered an expense and when accounting for cost per ton, usually only expenses are considered in cost. Taxation Implications on Depreciation 4.3.2.5 Most companies use the straight-line depreciation method for their financial statements. But they keep separate depreciation records for income taxes. For tax purposes, most companies use an accelerated method. The IRS allows the DDB depreciation method, and most managers prefer that to straight-line depreciation. Why? Because it provides the most depreciation expense as quickly as possible. The accelerated depreciation method decreases immediate tax payments. You can then invest the cash you save to earn more income. This is a common strategy.
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To understand the relationships between cash flow (cash provided by operations), depreciation, and income tax, recall our earlier depreciation of the truck: First-year depreciation is $8,000 under straight-line and $16,400 under double-declining-balance. Now let's assume that DDB is permitted for income tax reporting, and let's apply DDB to the truck as before. This company has $400,000 in cash sales and $300,000 in cash operating expenses during the truck's first year and an income tax rate of 30%. The cash-flow analysis appears in Figure 4-13.
Figure 4-13: Cash-Flow Advantage Depreciation for Tax Purposes
of
Accelerated
over
Straight-Line
4.3.2.6 Fully Depreciated Asset A fully depreciated asset is an asset that has reached the end of its estimated useful life. No more depreciation is recorded for the asset. If the asset is no longer suitable for its purpose, it is disposed of. However, the company may be unable to replace the asset. Or the asset may remain useful. In any event, companies sometimes continue using fully depreciated assets. The asset account and its accumulated depreciation remain on the books, even though no additional depreciation is recorded.
4.3.3 Natural Resources

Natural resources such as ore, petroleum (oil), natural gas, and timber are plant assets of a special type. Natural resources are like inventories in the ground (ore) or on top of the ground (timber). Natural resource assets are expensed through depletion. Depletion expense is that portion of the cost of natural resources used up in a particular period. Depletion expense is computed in the same way as units-of-production depreciation:
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An oil well may cost $100,000 and contain an estimated 10,000 barrels of oil. The well has no residual value. The depletion rate would thus be $10 per barrel ($100,000/10,000 barrels). If 3,000 barrels are extracted during the year, depletion expense is $30,000 (3,000 barrels $10 per barrel). If 4,500 barrels are removed the next year, that period's depletion is $45,000 (4,500 barrels $10 per barrel). Accumulated Depletion is a contra account similar to Accumulated Depreciation. Note that in the case of ore, the cost to acquire and/or characterize the orebody is what is used as the depletion cost.
4.3.4 Intangible Assets

Intangible assets are not a key focus in operational planning but a brief discussion provides some insight into the accounting fiascos of the early 2000s. As we saw earlier in the chapter, intangible assets are long-lived and have no physical form. Instead, these assets are special rights from patents, copyrights, trademarks, and so on. In today's technology-driven economy, intangibles are surpassing tangible assets in value. The electronic economy rewards brand and customer loyalty. Consider on-line auction pioneer eBay. The company has no physical products or equipment, but it is widely recognized as a reliable auction service. Alas, accountants typically deal with historical costs rather than future value. A company's intellectual capital is difficult to measure. But when one company buys another, we get a glimpse of the value of the acquired company's intellectual capital. For example, America Online announced it would acquire Time Warner. AOL said it would exchange $146 billion worth of stock and agree to pay $38 billion of future liabilities for Time Warner's net tangible assets of only $9 billion. Why? Because Time Warner's intangible assets were worth $190 billion. Intangibles can account for as much as 85% of a company's perceived value, so companies must find ways to account for intangibles just as they do for their inventory and equipment. The acquisition cost of a patent is debited to Patents, an asset account. The intangible is expensed through amortization, the systematic reduction of the asset's carrying value on the books. Amortization applies to intangible assets exactly as depreciation applies to plant assets and depletion applies to natural resources. Depreciation, depletion, and amortization are conceptually the same. Amortization is generally computed on a straight-line basis over the asset's estimated useful lifeup to a maximum of 40 years, according to generally accepted accounting principles. But obsolescence often shortens an intangible's useful life. Amortization expense for an intangible asset can be written off directly against the asset account rather than held in an accumulated amortization account. The residual value of most intangible assets is zero. Specific categories of intangibles are patents, copyrights, trademarks, brand names, franchises, and goodwill. Most of these are relatively straightforward
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except goodwill. The term goodwill in accounting has a very different meaning from the everyday term, "goodwill among men." In accounting, goodwill is the excess of the cost to purchase another company over the market value of the other company's net assets (assets minus liabilities). Wal-Mart has now expanded into Mexico. Suppose Barrick acquired Normandy mining company at a cost of $200 million. The sum of the market values of Normandy mining company assets was $350 million and its liabilities totaled $200 million, so Normandy mining company net assets totaled $150 million. In this case, Barrick $50 million for goodwill.
4.3.5 Research and Development Costs

Accounting for exploration, and research and development (R&D) costs is one of the toughest issues the accounting profession has faced. R&D is the lifeblood of many companies. The cost of R&D activities is one of these companies' most valuable (intangible) assets. But, in general, they do not report R&D assets on their balance sheets. GAAP requires companies to expense R&D costs as they incur those costs. Only in certain circumstances may the company capitalize an R&D asset.
4.3.6 Ethics
The main ethical issue in accounting for plant assets and intangibles is whether to capitalize or to expense a particular cost. In this area, companies have split personalities. On the one hand, they all want to save on taxes. This motivates them to expense all costs in order to decrease their taxable income. On the other hand, most companies also want their financial statements to look as good as possible, with high net income and high reported amounts for assets. In marginal industries, where profits are rare, companies would tend to capitalize the costs as it is recorded into the depreciable asset, making the company look as though it has costs under control, rather than saving money (because of the marginal nature of the company, little, if any, tax savings would be incurred). In most cases, a cost that is capitalized or expensed for tax purposes must be treated the same way for reporting to stockholders and creditors in the financial statements. What, then, is the ethical path? Accountants should follow the general guidelines for capitalizing a cost: Capitalize all costs that provide a future benefit for the business, and expense all other costs. Many companies have gotten into trouble by capitalizing costs they should have expensed. They made their financial statements look better than the facts warranted.
ADDITIONAL RESOURCES XI
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4.4 Accounting Information Systems.

Computerized accounting systems have replaced manual systems. The three stages of data processing are inputs (data), processing (accounting), and outputs (reports). Inputs represent data from source documents, such as sales receipts, bank deposit slips, fax orders, and other telecommunications. Inputs are usually grouped by type. For example, a firm would enter cashsale transactions separately from credit sales and purchase transactions. In a manual system, processing includes journalizing transactions, posting to the accounts, and preparing the financial statements. A computerized system also processes, but without the intermediate steps (journal, ledger, and trial balance). Outputs are the reports used for decision making, including the financial statements (income statement, balance sheet). Business owners are making better decisionsand prosperingbecause of the reports produced by their accounting system. Exhibit 6-2 is an overview of a computerized system. Start with data inputs in the lower left corner.
Figure 4-14: Overview of a Computerized Accounting System
Design of the accounting system begins with the chart of accounts. In the accounting system of a large, complex company, account numbers take on added importance. It is efficient to represent a complex account title, such as Accumulated DepreciationPhotographic Equipment, with a concise account number (for example, 12570). Note that the numbers can represent categories. For example, in the INCO chart of accounts, the numerical name would could identify where the cost was incurred. For example, for a particular labor charge, the account would be made up of a 27 digit identifying number. Note that not all these numbers would identify the account, some would identify the type of charge. Computerized accounting systems rely on account translate accounts and their balances into properly statements and other reports. For example, accounts (assets, liabilities, and owner's equity) are sorted to the number ranges to organized financial numbered 101399 balance sheet, while
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accounts numbered 401599 (revenues and expenses) go to the income statement. Naming charts of accounts are not Posting in a computerized system can be performed continuously as transactions are being recorded (on-line processing) or later for a group or batch of similar transactions (batch processing). In either case, posting is automatic. Batch processing of accounting data allows accountants to check the entries for accuracy before posting them. In effect, data are "parked" in the computer to await posting, which simply updates the account balances. Outputsaccounting reportsare the final stage of data processing. In a computerized system, financial statements can be printed automatically. For example, the Reports option in the main menu gives the operator various report choices, which are expanded in the Reports submenu of Exhibit 6-5. In the exhibit, the operator is working with the financial statements, and specifically the balance sheet, as shown by the highlighting.
ADDITIONAL RESOURCES XII
4.5 Managerial Accounting

Financial and management accounting both use the accrual basis (accumulation of records and thereby financial history), and both reflect the same underlying economic transactions. However, their focus differs. Financial accounting focuses on preparing financial statements that allow stockholders and creditors to make informed investment decisions. These highly summarized reports, which are constrained by GAAP, focus on the company's past financial performance. In contrast, company managers need more detailed and timely information to decide how to run the company Table 4-1 summarizes the efficiently and effectively in the future. distinctions between management accounting and financial accounting.
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MGE 409 Management Operations Technology Table 4-1: Management and Financial Accounting Compared
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There are no GAAP-type standards for preparing the information that managers use to plan and control a company's operations. Managers are thus free to tailor the company's management accounting system to provide information that will help them make better decisions. In this discussion, engineers and managers are used interchangeably as most engineering plans require a cost/benefit analysis (which is why this material is being presented). Weighing costs against benefits to help make decisions is called cost-benefit analysis. The methods and standards used to develop cost and benefit analyses differ among companies therefore no specific methodology is presented. Manufacturing and natural resource businesses (now to be used interchangeably) use labor, plant, and equipment to convert raw materials into new finished products. Manufacturing companies can be compared to merchandizing (such as retail) and service (such as consulting) in several levels, as seen in Figure 4-15. However, a central aspect to manufacturing is the value chain, as seen in Figure 4-16. What is not represented is the feedback look between the processes in the value chain. Customer service communicates with R&D, design, and the production system to facilitate quality and market requests. R&D in the case of natural resources includes both determining market needs but also exploring for new raw materials.
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Figure 4-15: Comparison of Business Types
Figure 4-16: Value Chain
4.5.1 Cost Objects, Direct Costs, and Indirect Costs

A cost object is anything for which managers want a separate measurement of costs. For example, a manager may want to isolate the costs associated in producing lead from those that contribute to the zinc, or between departments such as engineering versus operations. Costs that can be specifically traced to the cost object are direct costs. Costs that cannot be specifically traced to the cost object are indirect costs. For example, drill steel and bits can be considered a direct cost. The ventilation needed to bring fresh air to the drilling side would be considered an indirect cost. Accountants use the term product costs for the costs of producing (or purchasing) tangible products intended for sale. We distinguish between two types of product costs: full product costs and inventoriable product costs. Managers use full product costs for certain decisions, like setting long-term sale prices for the goods and services their companies sell. Full product costs are the costs of all resources used throughout the value chain for a product. Inventoriable product costs are product costs that are initially regarded as an asset for external financial reporting and are not expensed until the product is sold. Manufacturers' inventoriable costs include raw materials plus all other costs incurred in the manufacturing/production process. These include; direct labor, direct equipment, direct material, and overhead. The key point is that 136
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manufacturing overhead includes only indirect manufacturing coststhat is, indirect costs related to the manufacturing plant.
4.5.2 Product Costing

It is hard for companies to figure out how much it costs to manufacture a particular product. The amount of labor and materials for a particular workplace or product can be tracked, however, the component of support costs such as ventilation, shaft costs, or pumping cannot be related directly back to a particular workplace. Instead, companies use product costing systems that average costs across products. There are two broad types of systems: Process costing Most widely used in mining, process costing is used by companies that produce large numbers of identical units in a continuous fashion through a series of uniform production steps or processes. The costs for a particular process are first accumulated using a separate chart of accounts or other means. Next, the company averages the costs of the process over all units passing through the process. This is repeated for all the processes throughout the production system. To get the total costs of each final unit produced, a common output unit is calculated back through the production system, in mining, the most commonly used unit of cost is a ton of broken rock. Job costing - assigns costs to a specific unit or to a small batch of products or services that pass through production steps as a distinct identifiable job lot. Different jobs can vary considerably in terms of materials, labor, and overhead costs, so job costing accumulates costs separately for each individual job. Since earthmoving businesses are somewhere between construction (job) and manufacturing (process) production systems, each method is used. Job costing is used for isolating the costs of excavation particular stopes or benches. Process costing is used to control the costs of doing the work. Job costing is also used in maintenance where the costs for a particular repair are accumulated on a work order.
Table 4-2: Comparative Table.
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Engineers developing management accounting reports to develop cost benefit analyses no longer have to focus on the mechanisms that accountants use to record financial transactions for the different costing types. Information technology has facilitated the task of tracking how individual transactions can be allocated to a particular process and to a specific job. Techniques such as linking the chart of accounts to a particular process, and inclusion of a job number on any transaction, allows isolation of the costs in a database. For example, consider the situation where the chart of accounts has an account called truck haulage. All transactions that were made such as repairs, labor, consumables, are charged to that account. To determine the truck haulage process costs, all charges to the truck haulage account for a particular period are accumulated. Job costing is key in determining capital projects such as main haulage drift development. In this case, an account is created where all costs are charged regardless of the type of purchase. (to be discussed in class).
4.5.3 Overheads
Managers want to know the costs incurred in each job or process, including both direct and indirect costs. Accountants use cost tracing to assign direct costs (such as direct materials and direct labor) to cost objects such as jobs or processes. They use cost allocation to assign manufacturing overhead and other indirect costs to cost objects. The general term cost assignment refers to tracing direct costs and allocating indirect costs to cost objects (jobs, in a job costing system). Direct material and direct labor costs are traced directly to each job, as we've seen. But managers also want to know the total manufacturing costs incurred on each job, including manufacturing overhead costs. Somehow, the company must allocate to each individual job its share of the wide variety of indirect manufacturing costs like depreciation and insurance on the plant and equipment, indirect materials, and indirect labor. The key to assigning indirect manufacturing costs to jobs is to identify a manufacturing overhead allocation base. The allocation base is a common denominator that links indirect manufacturing overhead costs to the cost objects. Ideally, the allocation base is the primary cost driver of manufacturing overhead costs. In the case of earthmoving businesses, the most common cost driver used in tons. Most other companies use direct labor to attribute overhead costs and much of that overhead is are costs such as supervision, human resources, and infrastructure associated with people. A more complex and accurate method is Activity Based Costing (ABC) which will be covered in a later section.
4.5.4 Cost Types

The following subsection will review some of the more commonly known cost types known by engineers and introduce a few new terms.
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Variable costs change in total in direct proportion to changes in the volume of activity. The use of contractors is an example of a variable cost, using more will increase costs roughly linearly A fixed cost does not change in total despite wide changes in volume. A mixed cost is part variable and part fixed. relevant range is a band of volume within which a specific relationship exists between cost and volume. A fixed cost is fixed only within a given relevant range of volume (usually large) and a given time span (often a month or a year).
Note that some income statement reports separate fixed and variable costs. Large earthmoving businesses typically have high fixed costs due to the high assets and inflexible workforce levels. In previous discussions, both variable and fixed manufacturing costs have been allocated to products through process or job costing. This approach is called absorption costing because products absorb fixed manufacturing costs as well as variable manufacturing costs. Supporters of absorption costing argue that companies cannot produce products without fixed manufacturing costs, so these costs are an important part of product costs. For planning and decision making, many managers prefer a different approach. Variable costing assigns only variable production costs to products. Under variable costing, fixed manufacturing costs are considered period costs, and are expensed in the period when they are incurred. Supporters of variable costing argue that fixed manufacturing costs (such as depreciation on the plant) provide the capacity to produce during a period. Because the company incurs these fixed expenses whether or not it produces any products or services, they are period costs, not product costs. While variable costing often provides a more useful basis for management decisions, companies can use variable costing only for internal reports. The opinion on how to cost or justify annual mine budgets vary between mine managers or senior engineers (even within the same company!) although these are internal costing functions. GAAP requires that inventory be costed at the full cost to manufacture (or purchase) the goods. Consequently, published financial statements are based on absorption costing.
4.5.5 Budgets and Responsibility Accounting.

Managers undertake several key activities. First, they develop strategies overall business goals for the future. Next, they plan and take specific actions to achieve those goals. Finally, managers control operations by comparing actual results with plans or budgets. This performance evaluation provides valuable feedback. Managers develop budgets to implement the organization's strategy, and then use these budgets to plan, act, and control business operations. The process is continuous: Determine strategy, develop plans and budgets to implement the strategy, act to implement the strategy,
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control by comparing actual results to the budget or plan, and then use feedback from the control step to start the process again. Budgets can have both long-term and short-term focus. The short-term will be reviewed first. The following review some of the benefits of undertaking short-term budgets. Budgets promote Coordination. 4.5.5.1 The master budget coordinates the company's activities. It forces managers to consider relationships among operations across the entire value chain. Budgets are frequently directly calculated from the aggregate plan or longterm plan (note from discussions in module 2). Coordination requires effective communication. Budgets can communicate a consistent set of plans throughout the company. Suppose Heclas engineers plan to begin using bulk mining methods for their silver mines in Idaho. By participating in the budgeting process alongside the engineers, the operations vice president can see how to change the production process. He explains the plan to plant managers so they can make the changes in an orderly way. Budgets provide comparatives benchmarks. 4.5.5.2 Managers can evaluate a department or activity by comparing actual results with either the budget or past performance. The budget is usually a better benchmark because the company's operations or its markets may have changed since last year. Another problem with past results is that they may represent inefficient performance Budgets Control/Motivate Employees 4.5.5.3 Budgets motivate employees to achieve the business's goals, especially when employees believe the budget is fair. For this reason, companies often ask employees to help prepare the budgets that will be used to judge their performance. We have seen how budgets can help managers plan. However, budgets are just as useful for controlling. To control operations, managers prepare performance reports that compare actual results to the budget. These reports help managers: Evaluate operations Decide how to fix problems Prepare next period's budget
4.5.6 The Master Budget

The master budget is the set of budgeted financial statements and supporting schedules for the entire organization. This comprehensive budget
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includes (1) the operating budget, (2) the capital expenditures budget, and (3) the financial budget. The operating budget sets the expected revenues and expensesand thus operating incomefor the period. The capital expenditures budget presents the company's plan for purchases of property, plant, equipment, and other long-term assets. The financial budget projects cash inflows and outflows, the period-ending balance sheet, and the statement of cash flows. This chapter focuses on the operating budget and the financial budget. You learned about the cash budget in Chapter 7; here we will show more details behind the figures in the cash budget. Chapter 26 covers budgeting for capital expenditures. The components of the master budget include: 1. Operating budget a. Sales budget b. Inventory budget and purchases and cost of goods sold budget c. Operating expenses budget d. Budgeted income statement 2. Capital expenditures budget 3. Financial budget a. Cash budget: statement of budgeted cash receipts and payments b. Budgeted balance sheet c. Budgeted statement of cash flows The end result of the operating budget is the budgeted income statement, which shows expected revenues, expenses, and operating income for the period. The financial budget results in the budgeted statement of cash flows, which shows budgeted cash flows for operating, investing, and financing activities. The budgeted financial statements look exactly like ordinary statements. The only difference is that they list budgeted rather than actual figures. In the mining industry, the revenues are predicted on a given metal price (usually set by the corporate office who take into account hedging, metal contracts, and a risk assessment). The predicted product are linked to the anticipated mining area and the geological metal inventory (geological reserves). The mine plan is used as a baseline from which the budget is developed. Engineers will commonly be responsible for developing the operating budget and the capital expenditures budget. Software programs exist from which budgets can be developed, however, most are created on spreadsheet software. The use of spreadsheets also facilitate undertaking sensitivity analyses. Developing integrated information systems or the use of fully integrated Enterprise Resources Planning software facilitate the budget creation process as all the accounting and production information is integrated. Therefore process costs calculated directly from production and accounting records, provide a level of flexibility and accuracy previously known. Budgets can be divided into departmental areas as organized by the responsibility accounting structure. This facilitates the use of budget as an
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managerial control tool as the managers are measured only on the budget for which they are responsible.
4.5.7 Responsibility centers

A responsibility center is a part or subunit of the organization whose manager is accountable for specific activities. Lower-level managers are often responsible for budgeting and controlling costs of a single value-chain function. For example, a foreman can be responsible for planning and controlling the production in a particular section of the mine, while another is responsible for planning and controlling the distribution of the materials needed to mine. Lower-level managers report to higher-level managers who have broader responsibilities. For example, managers in charge of a mine may report to managers that are responsible for the mine and processing facility. Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. Responsibility accounting reports compare plans (budgets) with actions (actual results) for each responsibility center. Superiors then evaluate how well each manager: (1) used the budgeted resources to achieve the responsibility center's goals, and thereby (2) controlled the operations for which he or she is responsible. Several types of responsibility centers exist: Responsibility Accounting You've now seen how managers set strategic goals, and then develop plans and budget resources for activities that will help reach those goals. Each manager is responsible for planning and controlling some part of the firm's activities. A responsibility center is a part or subunit of the organization whose manager is accountable for specific activities. Lower-level managers are often responsible for budgeting and controlling costs of a single valuechain function. For example, one manager is responsible for planning and controlling the production at the plant, while another is responsible for planning and controlling the distribution of the product to customers. Lowerlevel managers report to higher-level managers who have broader responsibilities. For example, managers in charge of production and distribution report to senior managers responsible for profits (revenues minus costs) earned by the entire product line. Types of Responsibility Centers 4.5.7.1 Responsibility accounting is a system for evaluating the performance of each responsibility center and its manager. Responsibility accounting reports compare plans (budgets) with actions (actual results) for each responsibility center. Superiors then evaluate how well each manager: (1) used the budgeted resources to achieve the responsibility center's goals, and thereby (2) controlled the operations for which he or she is responsible. Exhibit 23-16 illustrates four types of responsibility centers: cost centers, revenue centers,
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profit centers, and investment centers. Note: responsibility centers are often called departments. Cost center: A responsibility center where managers are accountable for costs (expenses) only. The line foreman controls costs by ensuring that employees work efficiently with minimal waste. The foreman is not responsible for generating revenues, but is responsible for creating work-inprocess inventory (or products that internal customers use). Some may label this addition to include a profit center but the two are used interchangeably. The plant manager evaluates the foreman on his ability to control costs by comparing actual costs to budgeted costs. All else being equal (for example, holding quality constant), the manager is likely to receive a more favorable performance evaluation if actual costs are less than budgeted costs. Revenue center: A responsibility center where managers are primarily accountable for revenues. Examples include sales people, which does not necessarily apply to the engineer. Profit center: A responsibility center where managers are accountable for revenues (can be internal products and costs (expenses), and therefore profits. All else being equal, the manager is likely to receive a more favorable performance evaluation if actual profits exceed the budget. Investment center: A responsibility center where managers are accountable for investments, revenues, and costs (expenses). Examples include Falconbridge, which is owned by Noranda. Managers of investment centers are responsible for: (1) generating sales, (2) controlling expenses, and (3) managing the amount of investment required to earn the income (revenues minus expenses). The costs, revenues (product rates), or ratios of the two, are frequently evaluated over time. These are usually reviewed on a weekly, monthly, or annual basis. Managers investigate large favorable variances as well as large unfavorable variances. A large favorable variance could reflect good performance (if the measures are designed correctly, sometimes managers may appear to be performing well only focus on the measures). Reviewing variances is commonly known as management by exception. As discussed in previous sub-sections, direct costs are traceable to a particular department or product. Indirect costsall expenses other than direct costsare not traceable to a single department. We saw how process or product costs absorbed indirect costs through an allocation scheme, a similar process is used for responsibility centers: Choose an allocation base for the indirect cost Compute an indirect cost allocation rate:
total direct cost total quantity of allocation base

Allocate the indirect cost:
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Quantity of allocated base used by department
Indirect cost allocation rate
As was mentioned in relation to product or process costing, departmental cost allocation is greatly simplified through structuring data and information systems.
ADDITIONAL RESOURCES XIII
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Module 5:
Information Technology 28
The information technology section will be covered in the lectures as PowerPoint slides. A considerable amount of material is available in the topics covered; however, most is extremely complex and extensive, focused toward IT practitioners rather than engineers.
ADDITIONAL RESOURCES XIV
This module is additionally supplemented by: Lecture for Module 5
Module 6:
Management Strategy 29
Strategic management can be defined as a set of philosophic or guiding principles that can direct activities at a lower levels. The strategies can be improvement strategies such as Reengineering and Total Quality Management (TQM) as well as motivational or supportive strategies. At the root of most companys strategic management is the mission and vision statements. These are usually clearly presented in promotional material. The development of these carefully scripted statements is an executive function and will therefore not be discussed further. What may be important to a junior engineer is familiarity with improvement strategies and motivational strategies to understand how and why particular processes are set in most organizations. A key change strategy, TQM or continuous improvement (CI) will be covered in a graduate project. Motivational theory and strategies are discussed in the sub-section below. Note that this module for the spring of 2003, is provided for interest only. Time constraints do not allow for an extensive exploration of these issues.
6.1 Motivation
Motivating and rewarding employees is one of the most important and one of the most challenging activities that managers perform. Note that just because you are motivated by being part of a cohesive work team, don't assume everyone is. Or just because you're motivated by challenging work doesn't mean that everyone is. Effective managers who want their employees to put forth maximum effort recognize that they need to know how and why
28
Some of the text for this module is taken directly from Horngren, Charles T., Walter T. Harrison, and Linda S. Bamber. Accounting. Upper Saddle River, New Jersey: Prentice Hall. 2002. activebook. It has been edited for content and application.
A large part of this module is taken directly from Robbins, Stephen P. and Mary Coulter. Management Upper Saddle River, New Jersey: Prentice Hall. 2002. activebook. Dessureault 1/11/2006
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employees are motivated and to tailor their motivational practices to satisfy the needs and wants of those employees.
6.1.1 What Is Motivation?

Motivation is the result of the interaction between the person and the situation. Certainly, individuals differ in motivational drive, but overall motivation varies from situation to situation. As we analyze the concept of motivation, keep in mind that the level of motivation varies both between individuals and within individuals at different times. Motivation is the willingness to exert high levels of effort to reach organizational goals, conditioned by the effort's ability to satisfy some individual need. Although, in general, motivation refers to effort exerted toward any goal, we're referring to organizational goals because our focus is on work-related behavior. Three key elements can be seen in this definition: effort, organizational goals, and needs. The effort element is a measure of intensity or drive. A motivated person tries hard. But high levels of effort are unlikely to lead to favorable job performance unless the effort is channeled in a direction that benefits the organization. Therefore, we must consider the quality of the effort as well as its intensity. Effort that is directed toward, and consistent with, organizational goals is the kind of effort that we should be seeking. Motivation is discussed here as a need-satisfying process, as shown in Figure 6-1.
Figure 6-1: The Motivation Process
We can say that motivated employees are in a state of tension. To relieve this tension, they exert effort. The greater the tension, the higher the effort level. If this effort leads to need satisfaction, it reduces tension. Because we're interested in work behavior, this tension-reduction effort must also be directed toward organizational goals. Therefore, inherent in our definition of motivation is the requirement that the individual's needs be compatible with the organization's goals. When the two don't match, individuals may exert high levels of effort that run counter to the interests of the organization. Incidentally, this isn't all that unusual. Some employees regularly spend a lot of time talking with friends at work to satisfy their social need. There's a high level of effort but little being done in the way of work. Motivating high levels of employee performance is an important organizational consideration. Both academic researchers and practicing managers have been trying to understand and explain employee motivation
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for years. In this chapter, we're going to first look at the early motivation theories and then at the contemporary theories. We'll finish by looking at some current issues in motivation and then providing some practical suggestions managers can use in motivating employees. We're going to be looking at three early theories of motivation that, although now somewhat questionable in terms of validity, are probably still the bestknown explanations for employee motivation. These three theories are Maslow's hierarchy of needs, McGregor's Theories X and Y, and Herzberg's motivation-hygiene theory. Although more valid explanations of motivation have been developed, you should know these early theories for at least two reasons: (1) They represent the foundation from which contemporary motivation theories were developed, and (2) practicing managers continue to regularly use these theories and their terminology in explaining employee motivation.
6.1.2 Maslow's Hierarchy of Needs Theory

The best-known theory of motivation is probably Abraham Maslow's hierarchy of needs theory. Maslow was a humanistic psychologist who proposed that within every person is a hierarchy of five needs: Physiological needs: food, drink, shelter, sexual satisfaction, and other physical requirements. Safety needs: security and protection from physical and emotional harm, as well as assurance that physical needs will continue to be met. Social needs: affection, belongingness, acceptance, and friendship. Esteem needs: internal esteem factors such as self-respect, autonomy, and achievement and external esteem factors such as status, recognition, and attention. Self-actualization needs: growth, achieving one's potential, and selffulfillment; the drive to become what one is capable of becoming. In terms of motivation, Maslow argued that each level in the hierarchy must be substantially satisfied before the next is activated and that once a need is substantially satisfied it no longer motivates behavior. In other words, as each need is substantially satisfied, the next need becomes dominant. In terms of Figure 6-2, the individual moves up the needs hierarchy. From the standpoint of motivation, Maslow's theory proposed that, although no need is ever fully satisfied, a substantially satisfied need will no longer motivate an individual. If you want to motivate someone, according to Maslow, you need to understand what level that person is on in the hierarchy and focus on satisfying needs at or above that level. Managers who accepted Maslow's hierarchy attempted to change their organizations and management practices so that employees' needs could be satisfied.
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Figure 6-2: Maslow's Hierarchy of Needs
In addition, Maslow separated the five needs into higher and lower levels. Physiological and safety needs were described as lower-order needs; social, esteem, and self-actualization were described as higher-order needs. The difference between the two levels was made on the premise that higherorder needs are satisfied internally while lower-order needs are predominantly satisfied externally. In fact, the natural conclusion from Maslow's classification is that, in times of economic prosperity, almost all permanently employed workers have their lower-order needs substantially met. Maslow's need theory received wide recognition, especially among practicing managers during the 1960s and 1970s. This recognition can be attributed to the theory's intuitive logic and ease of understanding. Unfortunately, however, research hasn't generally validated the theory. Maslow provided no empirical support for his theory, and several studies that sought to validate it could not.4
6.1.3 McGregor's Theory X and Theory Y

Douglas McGregor is best known for his formulation of two sets of assumptions about human nature: Theory X and Theory Y.5 Very simply, Theory X presents an essentially negative view of people. It assumes that workers have little ambition, dislike work, want to avoid responsibility, and need to be closely controlled to work effectively. Theory Y offers a positive view. It assumes that workers can exercise self-direction, accept and actually seek out responsibility, and consider work to be a natural activity. McGregor believed that Theory Y assumptions better captured the true nature of workers and should guide management practice. What did McGregor's analysis imply about motivation? The answer is best expressed in the framework presented by Maslow. Theory X assumed that lower-order needs dominated individuals, and Theory Y assumed that higherorder needs dominated. McGregor himself held to the belief that the assumptions of Theory Y were more valid than those of Theory X. Therefore, he proposed that participation in decision making, responsible and challenging jobs, and good group relations would maximize employee motivation. Unfortunately, there is no evidence to confirm that either set of assumptions is valid or that accepting Theory Y assumptions and altering your actions
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accordingly will make employees more motivated. For instance, when Bob McCurry was vice president of Toyota's U.S. marketing operations, he essentially followed Theory X. He drove his employees hard and used a "crack-the-whip" style, yet he was extremely successful at increasing Toyota's market share in a highly competitive environment.
6.1.4 Herzberg's Motivation-Hygiene Theory

Frederick Herzberg's motivation-hygiene theory proposes that intrinsic factors are related to job satisfaction and motivation, whereas extrinsic factors are associated with job dissatisfaction. Believing that an individual's relation to his or her work is a basic one and that his or her attitude toward work determines success or failure, Herzberg investigated the question "What do people want from their jobs?" He asked people for detailed descriptions of situations in which they felt exceptionally good or bad about their jobs. These findings are shown in Figure 6-3.
Figure 6-3: Herzberg's Motivation-Hygiene Theory
Herzberg concluded from his analysis of the findings that the replies people gave when they felt good about their jobs were significantly different from the replies they gave when they felt badly. Certain characteristics were consistently related to job satisfaction (factors on the left side of the exhibit) and others to job dissatisfaction (factors on the right side). Those factors associated with job satisfaction were intrinsic and included things such as achievement, recognition, and responsibility. When people felt good about their work, they tended to attribute these characteristics to themselves. On the other hand, when they were dissatisfied, they tended to cite extrinsic factors such as company policy and administration, supervision, interpersonal relationships, and working conditions. In addition, Herzberg believed that the data suggested that the opposite of satisfaction was not dissatisfaction, as traditionally had been believed. Removing dissatisfying characteristics from a job would not necessarily make that job more satisfying (or motivating). As shown in Figure 6-4, Herzberg proposed that his findings indicated the existence of a dual continuum: The opposite of "satisfaction" is "no satisfaction," and the opposite of "dissatisfaction" is "no dissatisfaction."
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Figure 6-4: Contrasting Views of Satisfaction-Dissatisfaction
According to Herzberg, the factors that led to job satisfaction were separate and distinct from those that led to job dissatisfaction. Therefore, managers who sought to eliminate factors that created job dissatisfaction could bring about workplace harmony but not necessarily motivation. Because they don't motivate employees, the extrinsic factors that create job dissatisfaction were called hygiene factors. When these factors are adequate, people will not be dissatisfied, but they will not be satisfied (or motivated) either. To motivate people on their jobs, Herzberg suggested emphasizing motivators, the intrinsic factors that increase job satisfaction. Herzberg's theory enjoyed wide popularity from the mid-1960s to the early 1980s, but criticisms were raised about his procedures and methodology. Although today we say the theory was too simplistic, it has had a strong influence on how we currently design jobs. Modern theories of motivation include the three needs, goal-based and R+ (reinforcement theory). These three are discussed next.
6.1.5 Three Needs

David McClelland and others have proposed the three-needs theory, which says there are three needs that are major motives in work. These three needs include the need for achievement (nAch), which is the drive to excel, to achieve in relation to a set of standards, and to strive to succeed; the need for power (nPow), which is the need to make others behave in a way that they would not have behaved otherwise; and the need for affiliation (nAff), which is the desire for friendly and close interpersonal relationships. Of these three needs, the need for achievement has been researched most extensively. Research showed us that people with a high need for achievement are striving for personal achievement rather than for the trappings and rewards of success. They have a desire to do something better or more efficiently than it's been done before. They prefer jobs that offer personal responsibility for finding solutions to problems, in which they can receive rapid and unambiguous feedback on their performance in order to tell whether they're improving, and in which they can set moderately challenging goals. High achievers aren't gamblers; they dislike succeeding by chance. They are motivated by and prefer the challenge of working at a problem and accepting the personal responsibility for success or failure. An important point is that high achievers avoid what they perceive to be very easy or very difficult
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tasks. Also, a high need to achieve doesn't necessarily lead to being a good manager, especially in large organizations. The reason high achievers don't necessarily make good managers is probably because high achievers focus on their own accomplishments while good managers emphasize helping others accomplish their goals. However, we do know that employees can be trained to stimulate their achievement need. The other two needs in the three-needs theory haven't been researched as extensively as the need for achievement. However, we do know that the needs for affiliation and power are closely related to managerial success. The best managers tend to be high in the need for power and low in the need for affiliation.
6.1.6 Goal Setting Theory

There is substantial support for the proposition that specific goals increase performance and that difficult goals, when accepted, result in higher performance than do easy goals. This proposition is known as goal-setting theory. Intention to work toward a goal is a major source of job motivation. Studies on goal setting have demonstrated the superiority of specific and challenging goals as motivating forces. Specific, hard goals produce a higher level of output than does the generalized goal of "do your best." The specificity of the goal itself acts as an internal stimulus. Will employees try harder if they have the opportunity to participate in the setting of goals? Although we can't say that having employees participate in the goal-setting process is always desirable, participation is probably preferable to assigning goals when you expect resistance to accepting difficult challenges. In some cases, participatively set goals elicited superior performance; in other cases, individuals performed best when their manager assigned goals. But a major advantage of participation may be in increasing acceptance of the goal itself as a desirable one toward which to work. Finally, people will do better when they get feedback on how well they're progressing toward their goals because feedback helps identify discrepancies between what they have done and what they want to do; that is, feedback acts to guide behavior. But all feedback isn't equally effective. Self-generated feedbackwhere the employee is able to monitor his or her own progress has been shown to be a more powerful motivator than externally generated feedback. In addition to feedback, three other factors have been found to influence the goals-performance relationship. These are goal commitment, adequate selfefficacy, and national culture. Goal-setting theory presupposes that an individual is committed to the goalthat is, an individual is determined not to lower or abandon the goal. Commitment is most likely to occur when goals
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are made public, when the individual has an internal locus of control, and when the goals are self-set rather than assigned. Self-efficacy refers to an individual's belief that he or she is capable of performing a task. The higher your self-efficacy, the more confidence you have in your ability to succeed in a task. So, in difficult situations, we find that people with low self-efficacy are likely to reduce their effort or give up altogether, whereas those with high self-efficacy will try harder to master the challenge. In addition, individuals with high self-efficacy seem to respond to negative feedback with increased effort and motivation, whereas those with low self-efficacy are likely to reduce their effort when given negative feedback. Finally, goal-setting theory is culture bound. It is well adapted to countries such as the United States and Canada because its main ideas align reasonably well with North American cultures. It assumes that subordinates will be reasonably independent (not too high a score on power distance), that managers and employees will seek challenging goals (low in uncertainty avoidance), and that performance is considered important by both managers and subordinates (high in quantity of life). National/cultural implications in motivation are especially important as the mining further invests in international projects. Although a politically charged topic, understanding cultural motivation may be an important factor to managerial success in other countries.
Figure 6-5: Goal Setting theory
6.1.7 Reinforcement Theory

In contrast to goal-setting theory, reinforcement theory says that behavior is a function of its consequences. Goal-setting theory proposes that an individual's purpose directs his or her behavior. Reinforcement theory argues that behavior is externally caused. What controls behavior are reinforcers, consequences that, when given immediately following a behavior, increase the probability that the behavior will be repeated. The key to reinforcement theory is that it ignores factors such as goals, expectations, and needs. Instead, it focuses solely on what happens to a person when he or she takes some action. People will most likely engage in
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desired behaviors if they are rewarded for doing so; these rewards are most effective if they immediately follow a desired behavior, and behavior that isn't rewarded, or is punished, is less likely to be repeated. Following reinforcement theory, managers can influence employees' behavior by reinforcing actions they deem desirable. However, because the emphasis is on positive reinforcement, not punishment, managers should ignore, not punish, unfavorable behavior. Even though punishment eliminates undesired behavior faster than nonreinforcement does, its effect is often only temporary and may later have unpleasant side effects including dysfunctional behavior such as workplace conflicts, absenteeism, and turnover.
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University of rizona Mining and Geological Engineering

409 - Management Operations Technology

Modules 1-6 Compiled by: Dr. Sean Dessureault

MGE 409 Management Operations Technology

ADDITIONAL RESOURCES I................................................................................................................. 5 MODULE 2: OPERATIONS MANAGEMENT, ............................................................................... 6

MGE 409 Management Operations Technology

ADDITIONAL RESOURCES XIV....................................................................................................... 145 MODULE 6: MANAGEMENT STRATEGY ................................................................................ 145

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

Figure 2-2: Project planning and control.

2.1 Aggregate Planning

MGE 409 Management Operations Technology

2.1.1 Integrating Operations Management with Other Functions

MGE 409 Management Operations Technology

2.1.2 Planning for the Intermediate Term

MGE 409 Management Operations Technology

Figure 2-3: Planning to Deliver the Product-Service Bundle

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

2.1.3 Aggregate Planning Variables

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

2.1.4 General Aggregate Planning Strategies

Compatible Competitive Priorities

Environments Where Most Common

MGE 409 Management Operations Technology

September 26,000 35,000 21,000

MGE 409 Management Operations Technology

Figure 2-4: Jimbobs Minerals Level Production

MGE 409 Management Operations Technology

MGE 409 Management Operations Technology

0 0 0 0 0 0 0 $2,000 0 0 0 $500 0 0 $500 0 0 0

0 $1,500 0 $1,500 0 0 0 0 $1,500 $4,500 $1,500 0 0 0 0 $1,500 0 0

MGE 409 Management Operations Technology

Figure 2-6: Simons Engineering Consulting group peak demand strategy.

May June July

1,680 1,680 1,848

MGE 409 Management Operations Technology

0 0 (3) (1) 3 0 (4) 0 2 2 0 3 (2) (1) (2)

0 0 0 0 $ 7,500 0 0 0 $ 5,000 $ 5,000 0 $ 7,500 0 0 0 $27,500

0 0 $ 7,500 $ 2,500 0 0 $10,000 0 0 0 0 0 $ 5,000 $ 2,500 $ 5,000 $32,500

0 0 0 0 0 0 0 0 0 0 $16,000 0 $ 5,600 $ 6,000 0 $89,200

MGE 409 Management Operations Technology

Figure 2-7: Jimbobs quarry Mixed Strategy

MGE 409 Management Operations Technology

Table 2-5: Jimbobs Quarry.

Reg. Time Hours

Reg. Time Cost

0 0 0 $500 0 0 0 0 0 0 0 0 0 0 0 $1,000 0 0 $1,500

$1,500 0 0 0 0 0 0 0 0 $1,500 0 0 0 0 0 0 0 0 $3,000

0 0 0 $90 $900 $900 $900 $5,400 0 0 0 0 $270 $1,090 $1,090 0 0 0 $10,620

MGE 409 Management Operations Technology

2.1.5 Aggregate Planning Methods

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MGE 409 Management Operations Technology

2.2.1 Choosing a Forecasting Method

2.2.2 Forecasting Model Types

MGE 409 Management Operations Technology

2.2.3 Time Series Components

MGE 409 Management Operations Technology