- Define key vocabulary terms
Capacity describes the rate at which a manufacturing plant produces goods or the rate at which services are provided to customers. (See the definition of goods and services below.) Capacity is expressed in units of whatever is being processed per some period of time. For example, an automobile manufacturing plant might manufacture 60 cars per hour, which would be its capacity. Capacity can be stated in units per hour, units per year, or units per any other unit of time.
The cost of conducting business is comprised of all the money that a company spends for raw materials, employee wages, equipment, and any other expenses that are required to provide goods and services to its customers.
Customer service is a measure of how well customers are treated. Ideally, these are numerical measures that determine how satisfied customers are with the physical goods or services that have been provided to them. For example, customers generally care about how long they wait to have their services performed, whether goods can be shipped immediately upon their request, whether physical products have defects, and whether errors are made in the fulfillment of services. For example, customer service measures might include the average percentage of the items sold by a store that it has in stock for immediate delivery, or the average time that elapses between customers placing orders and customers receiving the goods.
Customers create the demand for goods and services from a company. The level of demand can be stated in many ways, depending on which is most appropriate for the situation. Sometimes demand is stated as the number of units that customers request. Demand is usually stated as a rate, that is, the number of units requested during some time period, such as units per hour. Alternately, demand can be stated as the number of customers per hour, or the number of customers per year that make requests of a goods or service provider. Measuring demand by the number of customers rather than the number of units of goods that need to be delivered is appropriate when each customer requests one item from a company. If customers can request multiple items, then measuring demand by the number of units over some time period is most appropriate.
Goods are physical entities that are processed or produced in a manufacturing operation. "Finished" goods are completed goods at the end of a company’s manufacturing process. "Finished" may refer to goods that are in the form in which they will be received by the customer, or to goods that one company finishes and provides to another company for further processing. Goods might also include incomplete units (work in process) or the raw materials that manufacturing companies start with before they do any processing.
Physical goods that reside in manufacturing and distribution supply chains are called inventory. Inventory can be stored prior to the start of a process, called raw materials inventory; in the middle of a process, called work in process; and at the end of a process, called finished goods inventory.
Profit is the amount of money taken in by a company over and above the costs of performing whatever services or manufacturing operations are required to generate those revenues. This residual amount of money is available to disperse among those who have invested in the company or to invest in developing additional business for the company.
A rate is a measurement that is expressed in units per some time period. For example, see the definition of capacity above.
Raw materials are goods purchased by a company that, through manufacturing, fabrication, and assembly operations, the company transforms into finished products that it sells to its customers. Raw materials are inputs into a company and the finished goods are outputs.
A service level is a numerical measure that describes how well a company serves its customers.
Services are activities requested by customers and performed for customers but do not involve the manufacture and delivery of physical goods. For example, performing accounting services, processing an insurance claim, and depositing a check into a banking account are all services executed for the benefit of a customer where no physical product is given to the customer.
Check Your Understanding
This lesson requires no special prerequisite knowledge. The only experience that this lesson draws upon is the student’s experience as a customer in fast food restaurants.
This lesson introduces the types of decisions that business managers make, as well as the goals they are trying to achieve by making them.
Business managers must make many decisions on a day-to-day basis. For example, in a context that is familiar to most people, managers of fast food restaurants must decide how many people to hire, how many people to have working at a various times of the day, which tasks to assign to which employees (cooking burgers, cooking French fries, sweeping the floor, taking out the trash, etc.), and how many of each item (hamburgers, chicken sandwiches, salads, etc.) to have ready in the food warmer trays at different points in the day. Before the managers even get an opportunity to make these decisions, they must make other decisions when designing a restaurant about how much equipment to install, how many parking spots to have, how to design the steps a customer goes through for drive-thru service, and so forth. All these decisions are made with the goal of making the business as successful as possible. One measure of business success is profit, which is the money that a business generates for its owners. It is calculated by taking revenues, which is the total of all money taken in from customers, and subtracting the costs of operating the business. A restaurant incurs many different costs, such as:
- Paying its employees (wages or labor cost).
- Buying burgers, chicken, frozen French Fries, packing materials (raw materials cost).
- Purchasing cooking equipment (equipment cost).
- Purchasing the building (building cost) or leasing a building (lease cost).
- Purchasing cleaning supplies, office supplies, uniform cleaning, and the services to fix and maintain equipment and the building (maintenance and operating cost).
- Maintaining inventory (inventory holding cost).
A restaurant’s total cost is the sum of all these different types of costs, and possibly some others.
The equation for profit is:
Profit = Revenue - Cost.
For example, if a restaurant was paid $20,000 on one day by all its customers for food they purchased, and the cost of operating the business was $15,000 on that day, then profit is $5,000 on that day ($20,000 – $15,000 = $5,000).
Demand is the goods and services that customers order from companies. Because demand comes from customers, it is often called "customer demand." Demand can be stated in terms of the number of customers that ask a business to deliver some product to them or provide some service for them. For example, in a fast food restaurant, customer demand might be expressed as the number of customers who order meals. Alternately, demand might be stated as the number of burgers, orders of French fries, soft drinks, and so on that customers order. The approach used depends on the situation. More precisely, demand is usually stated as an average rate, that is, the number of customers that arrive over some period of time, such as customers per hour or customers per year. When the workload placed on a company is more appropriately described by the number of each item that is ordered, then demand might be expressed as burgers per hour, orders of French fries per hour, and so on for all the items offered by the fast food restaurant. The greater the demand, the more products a company sells, and the greater the revenues a company will have.
Capacity, in the context of the fast food restaurant, describes how many customers can be served per minute on average. When a restaurant makes decisions about its building, its equipment, the number of employees hired, and the number of employees doing each task, then it is determining its capacity, or the amount of food that can be made each minute or hour. Increasing capacity increases the speed at which food can be made, which improves customer service. Increasing capacity, however, also increases cost. For example, a greater number of employees implies higher labor costs.
Inventory is the quantity of food products that the restaurant has in its building. Inventory can be in the form of raw materials, as mentioned above, or in the form of food that is already prepared and ready to be served to customers (finished goods inventory). Storing food as finished goods has the advantage that it can be given to customers more quickly, thus providing better customer service, but it may need to be thrown away if it sits around too long before a customer orders — it may spoil or simply will not taste as good as the moment it was made. So, more inventory improves customer service, but it also increases cost.
There are, therefore, three fundamental characteristics about businesses that determine revenues, how much cost will be incurred, how well customers will be served, and thus how much profit a business will make. These are:
Furthermore, demand, capacity, and inventory are related through customer service. To provide a particular level of customer service, a company can rely either on having more inventory ready or by having more capacity to make goods quickly when customers arrive. A manager must, therefore, decide on the appropriate inventory and capacity levels to achieve the desired service level. The higher the demand rate, the more inventory and capacity will be needed. In addition, if capacity and inventory levels are set to provide excellent service, then demand and revenues will increase because customers will come back more often and recommend the company to friends. Therefore, decisions about capacity and inventory determine how much profit a company will make, and making wise decisions is important.
Profit can be increased by increasing revenues or reducing any of the costs mentioned above. Revenues can be increased by serving more customers. A company can entice customers to come back more often and to refer new customers by word of mouth if the current customers are happy with the customer service. So, increasing capacity or inventory can increase revenue, but, as discussed above, these actions also increase cost. The questions that need to be answered to determine whether adding capacity or inventory will increase profit are:
- If capacity is added, will revenue increase more than cost increases?
- If more inventory is held, will revenue increase more than cost increases?
It is difficult, however, to estimate how much customer service and demand change as changes are made in capacity and inventory. Computer simulation, which is the main topic of this chapter, helps answer that question.
Note that capacity and demand are similar types of data: both are expressed as an average number of customers over some time period, such as a minute or an hour. These types of numbers are called rates: they express how fast customers are arriving or being served.
- Profit is revenue minus cost.
- Customer service, in general, is how well companies treat customers. One aspect of customer service is how long it takes for a company to supply a customer with the product or service he or she orders.
- Demand is the rate at which customers request companies to deliver goods or services.
- Capacity is the rate at which companies are able to deliver goods and services.
- Inventory is comprised of the goods that companies have on hand. Finished goods inventory, goods that are completed and ready to give to customers, can be used to improve customer service.
- Managers need to make decisions about how much capacity and inventory to have.
- Capacity and inventory determine how well customers are served, and, therefore, they affect demand.
- Managers can influence revenues indirectly by deciding to have enough capacity and inventory on hand to satisfy customers quickly. Having greater capacity and inventory, however, increases costs.
- If on a given day a restaurant takes in $12,000 in revenues, and all costs of doing business together on that day total $9,000, then what is profit for the day?
- If on a given day a restaurant takes in $50,000 in revenues, and all costs of doing business together on that day total $30,000, then what is profit for the day?
- If on a given day a restaurant takes in $19,000 in revenues and its costs are as follows, then what is profit?
- raw materials cost: $11,000
- inventory cost: $1,500
- building cost: $1,000
- equipment cost: $500
Points to Consider
- If increasing capacity and inventory increases customer service and revenues, but it also increases costs, then how would a manager determine whether increasing capacity and inventory was a good decision? Keep in mind that increased revenues improve profit, but increased costs decrease profit.