Operations Management

Companies take profit as a measure of investment success, however profit alone isn't a measure. Profit is often defined as net income, which provides an absolute measure but lacks the input comparison necessary for a measure of productivity. The three most common measures of profitability are profit margin, return on assets and return on equity.

Profit Margin=Income/Sales

Return on Assets=Net Income/Total Assets

Return on Equity=Net Income/Total Equity

In order to calculate these measures first we have to determine net income. When we subtract the cost of goods sold and depreciation from net sale and than subtract interest paid and taxable income we can calculate net income.

Profit Margin measures the productivity of our entire business and tells us how much profit is generated per dollar of sales. A high profit margin can result from low expenses relative to sales or high sales relative to expenses. Basically, customers determine the value of goods or services, which are created by the process. If costs are low that can mean that inventory, workforce, equipment, capacity and facilities are managed efficiently. Effectively managed processes can provide a double impact on net income by increasing net sales and decreasing cost of goods sold.

Return on Assets is an indication of profit per dollar of assets. ROA is the mostly used measure of asset productivity and it's measures how well assets are used to generate income. If the ROA is lower than desired, a red flag is raised, but management still has to identify those assets not being used to their fullest.

Return on Equity determines how well stockholders did during a year by providing a measure of the productivity to their investment. ROE is not typically used as a performance measure, because ROA and provide margin provide more transparent indicators of asset productivity.

Operating resources are often divided into four broad categories: inventory, workforce, capacity and facilities.

Inventory is described as a sum of products and the components of products sold. Some of them are retail items and some of them are raw materials. Inventory management has a big importance in productivity measure; especially when it comes to excess inventory that has a huge drain on the productivity of assets. With reengineering and continuous replenishment inventory level can be managed effectively.

The following example is going to demonstrate financial implications of different delivery patterns and inventory levels:

Let's suppose that retailer buys each laptop for $2,000 and sells for $2490. If the retailer takes delivery and pays for all 100 laptops on the first day of the month he has invested $200,000 in the inventory at the beginning of the month. The average inventory investment level in that would be $100,000. For $100,000 investment the return is 49 percent, i.e. $49,000 in one month.

Now instead of one monthly delivery, the retailer took a daily delivery of 5 laptops every weekday and paid for them as he received them, instead of one monthly delivery. In this case the average inventory investment is $5,000. At the end of the month our retailer would have sold all 100 laptops and made $49,000 on an average daily investment of $500. As it can be concluded from the above calculation, with a simple reengineered inventory supply a 980 percent return in a month can be achieved.

The most frequently used measure of inventory productivity is known as inventory turnover. Inventory turnover compares annual sales generated by the inventory to the average level of inventory. The more frequently it turns over the greater its productivity.

The workforce consists of all of the employees of the company. Employees are often described company's most important asset due to their reasoning, critical thinking and flexibility. Even though workforce is expensive and they are getting more and more difficult to attract as labor markets become tighter is some industries, replacement with automated machines and robots do not provide qualities that humans possess. Productivity measures for employees are often a challenge to create and interpret and they can be quite deceiving. Sometimes low-quality service is the employee's fault, but systems and processes that don't take advantage of the employee's strengths and weaknesses may well cause it. To achieve full utilization of employees' abilities management need to approach to this issue with responsibility and create needs for full utilization. Employees are subject of productivity measures that compare outputs to inputs. Such ratios compare sales dollars and units produced to hours/weeks, customers and calls. Ratios of outputs to inputs for individuals can create productivity measures that are like local profitability measures for individual salesperson.

Capacity is defined as the capability of workers, machines, plants, servers or organizations to produce output in a specific period of time. Management's high priority is maximizing the return on equipment. If a measurement of the productivity of equipment is ineffective it can result a poor decision-making and disagreement for many businesses. Very often management questions if purchase of a bigger and faster machine could reduce the per-unit cost of what it makes. To answer this question a measure of machine productivity known as machine utilization is computed:

Utilization=Actual Running Time/Time Available

By producing more units, the fixed cost will be allocated over more units, however it will not necessarily result in an increase in net income. One of the reasons for this is a high production rate that is greater than demand rate, actually results in a reduction in net income, because costs are increasing but sales revenues aren't. Utilization can be an important measure of resource productivity, however applied inappropriately can cause problems that lead to bad decisions.

Another capacity related measure if efficiency, which is often misunderstood and interpreted as how well something works or how effective it is. Efficiency is actually a productivity measure that is calculated using the following formula:

Efficiency: Actual Output/Standard Output

Efficiency measures what the machine actually did divided by a measure of what the machine could have or should have done.

Facilities contribute directly to the customer's perception of value