Facility Location

Learning Objectives

After completing this chapter, you should be able to:

• Discuss location as a strategic decision.

• Discuss the quantitative and qualitative factors influencing location decisions.

• Integrate qualitative and quantitative factors to make effective location decisions.

• Describe how location influences other operating decisions.

• Describe the process selection decision and how it is influenced by the volume of product demanded.

• Define the different process types: line flow, batch flow, flexible manufacturing system, manufacturing cell, job shop, and project.

• Construct a cost-volume-profit model of a firm, and understand how to use the model to manage the firm.

• Calculate the break-even point for cases involving both single- and multiple-product breakeven.

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Facility Location and Process Selection

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CHAPTER 7Section 7.1 Facility Location

7.1 Facility Location

The previous chapters in this book have provided an understanding of what oper-ations are, why they are important, how they can be used to create competitive advantage, how they impact key business elements such as cost and quality, and how they relate to suppliers. This chapter provides some organizational context for the study of operations.

The purpose of an organization is to manufacture a good or provide a service, and opera- tions play a key role. This begins with designing the production system, which includes:

1. Designing a product, which was discussed in an earlier chapter 2. Determining where and how the product will be created (location and process) 3. Setting the capacity of the organization

There are other decisions involved in designing the system that produces these goods and services, such as how to lay out and organize the facility and design the individual jobs that employees must perform. However, these topics are beyond the scope of this text.

Facility location is the placement of a facility with regard to a company’s customers, sup- pliers, and other facilities with which the company interacts. The location decision usually commits substantial resources and cannot be easily changed. Many of the principles and techniques used in locating a facility are the same whether an organization is selling fried chicken or groceries, provides fire protection or health services, stores electronic parts or food, or makes computer chips or paper. Managers making the decision should consider the costs of operating at a particular location, including costs to acquire the land and build the facility, as well as costs for labor, taxes, and utilities. They should consider the conve- nience of a particular location for customers as well as the cost to transport materials to the facility and move finished product from the facility. Managers should also consider access to banking, educational, and other activities that are important to the success of their organization. Thus, many factors, both quantitative and qualitative, influence the location decision. Quantitative factors are easily measurable, while qualitative factors are more subjective.

What often differs from one industry to another are the weights assigned to these various factors. The size of the weight assigned to a factor indicates its importance. For example, a primary factor in locating a fire station is its response time to the buildings within that fire district. Thus, response time should be assigned a large weight. When locating a res- taurant, easy customer accessibility may be more important than the cost to transport raw material (food and beverages) to the facility. An organization producing solar cells may feel that it is very important to locate in an area close to a university or research park that specializes in key technology. Organizations that produce plywood, dimensional lum- ber, or paper need a readily available supply of wood, so they usually locate near timber resources. Managers of labor-intensive operations may feel that low labor cost is the criti- cal factor that determines the location of their facility.

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CHAPTER 7Section 7.1 Facility Location

Location as a Strategic Decision The location decision usually involves commitment of a large capital investment that can- not be moved. As a result, location should be viewed as a long-term, strategic decision because it will have a major impact on the organization’s ability to compete. The location decision should not be based solely on marketing issues, production factors, or transpor- tation costs. Successful managers integrate the relevant factors and weigh them appropri- ately in order to make the best long-term decision for the organization.

This long-term commitment should fit with the organization’s overall strategy. In some cases, organizations develop marketing and operating strategies that have an impact on the location decision. A regional facility strategy requires that each production facility has a defined marketing area and each facility produces a complete line of products for that area. This is often done when customer convenience and access are important, or when out- bound transportation costs are very high. Fast-food restaurants, instant oil change opera- tions, hospitals, and branch banks are examples of operations located to provide maxi-

mum customer convenience and access. Many customer- oriented service operations are located in this way. Bottle mak- ing, corrugated box produc- tion, and aluminum can making operations are examples of facil- ities that are located by region to keep outbound transporta- tion costs low. These finished products have high shipping costs because they occupy a lot of space—shipping a can to the beverage company means ship- ping a lot of empty space. When these low-value finished prod- ucts are shipped long distances, transportation costs increase the cost of the product, making the company less price competitive.

A product facility strategy means that one facility is responsible for producing one prod- uct or product line and shipping that product throughout the country and the world. This approach is appropriate when the production process is complex and hard to con- trol, such as making ceramic heat shields for spacecraft. It can be used when a firm does not want to duplicate expensive equipment, facilities, and highly trained personnel. This approach is also popular when there are advantages to specialization and economies of scale, and when transportation costs are not prohibitive. The production of igniters for jet aircraft engines, for example, would benefit from a product facility strategy. This item is small, so shipping costs are low. An igniter is high in value, so shipping cost, as a percent of purchase price, is also small.

© age fotostock / SuperStock

Fast-food restaurants, hotels, hospitals, and gas stations are often located on heavily traveled roadways in order to provide customer convenience and accessibility.

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CHAPTER 7Section 7.1 Facility Location

Manufacturing Location Factors There are differences in the location decision for manufacturers and service providers. Manufacturing firms consider a variety of factors.

Quantitative factors for manufacturers include:

• Labor costs • Material costs • Transportation • Utilities, taxes, real estate costs, and construction costs • Government incentives

Qualitative factors include:

• Labor climate • Quality of life • Proximity to customers and markets • Proximity to suppliers and resources

Service Location Factors In service operations, many of the factors identified with manufacturing are still relevant. In most service operations, service providers would consider labor cost, taxes, real estate costs, construction costs, and government incentives as important elements in a location decision. On the other hand, material cost and transportation costs would be relevant for only some service providers, such as restaurants and retail operations that purchase, transport, and resell goods. Utility costs are not a significant factor for most service opera- tions because consumption is generally low compared to manufacturing. The qualitative factors listed for manufacturers are likely to be relevant for service providers, with the exception of proximity to suppliers and resources. This is because materials and compo- nent parts are not always shipped from suppliers.

If a business has customers that utilize a service facility in person, being close to customers is very important. For example, retail operations require this proximity to the customer, but a call center can be located anywhere in the world. Customers often place a high value on their time, therefore, convenience is essential. Transportation costs are important for warehousing and distribution, but response time—the time elapsed between a request for service to the delivery of that service—may be even more important. If travel distance and time are short, total inventory in the system can be kept very low. In some cases, the trip from producers to the distribution center to the retail store can be one day or less.

Location of competitors may also be an important factor for service operations. In some services, such as newspaper publishing, having competitors in the immediate area often has a significant negative impact on sales. In others, service providers tend to cluster together. In many cases, they advertise together. Nearly every medium-size town and large city has an “auto mile” or “auto strip” where one of every car dealer is located. The idea of such a location is to create a critical mass, so customers can quickly and easily

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CHAPTER 7Section 7.1 Facility Location

compare products from different dealers. Fast-food restaurants will often locate in simi- lar clusters. These clusters are caused to some extent by the need to deal with customer choice. For example, in a large group of potential customers, some will want pizza, some will want burgers, and others will want chicken. Fast-food chains locate their restaurants near high-volume activities, such as large shopping malls, sport centers, and expressway exits in large urban areas.

The location of emergency units, such as fire protection and ambulance service, is deter- mined by minimizing response time, providing minimum coverage, and operating from a mobile location. Response is important when time is a critical factor. The objective is to locate a facility so that the maximum response time to any point served by the emergency unit is minimized.

Minimum coverage implies that all customers have a minimum level of coverage. For example, no house in the city will be more than one mile from a fire station or an ambu- lance service. The number and placement of facilities required to provide minimum cov- erage can be determined by grouping customers into appropriate population centers and examining candidate facility locations to see if the minimum coverage is provided. This can be accomplished by listing the population centers in the columns of a table and listing the potential facility locations in the rows of the same table. Then, each potential facility can be judged to determine if the minimum coverage is achieved. In many cases, more than one candidate facility may be required to provide that coverage.

Government Incentives Many states and local governments have been very aggressive in their efforts to attract new businesses. One incentive offered by state and local governments is a significant reduction in property taxes. They have also offered low-interest loans, provided free train- ing to workers, and subsidized wages for a specified period of time. In addition, many states and cities have established agencies that can help private industry slice through governmental red tape. In some cases, state and local governments have put together parcels of land by using their powers of eminent domain. Simply stated, eminent domain means that an owner can be forced to sell property to the government at fair market value if it will be used for the good of all. Once obtained, properties are sold to private industry for development. Governments can acquire property more quickly and less expensively than private industry can. As soon as word gets out that private industry is interested in developing an area, the land prices are sure to increase significantly. With the power of eminent domain, the government can avoid being delayed by owners of key parcels.

In some cases, businesses that have been in a state for years are grumbling about the preferred treatment given to newcomers, and some states are beginning to wonder if the jobs created are worth the costs of the incentives. Despite this, bidding wars among states for the jobs these new developments bring are likely to continue. The pressure on elected officials to create jobs in the short term seems to mask the long-term impact that this treat- ment may have on future revenues and expenses of the state.

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CHAPTER 7Section 7.2 Evaluating Locations

7.2 Evaluating Locations

The factors that must be weighed when evaluating locations are grouped into three subsections: (1) managing the quantitative factors, including the impact of location on cost and the increasing importance of government incentives; (2) describing the qualitative factors and illustrating how these can be analyzed, as well as integrated with the quantitative factors; and (3) discussing the effects of the location deci- sion on other operating factors.

Managing Quantitative Factors Quantitative factors include the costs associated with facility construction, production, overhead, and transportation to and from the facility. State and local governments offer incentives to attract and retain businesses and jobs. Such incentives include tax abatement, low-interest loans, help in cutting through red tape, low business taxes, and low rates for unemployment insurance and work- er’s compensation. Finally, the location can affect sales volume and selling price. The announce- ment of a new facility may initiate price-cutting or other costly product promotion activities by existing competitors in the area.


State and local governments offer incentives such as tax breaks, low-interest loans, and help cutting through red tape to attract and retain businesses and jobs.

Highlight: Changing Locations for Automotive Assembly

For many years, automobile assembly plants were located in the Midwest, and new facilities were built in this region in order to provide good, low-cost access to a large percentage of the North American population. As the population has increased in the South and Southwest, many automobile companies—especially foreign producers—have located new assembly facilities in the South to take advantage of lower labor costs, lower construction costs, cheaper land, and government incentives. Alabama persuaded Mercedes-Benz to build an assembly facility for making sport utility vehicles. Honda opened a facility in Lincoln, Alabama, that employs more than 2,000 people to make its Odys- sey minivan. Toyota has constructed an engine assembly facility in Huntsville, Alabama. Hyundai Motor Company of South Korea has built a final assembly facility in the South.

These efforts have cost Alabama nearly $700 million in incentives. Critics argue that the state has not received sufficient return on its investment. Also, these investments have taken money away from schools and services, and made it difficult for the state to provide tax relief for its low-income residents. Proponents argue that these efforts are “Alabama’s new day.” Other companies are inves- tigating the potential that Alabama has to offer.

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CHAPTER 7Section 7.2 Evaluating Locations

Location decision plays an important role in shaping the cost function. The total-cost equation is:

TC 5 (VC)X 1 FC

where TC 5 total cost

VC 5 variable cost per unit

X 5 the number of units produced

FC 5 fixed costs

Variable costs are affected by prevailing wage rates, material costs, utility rates, and trans- portation costs for incoming materials and outgoing finished products. Fixed costs are affected by construction and land costs and the cost of administration, all of which are likely to be lower in rural areas. There also may be tax incentives or other special consid- erations for a particular site.

To prepare cost estimates for a site, data are collected and analyzed. To illustrate, Table 7.1 contains data for a site in Indianapolis, Indiana, for a facility to build computer control panels. These data can be used to prepare a pro forma operating budget.

Table 7.1: Data for site in Indianapolis, Indiana

Production Costs

Type Rate Projected Usage

Labor Welding Electrical General assembly

$10.00/hr. $12.00/hr. $9.00/hr.

0.5 hrs./unit 0.3 hrs./unit 1.1 hrs./unit

Material Sheet metal Threaded fasteners Electrical wire

$.40/lb. $2.00/100 $.06/lineal ft.

100 lbs./unit 20/unit 70 lineal ft./unit

Utilities Natural gas Electricity

$4.00/1,000 cu. ft. $.06/kilowatt hr.

500 cu. ft./unit 200 kilowatt hrs./unit

Transportation* In rail In motor carrier In motor carrier Out motor carrier

$.03/lb. (sheet metal) $.04/lb. (fasteners) $.04/lb. (wire) $20/unit (finished)

100 lbs./unit 5 lbs./unit 4 lbs./unit 1

Facility Overhead Initial Investment

Land acquisition costs Building construction Plan start-up costs Initial employee training

$2,100,000 $175,000,000

Special Considerations

Tax abatement Low-interest loans Supplementary training expenses


*Rates are given from specific origin to a specific destination, so distance has been accounted for.

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CHAPTER 7Section 7.2 Evaluating Locations

Table 7.1 contains projected labor, material, and utility usage in addition to the rates. Utili- ties may have both fixed and variable components. Some utility costs are variable and directly linked to producing a product, such as the power required to run a drill press. In other cases, utility costs cannot be linked to a product. An example is the energy needed to heat a building. The amount of heat required is not related to the number of units pro- duced. Table 7.1 shows variable utility costs. The fixed component of utilities is included in overhead expenses. Transportation costs are a function of the quantity of materials shipped, the distance traveled, and the type of carrier used.

Table 7.1 also lists as a lump sum an estimate of facility overhead expenses, such as super- visors, material handling, and plant management staff. The value of the investments in the facility and the value of any special considerations are also listed as lump sums. The special considerations figure is shown as a savings that should be deducted from the ini- tial investment.

Table 7.2 shows a pro forma operating budget based on producing 45,000 units per year at the site described in Table 7.1. An operating budget usually does not include capital costs for facilities. The costs of making products at this facility can now be estimated. Consider- ing only the variable costs, the unit variable cost is calculated as follows:

Unit variable cost 5 $4,520,700

45,000 units

5 $100.46/unit

The cost including a share of the annual facility overhead is:

Cost with overhead 5 $6,620,700

45,000 units

5 $147.13/unit

Table 7.2: Pro forma operating budget for one year based on estimated sales of 45,000 units

Labor Welding Electric Assembly

Total Labor costs

($10.00/hr.)(0.5 hrs./unit)(45,000 units) ($12.00/hr.)(0.3 hrs./unit)(45,000 units) ($9.00/hr.)(1.1 hrs./unit)(45,000 units)

$ 225,000 162,000

445,500 $ 832,500

Material Sheet metal Fasteners Wire

Total material costs

($.40/lb.)(100 lbs./unit)(45,000 units) ($2.00/100)(20/unit)(45,000 units) ($.06/lin. ft.)(70 lin. ft./unit)(45,000 units)

$ 1,800,000 18,000

189,000 $ 2,007,000

Utilities Natural gas Electricity

Total utility costs

($4.00/1,000 cu. ft.)(500 cu. ft./unit)(45,000 units) ($.06/kwh)(200 kwh/unit)(45,000 units)

$ 90,000 540,000 $ 630,000


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CHAPTER 7Section 7.2 Evaluating Locations

Table 7.2: Pro Forma Operating Budget for One Year Based on Estimated Sales of 45,000 Units (continued)

Transportation Sheet metal Fasteners Wire Finished product

Total transportation costs

($.03/lb.)(100 lb./unit)(45,000 units) ($.04/lb.)(5 lb./unit)(45,000 units) ($.04/lb.)(4 lb./unit)(45,000 units) ($20.00/unit)(45,000)

$ 135,000 9,000 7,200

900,000 $ 1,051,200

Variable costs Facility overhead* Grand total

$ 4,520,700 2,100,000 $ 6,620,700

*Some overhead costs can be variable, but to simplify the discussion in this case, we will assume all overhead costs are fixed.

Comparing Quantitative Factors To make effective location decisions, management must organize the potential costs and revenues for each site in a way that allows them to be easily compared. Begin by examin- ing the cost data for the Indianapolis site (detailed in Tables 7.1 and 7.2), and for an alter- native site in Lexington, Kentucky. The new facility is scheduled to produce 45,000 units per year. The costs for both sites are summarized here. (The incentives are to be subtracted from the initial investment.)

Indianapolis Lexington

Variable Costs $100.46/unit $95.77/unit

Annual Overhead Cost $2,100,000/year $1,900,000/year

Initial Investment $175,000,000 $168,000,000

Incentives $25,000,000 $10,500,000

Several assumptions are made including: (1) revenue is not affected by either choice; (2) sales volume per year, selling price, unit variable costs, and fixed costs do not change over the period in question; and (3) the time value of money is ignored. The time value of money is the notion that one dollar received today is worth more than one dollar received at some future point. One dollar received today can be invested and earn a positive return, thereby making its value greater than one dollar.

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CHAPTER 7Section 7.2 Evaluating Locations


Compare the costs of the Indianapolis and Lexington sites over a five-year period, using the total-cost equation. (The subscript I stands for Indianapolis and the subscript L for Lexington.)

TC 5 (VC)X 1 FC

TCI 5 ($100.46/unit)(45,000 units/year)(5 years) 1 ($2,100,000/year)(5 years) 1 $175,000,000 2 $25,000,000

5 $22,603,500 1 $10,500,000 1 $150,000,000

5 $183,103,500

TCL5 ($95.77/unit)(45,000 units/year)(5 years) 1 ($1,900,000/year)(5 years) 1 $168,000,000

2 $10,500,000

5 $21,548,250 1 $9,500,000 1 $157,500,000

5 $188,548,250

Over a 5-year period, Indianapolis has a lower total cost.

At what point in time will the costs of these two sites be equal? In this case, X will represent the num- ber of years until costs are equal. This information may be very useful for managers when choosing between the alternative sites.


(100.46)(45,000)X 1 2,100,000X 1 175,000,000 2 25,000,000 5 (95.77)(45,000)X 1 1,900,000X 1 168,000,000 2 10,500,000

$4,520,700X 1 $2,100,000X 1 $150,000,000 5 $4,309,650X 1 $1,900,000X 1 $157,500,000

$6,620,700X 2 $6,209,650X 5 $157,500,000 2 $150,000,000

$411,050X 5 $7,500,000

X 5 18.25 years

Check the answer by substituting the time X into the cost equations for Indianapolis and Lexington and seeing if the costs are equal.

If the amount sold per year is allowed to vary, the point of equal costs could be viewed in a different way. In the model, the number of years could be a constant, and the number of units sold per year could become a variable. If the time period is set at five years, how many units must be sold each year if costs are equal? Here, the variable X represents the number of units sold each year.


(100.46)(X)5 1 (2,100,000)5 1 175,000,000 2 25,000,000 5 (95.77)(X)5 1 (1,900,000)5 1 168,000,000 2 10,500,000

X 5 277,186 units/year

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CHAPTER 7Section 7.2 Evaluating Locations

Including Qualitative Factors Qualitative factors do not usually have measurable, direct effects, but they do need to be carefully considered and integrated into the decision by management. The chapter 7 appendix contains a sample list of some of the qualitative factors that could be considered such as labor climate, cultural activities, and weather.

To integrate qualitative factors into the location decision, managers should:

1. Decide which factors are relevant 2. Weigh each of the factors—some may be more important than others 3. Evaluate each site so that rational comparisons can be made

Unless a manager makes a judgment about the importance of each factor, all the factors are assumed to have equal weight. These weights are usually selected prior to determin- ing the rankings or raw scores so that the scores do not bias the weights. The weights are multiplied by the scores to determine the weighted scores. Then, the weighted scores are added together to determine total scores.


A committee has determined that the following factors are relevant to the decision. Indianapolis and Lexington are ranked on a scale of 1 to 10, with 10 being most desirable. The rankings are subjective estimates.

Factor Weight Indianapolis Raw Score

Lexington Raw Score

Recreational activities

20 8 7

University research facilities

40 8 8

Union activity 40 4 7

Banking services 80 7 6

Available labor pool 60 7 5

The rankings can eventually be added; 10 is considered “good” in all cases, but a ten may not indicate more of that factor. For example, a 10 in university research activities is desirable and indicates high levels of research; a 10 in union activity is also desirable, but may indicate low levels of union activity.

Multiply the weight by the raw score for both Indianapolis and Lexington.


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CHAPTER 7Section 7.2 Evaluating Locations

On-Site Versus Off-Site Expansion Location can have a significant impact on an organization’s ability to compete. It can influence costs, selling price, demand, educational opportunities for employees and their families, and access to financial services. How can the location decision affect other factors in production?

Assume that demand for an organization’s product exceeds present capacity. An organi- zation can consider two options to increase capacity: build additions to the existing plant on-site, or design and build a new plant in another location. On-site expansion is more popular because it usually involves less capital investment. Many services, such as ship- ping, receiving, and administration, may not need to be expanded. Only the critical opera- tions—that is, the bottlenecks—require capacity increases.

However, on-site expansion can create many problems, especially if it is a repeated prac- tice. As more production space is added, material handling and storage become more difficult because inventory space is often converted to production. As new product varia- tions are added, the once simple product flow becomes complicated or stymied because plant additions often occur over many years and no long-term planning for future addi- tions is made. When on-site expansion is used to increase capacity, intra-plant transporta- tion and communication can become strained.

Staying at the same site often postpones the introduction of new product and process technologies. Old equipment and old production methods are used longer than they should be. Future product innovation, productivity increases, quality improvements, and cost reductions can be negatively affected. On-site expansion can mean a growing number of workers, products, and processes that must be managed. Such layering of expanded responsibilities creates complexities for managers at all levels.

Indianapolis Lexington

Weight Raw Score Weighted Score

Raw Score Weighted Score

Recreational activities 20 8 160 7 140

University research facilities

40 8 320 8 320

Union activities 40 4 160 7 280

Banking services 80 7 560 6 480

Available labor pool 60 7 420 5 300

Total 1,620 1,520

As long as the same weights are applied to each location, the weighted scores are comparable. The absolute value of each score does not have meaning, but comparing total scores is useful.

If Indianapolis is superior in profit and investment, then the choice between the two locations is easy because Indianapolis also has a slight qualitative edge. If Indianapolis is not superior in profit and investment, then management should judge the impact of these qualitative factors on the long-term success of the organization. Even though a mathematical model can be used to analyze the data, the results must still be interpreted and a decision made.

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CHAPTER 7Section 7.3 Foundations of Process Selection

7.3 Foundations of Process Selection

Process selection is determining the most appropriate method of completing a task. It is a series of decisions that include technical or engineering issues and volume or scale issues. The technical or engineering issues include the basic methods used to produce a service or good. For example, deciding to remove a gall bladder using laparo- scopic surgery versus traditional methods is a technical decision made by physicians. The decision depends on the patient’s condition and is often made at the time of surgery. On the other hand, determining the number of surgery rooms and the number of surgeries to perform each day at the regional medical center is a volume or scale decision that is related to demand. In general, the technical aspects of process selection are beyond the scope of this course, so the focus will remain on volume or scale issues.

There is a strong relationship among process selection and three critical elements in busi- ness: volume, cost, and profit. The volume or scale decision involves applying the appropri- ate mix of technology to leverage the organization’s workforce. Leverage means making a workforce more productive through the use of better tools. For example, one person work- ing alone with a few simple tools may be able to assemble an automobile, but he or she cannot build it at a cost that competes with organizations providing their employees with sophisticated tools and technology. The person working alone, or even with many others like him or her, cannot build enough cars to satisfy demand without significant automa- tion and an organization to leverage their time and talent. More sophisticated tools allow a workforce to produce more with the same commitment of time and effort. This productivity improvement lowers the unit cost of the product and raises the capacity of the workforce. Similarly, a surgeon performing a surgery without the proper equipment and an effective supporting staff will not only be less productive but could also be dangerous to the patient.

This presents an interesting trade-off between efficiency and costs in the process selection decision. As more sophisticated tools are applied to the production process, productivity

and capacity increase and labor cost per unit declines. As tools become more sophisticated, the cost of acquiring them often increases, which translates into increased fixed costs.

Process Selection Relates to Product Design and Capacity Product design, capacity, and process selection are decisions that should be considered simul- taneously. The way the product is designed affects how many people will buy it, and that affects the producer’s capacity planning decision. This, in turn, affects the process and the costs to produce the product, which affects how many people can

.Monty Rakusen/Getty Images

Leverage means making the workforce more productive through the use of better tools and equipment. One worker with a few simple tools may be able to assemble an automobile, but not at a competitive cost.

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CHAPTER 7Section 7.3 Foundations of Process Selection

afford to buy it. This logic can be represented as a circle with customers at the center, as illustrated in Figure 7.1.

Figure 7.1: Product design, process selection, and capacity decisions are closely related

Relating Process Selection to Product Design

Decisions made when designing a product have an impact on the process for making it. For example, if a bed is made of brass, there is no need for woodworking equipment in the manufacturing process. Process selection and process technology, in turn, influence the product design. Electronic funds transfers, music downloads, and streaming video are examples of products that are now feasible because of improvements in information and communication technology.

Relating the design of the product to process selection goes beyond the examples listed in the preceding paragraph. The teamwork concept is changing how organizations approach product design and process selection. In service organizations, such as fire departments,


How many should the organization be

capable of producing?

How should it be produced?

Product design

What should be produced?


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CHAPTER 7Section 7.3 Foundations of Process Selection


Quick-as-a-Blink Printing Center is growing rapidly, and many of its customers are demanding that their documents be professionally bound. Management has made a decision to purchase a binding machine. The options are to purchase a manual binding machine that requires continuous operator attention or an automatic machine that requires only periodic operator attention. The following data are available for analysis. Note that the costs of materials can be ignored because we are assum- ing that the cost of the printed documents and the binding material are the same regardless of the machine used.

Machine Annual Fixed Costs Variable Labor Costs

Production Rate

Manual $1,000 $18/hour 10 units/hour

Automatic $9,000 $2/hour 100 units/hour

teams of managers from various disciplines design the services, which may include fire prevention programs for homes and businesses, fire safety for school-age children, and firefighting. While developing a product design, the team examines various process selec- tion decisions, including the types of equipment and facilities needed, the techniques used in fighting fires, the methods used to develop education programs, and the type and level of training needed by employees who deliver these services.

Manufacturing firms combine design engineers with process engineers (sometimes called manufacturing engineers) to create a design team. This team, like the team at the fire department, is responsible for providing what is best for the customer. Because the design engineers and the process engineers work together, the lead time required to bring a new product from an idea to a reality is reduced. This effort, called concurrent engineering, enables the organization to participate in time-based competition. By doing what is best for the customer, the organization hopes to be rewarded with increased demand for its products and high profit margins. These teams also improve communication, which decreases the number of engineering change orders, avoids unnecessary delays, and gets the product to market more quickly, preventing mistakes that could increase costs.

Process Selection and Capacity

Process selection is also related to the volume demanded in the marketplace. If the market for the product is estimated at only 1,000 units per year, it may be difficult to justify expen- sive, specialized equipment that produces 100 units per hour. Such equipment would be required to operate only 10 hours each year. It is unlikely that the cost of this specialized equipment could be supported by the 1,000 units demanded unless a very high price is charged for each unit.


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CHAPTER 7Section 7.3 Foundations of Process Selection

Problem (continued)

The total-cost equation is as follows:

TC 5 FC 1 (VC)(Xp) where

TC 5 total cost

FC 5 fixed costs

VC 5 variable cost per unit

Xp 5 number of units produced

Comparing Costs: What is the cost to produce 1,000 units per year on each machine? From the fol- lowing calculations, it is clear that the manual machine has lower costs. Dividing the total cost by the volume produced gives a unit cost that includes the variable cost and a share of the fixed costs.


TC 5 $1,000 1 $18/hr.

10 units/hr. 11,000 units 2

5 $2,800

Unit Cost 5 $2,800 1,000

5 $2.80 per unit at a volume of 1,000 Automatic:

TC 5 $9,000 1 $2/hr.

100 units/hr. 11,000 units 2

5 $9,020

Unit Cost 5 $9,020 1,000

5 $9.02 per unit at a volume of 1,000

What happens if 10,000 books need to be bound? The marginal labor cost of binding each additional book on the automatic machine is only $.02 because the labor cost is $2.00 per hour and the output is 100 units per hour. On the manual machine, the marginal cost of binding a book is $1.80.


TC 5 1,000 1 18.00

10 110,000 2

5 $19,000

Unit Cost 5 $19,000 10,000

5 $1.90 per unit at a volume of 10,000 (continued)

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CHAPTER 7Section 7.3 Foundations of Process Selection

Problem (continued)


TC 5 9,000 1 2.00 100

110,000 2

5 $9,200

Unit Cost 5 $9,200 10,000

5 $0.92 per unit at a volume of 10,000

The unit cost for binding 10,000 books with the automatic operation is significantly lower. As demand increases, the automatic process becomes more and more appealing.

The Indifference Point: At what production volume are the costs of the manual and automatic machines equal? The variable X represents the volume produced. To check the accuracy of the fol- lowing calculations, substitute the computed value of X into the total-cost equation for each machine to determine if the two total costs are equal. Except for differences caused by rounding, they should be:

Total cost manual 5 Total cost automatic

1$1,000 2 1 $18.00 10 units

1X 2 5 1$9,000 2 1 $2.00 100 units

1X 2

(1,000) 1 (1.80)(X) 5 (9,000) 1 (0.02)(X) Solve for X:

(1.80 2 0.02)(X) 5 9,000 2 1,000

X 5 8,000 1.78

X 5 4,494 units

The Power of Volume to Reduce Costs: This problem illustrates how unit costs can be decreased by purchasing high-speed equipment and producing large numbers of parts. The following table lists the unit costs for various volumes. Verify the unit cost for binding 100,000 books.

Volume Manual Automatic

1,000 $2.80 $9.02

10,000 1.90 0.92

100,000 1.81 0.11

This example makes many simplifying assumptions, such as unlimited capacity, no increase in main- tenance costs, and no increase in the failure rate of the machine as volume increases. These and other relevant factors could be estimated and considered in the analysis. The impact of volume on unit cost is very clear based on this example.

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CHAPTER 7Section 7.4 Understanding Effects of Scale

7.4 Understanding Effects of Scale

Business leaders have long recognized the advantages that can be gained by having high-volume operations. The tremendous increase in prosperity in the United States and other developed countries was driven by making large quantities of the same or similar products on the same equipment, that is, the same fixed-cost base. This approach, often called mass production, is based on the concept of economies of scale. Recall from Chapter 3 that the economies of scale princi- ple states that there is a most efficient size for a facility, and a most efficient size for a firm. In practice, the principle has been used to jus- tify both building larger facilities for the pro- duction of goods and services and purchasing more automated equipment to speed produc- tion and lower costs.

An organization can use both or either of these approaches to leverage the time and talents of the people who create the large volume of services and goods that customers demand. If organizations and society are to progress, investments in equipment and facilities (fixed costs) must be made to increase the productiv- ity of labor and management.

The critical challenge when achieving econo- mies of scale is putting a large volume of prod- uct across the same equipment or fixed-cost base. In the past, it was necessary that different products produced on a machine where very similar because equipment was not flexible enough to cope with design differences. With technological advances, it is possible to achieve economies of scale by making differ- ent products on the same equipment, and this can be done without the extra costs that are incurred when equipment is stopped and changed over to make the new product. Econo- mies of scope is the term that describes this situation. Economies of scope are economies of scale across products. For example, Allen-Bradley has a facility that can produce a wide variety (100 different designs) of computer motherboards in production lot sizes as small as one unit. The facility can produce them at a rate and cost that rivals mass production.

Cost-Volume-Profit Modeling To understand scale, it is helpful to construct a simple model. A model is an abstraction of the key variables and relationships in a real problem, and is used to simplify the prob- lem and increase understanding. The cost-volume-profit (C-V-P) model uses estimates of costs, revenues, volume sold, and volume produced in order to estimate profit.


The economies of scale principle states that there is a most efficient size for a facility and a most efficient size for the firm.

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CHAPTER 7Section 7.4 Understanding Effects of Scale

C-V-P Model Formulation

The C-V-P model is formulated by determining total revenue and costs, as shown in the following equations:

TR 5 (SP)(Xs)


TR 5 total revenue

SP 5 selling price per unit

Xs 5 number of units sold

TC 5 FC 1 (VC)(Xp)


TC 5 total cost

FC 5 fixed cost

VC 5 variable cost per unit

Xp 5 number of units produced

The profit (P) equation is total revenue minus total cost: P 5 TR 2 TC

By substituting the TR and TC equations into the equation for profit, the following math- ematical model can be used to calculate profits, given sales and production volumes. This is the cost-volume-profit model.

P 5 SP(Xs) 2 [FC 1 VC(Xp)]

This model can also be manipulated to determine the volume required to earn targeted value for profit. In order to do this, assume that the number of units sold is equal to the number of units produced.

If X 5 Xs 5 Xp, then

P 5 SP(X) 2 [FC 1 VC(X)]

P 5 SP(X) 2 FC 2 VC(X)

P 1 FC 5 (S 2 VC) (X)

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CHAPTER 7Section 7.4 Understanding Effects of Scale

Solve for X as follows:

X 5 1P 1 FC 2 1SP 2 VC 2

If C is defined as contribution per unit, then C = (SP 2 VC). Thus, the equation becomes

X 5 P 1 FC

C (7.1)

The profit point is the number of units (X) that must be produced and sold at the con- tribution per unit (C) in order to cover the fixed costs (FC) and profit (P). Figure 7.2 rep- resents this model graphically and illustrates the profit point. If the profit is set to zero, equation 7.1 is recognizable as the break-even formula. The break-even point (BEP) is the volume that must be produced and sold so that profit is zero.

Figure 7.2: Cost-volume-profit model

profit point


VC(X) + FC + P

FC + P

Volume (X)

If profit (P) is set equal to zero, then the profit point is the break-even point.

D o

lla rs

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CHAPTER 7Section 7.4 Understanding Effects of Scale

C-V-P Assumptions

The C-V-P model, like any model, makes several assumptions. The assumption that sales volume equals production volume has already been mentioned. The model also assumes that total cost and total revenue are linear functions of volume. The model is based on his- torical data for costs and revenue. Any changes in these relationships caused by changes in technology, demand, or strategy may invalidate the use of this or any other model. Users of models should understand these assumptions, or they may apply the model inef- fectively and thus obtain misleading results.

The Multiple-Product Case of the C-V-P Mode

The discussion of the C-V-P model has considered only single-product firms. Many orga- nizations produce more than one product, using the same set of fixed costs. How can this


The mechanics of applying the C-V-P model are relatively simple. To calculate the profit point, you must know the selling price, variable costs, and fixed costs. Management can determine the pro- jected level of profit to be used in the model. In this example, the fixed cost and profit are for a one- month period.

SP 5 $8.00/unit

VC 5 $4.50/unit

C 5 $3.50/unit

FC 5 $25,000/month

P 5 $8,000/month

In this case, the number of units that must be produced and sold to make $8,000 profit in one month is 9,429 units; that is the profit point.

X 5 FC 1 P


5 $25,000/month 1 $8,000/month


5 9,429 units/month

Managers can use this number in many ways. Here are two examples. First, if the organization has a capacity of only 5,600 units per month, then achieving an $8,000 profit is not possible. Second, if the sales forecast is for 9,000 units, then that profit level will not be achieved because not enough units will be sold. Changes can be made to the model for the purpose of sensitivity analysis and to answer what-if questions. For example, what if the variable costs increased from $4.50 to $5.00 per unit? Under these circumstances, the profit point becomes 11,000 units per month.

X 5 $25,000/month 1 $8,000/month

$3.00/unit 5 11,000 units/month

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CHAPTER 7Section 7.4 Understanding Effects of Scale


A company repairs small appliances. The table that follows provides the average selling price, vari- able cost, and contribution for each service. The product mix and profit target are also listed. The fixed costs are shared by all three products.

Coffeepot Mixer Blender

Product mix 45% 20% 35%

Selling price/unit $12 $16 $9

Variable cost/unit $6 $7 $4

Contribution/unit $6 $9 $5

Profit target 5 $20,000/yr.

Fixed costs 5 $30,000/yr.

The mix is the number of each product repaired divided by the total number repaired. The weighted contribution is calculated as:

WC 5 a n

i51 Mi (SPi 2 VCi)


WC 5 weighted contribution per unit

Mi 5 product mix as a percentage of total sales for product i, where i 5 1,. . ., n for n different products or product lines

SPi 5 selling price for product i

VCi 5 variable cost for product i

Thus, the weighted contribution for the product mix shown above is:

WC 5 0.45($12/unit 2 $6/unit) 1 0.2($16/unit 2 $7/unit) 1 0.35($9/unit 2 $4/unit)

5 $6.25/unit

In the multiple-product case, the weighted contribution per unit substitutes for the contribution per unit in equation 7.1.

X 5 P 1 FC WC


5 $20,000 1 $30,000


5 8,000 units

firm be modeled? In this case, another set of variables, product mix, is added to the rev- enue and cost relationships. To solve the problem, a weighted contribution based on the mix of each product is calculated. Consider the following problem.


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CHAPTER 7Section 7.4 Understanding Effects of Scale

Problem (continued)

Interpreting the Results: The variable X is measured as a composite unit—a unit consisting of 45% coffeepot, 20% mixer, and 35% blender.

One composite unit with a weighted contribution 5 $6.25

45% Coffeepot

20% Mixer

35% Blender

Product Mix No. Required

Coffeepot 0.45 3,600 units

Mixer 0.20 1,600

Blender 0.35 2,800

8,000 units

The number of units, 8,000, represents the total number of coffeepots, mixers, and blenders that must be repaired to make a $20,000 profit. The number of coffeepots required is (0.45)(8,000 units), or 3,600 units.

What Happens to the Profit Point if the Mix Changes?: In this model, the mix affects the profit point. If the estimated mix is different from the actual mix, then the profit point will change. Assume the mix changes to 50% coffeepots, 10% mixers, and 40% blenders, and the total number of units repaired remains 8,000. How is profit affected?

Coffeepot Mixer Blender

Product Mix 50% 10% 40%

Selling price/unit $12 $16 $9

Variable cost/unit $6 $7 $4

Contribution/unit $6 $9 $5

Profit target (P) 5 unknown.

Fixed costs 5 $30,000/yr.

Equation 7.2 can be restated and used to calculate profit.

X 5 P 1 FC WC

WC(X) 5 P 1 FC

P 5 WC(X) 2 FC (continued)

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

Problem (continued)

The fixed costs are $30,000, and the volume is given as 8,000 units. First, the weighted contribution is calculated based on the new mix.

WC 5 a n

i51 Mi(SPi 2 VCi)

5 0.5($12/unit 2 $6/unit) 1 0.1($16/unit 2 $7/unit) 1 0.4($9/unit 2 $4/unit)

5 $5.90/unit

Now profit can be calculated.

P 5 $5.90(8,000 units) 2 $30,000 5 $17,200

The profit is only $17,200 dollars because demand shifted away from mixers, which have a higher contribution per unit, to the lower-contribution coffeepots and blenders. Profit is not only a function of the volume produced and sold, but also a function of the product mix.

7.5 Process Selection and Economies of Scale and Scope

From the perspective of economies of scale or economies of scope, process selection focuses on the volume of product demanded in the market. Organizations can influ-ence that volume by increasing advertising, providing better service, and producing higher quality products. Regardless of how that volume is generated, an organization needs to respond to higher demand with an appropriate process.

When does an organization have sufficient volume to justify specialized, high-speed equipment? Is a demand of 50,000 units per year sufficient? It is not possible to give spe- cific answers to these questions because the answers depend on what the organization produces. For example, if it produces space shuttles, then an annual demand of 50,000 would certainly be large enough to support specialized facilities, and even 5,000 would be considered a large volume. If, however, the organization is processing checks for a bank, 50,000 a year is a very small number, and even 1 million per year is not large.

In process selection, Hayes and Wheelwright (1979, p.133) have suggested that product and process can be viewed through two sides of a matrix. Figure 7.3 displays a series of process alternatives that can be matched with identifiable product characteristics so that efficient operations can be achieved. High-volume operations are usually referred to as line flow processes. One type of line flow is the continuous flow process. A continuous flow does not usually identify individual units; rather, the product is mixed and flows together in a continuous stream. Oil refining is a good example of a continuous flow pro- cess. Processing checks in a bank is another example. The term assembly line is used to describe the high-volume assembly of discrete products. A washing machine is a good example of an assembly-line product and making a fast-food pizza on a busy night is another. Continuous flow and assembly lines are usually dedicated facilities that produce large volumes with little, if any, difference in the products. Because the items produced

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

within such a facility are the same or very similar, the process involves economies of scale. To increase volume, cut costs, and achieve economies of scale, organizations traditionally move up the shaded diagonal in Figure 7.3 (see next page).

Batch is a term used to describe a production process that does not have sufficient volume from a single product to fully use a facility. In this case, the facility produces several products to build sufficient volume. When this resource sharing exists, a transition time, or changeover time, is usually required to change the facility from being able to make one product to being able to make the next. For example, Merck, which pro- duces medications, uses batch production. Merck has equip- ment that is designed to mix ingredients and form pills or capsules. Often this equipment can produce in a few weeks all

the capsules of a particular medication needed for an entire year. Because of shelf life considerations and inventory costs, making even a one-year supply in a single batch cre- ates too much inventory. So, companies like Merck produce different medicines in smaller batches using the same equipment. In between batches, the equipment must be thor- oughly cleaned so the next batch is not contaminated. These changes take time and cost money, but are necessary to maintain enough volume to support the large investment in equipment.

As product volume declines, batching operations may no longer be possible. Here, only a few units of a product are required, and there may be no assurance that the order will be repeated. The differences between products can be significant. In this situation, usually called job shop production, the facility is general and flexible enough to meet a variety of needs. To achieve this flexibility, job shops generally have a much higher unit cost than line flow or batch processes for the same product. Fancy restaurants and hospital emer- gency rooms are examples of job shops. Both types of organizations offer great product variety and cater to individual customer demands.

At the bottom of the volume scale in Figure 7.3 are projects, which are usually one-of- a-kind operations. Each job is different from the rest. Most large construction jobs are projects, and many service operations can be categorized as projects. Installing new com- puter hardware, adding new computer software, and implementing a new management planning and control system could all qualify as projects. The relationship between prod- uct and process, illustrated in Figure 7.3, indicates that there is a one-to-one relationship between product volume and the type of process. For example, Figure 7.3 indicates that one-of-a-kind products cannot be produced on an assembly line or in a continuous flow

.Associated Press/AP Images

An assembly line allows a company to make a fast-food pizza quickly and with low labor costs.

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

shop. Figure 7.3, therefore, implies that an organization’s options are limited to product and process matches on the diagonal. The diagram implies that if an organization wants to achieve the low cost obtained in continuous flow or assembly-line operations, it must significantly limit product variety. An organization that wants to achieve the product vari- ety obtained in a job shop or projects must incur high unit costs.

Figure 7.3: Matching process alternatives with product characteristics

P ro

ce ss

A lt

er n

at iv


Product Characteristics

Continuous flow

High volume,

commodity products

High volume, some

product variety

Moderate volume, multiple products

Low volume, many


One-of- a-kind


Assembly line

Batch flow

Job shop


High product variety

Low product variety

Low unit costs

High unit costs

Processing checking account


Assembling washing

machines Producing mufflers for the

replacement market

Operating a hospital

emergency room Designing

and implementing a customized information


Manufacturing cells and flexible manufacturing systems can help firms achieve low unit cost and high product variety, that is, economics of scope

Process alternatives with low product variety

and high unit cost are not desirable

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

However, with the advances in information and manufacturing technologies, organiza- tions have new process alternatives that are flexible, allowing changes from one product to another to be made quickly and with few costs. With these technologies, the products produced within a facility can be different, yet low in costs. This is economies of scope, and it implies moving off the shaded diagonal in Figure 7.3 toward the lower left corner of the diagram. This segment of the diagram implies both low cost and high variety, which is called mass customization and is discussed in a later section.

The following sections describe the traditional process alternatives: continuous flow, assembly line, batch, job shop, and project, as well as manufacturing cells and flexible manufacturing systems.

Line Flow Processes Continuous flow operations and assembly lines have some differences; yet both are high- volume, mass-production operations characterized by a standardized product with inter- changeable parts. Because of this, the process is the same for each unit, and the product has a dominant product flow through the facility. With little or no product variation, there is no reason to have more than one path through the facility. Furthermore, the equipment that processes the products should be arranged “around” the product so that material- handling and transportation costs are not excessive. This approach is called a product layout.

In terms of the cost structure, a continuous flow process or an assembly line has relatively high fixed costs and relatively low variable costs. The high fixed costs are, in part, a result of the substantial investment in specialized equipment.

There are some differences between a continuous flow process and an assembly line. In a continuous flow process, the product is often a commodity in which one unit is not distinguishable from another. In this case, the producer makes no attempt to track each unit separately. For example, in refining gasoline from crude oil, one gallon of unleaded regular gasoline is like another. Banks process checks one after another without changing methods. The production of fiberglass insulation is high-volume and fast-paced. It is not feasible to track and identify each piece produced. The emphasis is on measuring inputs and comparing them to outputs.

The traditional assembly-line process allows some variations among units. Options are usually selected from a list of possibilities, and the minor adjustments needed to cope with this variation can be made by workers on the production line. Adding green peppers to the standard pizza is easy to do. Adding custom floor mats to a car or a temperature probe to a microwave oven is also easy to do. As technology improves, assembly lines are becoming more flexible. The continuous flow and assembly-line characteristics are sum- marized in Table 7.3, along with the other process types.

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

Table 7.3: Characteristics of the process alternatives


Process Volume Product variety

Product flow

Facility layout

Fixed costs

Variable costs


Continuous flow

High Standard Dominant Product High Low Special purpose

Assembly line High Standard with minor modification

Dominant Product High Low Special Purpose

Batch High Some variation

Dominant Product High Low Some flexibility

Flexible manufacturing system

High Moderate variety

Dominant Product High Low Flexible

Manufacturing cell

High Moderate variety

Dominant Product Moderate Low to moderate


Job shop Low Major differences

Random Process Low High Flexible

Project One One-of-a- kind

Not applicable

Fixed position

Low to moderate

High Flexible

Batch Flow When quantities are not sufficient to support dedicated production facilities, several groups or batches are produced using the same facility. These products are usually similar in design and have similar processing requirements. For example, glass containers come in a variety of sizes but are designed and built similarly. A key to understanding whether or not differences among products are meaningful can be found when the equipment is shut down to change from one product to another. If the time for these changes is not sig- nificant and the sequence of operations is similar, then it is like a line flow process. How- ever, if the changeover time is significant, then these products are usually built in batches.

Because of the similar processing requirements in batch operations, one or a few prod- uct flows dominate. For example, appliance manufacturers may produce several differ- ent models of refrigerators on the same assembly line. In cases where changeover time is significant, manufacturers may produce a batch—for example, one week’s production of a particular model—and then switch to another model. Although the models show some differences from batch to batch, these differences are not significant enough to change the product-oriented layout of the facility. If a producer is able to design the product and the

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

process so that different models can be produced one after the other with zero or near zero changeover time, then the process is similar to an assembly line that is producing a standard product. The disadvantages of batch production are that (1) changeover time is nonproductive, and (2) extra inventory must be maintained to satisfy demand for the products that are not being produced.

Job Shops With limited product volume, batching operations may not be possible. Here, only a few units of a product are required, and there may be no assurance that the order will be repeated. The differences between products can be significant. In this situ- ation, usually called job shop production, the facility is gen- eral and flexible enough to meet a variety of needs. To achieve this flexibility, job shops gener- ally have a much higher unit cost than line flow or batch processes for the same product. Fancy restaurants and hospital emergency rooms are examples of job shops. Both types of orga- nizations offer great product variety, and cater to individual customer demands.

A job shop does not produce large quantities of the same or even similar products, but is dominated by a large number of different products produced in small volumes. Because the products are different, they do not follow the same path through the facility. In fact, the movement of products between work centers is best characterized as random. As a result, it is not possible to organize machines by product flow as in the line flow processes or in batch operations. It is necessary to group machines by process or type of operation because a job is as likely to require work at one work center as at any of the other centers. When similar equipment is grouped together it is called a process layout. The job shop is one of the process alternatives shown in Table 7.3.

Because the products are very different, specialized equipment cannot be justified. Job shops use flexible equipment to meet the needs of the diverse product group. A job shop produces different products on general-purpose machines using skilled labor. The cost structure has low fixed costs and high unit-variable costs.


A woodcarving business that makes carvings to order is one example of a job shop because it handles a large number of different products produced in small volumes, rather than producing large quantities of the same product.

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

Projects In a project, cost structure is not the same as in other processes because there is only a single unit. In one sense, the cost for the project is all variable. Fixed costs in the form of overhead begin to make sense when a firm is engaged in more than one project and can spread certain major equipment costs and overhead costs across several different projects.

Product flow is not meaningful in projects because the end product of most construction projects is designed to remain stationary. The usual term that describes the layout is fixed position. A project-oriented operation is very flexible, allowing extensive customizing of the finished products. Projects are common in service operations, for example, Seibel Systems develops and installs software systems that control banking operations. These software systems can monitor each transaction, keep a history on it, and assist in reconcil- ing the transaction to the account. To design these systems, software companies draw the needed talent from a pool of experts and form a project team. Because each system is dif- ferent, different groups may be used to develop each system. These companies provide a service and use project management to successfully complete the work.

Manufacturing Cells and Flexible Manufacturing Systems Manufacturing cells and flexible manufacturing systems (FMS) are process options that offer the potential to produce low-cost products that meet varying customer requirements. Manufacturing cells rely on group technology to build a family of parts with similar design and processing characteristics. Group technology is a set of methods that enables firms to classify parts based on size, shape, use, type of material, and method of production. A family of parts is a collection of parts with similarities in these characteristics. In this way, a product-oriented layout (cell) can be designed that will reduce material-handling costs, increase machine utilization, and shorten production lead times. Because the processing is similar, less time is required to change from one product within the family to another (see Table 7.3).

An FMS is similar to a manufacturing cell because it relies on group technology to build families of parts. Also, like a manufacturing cell, an FMS produces low-cost products with high variety. The major differences are that an FMS often has more automation, robots, and computer control than a manufacturing cell does, and it usually operates without people tending the machines.

Flexible manufacturing systems grew from the need to cope with demand for increasing product variations. With an FMS, an organization can capture new markets by accumulat- ing production requirements from several low-volume products. Higher-volume opera- tions allow the arrangement of a set of machines in one layout to produce all the different products. The products, however, must be similar enough to have the same or a similar sequence of operations, and the machines must be flexible enough to handle the differ- ences. This system is feasible with computer technology and robotics that can quickly be adapted to new products. A manufacturing cell and an FMS enable organizations to increase the volume of product moving across a group of machines and, thereby, reduce operating costs.

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CHAPTER 7Section 7.5 Process Selection and Economies of Scale and Scope

Mass Customization Mass customization offers an alternative to addressing product variety. Firms that seek mass customization are able to design, produce, and quickly deliver products that meet specific customer needs at close to mass-production prices. These firms develop close relationships with their customers, which depend on frequent information exchange.

From an operations perspective, mass customization is the low-cost, high-quality, large- volume delivery of individually customized goods and services. Put simply, mass cus- tomization combines the pursuit of economies of scale and scope, quality improvement, and flexibility. Economies of scale and scope imply achieving high-volume operations and low costs. When pursuing flexibility, there are three attributes to consider:

1. Range/variety—The number of viable states for the production system and the degree of difference in those states. From the perspective of range, the greatest variety is when a large number of very different products can be produced

2. Mobility/responsiveness—The ability to change quickly from producing one prod- uct to producing another. High mobility minimizes the need for long production runs. How long does it take for the service center to shift from doing brake work on a Ford to doing exhaust work on a Chrysler?

3. Uniformity—The ability to attain similar performance across the entire range of outputs. Will the quality on the brake job for the Ford be at the same high level as the quality of the exhaust system for the Chrysler?

Flexibility is the greatest when all three elements of flexibility are at the highest level. That is, the firm can produce a large number of products that are very different, can change between them quickly, and can maintain a high level of performance.

Flexibility is an important factor for the service industry. Following are some examples of the product variety that services face.

1. Hospitals and medical clinics attempt to treat patients with a wide variety of needs.

2. With the deregulation of financial markets, the differences between banks and brokerage houses have blurred. Banks are doing much more than taking deposits and making loans.

3. Universities are attempting to cope with an expanding number of majors, special- ized degree programs, and individualized study programs. When this expansion occurs, universities must have faculty who have the capabilities to teach and con- duct research across disciplines, else the capabilities of the faculty may not match the changing needs of the organizations that hire the graduates.

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CHAPTER 7Case Studies

Chapter Summary

• Facility location should not be based entirely on production factors and transpor- tation. Location is a long-term strategic decision that can have a major impact on the organization’s ability to compete.

• Locating a facility can have strategic implications. Some organizations employ a regional facility approach where one facility is responsible for producing all the products for that area of the country. Others employ the product facility strategy where one plant produces one product or product line and ships it throughout the country.

• Both quantitative and qualitative factors influence the location decision. These factors should be integrated if the decision-making process is to work effectively.

• Location influences costs, selling price, demand, and access to financial services. • Process defines the way that the products should be produced. • Process selection is closely related to the product design and capacity decisions. • A cost-volume-profit model is one way of reviewing processing options. This

model allows the organization to examine the risks associated with selecting a processing option. Mass-production alternatives involve greater risk, but have the potential for greater return.

• Process selection is a function of volume demanded. The different process types include line flow, which includes continuous flow and assembly line, batch, job shop, and project as well as manufacturing cells and flexible manufacturing sys- tems. Each of these process types is summarized in Table 7.3.

• Mass customization allows firms to achieve greater product variety while keep- ing costs low and production volumes high.

Case Studies

Tilley Video Disc, Inc. William (“Call Me Billy”) Tilley, founder, president, and chairman of the board of Tilley Video Disc, Inc., has a very pleasant problem. The market for digital video discs (DVD) is expanding rapidly, and he has accepted an attractive offer for his controlling interest in Tilley Video Disc, Inc., while retaining his current management responsibilities. The deal is contingent on Billy’s development of a plan to expand production from 10,000 to 50,000 units, and to lower production costs. Evers, Inc., the company that has made the offer, feels the growth in sales will be dramatic if costs can be significantly reduced.

Presently, production of the video discs takes place in one plant in Rimer, Oregon. The plant was formerly a slaughterhouse and meatpacking facility. Billy has quickly come to the conclusion that production could be maintained at this facility, but that significant on- site expansion is not sound. The equipment in the facility was purchased from a bankrupt company and has been used for several years. It can best be characterized as slow, general- purpose equipment. The following data has been compiled from the existing plant for the last 12 months:

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CHAPTER 7Case Studies

Selling Price $6.50/unit

Variable costs $3.25/unit

Total Production 9,824/year

Rejects 644/year

Sales 9,180/year

Estimated capacity 10,000/year

Annual fixed costs $20,000

Evers’ vice president of marketing thinks that the selling price should be reduced to about $5.00 in order to achieve the needed sales growth and to grab market share in the highly competitive consumer market. As a consultant to Billy Tilley, you are charged with devel- oping a plan that will allow the company to increase capacity by 400% and reduce variable costs by 20%. You should use the cost-volume-profit model in building your plan. Use an annual profit of $80,000 as a target profit. Provide a written report that addresses the fol- lowing questions:

1. Is it a good idea to keep the existing facility? 2. What benefits may be derived from the new technology? 3. Should one facility be built, or should the plan have several small facilities simi-

lar to the present facility? 4. Why and how will the cost structure of the new facility differ from that of the

existing one? Be specific. Use the C-V-P model to help describe the differences.

Dailey Computer Service Kathy Dailey, president of Dailey Computer Service, has called you into her office to help plan the company’s future. Profits have been declining even though sales have increased. During this time, selling price and costs have not changed. The company sells three ser- vices: a payroll package; data entry services; and computer forms. The following table shows the revenue and costs of these services:

Payroll Package

Data entry (per 1,000)

Computer forms (per 100)

Selling price $3,500 $25 $35

Variable cost $800 $16 $30

Fixed costs average $40,000 per month.

Sales data for the last two months are listed here.

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CHAPTER 7Discussion Questions

Two Months Ago Last Month

Units Sales Units Sales

Payroll (packages)

7 $24,500 5 $17,500

Data entry (1,000)

2,500 62,500 2,200 55,000

Forms (100) 1,400 49,000 2,000 70,000

Total sales $136,000 $142,500

1. How did the firm manage to increase sales, hold the line on price and costs, and make less money? Be specific; Dailey wants numbers to back up your answer.

2. If Dailey Computer Service maintains the same sales mix as last month, how can it achieve a profit of $10,000 next month? Be specific.

3. From what you have discovered in this analysis, answer the following questions: a. How should Dailey Computer Service approach marketing? b. Should price changes be considered?

Discussion Questions

1. Why is facility location important to an organization? 2. What factors are affected by the choice of locations? Which of these factors can be

measured in dollars, and which cannot? 3. How can qualitative and quantitative factors be integrated to make a sound and

logical location decision? 4. What hidden factors are influenced by on-site location, and how are they

influenced? 5. Why are spatial relationships important in the location decision? 6. What is process selection, and how can the organization use it to gain competi-

tive advantage? 7. How is process selection related to product design and capacity determination? 8. Explain how the cost-volume-profit model of a firm is derived. How is it useful

to operations managers in making the process selection decision? 9. What are line flow processes, and what characteristics help to define them? Give

examples. 10. What is batch flow, and what characteristics help to define it? Provide examples. 11. What is a job shop, and what characteristics help to define it? Provide examples. 12. What is a project, and what characteristics help to define it? Provide examples. 13. How will flexibility help an organization achieve a competitive advantage?

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CHAPTER 7Problems


1. Darwal Developers specializes in analyzing facility location decisions. Presently, the company is looking at two locations: Orlando, Florida, and Olympia, Wash- ington, for which it has determined the following cost information:

Orlando Olympia

Variable costs $14.70/unit $16.45/unit

Annual fixed costs $12,000,000 $11,000,000

Initial investment $166,000,000 $145,000,000

a. At a volume of 800,000 units per year for a 10-year period, which facility has the lower cost?

b. At what annual volume do these facilities have equal costs? Once again, assume a 10-year period.

c. Graph the results of Part b.

2. Marvin Manufacturing is considering three locations for its new plant: Tucson, Arizona; San Diego, California; and Newark, New Jersey.

Tucson San Diego Newark

Variable costs $1.60/unit $1.45/unit $1.50/unit

Annual fixed costs $1,800,000 $2,000,000 $1,900,000

Initial investment $14,000,000 $16,000,000 $15,000,000

a. At a volume of 2 million units per year for a 5-year period, which facility has the lowest cost?

b. At what annual volume(s) do these facilities have equal costs? Assume a 5-year period. (Hint: It is helpful to graph each of the cost equations before solving for the point where the costs are equal.)

3. Intensive Technologies consults for clients in the aerospace industry. Their corporate headquarters is located in Washington, D.C., but the organization is planning to relocate to the West Coast. It is considering three sites: Seattle, Wash- ington; Portland, Oregon; and Oakland, California. The full costs of operating at each site, which include initial investment, annual fixed costs, and variable costs, are approximately equal. A management team from Intensive Technolo- gies has visited each city, and has evaluated each site using the following criteria. The evaluation uses a 1-to-10 scale, with 1 being the best score. Top management selected the criteria and the weight assigned to each factor.

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CHAPTER 7Problems

Weight Oakland Score

Portland Score

Seattle Score

University research specializing in aerospace

50 4 2 2

Available pool of skilled engineers 50 4 3 2

Opportunity for advanced management education

40 2 3 3

Cultural activities 20 1 2 3

Recreational activities 20 2 4 3

a. What is the weighted score for each city? b. Which city has the advantage in terms of the qualitative factors? Is this advan-

tage significant? c. What is your recommendation to top management?

4. Barrel City Health Care System is looking for a new location for its corporate headquarters. It is considering Atlanta, Georgia, and Danville, Illinois. The cities are rated from 1 to 10 on each of the following factors, with 10 as the best score.

Weight Atlanta Score Danville Score

Cultural activities 40 8 6

University research facilities

80 8 8

Union activities 60 8 4

Banking services 60 6 8

Available labor 20 6 8

a. Determine the weighted scores for both cities. b. How can these scores be integrated with cost differences? c. Suppose the following costs apply:

Atlanta Danville

Operating costs $1,400,000/year $1,300,000/year

Initial investment $22,000,000 $20,000,000

Over a 10-year period, Danville has a $3,000,000 advantage. To determine that, take the difference in operating costs per year, and multiply it by 10 years. Then add the difference in initial investment. Under what circumstances might the company

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CHAPTER 7Problems

still choose Atlanta? How much would Barrel need to value each point of Atlanta’s qualitative advantage to make it the new headquarters?

5. Nelson, Neddel, and Nickersen (NNN) Stockbrokers are planning to invest in automated equipment that will process stock transactions. The equipment requires a $12 million annual investment. The operating costs are $120 per hour. The equipment can generate 5,000 transactions per hour. a. What is the unit cost of a transaction if 1 million are required? b. What is the unit cost if 10 million are required? c. What is the unit cost if 100 million are required? d. Why would NNN want to keep the level of transactions high?

6. George’s Mold Shop is planning to bid on a plastic part for automakers. If George’s gets the bid, the manager is planning to buy a new semi-automatic machine to speed up the production process. The annual fixed cost of the machine is $45,000. The machine requires only part-time supervision, and the labor cost is estimated at $1.50 per hour. This has been calculated as 0.08 hour of labor at $18.75 per hour. On average, the machine can produce 140 pieces per hour and is expected to operate for 2,000 hours per year. a. What is the unit cost of a plastic part if 10,000 are required? b. What is the unit cost if 100,000 are required? c. What is the unit cost if 200,000 are required? d. What is the unit cost if the machine operates at capacity for the entire year?

7. Slimline Manufacturing makes briefcases. It is considering the purchase of new stitching machines for its final assembly. Following are the data for analysis:

System Annualized Fixed Costs Variable Costs

Spurance $3,500 $1.25/unit

Yamamoto $8,000 $0.85/unit

a. If Slimline’s demand is for 8,300 briefcases per year, which system should the company use?

b. If Slimline needs to stitch 19,800 cases per year, which system has the lower cost?

c. At what volume do the two alternatives have equal costs?

8. Finn Bank and Trust is comparing a manual system for processing checks with a highly automated system. Presently, the bank processes about 10,000 checks each workday, and it operates 250 days per year. In the near future, it is planning to sell check-processing services to other small rural banks in the area. The bank’s management has collected the following data:

System Annualized Fixed Costs Variable Labor Costs

Manual $50,000 $0.045/check

Automatic $350,000 $0.005/check

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CHAPTER 7Problems

a. At its present volume of checks, which system should Finn use? b. If Finn can process checks for other banks and boost its volume to 100,000

checks per day, which system has the lower cost? c. At what volume do the two alternatives have equal costs?

9. The X-ray machine at Marchal Medical Center was purchased and installed nearly four decades ago. Medically, the machine functions very effectively, but requires excessive time to adjust for each patient. A new X-ray machine is avail- able that will reduce the time required to serve a patient.

System Annualized Fixed Costs Variable Labor Costs

Old X-ray $40,000 $4.00/X-ray

New X-ray $120,000 $1.00/X-ray

a. Which system would provide lower costs if the annual patient demand is 15,000?

b. If volume could be boosted to 20,000 patients per year, which system would provide the lower costs?

c. At what patient volume do these alternatives have equal costs?

10. Quill Pen Company sells pens that are often purchased as graduation presents. The pens sell for $5.50 each and cost $1.50 per unit to produce. Fixed costs total $40,000 per year. a. How many pens must Quill sell to cover fixed costs? b. How many units must Quill sell to make $50,000 profit per year? c. If fixed costs increase by $10,000 per year, what are the answers to Parts a and


11. Brockman Visiting Nurse Service has determined that it will cost approximately $20 each time one of its nurses visits a sick person at home. The charge is $30, part of which is paid by the patient and part by insurance. Overhead expenses are $7,000 per month. a. How many calls must the service make to cover overhead expenses? b. How many calls must it make to ensure a $3,000 profit per month?

12. A.J. Electronics produces monitors for microcomputers. It has a one-shift opera- tion with fixed costs of $25,000 per month. The cost of purchased parts is $20 per unit, and the standard labor cost is $15 per unit. The company sells the monitors for $55 each to customers who sell them under their own brand names. a. How many monitors does A.J. have to produce and sell each month to cover

costs? b. How many monitors must be produced and sold to meet a $5,000 target


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CHAPTER 7Problems

13. Presently A.J. has the capacity to produce 1,600 monitors each month if it maintains a one-shift operation. The A.J. sales staff is negotiating a deal with a major seller of microcomputers that will increase units sold per month from approximately 1,400 to 3,000. If the deal is successful the operations manager plans to add a second shift. Adding a second shift will increase fixed costs by $10,000 per month and increase production labor costs to $16 per unit for those units produced on the sec- ond shift. This increase is due entirely to paying a premium (shift differential) for second-shift labor. The unit price for purchased parts will drop by $0.50 for units produced on both shifts because of discounts for buying larger quantities. The addition of a second shift will add 1,600 units per month to capacity. a. Graph A. J.’s cost-volume-profit relationship for one shift only. b. Graph A.J.’s cost-volume-profit relationship for two shifts. c. How many units must A.J. produce and sell to cover its costs when the second

shift is in place? d. At what volume does A. J. make a $24,000 profit per month? e. What happens to the company’s profit if the selling price of monitors drops

by $5 per unit? Be specific, using calculations to support your answers.

14. Carder Kitchen Utensil Production makes steak knives and salad forks in the same facility.

Steak Knives Salad Forks

Product mix 0.7 0.3

Selling price $0.80 $0.40

Variable cost/unit $0.50 $0.25

Annual fixed costs are estimated at $250,000

a. At what volume will Carder cover its costs, given the present mix? b. At what volume will Carder report a $150,000 annual profit, given the present

mix? c. If the mix changes to 0.6 for steak knives and 0.4 for salad forks, recalculate

the answers to Parts a and b. d. If the price of a steak knife is raised by $.05, what is the impact of this new

mix on the volume required to make a $150,000 profit?

15. Junge Hardware Products makes nuts, bolts, and washers in the same facility.

Nuts Bolts Washers

Product mix 0.4 0.4 0.2

Selling price $0.07 $0.09 $0.03

Variable cost/unit $0.03 $0.06 $0.001

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CHAPTER 7Key Terms

assembly line A process through which discrete parts are put together to make a finished product. It is a high volume operation that produces products that are very similar in features and performance.

batch A term used to describe a produc- tion process that does not have sufficient volume from a single product to fully use the facility. The facility must produce several products to have sufficient volume to achieve economies of scale. There is an equipment changeover prior to making each product.

break-even point (BEP) The volume of a good or service that must be produced and sold so that profit is zero. This is the zero profit point in the cost-volume profit model.

changeover time The time required to change the facility or equipment from making one product to making the next product.

concurrent engineering Occurs when design and process engineers work together to make better decisions and reduce the time it takes to bring products to market.

continuous flow process A process for mass producing products that does not identify individual units. The products are mixed and flow together in a continuous stream. Oil refining is a good example of a continuous flow process.

Annual fixed costs are estimated at $2,500,000.

a. At what volume will Junge cover its costs, given the present mix? b. At what volume will it report a $1,500,000 annual profit, given the present

mix? c. If the price of a bolt is raised by $.01, what happens to the volume required to

make a $1,500,000 profit?

16. Winken, Blinken, and Knod, Inc., is considering three different machines to grind contact lenses. The annual costs and operating costs are listed below.

Annualized Fixed Costs

Variable Operating Costs

Manual grinder $9,000 $5.00/lens

Automatic grinder $30,000 $2.50/lens

Computer controlled automatic grinder $50,000 $0.75/lens

a. If 10,000 lenses are needed, which option has the lowest cost? b. If 20,000 lenses are needed, which option has the lowest cost? c. At what volume(s) of lens production do the alternatives have equal costs? d. How would you explain these options to management?

Key Terms

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CHAPTER 7Key Terms

contribution per unit The selling price of a unit minus the variable cost of producing the unit. It is the amount that each unit of sale contributes toward covering overhead costs and meeting profit objectives.

cost-volume-profit (C-V-P) model A simple model of an organization that uses estimates of costs, revenues, volume sold, and volume produced in order to estimate profit.

economies of scope Economies of scale across products. Implies building the volume necessary to cover fixed costs by producing a variety of products on the same equipment. This requires flexibility within the organization.

family of parts A group of parts that require similar machining operations.

group technology A set of methods that enables firms to classify parts based on size, shape, use, type of material, and method of production.

job shop A facility capable of producing a wide variety of products in very small volumes. The production facility is general purpose and flexible enough to meet a variety of needs.

leverage When referring to operations and productivity, leverage makes the work force more productive through the use of better tools.

line flow processes High volume opera- tions. Two examples of line flow processes are continuous flow processes and assem- bly lines.

mass customization The ability to quickly design, produce, and deliver products that meet specific customer needs at close to mass-production prices. This is the low- cost, high-quality, large volume delivery of customized products.

process layout The grouping or arrange- ment of equipment by the type of process that the machine performs, such as all drilling equipment in one location.

process selection A series of decisions that include technical or engineering fac- tors and volume or scale factors. The result determines how the services or goods will be produced.

product facility strategy A strategy wherein one facility is responsible for both producing a product or product line and shipping that product all over the country and around the world.

product layout The physical arrangement of facilities so that products move along one path. Resources are arranged around this path to minimize material movement, reduce material handling costs, and elimi- nate delays in production.

profit point The number of units that must be produced and sold at a given con- tribution per unit in order to cover fixed costs plus profit. The break-even point is a special case of the profit point where target profit is zero.

project A process for making one-of-a- kind products.

regional facility strategy A location strategy in which each facility is assigned a market area and each facility produces a complete line of products for that area.

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CHAPTER 7Chapter 7 Appendix

Chapter 7 Appendix


Many factors that cannot be measured in dollars should be considered in the location decision. The factors in the following list are often important.


Water supplied by: _______________________________Municipal _________Private _____ Name of supplier: ____________________________________________________________ Address: ____________________________________________________________________ For rate information, contact: __________________________________________________

Source of city water: River(s) ________ Wells _______ Lake(s) or reservoir(s) ___________ Supply of river water available: ___________________ cu. ft./sec. Supply of lake or reservoir water: _________________ gals. Water supply approved by State Board of Health: Yes ________ No ____________ Capacity of water plant: _________________________ gals./min. Average consumption: __________________________ gals./day Peak consumption: _____________________________ gals./day

Sanitation Type of sewage treatment plant: _______________________________________________ Treatment plant certified by the State Board of Water Pollution: Yes ______ No ________ Characteristics of waste treatment plant:

Measurement Capacity Present Load Gallons per day ________________ ________________ Population equivalent ________________ ________________

Natural gas Natural gas service available: Yes _________ No_______ Name: ____________________________________________________________________ Address: ___________________________________________________________________ For rate information, contact: __________________________________________________

Electricity Suppliers: Municipal ______ Private _______ Co-op ______ Name(s): ________________________________________________________ Address(es): ____________________________________________________ For rate information, contact: ______________________________________

LOCAL MANUFACTURING CHARACTERISTICS Number of manufacturing plants in community: _________________________________________ Number of manufacturing plants with unions: __________________________________________ Number of manufacturing employees in community: ____________________________________ Strikes within last 5 years affecting 5% or more of the labor force: _________________________ Major manufacturers or other large employers in community: ____________________________ Name of firm: ______________________________________________________________________ Employment: ______________________________________________________________________ Product(s) manufactured: ___________________________________________________________

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CHAPTER 7Chapter 7 Appendix

LABOR MARKET ANALYSIS Date of last labor market survey: __________________________________________________ Results of survey: ______________________________________________________________ Estimated labor force available: ___________________________________________________

This estimate can be documented: Yes ___________ No ____________ County labor data: Civilian work force (annual average):______ Unemployed: _____________________________________ Unemployed as a percentage of workforce: _____________ Total employment: _________________________________

Agricultural employment: ________________________ Nonagricultural employment: _____________________ Manufacturing employment: _____________________ Nonmanufacturing employment: __________________

HEALTH FACILITIES Number of hospitals in community: _________ Number of beds: ___________ If no hospitals, distance to nearest facility: __________________________________________ Clinic in community: Yes ___________ No ____________ Medical personnel: MD(s) ________ DO(s) __________ Nurses: Registered _____ Practical

RECREATIONAL FACILITIES Type of recreational facilities available in city or within 10 miles:

Public golf course(s) _______________ Public park(s) _________________ Public tennis court(s) ______________ Public swimming pool(s) _________

Country clubs available: Yes __________ No ____________ Nearest public access to lake or river: _____________________miles Activities allowed:

Swimming _______________________ Fishing _______________________ Water skiing _____________________ Motor boating _________________

LOCAL INDUSTRIAL DEVELOPMENT ORGANIZATION Name of group: ________________________________________________________________ Person to contact: ______________________________________________________________ Address: _____________________________________________________________________ Phone number: _______________________________________________________________

Home: _______________________________________ Business: _____________________________________

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