Operations Strategy

Session 2
Dr. Partha P. Datta Operations Management Group E-mail: ppdatta@iimcal.ac.in

Dr Reddys Passage to India

For 25 years focus was on west US is still largest market Sales fell in Oct-Dec quarter by 55% In 2009 recall of products, lost a large customer Acquisition of 5th largest German generic drug company gone haywire Reverses in Drug Discovery Programme All big pharma companies have their own generic arm

Indian Market & Dr Reddys

Complex market 20000 companies, 50 brands/molecule Dr Reddys products are in acute therapy, not grown as fast in India as in chronic drugs Real strength is in mass market prescribed products Launched 65 brands in current financial year But IS IT ENOUGH? Cipla covers 75% of molecules Medical Representatives & Doctors Sales force beefed up Rural Market DRL focused on few chosen brands as Nise, Omez and became market leaders Play to strengths launch of biosimilars (Reditux launch in India to fight CANCER), alliance with Merck to develop biosimilars Focus on research dermatology, pain management, antiinfectives, mostly incremental innovation

Rural & Urban Markets

Access to Doctors & Patients
Field force ramp up (to 4600 with special focus on rural segment) Strong brand equity with urban doctors Crowded Urban market, Rural market is scattered Rural market income is going up, National Rural Health Mission Use local entrepreneurs, health camps and use of existing infrastructures like e-choupal

The market requirements and operations resource analysis of Dr Reddys India Entry
Resources Equipment Staff Brand Equity Relationships Experience Operations strategy decisions Capabilities Productivity per medical representative Rs 400000/month Supplies active therapies and generic drugs in world market Processes Doctor Access Drug Discovery process Distribution process Rural patient capture Ramping up Medical representatives force Drug discovery research brought together with research on existing molecules Use of local entrepreneurs Health camps Using existing infrastructure

Customers 6m Doctors in urban areas 0.2m Doctors in rural Prescription Process

Performance objectives Fast and dependable supply Right supply at affordable price Innovative products

Market position Traditionally differentiated on mass market prescribed product

Competitors Cipla dominating, flooding market with new brands molecule share Crowded Chronic Disorders drug market Crowded Urban but scattered thin rural developing market Market is fragmented

External Evaluation of Operations: Due Diligence and Operations Forensics

Due Diligence:
Get information and verify information obtained, Identify key performance drivers Develop a plan to enhance the value of the company, Make actionable decisions.

Financial statements can be informative (yet manipulated)

Operations Forensics as additional insight

Sometimes, Its Because We Cant Stop Believing

The old Hong Kong sardine dodge

But Wait
We must acknowledge the usefulness of financial statements in revealing something about operations and business models Lets do a small exercise on the next page...

You have financial statements: What do we learn about operations? Exercise

Take 10 minutes and deduce which balance sheet is for:
Grocery chain Online computer vendor, to mix of retail and business customers Commercial bank Restaurant chain?

Source: Richard Lai (2011)

Financials Can Give Clues to Operations

Lets first go through these Then well come back to the exercise.

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Clue 1: Asset Intensity

At least two types of asset-intensive businesses:
Financial assets. A bank is a typical example. What are the assets and liabilities of a bank? Physical assets. Manufacturing plant. Aircraft. Many banks and retail chain lease their stores, so they may not have many physical assets.
Cisco
Income/assets (ROA) PPE/assets Equity/assets
Source: Capital IQ, in billions of dollars, for 2007.

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11.3% 7.1% 83.3%

J.P. Morgan Chase 1.1% 0.04% 8.2%

Am. Airlines 1.9% 56.3% 15.6%

Asset-lite Businesses
Some models and examples:
Brokerage. London Stock Exchange (LSE) Group. Professional services. Accenture. Online. Yahoo! Consignment. Troc de llle, a consignment sales chain for second-hand electric household appliances and is based in France with stores throughout much of Europe.
LSE Group 31.6% 17.5% 0%
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Income/assets (ROA) PPE/assets Inventory/assets

Accenture 16.4% 7.0% 0%

Yahoo! 2.9% 12% 0%

Troc 3.8% 19.2% 6.2%

Source: Capital IQ, in billions of dollars, for 2008, except for the LSE Group, which is for 2006.

Clue 2: Perishables and Services

Inventory turnover = annual COGS / inventory Other side of same coin: days of inventory = Inventory / annual COGS X 365 Perishables and services: high turnover, few days of inventory Durables: opposite

As usual, ask: when does this not work?

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Examples
McDonalds 0.12 14.9 2.9 StarBucks 0.67 4.3 56.9 Dominos 0.026 1.0 9.3

Average inventory COGS Days of inventory = Inventory/annual COGS X365

Source: Google Finance, 2008 data in billions of dollars.

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Clue 3: Retail vs. Business Customers

Customers often receive some form of credit Receivables collection period (days)1 = accounts receivables / annual sales X365

Retail customers: days of receivables < 30 days Business customers: 30-90 days
Why? This (like the rest the follows) is a rule of thumb. When does this not work?
1. Line 20 in the balance sheet table on previous page. Often also called days of receivables.
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Useful Digression: Credit Card Receivables

Issuing bank 3. Request for and receipt of payment (month end)
1. Goods Customer Merchant

Acquiring bank
2. Request for and receipt of payment (days)

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Examples
Comp Micros USA oft 0.2 1.5 5.2 14.0 15.3 35.8 Dell 1.5 12.3 44.5

Accounts receivables (AR) Revenues Days of receivables = AR/revenues 365

Source: Capital IQ, in billions of dollars, for 1998 data, the last year for which CompUSA has data.

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Clue 4: Days of Working Capital

We just described:
Days of receivables = AR/annual sales X365
(how long before we collect from customers, after goods sold)

Days of inventory = Inventory / annual COGS X 365

(how long between goods received and goods sold)

Naturally, we have: Days of payables= AP/annual COGS X365

(how long before we need to pay suppliers, after goods received)

Days of working capitala result of the above three: next page

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The cash conversion cycle

Goods Goods sold Customer received and shipped pays Days of Days of inventory receivables (DR) (DI) Pays Days of supplier payables (DP) Days of working

capital What does a long DWC mean?

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Examples
Days of inventory receivables payables working capital CompUSA Micro Dell 39.9 29.9 6.8 12.6 38.6 41.5 38.3 44.6 79.8 14.2 23.9 -31.5 What does a negative DWC mean?
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What Do Days of Working Capital Tell Us?

Business models with short or negative DWC:
Make-to-order businesses: low inventory, often using Internet to facilitate process. Example: Dell Pay-upfront businesses: sometimes in the form of downpayments. Examples: tuition, my renovation contractor, my construction suppliers

Business models with long DWC:

Those offering easy credit terms to customers: furniture or auto dealers who say no interest payment until next year!
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Balance sheet percentages

Back to the exercise. BANK (N) Clue 1: Financial asset intensive Clue 2: No inventory Clue 3: Both retail and business customers Clue 4: N/A
Financial ratios

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Balance sheet percentages

Back to the exercise. RESTAURANT (H) vs. GROCERY (I)

Clue 1: Both are physical asset intensive

Clue 2: Restaurant has less inventory Clue 3: Both retail, but restaurant more likely to be cash Clue 4: N/A
Financial ratios

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Balance sheet percentages

Back to the exercise. ONLINE PC VENDOR (C) Clue 1: Physical asset lite Clue 2: Little inventory Clue 3: Both retail and business customers Clue 4: Low working capital* (you will see that C has the lowest working capital)
Financial ratios

25 * DWC = DI+DR-DP. In the exercise, DR is given. DI and DP requires COGS, which can be found from sales and margin (the former is obtainable from DR, the latter is also given).

Simple ROA Tree

Note an operational identity:
sales = flow rate price
Sales Price Earning Flow rate WIP Flow time Batch size Setup time Processing time Cost of goods sold + Yield losses ROA Expenses + Labor expense + Others Assets Hard + Soft Installed capacity + Others Customer goodwill + Others
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Processing time + Queueing time

Number of servers Wage rate Used capacity Utilization

(contd)
Another operational identity:
flow rate = WIP flow time
Flow rate Sales Price Earning WIP Flow time Batch size Setup time Processing time Cost of goods sold + Yield losses ROA Expenses + Labor expense + Others Assets Hard + Soft Installed capacity + Others Customer goodwill + Others
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Processing time + Queueing time

Number of servers Wage rate Used capacity Utilization

(contd)
Yet another operational identity:
flow time = processing + queueing times
Flow rate Sales Price Earning WIP Flow time Batch size Setup time Processing time Cost of goods sold + Yield losses ROA Expenses + Labor expense + Others Assets Hard + Soft Installed capacity + Others Customer goodwill + Others
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Processing time + Queueing time

Number of servers Wage rate Used capacity Utilization

Some Steps for Developing ROA Trees (contd)

1. Exploit operational identities 2. Use language of industry (e.g., airlines)
Often, these are names for what we already know
Block time = processing time, gate time = wait time Load factor = utilization

and so provide clues for the tree structure

Utilization = revenue-pax-miles / available-seat-miles

Also, they indicate that these are likely to be indicators of performance (otherwise, why the jargon)
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(contd)

3.

Use different trees for different roles

A CFO might want a broad ROA tree A line manager might want a narrow ROA tree A plant manager might even want just a sub-tree, not with ROA as the root but say, sales as the root

4.

If different decompositions are possible, pick the ones which are actionable
Flow rate = inventory flow time Flow rate = batch size (setup time + processing time) Flow rate = sales / price
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(contd)

5. Be clear about the real drivers

Example: for airlines, which is the better driver of maintenance cost, depreciation, and fuel cost?
A. Block hours or B. Available seat miles (ASM) Note: both are proxies for size; and there may be other drivers (such as fleet mix).

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Number of planes

Example : Airlines
ASM

Average seats per plane Departures per plane Route mix Overbooking costs

ASM = available seat miles RPM = revenue pax miles FFP = frequent flyer program
Revenues Passenger revenues + Cargo revenues RPM

Load factor

FFP redemptions

Yield (revenue per RPM)

Earnings Maintenance cost + Depreciation + Fuel cost Expenses ROA + Overhead + Plane leasing + Gate and landing charges + Distribution + Labor cost Planes owned + Gate rights Assets + Flight rights + Customer goodwill 32 FFP liabilities Fuel used Fuel price

Product mix Competitors yield Fleet mix Block hours

Average age of plane

Fuel per block hour Number Wage rate

Flight attendants Pilots Ground staff, etc.

Number
Wage rate

Other Trees you can develop

Gaming Home building Hotel and hospitality Healthcare Semi-conductors Oil exploration and development Retailing Telecom Life insurance Securities brokerage Pharmaceuticals Retail Banking
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I encourage to send me your favorite trees

Decomposing the ratio profit/total assets to derive the four strategic decision areas of operations strategy
Profit Total assets
=

Output Total assets

Profit Output

Profit Output

Revenue Output Average revenue

Cost Output Average cost

Output Total assets

Output Capacity

Fixed assets Total assets Working capital

Capacity Fixed assets Productivity of fixed assets

Utilisation

Operations strategy decision areas

Capacity

Supply network

Process technology

Development and organisation