Question

PRODUCTION PLANNING AT VIKTOR LENAC SHIPYARD

Professor Giorgio Sinković and Professor David M. Currie prepared this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality.
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As the late afternoon sun descended over Mount Učka, Ivana Borić sat down to prepare the production plan for the coming year at Viktor Lenac Shipyard. It was late May 2017, and the choppy seas caused by the yugo wind from the south reminded her of the turbulent times facing Viktor Lenac. Recent expansion had increased fixed costs beyond the level that could be supported by the current volume of sales, jeopardizing Viktor Lenac’s future. The shipyard had gone through bankruptcy and several owners over the past decade, so managers needed to discover ways to increase profits from current operations.

Borić’s supervisor, the manager of production for the shipyard, suggested that she explore ways to improve Viktor Lenac’s profitability by changing the mix of products. From her training as an engineer, Borić realized that there were several alternatives for improving profitability: training employees, using more modern technology and changing production processes. However, some of these methods required a long time to implement and show results, while others involved significant expenditures of funds at a time when cash was tight. She hoped that by changing the mix of products it would be possible to realize a quick improvement in profits without incurring a large outlay of funds.

MODERNIZATION AT VIKTOR LENAC
Viktor Lenac (pronounced LEN-atz) was one of two shipyards in Rijeka, a city of 200,000 located on the north coast of Kvarner Bay, between the Istrian Peninsula and the eastern Adriatic coast of Croatia. Opened originally in 1896 as Lazarus Shipyard, Viktor Lenac was renamed for a Croatian hero of the Second World War and became one of Yugoslavia’s important shipyards in the four decades of the Yugoslav Federal Republic.

Croatia became an independent country in 1991 when it and Slovenia seceded from the Yugoslav Federal Republic. Serbia opposed the secession, which led to brief military confrontations in 1991 and 1995 and caused a crisis in the Croatian shipbuilding industry. Foreign companies, who were major purchasers from Croatian shipyards, hesitated to spend millions of dollars to purchase a new ship that might require two years to complete, with hostilities threatening the project. Because Viktor Lenac specialized in repairs, it survived the crisis better than most of its sister yards. Repairs took weeks rather than years and did not require the

Following independence, Croatia began an effort to modernize and move toward a market economy. The effort included privatizing firms previously owned by the government. Attracted by the shipyard’s profitability, a consortium of investors from Italy and the United States purchased a 65 per cent stake in Viktor Lenac in 1993. The remaining 35 per cent was distributed to current and former employees. In 1996, the new owners decided to modernize the shipyard to improve productivity and expand product offerings. When these efforts failed, Viktor Lenac entered bankruptcy in the early 2000s and a new set of owners replaced the previous ones. By 2017, the yard continued to operate while in bankruptcy but required cash infusions.
Modernization was financed by an $80 million1 loan package from the International Finance Corporation (part of the World Bank Group) and several private banks. The first phase of expansion began in 2000, but immediately experienced delays and cost overruns. Because of the delays, the shipyard did not yet have the cranes, steel workshops, and other equipment appropriate for newbuilding. High fixed costs caused the yard to lose its competitive advantage in repairs, which were the heart of Viktor Lenac’s business. Neither of these situations would improve until productivity increased, which would result from the second phase of the modernization program.

THE SHIPBUILDING INDUSTRY

The manufacturing facility in which a ship is built is called a shipyard, and shipyards around the world specialized in various aspects of shipbuilding: newbuilding (building a ship from the beginning), repair (overhauling a ship), conversion (converting a ship of one type into another), and drilling platforms (facilities for offshore exploration). Viktor Lenac traditionally emphasized repairs, but one of the justifications for the recent expansion was to enable the company to become a full-service shipyard with capabilities in multiple areas. Each activity had a different impact on Viktor Lenac’s operating income, which management termed “contribution” and defined as revenues less direct production expenses.

Repairs
Ships need repair for a variety of reasons. First, insurance policies, international safety regulations, and port regulations require regular maintenance, including check-ups of the ship’s important functions — vessel integrity, the propulsion system, environmental protection, and safety. Second, the natural effect of salt water is that animal and vegetable matter accumulate on a ship’s hull, which can reduce the ship’s speed and lead to deterioration of the hull. Painting the hull with anticorrosive, antivegetative paint requires that the ship be docked out of the water. Third, repairs may be necessary on an emergency basis if the engine fails, if there is a fire on board, if the hull is damaged, or if some other event renders the ship unsafe or unable to operate.
Ship owners estimate the yearly cost of maintenance at approximately 1 per cent of the purchase price of the vessel. Because the average life of a ship is 25 years, the worldwide market for repairs is about 25 per cent of the market for new construction. Because of the size of the market and Viktor Lenac’s history as a repair yard, many executives (particularly those with long experience with the company) favored emphasizing repairs as part of the company’s strategy. Viktor Lenac had spent many years earning the trust of clients
                                                 1All currency amounts are in US$ unless otherwise specified.

because of its expertise in bidding contracts. It was impossible to know beforehand the total cost of repairs because the true extent of damage may not be discovered until repairs are begun. Some shipyards purposely bid low prices to lure clients, then changed work orders to secure higher prices. Viktor Lenac’s reputation for quality work and honest negotiations had secured the trust of numerous clients.

The marketing department told Borić that it had received a variety of contracts from regular customers to repair up to 40 ships this year. If approved by management, each contract would contribute approximately a half million dollars to Viktor Lenac’s operating income (see Exhibit 1).

Conversions
Conversion is an alternative to constructing a new ship. A frequent method is to convert a passenger ship into a transport. For example, if the demand for livestock increases while passenger travel declines, owners will need more transports and fewer passenger vessels. In other situations, a transport of one type is converted to a different type. Owners may have to wait two years or more for a new ship, but often it is possible to convert an existing ship to one purpose from another in half the time. The saving in delivery time helps offset the cost of converting because it returns a ship to active service when it might otherwise be idle.

Several of the newer executives at Viktor Lenac proposed entering the market for conversions as part of the company’s strategy. They pointed out that each conversion would help the company diversify its product offerings and provide a much higher contribution to profits than repairs (see Exhibit 1). The marketing department had contracts for up to four conversions over the coming year, but Viktor Lenac management had not yet approved the contracts.


Newbuilding
Construction of a new ship is called newbuilding and can require two years or more to complete. Newbuilding consisted of:

 Bidding, including the preliminary design that becomes part of the contract  Detailed design, including material specification for the 25,000 items that are part of the ship  Production, composed of two stages — vessel production and outfitting the vessel  Trial and delivery

Because of the high cost and the need to meet complex contract specifications, both the purchaser and the shipyard appoint one or more persons each to represent their interests. These representatives observe the production process from beginning to end and verify compliance with the contract to the satisfaction of both parties. Unlike repairs, the client and the shipyard agree on the price and exactly what work is to be accomplished before signing the contract. In almost all cases, the client wants a turnkey ship that is ready for immediate use upon delivery.

The new owners of Viktor Lenac were particularly keen to enter the newbuilding market. The managing director stressed the importance of newbuilding if Viktor Lenac wanted to be a player in the global market. The director of finance pointed out the lower contribution of only $1.6 million for each new ship (see Exhibit 1), but the engineers responded that the expertise gained from newbuilding would benefit the company in the long run. The marketing department thought that it could secure contracts for no more than two ships for the coming year. Both contracts would be for tugboats rather than for transports because Viktor Lenac did not yet possess the expertise to compete in the transport market.

Offshore jackets
Oil and gas reserves frequently are located on the ocean floor rather than on dry land. Exploring and extracting oil or gas must be done from a platform that provides housing for the crew as well as allowing drilling at depths of several hundred meters. Platforms in shallow water have a component called an “offshore jacket,” which is the superstructure of the platform. The jacket is constructed using technology and resources similar to those of shipbuilding.

Viktor Lenac produced offshore jackets in the 1980s but left the market to focus on repairs. It would be possible to reenter the market by partnering with an Italian firm that had expertise in constructing the platform’s production module. Each jacket would provide a contribution of $3.1 million (see Exhibit 1). Because Viktor Lenac was new to the market, it could reasonably expect to produce only two offshore jackets in the next year.

RESOURCES FOR PRODUCTION
Borić had anticipated questions involving production, so she had asked the production manager to identify which stages in the production process or which resources used were likely to limit production. The production manager identified four possible tight spots: steel, corrosion protection, dock capacity, and labor hours (see Exhibit 2).


Steel
The basic raw material in all shipyard activities is steel, which must be cut into correct shapes, then welded to other components. Viktor Lenac purchased steel from the Czech Republic, one of the few countries in Eastern Europe producing steel of sufficiently high quality for shipbuilding. Because it was necessary to order and ship steel in advance of the year’s production, the amount of steel available this year was limited to 5,500 tons.


Corrosion Protection
A ship’s components must be protected against corrosion and the accumulation of vegetative matter. Recent modernization included constructing an enclosed building in which anticorrosive, antivegetative paint could be applied to components. Because of the paint’s potentially harmful effect on the environment, the circulation system in the building prevents vapors and wastage from being released into the atmosphere or the harbor. The building had a capacity of 500,000 square meters of anticorrosion paint annually and could not be expanded without a significant investment of money and time.


Dock Days
Any of the procedures involving a ship’s hull must be completed in a dry dock so laborers have external and internal access to the complete hull. Viktor Lenac had two docks that could accommodate ships of the size


in which Viktor Lenac specialized. Because national holidays limit operation of the yard, the docks could be open no more than 350 days during the year, so total dock capacity was 700 days. The second dock was part of the recent modernization program, and there were no plans for erecting a third dock during the second phase

THE DECISION
It was apparent to Borić that strategic as well as financial considerations would influence the decision about what to produce over the coming year. Although the production manager’s instructions did not include consideration of strategy, Borić realized that the most important concern was keeping the firm in business. The existing production plan, which continued Viktor Lenac’s traditional emphasis on repairs, would lead to a contribution of approximately $16.6 million. A contribution of approximately $30 million was necessary to cover fixed expenses such as administration, marketing, and debt service. Borić wondered if changing the mix of contracts would improve the contribution sufficiently to cover fixed expenses.

Borić next turned her attention to the resources and processes used to generate the contribution.

Quesions:

-What is the modeling solution or alternative solutions along with analyses of their pros and cons?

-What is your recommendation? along with basic reasonings (3 justifications)

Answer 1

1.answer:The use of models and modelling in the economic assessment of health care technologies including pharmaceuticals to help answer the costelTectiveness questions (does it work, and if so does it represent value-for-money?) is controversial. We use the term model in two quite different ways (Rittenhouse, 1996). It can be any artificial simplification of reality designed to enable us to better understand the world. A road map would fall into this category as would a randomised controlled trial. It is the second meaning of the term model that is more controversial - where the simplification of reality includes the use of techniques to combine data from different sources, and, usually, the use of assumptions to enable extrapolation from the combined data or to fill gaps within the required data set. In this case an important issue is whether models are being used to predict cost-effectiveness or to highlight issues on which judgements must be made or further research commissioned.  

• definitions of models; • the use of models outside of economic evaluation; • the uses of models in economic evaluation; • why modelling in economic evaluations has become such an important issue; • the benefits of models in economic evaluation; • the problems with modelling in economic evaluation; • the alternatives to modelling; • the way forward. The paper ends with concluding comments on the issues raised by the session. Professor Drummond introduced the session by highlighting the two alternative approaches to economic evaluation: • the 'trial-based' approach with concurrent data collection (for example on resource use) alongside a clinical trial; • the integrative study, with modelling of, or a synthesis of, data from a number of sources.

DEFINING MODELS Professor Sheldon described modelling as a way of representing the complexity of the real world in a more simple and comprehensible form. It involved a theoretical description that helps us to understand how a system or a process works or might work, simplifying reality in order to try and understand that reality a bit more. Professor Bloom focused on the modelling technique known as decision analysis. He defined this as a tool for expressing the known, observed or expected reality in mathematical terms. In the context of health care this could be a disease state, a treatment or an entire episode of care. It allows us to simulate or estimate various realities in order to help predict the future. Clinical and economic features can be defined based on known and estimated inputs and interactions. Of course, the accuracy of the prediction can only be proven with time and will be dependent on the assumptions and inputs used as the basis for the probabilities and costs of events occurring. Decision analysis, like every research tool, works best when the assumptions, logic and inputs are grounded in fact, but often the greatest value of decision analysis is when there are too few known inputs to make an easy decision.  

T HE USE OF MODELS OUTSIDE OF ECONOMIC EVALUATION Professor Sheldon commented that forms of modelling were often used in health services research outside of economic evaluation. For example: it occurs in data collection (we simplify whenever we code data with some sort of categorical variable to slot people into pigeon holes); when using regression analysis; and when calculating an odds ratio. He gave three more substantive examples of the use of models in clinical research outside of economic evaluation, introducing a note of caution as to their use: • Subgroup analysis - when we attempt to model whether an intervention is of use to certain types of patients within a larger study. The DICH study, carried out in Oxford, showed that you can identify lots of apparently 'significant' subgroups that are the result of chance (Counsell et al, 1994);

• Meta-analysis - a form of modelling that involves combining evidence from different studies to obtain more precise or unbiased estimates of effect. There can be problems - particularly with publication bias (small studies are more likely to be completed, submitted and accepted for publication if they show significant positive effects). If, for example, we consider the use of streptokinase at the time of a heart attack, we can plot the results of existing trials. These included small trials, alongside very large randomised controlled trials

• Observational data needs to be adjusted, for example, for confounding by case mix or indication. Again it is difficult to know whether we have adequately modelled to remove confounding. There are several examples where the use of observational data often combined with trials or other sorts of data have given, in retrospect, biased answers. One well known example is by Fddy et al (1988) which used complex confidence profile Bayesian techniques to combine poor data. It produced a misleading result which suggested that there was value in providing breast cancer screening to women under 50.

• We have seen similar problems in more commercially important areas like that of selective seralonin re-uptake inhibitor (SSRI) anti depressants versus tricyclics (TCAD). The result of (lie meta-analysis by Song et al, (1993), which examined drop out rates, is given in Figure 2. There is symmetry with an overall estimate of little difference in drop out. Another meta

USE OF MODELS WITHIN ECONOMIC EVALUATION Professor Buxton outlined the situations where models are used in economic evaluation. There arc elements of modelling in exploring: • clinical outcomes, when moving from: • intermediate to final outcomes; • short term to long term outcomes; • efficacy to effectiveness; • resources, when moving from: • patient management patterns to resource use;   resource use to cost; • trial context to normal practice. • context, when moving to: • broader clinical decision-making; • a different practice setting; • a different country.