Lecture Fundamentals of operations management (4/e): Chapter 7 - Davis, Aquilano, Chase

Chapter 6 Financial analysis in operations management, after studying this chapter you will be able to: Introduce various cost definitions and demonstrate how they are applied in operations management; demonstrate how break-even analysis is used within an operations management context; demonstrate how concepts of obsolescence, depreciation, and taxes impact the decision-making process with an operations management context;...

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Financial Analysis in Operations Management

© The McGraw-Hill Companies, Inc., 2003

supplement 5

DAVIS AQUILANO CHASE

PowerPoint Presentation by Charlie Cook

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Management 4e

• Demonstrate how break-even analysis is used within

an operations management context

• Demonstrate how concepts of obsolescence,

depreciation, and taxes impact the decision-making process with an operations management context

• Introduce and demonstrate how the time value of

money can be used as a financial tool in the making process with respect to various types of

decision-operations management issues

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S5–4

Cost Definitions

• Fixed Costs

–Expenses such as rent that remain constant

over a wide range of output volumes.

• Variable Costs

–Expenses such as material and direct labor that

vary proportionately with changes in output.

• Sunk Costs

–Expenses already incurred that have no salvage

value.

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S5–6

Cost Definitions (cont’d)

• Opportunity Costs

–Profits lost when one alternative is chosen over

another that would have provided greater

financial benefits.

• Avoidable Costs

–Expenses such as higher labor costs resulting

from poor productivity incurred if an investment

is not made.

• Out-of-Pocket Costs

–Actual cash outflows associated with a

particular alternative.

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S5–7

Cost Definitions (cont’d)

• Cost of Capital

–Usually expressed as a percentage rate, it

reflects the cost of the money invested in a

project.

–Comparisons:

• The cost of borrowing money to finance the

project.

• Interest lost on short-term notes.

• Opportunity cost of forgoing one of several other

projects that require funding.

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S5–8

ActivityBased Costing

• Activity-Based Costing

–An accounting technique that allocates

overhead costs in actual proportion to the

overhead consumed by the activity.

• Stage 1: Assign overhead costs to activity pools.

• Stage 2: Assign costs from pools to activities.

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S5–9

Traditional and ActivityBased Costing

Exhibit S5.2

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S5–12

BreakEven Analysis

• Break-Even Analysis

–Determination of product volume where

revenues equal total costs or costs associated with two alternative processes are the same.

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S5–13

BreakEven Analysis (cont’d)

• Revenues versus Costs (Assumptions)

–The selling price per unit is constant.

–Variable costs per unit remain constant.

–Fixed costs remain constant.

unit unit

total units SP VC

FC BE

Selling price (per unit) = SPVariable costs (per unit) = VC

Fixed costs (total) = FC

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S5–15

BreakEven Analysis (cont’d)

• Choice of Processes

–Used to choose from among alternative

processes a company can use.

–Break-even point is defined as that volume

where we are indifferent with respect to the

costs of the alternative processes.

X VC

Volume = XFixed cost = FC

X VC

FC X

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S5–16

BreakEven Analysis for Alternative Types of Processes

Exhibit S5.5a

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S5–17

BreakEven Analysis for Alternative Types of Processes

Exhibit 5S.5b

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S5–18

Obsolescence, Depreciation, and Taxes

• Obsolete

–The status of an asset when it has worn out or

been surpassed by a superior performing asset

• Economic Life

–The useful life of an asset in which

it provides the best method of

operation to an organization.

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S5–19

Types of Depreciation

• Straight-Line

–Asset’s book value is reduced in uniform annual

amounts over its estimated useful life

life useful Estimated

Salvage -

Cost d

depreciate be

to amount Annual

• Sum-of-the-Years’-Digits (SYD)

–Asset’s book value is reduced rapidly in the

early years of its estimated useful life and at a lower rate in its later years.

digits years'

of Sum

Year percentage

on depreciati Annual

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S5–20

Types of Depreciation (cont’d)

• Declining-Balance Method

–Asset’s book value is reduced annually by a

constant percentage rate that approximately matches its useful life.

• Double-Declining-Balance Method

–Asset’s book value is reduced by twice the

straight line rate over the life of the item.

• Depreciation-by-Use Method

–Asset’s book value is reduced in proportion to

its use; assumes it will perform an estimated number of operations before wearing out.

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S5–21

Types of Economic Decisions

1 Purchase of new equipment or facilities.

2 Replacement of existing equipment or

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S5–22

Financial Definitions

• Compound Value of a Single Amount

• Compound Value of an Annuity

• Present Value of a Future Single Payment

• Present Value of an Annuity

• Discounted Cash Flow

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Management 4e

S5–23

Methods for Evaluating Investment Alternatives

• Net Present Value

–The present value of a stream of future cash

flows.

• Payback Period

–The time necessary for a firm to recover its

initial investment by the return of earnings from the investment.

• Internal Rate of Return

–The interest rate that equates present value of

future cash flows with the cost of an investment.

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