OPERATIONS MANAGEMENT INTEGRATING MANUFACTURING AND SERVICES FIFTH EDITION Mark M. Davis Janelle Heineke Copyright ©2005, The McGraw-Hill Companies, Inc. PowerPoint Presentation by Charlie Cook, The University of West Alabama

SUPPLEMENT PowerPoint Presentation by Charlie Cook The University of West Alabama Copyright © 2005 The McGraw-Hill Companies. All rights reserved. Financial Analysis in Operations Management S2

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–3 SUPPLEMENT OBJECTIVES 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 the concepts of obsolescence, depreciation, and taxes impact the decision-making process within an operations management context. Introduce and demonstrate how the time value of money can be used as a financial tool in the decision-making process with respect to various types of operations management issues. Demonstrate the use of various financial functions that are available on Excel.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–4 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–5 Fixed and Variable Cost Components of Total Costs Exhibit S2.1

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–6 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–7 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–8 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–9 Traditional and Activity-Based Costing Exhibit S2.2

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–10 Overhead Allocations by an Activity Approach Exhibit S2.3 Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p. 94. © 1991 by The McGraw-Hill Companies, Inc. Reprinted by permission.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–11 Overhead Allocations by an Activity Approach (cont’d) Exhibit S2.3 (cont’d) Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p. 94. © 1991 by The McGraw-Hill Companies, Inc. Reprinted by permission.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–12 Overhead Allocations by an Activity Approach (cont’d) Exhibit S2.3 (cont’d) Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p. 94. © 1991 by The McGraw-Hill Companies, Inc. Reprinted by permission.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–13 Break-Even Analysis –Determination of product volume where revenues equal total costs or costs associated with two alternative processes are the same.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–14 Break-Even Analysis (cont’d) Revenues versus Costs (Assumptions) –The selling price per unit is constant. –Variable costs per unit remain constant. –Fixed costs remain constant. Selling price (per unit)= SP Variable costs (per unit)= VC Fixed costs (total)= FC

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–15 Break-Even Analysis for Revenues versus Costs Exhibit S2.4

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–16 Break-Even 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. Total cost = TC Variable cost= VC Volume= X Fixed cost= FC

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–17 Break-Even Analysis for Alternative Types of Processes Exhibit S2.5A

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–18 Break-Even Analysis for Alternative Types of Processes (cont’d) Exhibit S2.5B

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–19 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. Depreciation –Method for allocating capital equipment costs over more than one time period.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–20 Types of Depreciation Straight-Line –Asset’s book value is reduced in uniform annual amounts over its estimated useful life 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–21 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.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–22 The Effect of Taxes

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–23 Types of Economic Decisions 1.Purchase of new equipment or facilities. 2.Replacement of existing equipment or facilities. 3.Make-or-buy decisions. 4.Lease-or-buy decisions. 5.Temporary shutdown or plant-closing decisions. 6.Addition or elimination of a product or product line.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–24 Financial Definitions Compound Value of a Single Amount =FV (rate, oper, pmt, pv, type) Compound Value of an Annuity =FV (rate, nper, pmt) Present Value of a Future Single Payment =PV (rate, nper, pmt, fv) Present Value of an Annuity = PV (rate, nper, pmt) Discounted Cash Flow = NPV (rate, value1, value2,...)−Initial investment

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–25 Methods for Evaluating Investment Alternatives Net Present Value (NPV) –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 (IRR) –The interest rate that equates present value of future cash flows with the cost of an investment.

Copyright © 2005 The McGraw-Hill Companies. All rights reserved. McGraw-Hill/Irwin S2–26 Application of Excel to Determine Net Present Value and Internal Rate of Return