1. Developing Capacity Alternatives
Reported By:
Donnalyn S. Boncodin

2. Developing Capacity Alternatives
Design flexibility into systems.
Take a “big picture” approach to capacity changes
Prepare to deal with capacity “chunks”
Attempt to smooth out capacity requirements
Identify the optimal operating level

3. Evaluating Alternatives
Cost-Volume (Break-Even) Analysis
Financial Analysis
Decision Theory – is a helpful tool for financial comparison of alternatives under conditions of either risk or uncertainty.
Queuing Analysis – Often useful for designing service systems.

4. Evaluating Alternatives
Figure 5.3
Production units have an optimal rate of output for minimal cost.
Minimum
cost
Average cost per unit
Rate of output
Minimum average cost per unit

5. Evaluating Alternatives
Figure 5.4
Minimum cost & optimal operating rate are
functions of size of production unit.
Small
plant
Average cost per unit
Medium
plant
Large
plant
Output rate

6. Cost-Volume Relationships
Cost-Volume (Break-Even) Analysis – focuses on relationships between cost, revenue and volume of output.
Total Cost = Fixed Cost + Variable Cost x Q units
Fixed Costs – are those that tend to remain constant regardless of volume of output.
Variable Costs – vary directly with volume of output.

7. Cost-Volume Relationships
Figure 6.5a
Amount ($)
Q (volume in units)
Total cost = VC + FC
Total variable cost (VC)
Fixed cost (FC)

8. Cost-Volume Relationships
Figure 5.5b
Amount ($)
Q (volume in units)
Total revenue
B. Total Revenue increases linearly with output.

9. Cost-Volume Relationships
Figure 5.5c
Amount ($)
Q (volume in units)
BEP units
Profit
Total revenue
Total cost
C. Profit = TR - TC

10. Assumptions of Cost-Volume Analysis
One product is involved
Everything produced can be sold
Variable cost per unit is the same regardless of volume
Fixed costs do not change with volume
Revenue per unit constant with volume
Revenue per unit exceeds variable cost per unit

11. Cost-Volume Relationships
Formula:
Profit = Total Revenue – Total Cost
= Revenue per unit x Q – (Fixed Cost +
(Variable Cost x Q)
Volume = Specified Profit + Fixed Cost
Revenue per unit – Variable Cost
QBEP = Fixed Cost
Revenue per Unit – Variable Cost per Unit

12. Cost-Volume Relationships
Example:
Old-Fashioned Berry Pies, Ltd. Currently operates a single bakery but is now considering a second location in a new shopping mall. The owner estimates that fixed cost would be $3,000 per week and that labor and materials to produce pies at that location will be 60 cents pe pie. Pies will be sold for $1.60 each.
What number of pies be sold in order to break-even?
What profit (or loss) would there be on sales of 10,000 pies in one week?
What volume would be required in order to realize a profit of $12,000?

13. Cost-Volume Relationships
Solution:
1. FC = $3,000, VC = $ 0.60 per unit, Rev = $1.60 per unit
QBEP = FC = $ 3, = 3,000 pies / week
Rev - VC $ $0.60
2. Profit = Rev x Q – (FC + (VC x Q))
= $1.60(10,000) – ($3,000 + ( $0.60 x 10,000))
= $7,000
3. Volume = SP + FC = $12,000 + $3,000 = 15,000 pies
Rev - VC $ $0.60

14. Financial Analysis
Cash Flow - the difference between cash received from sales and other sources, and cash outflow for labor, material, overhead, and taxes.
Present Value - the sum, in current value, of all future cash flows of an investment proposal.

15. Financial Analysis Methods:
Payback – widely used method that focuses on the length of time it will take for an investment to return to its original cost.
Present Value Method – summarizes the initial cost of an investment, its estimated annual cash flows, and any expected salvage value of an investment in a single value called the equivalent interest rate, taking into account the time value of money.
Internal Rate of Return (IRR) – summarizes the initial cost, expected annual cash flows, and estimated future salvage value of an investment proposal in an equivalent interest rate.

16. Payback Period Analysis
Example:
Determine the payback period for each of the follow in proposals given their estimated cash flows. Assume each requires an initial investment of $40,000.
Year A B C
$10, $20, $1,000
, , ,000
, , ,000
, , ,000
, ,000
, ,000

17. Payback Period Analysis
Solution:
Calculate the cumulative cash flows for each alternative, and note when the cumulative amount equals the original investment.
Year A B C
$10, $20, $1,000
, , ,000
, , ,000
, ,000
,000
Thus, A’s payback period is exactly four years. B’s is exactly two years and C’s is between four and five years. Alternative B is the most attractive, and C is the least.

18. Net Present Value Net present value = Present value of - Initial Cost
future cash flows
Example 1: ( Annual cash flows are all the same amount.)
Determine the net present value of a proposal that has an economic life of nine years, an initial cost of $30,000, and an annual cash flow of $10,000. The firm’s cost of capital is 12%.
Solution: n = 9, A = $10,000, Initial Cost = $30,000 and i=12%
Find annuity factor : 5.328
Find the present value of cash flows: $10,000(5.328) = $53,280.
Determine the net present value: $53,280 - $30,000 = $23,280.

19. Net Present Value
Example 2: ( Annual cash flows are not all the same amount.)
A newspaper is considering two investment proposals for new piece of equipment. Proposal A has an initial cost of $2,000, and proposal B has an initial cost of $1,000. Given the following cash flow information and the firm’s cost of capital of 10%, determine which proposal has the higher present value.
Cash Flows
Year Proposal A Proposal B
$1, $2,000
, ,000 ,

20. Net Present Value Solution: Find the present value of cash flows
Proposal A
Proposal B
Year
Cash Flow x PVF = PV 1
1,000.00
0.909
909.00
$2,000
0.91
1,818.00 2
2,000.00
0.826
1,652.00
0.83
826.00 3
3,000.00
0.751
2,253.00
800.00
0.75
600.80 4
100.00
0.68
68.30
$4,814
$3,313.10

21. Net Present Value Solution:
2. Subtract the Initial Investments to find the present value of each investments.
Proposal A: $4,814 - $2,000 = $2,814
Proposal B: $3,313 - $1,000 = $2,313
Hence, proposal A has a higher present value.

22. Internal Rate of Return
PVA = Initial investment = I
Annual Cash Flows A
Example: An automatic bottlecapping machine requires an initial investment of $9,000. During its estimated useful life of 11 years, it will provide an annual cash flow of $1,800. At the end of 11 years, the machine will have no salvage value. Determine the internal rate of return.
Solution: I = $9,000, A= $1,800, n = 11 years,
I = $9, =
A ,800
Referring to Table for n= 11, we find PVA = for i=16% and PVA = for i=18%. Since the computed value is approximately we conclude that the IRR is approximately 16%.