1. F O U R T H E D I T I O N Financial Analysis in Operations Management © The McGraw-Hill Companies, Inc., 2003 supplement 5 DAVIS AQUILANO CHASE PowerPoint Presentation by Charlie Cook

2. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–2 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 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 decision- making process with respect to various types of operations management issues.

3. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–3 Chapter Objectives (cont’d) Demonstrate the use of various financial functions that are available on Excel.

4. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–4 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.

5. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–5 Fixed and Variable Cost Components of Total Costs Exhibit S5.1

6. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–6 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.

7. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–7 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.

8. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–8 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.

9. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–9 Traditional and Activity-Based Costing Exhibit S5.2

10. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–10 Overhead Allocation by Activity Approach Exhibit S5.3a Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.

11. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–11 Overhead Allocation by Activity Approach (cont’d) Exhibit S5.3b Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.

12. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–12 Break-Even Analysis –Determination of product volume where revenues equal total costs or costs associated with two alternative processes are the same.

13. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–13 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

14. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–14 Break-Even Analysis for Revenues versus Costs Exhibit S5.4

15. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–15 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

16. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–16 Break-Even Analysis for Alternative Types of Processes Exhibit S5.5a

17. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–17 Break-Even Analysis for Alternative Types of Processes Exhibit 5S.5b

18. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–18 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.

19. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–19 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.

20. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–20 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.

21. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–21 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.

22. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–22 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

23. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–23 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.

24. Fundamentals of Operations Management 4e© The McGraw-Hill Companies, Inc., 2003S5–24 Application of Excel to Determine Net Present Value and Internal Rate of Return Exhibit S5.6