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Production and Inventory Management

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1 Production and Inventory Management
Before we get started, let’s take a minute or two to remember where we are. We began the course by discussing the planning management function. Everything we did was focused on deciding what firm’s values were, what consumer need it was going to fill, and finally how it was going to fill that need in a way that would grant it a sustainable competitive advantage. Next we turned our eyes to setting up an organizational structure that would permit the business to efficiently and effectively carryout the firm’s purpose and objective. Now it is time to move to the 3rd business function (controlling) where the feedback mechanisms are developed to measure our progress toward accomplishing those goals set in planning. In the last chapter we reviewed production theory from economics so we will know how to manage our production so we can maximize our long-run profits. Let’s put what we learned in that chapter to work.

2 Production and Inventory Management
Understand Cost Relationships Economic efficiency (profits) Understanding of relationships helps managers Effective production decisions Experience has shown that business managers who understand the economics underlying production have a better chance of achieving maximum profits (maximum economic efficiency). They are more profitable because they understand the economic relationships that are at work and use that knowledge to their advantage in the form of better decision making. This makes them better able to achieve the financial goals sets in the planning function. Managers are Better Able to Meet Financial Objectives

3 Management Information Systems
MIS provides Accurate and timely production Cost information All phases of business Data in proper form needed Accounting information that allow accurate and quick development of business financial documents Efficiently and effectively monitoring and controlling business production costs The first step in this process is to have a good accounting system. But this is never enough. Accounting tells you what happened but only after the period ended and usually not in a form that managers can use directly in decision-making. It does not give you information on the current situation nor does it help you make decision about the future. Management information systems (MIS) fill this void by giving accurate and timely information in forms that managers can quickly use to make decisions and control ongoing operations. There is no need to wait until the end of year or month to find out what’s happening. MIS makes it easier to control production processes and costs. The IT revolution has made it feasible for firms of all sizes to have an efficient and effective MIS for nearly everything it does. Many business analysts attribute much of eBay’s success to its MIS that closely monitors just about everything it does and allows it can rapidly adjust to changes in its business environment.

4 Cost Concepts Cost: Acquire good or service
Opportunity cost: Return (measured by highest value) Implicit cost: Do not include cash payments Included in calculation of total cost of product Another source of confusion in this area is what do we mean when we say cost. To some cost means what you give up to acquire something. It can be money, but it can also be time, expertise, or another good. An economist would take this even further to include the thing of highest value that is given up to acquire the product. For example, the real cost of attending college is not just what you are paying for tuition, and room and board. The real cost should also include the income you are passing up each year by attending college. This what you compare to what you will make with your college degree down the road. The next cost concept we will look at here are implicit costs. These are costs that need to be included in the cost calculation even if they do not change because of it.

5 Cost Concepts Controllable and Uncontrollable Costs
Incremental, Avoidable, and Sunk Costs Total Cost = Total Fixed + Total Variable Costs Costs Total Fixed Cost (TFC) Total Variable Cost (TVC) Total Cost (TC) Now we can move to another view of costs. From this perspective we look at costs in terms of whether they are either controllable or uncontrollable. The separation of costs in this way are just as they sound. Another way to classify costs is determine if they are incremental—they change, avoidable—can be end with a decision, or sunk—can never be recovered. Each of these classifications has a place in cost determination depending on the situation. So when you hear term cost be sure to know which form of costs you are talking about because each conveys a very different meaning. The most useful way to look at cost is to separate them into fixed (costs that to not vary with output) and variable cost (costs that do vary by output level). As you can see total cost of production is the sum of these two cost groups.

6 Contribution = Selling Price/Unit minus Variable Cost/Unit
Contribution Concept Selling Price/Unit = Total Cost/Unit + Profit/Unit Total Cost/Unit = Variable Cost/Unit + Fixed Cost/Unit Selling Price/Unit – Variable Cost/Unit = Fixed Cost/Unit + Profit/Unit Contribution = Selling Price/Unit minus Variable Cost/Unit Separating costs into either fixed and variable costs is pretty simple, but give us is very powerful way to deal with costs. Let’s take a look at one of the things we can do using this approach—the contribution concept. To understand the contribution concept we have to start with the selling price formula where the selling price per unit is equal to the total cost per unit plus the profit per unit. We then break the total figure down to its two to parts—variable and fixed costs per unit, and substitute this into the first equation. The next step is to move the variable cost per unit to the other side of the equals sign so selling price per unit minus variable cost per unit is now equal to fixed cost per unit and profit per unit. Now let’s give the part to the left of the equals sign the title contribution. This is how much is contributed to fixed costs per unit and profit per unit when a unit is sold. This is equal to the selling price per unit minus the variable cost per unit. The contribution per unit is also a powerful tool that we can use in many ways to better manage our production. On the next couple of slides we will see what we can do with it.

7 The Contribution Concept
Selling Price/Unit = $ % Minus: Variable Cost/unit = -$ % Contribution to Fixed Costs = $ % and Profit/Unit We can use this information to make pricing decisions One of the most common uses of the contribution concept is for pricing decisions. Many firms apply a standard formula to price their new products. As you can see on the slide the contribution to fixed costs and profits is $80. If this is the standard for the firm it is often easier to report this as a percentage of the price of a typical unit. Here, for example, the contribution is said to be 40 percent.

8 Applying the Contribution Concept
Establish Selling Price of New Product If contribution/unit is typically 40% of selling price/unit, the proper selling price/unit for a new product would be: Total Variable Costs Per Unit = [1- Contribution Margin Percentage] * [Selling Price Per Unit] To keep things simple, let’s rework this equation assuming we have a new product for sale that has a total variable cost per unit of $120. If the firm typically operates with a 40% contribution it is easy to quickly determine the proper selling price for this item using the formula given on the slide---$200/bag $ = [1 – 0.40] * Selling price per bag $ = Selling price per Bag

9 Shutdown Point Short run
Short Run vs Long Run Pricing Short run Firm with idle capacity can take job where price does not cover all total cost Contribution is positive (P- AVC > 0). Contribution is negative (P-AVC < 0) firm is better off to shut down. Long Run All costs covered The contribution concept can also be applied to another important area of production management---Determining the Shutdown Point. The shutdown point is the minimum price a firm can accept for a job and be better off for taking the job rather than refusing the job and shutting down. In the short run, firms with idle capacity should take a job if the contribution is positive---Price/Unit >Variable Cost/ unit. When this happens the firm covers all the variable costs and makes a contribution to total fixed costs. Thus, the loss is smaller than if they refused the job. If the contribution to negative---Price/Unit < Variable cost/unit, the firm does not cover all its variable cost per unit. It ends up losing on the variable cost plus having to pay the fixed cost. It is better off to shutdown because it loses less money. This can be done only in the short run. In the long run you must cover all of your costs.

10 Are we better off to harvest the crop just leave it in the field?
Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 A drought has hit the farm and now it is harvest time We have $18/acre invested in our crop Going in to harvest what is left will cost an additional $6/acre (the variable cost) for a total cost $24/acre Crop is expected to yield six bushels per acre and market price is $2/bushel Now let’s take the shutdown decision up one level. Ken Casavant and co-authors in a great introduction to agricultural economics textbook that we use in AG BM 101 use this example to illustrate how knowledge about the combination of sunk costs and the shutdown point lead to better production decisions. These values come from Casavant’s family farm in North Dakota. A severe drought has reduced their crop yields significantly. They estimated that they have already invested $18/acre in their wheat crop. It will cost them another $6/acre to harvest it. They expect to get a yield of 6 bushels/acre that they can sell for $2/bushel. The management decision is are we better off harvesting the crop or just leaving it in the field and starting over next year? Are we better off to harvest the crop or just leave it in the field?

11 Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 The Answer
Harvest the crop! Incremental Revenue > Incremental Cost $12/acre > $6/acre We will have $6/acre more to reduce the fixed costs than if we don’t harvest The answer is that we are better off harvesting the crop. We arrived at that answer buy using incremental analysis and knowing the difference between sunk and incremental costs. The only costs that are relevant to the decision are the incremental ones—the ones that change as a result of our decision. All the other costs are sunk costs—they are the same regardless of what we do. Let’s look at the incremental revenues and costs. The incremental revenue per acre is $2 x 6 bushels or $12 The incremental cost per acre is $6 The farm is $6/acre better off if it harvests the crop. It is not enough to recover the $18 of sunk costs but the losses are smaller. Harvesting is the better choice. Once again, understanding costs helps managers make better decisions!!! In the short run do not worry about the sunk costs Look only at incremental revenue and cost

12 Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 The Answer
If we do not harvest we lose $18/acre (the sunk costs) If we do harvest we lose $12/acre $18/acre sunk cost + $6/acre harvesting cost = $24/acre total cost Total Revenue: $12/acre (6 bu/acre x $2/bu) Less: Total Cost - $24/acre Loss - $12/acre For those with some doubts about this decision here is the no harvest alternative's costs so you can compare them.

13 Break-Even Analysis Break-Even Analysis helps managers find combination of costs, output, and selling price that permits firm to break-even, no profits and losses Selling Price The best known application of the contribution applications is Break-Even Analysis (BEA). BEA helps managers find the right combination of costs, output, and selling price that will allow the firm to just break-even, no profits or losses. The break-even point helps managers assess their prospects for success in the market, make pricing decisions, and evaluate changes in costs for things such as advertising and plant expansions. The triangle in the slide reminds us of the interrelatedness of the cost, output levels, and selling prices. If we know any two of these we can calculate the missing item. First, we are going to build the break-even equation from the contribution concept and show how to use it to make better production decisions. The section will end with a brief look at the many extensions of break-even analysis that a covered in ore detail in the book. Time to get started!!! Output Costs

14 Calculating The Break-Even Point in Units
The break-even point is calculated from the profit equation when profit is zero Profit = 0 = Total Revenue - Total Cost 0 = Total Revenue - TVC/Unit - TFC = P*Y VC*Y TFC Again we return to our basic profit and cost model. In this case we set the profit to zero and manipulate the variables until we can solve for Y---the number of units we need to sell to just break-even. Let’s look at what we have in our final equation. The numerator is total fixed costs. It is divided by price minus variable cost. So the numerator is just contribution. If we assume that we devote all of the contribution until we reach the break-even levels of sales to paying off our fixed costs we end up with this equation saying: How many units do we need to sell where each unit contributes X amount to paying fixed costs until all the fixed costs are paid? The contribution from sales above the break-even point is all profit. The derivation of this and all the other break-even extensions can be found in the text. = (P-VC) Y - TFC TFC = (P-VC) Y TFC (P-VC) Y = = Break-Even Point in Units

15 Calculating The Break-Even Point in Dollars
Where: BEP$= Break-even point in dollars TFC = Total fixed costs CMP = Contribution Margin Percentage For example, BEP$ = $750,000 0.40 BEP$ = $1,875,000 = the Break-Even Point in Dollars TFC CMP BEP$ = The break-even point can also be calculated in dollars as well as units. In this situation you determine the level of contribution per unit as a percentage of the unit selling price---contribution margin percentage. This percentage figure replaces the dollar amount in the denominator in our equation. This gives us a quick way to determine the break-even point in either units or dollar sales.

16 Production Costs The relationship between the numbers can also be seen in this graph from the text. Here you can see that profits are negative until total revenue is equal to total cost.

17 Meeting Profit as Percentage of Sales Objective Using Break-Even Analysis
TFC (CMP – RPP) BEP$ = RPP = Required Profit Percentage For example, BEP$ = (0.40 – 0.10) $750,000 = $2,500,000 (or 20,000 bags at $125 per bag) Here is the fist of a number of extensions of the basic break-even model. In this case we can find what level of sales are need to not break-even but to achieve a specific profit objective.

18 Evaluating Changes in Fixed Costs Using Break Even Analysis
Change in Fixed Costs Contribution Margin Percentage = Minimum Change in Dollar Sales Needed to Break-Even for For example: $1.00 This is one of the more important extensions for break-even analysis. Firms are often faced with decisions that involve changing their plant size, putting in processing equipment, or spending money on advertising. This variation is quick way to evaluate the economics of those decisions by establishing the minimum increase in sales needed to pay for such expansions. Let’s work two variations of the equation on the slide. First. Let’s assume the firm is looking to spend $1,000,000 on advertising. How will they know they get their money’s worth? Based on this equation sales would have to rise by $2,500,000 just to pay for the cost of the ads. Managers can use this number to better assess their chances for success. This same approach could be applied to a plant expansion, the investment of $100,000 in a plant expansion would require a minimum sales increase of $250,000 to pay for the investment. Note that in the numerator we can just look at the change in fixed costs---this is just another version of the incremental decision process we have used many time before = $2.50 = minimum increase in dollar sales needed to break-even for each new dollar spent on fixed costs 0.40

19 Determining a Selling Price Using Break Even Analysis
Selling Price/Unit = Contribution + Variable Cost/Unit In this case we are going to rearrange our equation to solve for a selling price for our product that is compatible with our costs and expected sales.

20 Determining a Selling Price Using Break Even Analysis
If Variable Cost/Unit is known, all needed is Contribution TFC Y = Contribution Let’s start by rearranging our basis BEA model to solve for contribution. We can then define the contribution but its two parts (Price – average variable cost) and then solve just for price.

21 Determining a Selling Price Using Break Even Analysis
Determine contribution by rearranging terms of the break-even equation TFC Contribution = Y Here is the derivation of the price equation. With this equation mangers know the price of their product that is compatible with this level of sales and costs. These are just some of the most useful applications of break-even analysis. Don’t forget that all this is based on our separation of fixed and variable costs. Be sure to read the text carefully so you get all the deails. ____TFC___ = P – VC Y ____TFC__ + VC = P

22 Inventory Management Reasons to hold inventory
Matching supply with demand Prevent stockouts Lower purchasing costs Reasons Not to hold inventory High maintenance cost High protection cost Depreciation and obsolescence Taxes The last section of this chapter is devoted to inventory management. Inventory and distribution are two of the hottest areas of business management. MIS and good inventory management systems enable business to closely match sales with production so they can avoid wasteful over production and not miss out on the sales of popular items.

23 Impact of Inventory on Profits
Inventory Value = $100,000 Inventory Carrying Cost = $25, (25 percent) Each $1,000 reduction In Inventory = $250 Profits In Inventory = $5,000 in Sales We put together this chart to show you the financial impact that good inventory management can have on the business profits. The example cover a fairly typical situation where the cost of having inventory in terms of people to count it, keep it safe, and so on run around 25% of the value of the inventory. If this is perishable items such a flowers or food this number would be higher and benefits of inventory management would be greater. As you can see just a small decrease in inventory can bring sizeable savings to the firm and are equivalent to substantial increases in sales. This is why it pays to keep inventories low!!! Why It Pays to Keep Inventories Low!

24 Basic Inventory Management Model
Total cost of inventory (TC) Ordering costs sum (OC) Carrying costs (CC) TC = CC + OC Maintaining the proper level of inventory is a two-edged sword. If you maintain a large inventory you will always have the items your customers want. However, a large inventory, as you just saw, is expensive. What we need to do is find a happy middle position that allow us to satisfy both of these objectives. On the next several slides we will lay out the basics of inventory management. If you find these intriguing I can give much more complicated models. For what we are trying to do the basic inventory model will be fine. The total cost of inventories is made up of the costs of ordering items, and the cost of holding (carrying) inventory. The details of the derivation of each of these parts is covered in detail in the text.

25 Managers’ Goal Managers determines Economic Order Quantity (EOQ):
Number of items to order each time Minimizes total cost Reorder Point (ROP): When to reorder more Stockouts minimized Our analysis of our inventory has two objectives. First, to determine how much inventory we should order each time we place an order to we can minimize our total cost of inventory. This amount is called the Economic Order Quantity (EOQ). As you can see on the graph on the next slide the EOQ is where the cost of ordering stuff (OC) for inventory is equal to the cost of holding inventory (CC). Our second goal is to know when we need to place an order so we will never run our of anything. This second goal is called the reorder point (ROP). Details on the derivation and calculation of both of these items are in the text.

26 Basic Inventory Model This figure from the book gives you a visual view of what the inventory management process is all about.

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