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

DAVIS
F   O   U   R   T   H       E   D   I   T   I   O   N

AQUILANO
CHASE

supplement 5

Financial Analysis in 
Operations Management

© The McGraw-Hill Companies, Inc., 2003

PowerPoint
Presentation
by
Charlie
Cook


Supplement Objectives
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 decisionmaking process with respect to various types of

operations management issues.© The McGraw­Hill 
Fundamentals of Operations 
Companies, Inc., 2003
Management 4e 
S5–2


Chapter Objectives (cont’d)
Chapter Objectives (cont’d)
• Demonstrate the use of various financial functions that
are available on Excel.

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–3


Cost Definitions
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.
Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–4


Fixed and Variable Cost Components 
Fixed and Variable Cost Components 
of Total Costs
of Total Costs

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.1
S5–5


Cost Definitions (cont’d)
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
© The McGraw­Hill 
particular alternative.
Fundamentals of Operations 
Companies, Inc., 2003
Management 4e 
S5–6


Cost Definitions (cont’d)
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.

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–7


Activity­Based Costing
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.

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–8


Traditional and Activity­Based Costing
Traditional and Activity­Based Costing

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.2
S5–9


Overhead Allocation by Activity Approach
Overhead Allocation by Activity Approach

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.3a
S5–10

Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.


Overhead Allocation by Activity Approach 
Overhead Allocation by Activity Approach 
(cont’d)
(cont’d)

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 

Companies, Inc., 2003
Exhibit S5.3b
S5–11

Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.


Break­Even Analysis
Break­Even Analysis
• Break-Even Analysis
–Determination of product volume where
revenues equal total costs or costs associated
with two alternative processes are the same.

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–12


Break­Even Analysis (cont’d)
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.
Selling price (per unit) = SP
Variable costs (per unit) = VC

Fixed costs (total) = FC

BE units

FC total
SPunit VC
unit
© The McGraw­Hill 

Fundamentals of Operations 
Management 4e 

Companies, Inc., 2003
S5–13


Break­Even Analysis for Revenues versus 
Break­Even Analysis for Revenues versus 
Costs
Costs

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.4
S5–14

Break­Even Analysis (cont’d)
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.
  Total cost 
Variable cost
Volume
Fixed cost

= TC
= VC
= X
= FC

Fundamentals of Operations 
Management 4e 

TC1 VC1 X
TC 2 FC 2 VC 2 X
TC1 TC 2

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VC1Companies, Inc., 2003
X FC 2 VC 2 X
S5–15

Break­Even Analysis for 
Break­Even Analysis for 
Alternative Types of Processes
Alternative Types of Processes

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.5a
S5–16


Break­Even Analysis for 
Break­Even Analysis for 
Alternative Types of Processes
Alternative Types of Processes

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit 5S.5b
S5–17


Obsolescence, Depreciation, and Taxes

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.

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–18


Types of Depreciation
Types of Depreciation
• Straight-Line
–Asset’s book value is reduced in uniform annual
amounts over its estimated useful life
Annual amount to be depreciated

Cost - Salvage
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.
Annual depreciation percentage

Fundamentals of Operations 
Management 4e 

Year
© The McGraw­Hill 
Sum of years' digits

Companies, Inc., 2003
S5–19


Types of Depreciation (cont’d)
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
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number of operations before
wearing out.
Fundamentals of Operations 
Companies, Inc., 2003
Management 4e 
S5–20


Types of Economic Decisions
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.
Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–21


Financial Definitions
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

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
S5–22


Methods for Evaluating 
Methods for Evaluating 
Investment Alternatives
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.

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


Application of Excel to Determine Net Present 
Application of Excel to Determine Net Present 
Value and Internal Rate of Return
Value and Internal Rate of Return

Fundamentals of Operations 
Management 4e 

© The McGraw­Hill 
Companies, Inc., 2003
Exhibit S5.6
S5–24