The formula for the moving average is:Evaluating Alternatives, Financial Analysis

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Production and Operations Management MGT613

Lesson 17

In our earlier lectures we talked about importance of capacity planning along with the idea that capacity

planning decisions are carried out with certain objectivity in mind both at the individual level as well as

at the organizational level. We also learnt the various measures of capacity. We now focus our attention

on various alternatives available to us along with cost volume relationship.

Evaluating Alternatives

Minimum Average Cost per Unit

Average cost

per unit

Minimum Cost

Rate of output

Explanation of the Cost Curve

The explanation for the shape of the cost curve is that low levels of output (Production), the costs of

facilities and equipment must be absorbed (paid for) by few units. Hence the cost per unit is very high.

As the output is increased, there are more units to absorb the fixed cost of utilities, facilities and

equipment, so unit cost is decreased.

Minimum Cost would be recorded at the optimal rate, beyond that the unit cost will

start to increase. Other factors now become more important which include worker fatigue, equipment

breakdown, the loss of flexibility, which leaves less margin for error and increases difficulty in

coordinating activities.

Evaluating Alternatives

Minimum cost & optimal operating rate are functions of size of

production unit.

Average cost per unit

Small

Medium

plant

Large

plant

Output rate

Production and Operations Management MGT613

Evaluating Alternatives

As the general capacity of the plant increases, the optimal output rate increases and the

minimum cost for the optimal rate decreases. This is the prime reason why larger plants tend to

have higher optimal output rates and lower minimum costs than smaller plants. The senior

management normally takes in to account the same considerations in addition to availability of

financial, capital resources and forecasted demand.

The important step is to determine enough points for each size facility to be able to make a

comparison among different sizes. In some industries or types of services, facility sizes are

given, where as in other facility size are continuous variable. Occasionally the management

decides for a size which does not have the desired rate of output. E.g. Pharmaceutical Company,

oil field, gas fields.

An organization needs to examine the alternatives for future capacity from a number of different

perspectives. Economic Conditions set the external conditions which influence the following

5. Will Alternative be feasible.

6. How much will it cost?

7. How soon can we have it?

8. What will be the operating and maintenance costs?

Possible Negative Opinion due to the following decisions.

4. Decision to build a new power plant, nuclear, coal, geothermal

5. Displacement of people if a new hydro plant is to be built.

6. Environmental issues related to company's new project.

Planning Service Capacity

Services are different that manufacturing cant be inventoried while services cannot be inventoried, this

reason alone makes it necessary and pertinent to plan for service capacity.

Need to be near customers as Capacity and location are closely tied.

Inability to store services as Capacity must be matched with timing of demand

Degree of volatility of demand it can vary between peak and low periods.

Cost-Volume Relationships

Production and Operations Management MGT613

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

Cost Volume Relationship focuses on relationships between costs, revenue and volume of output. The

primary purpose of cost volume analysis is to estimate the income of an organization under different

operating conditions. It is particularly useful as a tool for comparing capacity alternatives.

The application of Cost Volume Relationships requires identification of all costs related to the

production of a given product. These costs are assigned to fixed costs or variable costs.

Fixed costs tend to remain constant regardless of volume of output. Examples include Rental costs,

property taxes, equipment costs, heating and cooling expenses, and certain administration costs.

Variable costs vary directly with volume of output. The major portions of variable cost are materials

and labor cost. For our analysis part we can assume that the variable cost per unit remains the same

regardless of volume of output.

Let us construct the model for Cost Volume Relationship. If we select FC , VC, TC, TR R , Q, QBEP , P

and R to represent Fixed Cost, Variable Cost, Total Cost, Total Revenue, Revenue per unit, Quantity or

Volume of Output, Quantity or Volume of Output at BREAK EVEN and Profit respectively then

Step I

The total cost TC associated with a given volume of output is equal to the sum of the fixed cost FC and

the Variable Cost per Unit

TC= FC+ VC X Q

Step II

Revenue per unit, like variable cost per unit, is assumed to be the same regardless of the quantity of

output. Total Revenue will have a linear relationship with the output.

TR= R X Q

Cost-Volume Relationships

Step III

Production and Operations Management MGT613

Profit is P difference between Revenue TR and Costs TC. Construct the model for Cost Volume

Relationship

P= TR-TC

P= R X Q (FC + VC X Q)

Rearranging and factorizing

P=Q ( R-VC) FC

Or P + FC= Q ( R-VC)

Also Q = ( P +FC)/ (R-VC)

Q= Quantity or Volume of Output

QBEP= Quantity or Volume of Output at BREAK EVEN, would be where

P=Profit is 0

So QBEP = FC/ R-VC

Cost-Volume Relationships

Capacity alternatives involve step costs.

These step costs increase in stepwise as potential volume increases.

For example an organization may have the option of purchasing one, two or three machines, with

each additional machine increasing fixed cost in a non linear way.

In such a scenario, the fixed costs and potential volume would depend on number of machines

purchased or installed.

Break-Even Problem with Step Fixed Costs

Production and Operations Management MGT613

The implication is that multiple break even quantities may occur, possibly one for each range.

Note the total revenue line might not intersect the fixed cost line in a particular range, meaning that

would be no break even point in the first range.

In order to decide how many machines to purchase a manager must consider projected annual

demand (volume) relative to Multiple Break Even Points and the most appropriate number of

machines.

Example

The Business Owner of a sports good factory in Sialkot is contemplating adding a new line of cricket

bats, which will require leasing new equipment for a monthly payment of Rs. 60,000. Variable Costs

would be Rs. 200 per bat and Bats would be sold for Rs. 2000 only.

1. How many bats would be sold in order to break even?

2. What would be the profit or loss if the 100 bats are made and sold in 1 month?

3. How many bats must be sold to realize a profit of Rs. 40,000?

Solution

1. QBEP= FC/ ( R-VC)

=Rs. 60,000/ 2000-200= 60,000/1800

= 33.33 bats = 33 Bats

2. For Q =100 bats, the Profit or Loss would be

P= Q(R-VC)-FC=100(2000-200)-60,000=100X 1800-60,000=180,000-60,000=120,000

3. For P =40,000

Q = (FC+P)/ ( R-VC)=(60,000+40,000)/(2000-200)

=100,000/1800=55.56 = 56 Bats

Financial Analysis

Mathematical Techniques that can be used to evaluate alternatives are

·Cost Volume Relationships

·Financial Analysis

·Decision Theory

·Waiting Line Analysis

Production and Operations Management MGT613

Capacity alternatives are often evaluated with the aid of certain financial analyses. Operations manager

along with managerial accountant often work to calculate what cash flow or present value in terms of

rupees is available for the organization to proceed with a capacity alternative decision. It is important to

understand what cash flow and present values are

1. Cash Flow - the difference between cash received from sales and other sources, and cash

outflow for labor, material, overhead, and taxes.

2. Present Value - the sum, in current value, of all future cash flows of an investment proposal.

Waiting Line Analysis and decision theory are also two important ways in which capacity alternatives

are evaluated.

Conclusion

Capacity planning is important that it helps an organization to formulate its long term (organizational)

strategy and short term (operational) strategy. Long term capacity decisions relate to overall level of

capacity while short term capacity decisions refer to seasonal, random or irregular variations in demand.

Ideally capacity should match demand but it rarely happens. Capacity alternative decisions should be

taken in view of what we have already covered the concept of systems approach or the over all big

picture approach as quite often removing a bottle neck at the department level may not improve the

organizations effectiveness. An effective operations manager would make use of qualitative as well as

quantitative analysis to evaluate capacity alternatives.

Capacity decisions are often based on facilities layout and together they define the very existence of an

organizational unit.

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