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
• 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.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–2
Chapter Objectives (cont’d)
• Demonstrate the use of various financial functions that
are available on Excel.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–3
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 McGraw-Hill Companies, Inc., 2003
S5–4
Fixed and Variable Cost Components
of Total Costs
Exhibit S5.1
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–5
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.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–6
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 McGraw-Hill Companies, Inc., 2003
S5–7
Activity-Based 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 McGraw-Hill Companies, Inc., 2003
S5–8
Traditional and Activity-Based Costing
Exhibit S5.2
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–9
Overhead Allocation by Activity Approach
Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.
Fundamentals of Operations Management 4e
Exhibit S5.3a
© The McGraw-Hill Companies, Inc., 2003
S5–10
Overhead Allocation by Activity Approach
(cont’d)
Source: Ray Garrison, Managerial Accounting, 6th ed. (Homewood, IL: Richard D. Irwin, 1991), p.94.
Fundamentals of Operations Management 4e
Exhibit S5.3b
© The McGraw-Hill Companies, Inc., 2003
S5–11
Break-Even 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 McGraw-Hill Companies, Inc., 2003
S5–12
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
FC total
BEunits 
SPunit  VCunit 
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–13
Break-Even Analysis for Revenues versus Costs
Exhibit S5.4
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–14
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
Variable cost
Volume
Fixed cost
= TC
= VC
=X
= FC
TC1  VC1X
TC2  FC2  VC2 X
TC1  TC2
VC1X  FC2  VC2 X
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–15
Break-Even Analysis for
Alternative Types of Processes
Exhibit S5.5a
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–16
Break-Even Analysis for
Alternative Types of Processes
Exhibit 5S.5b
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–17
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 McGraw-Hill Companies, Inc., 2003
S5–18
Types of Depreciation
• Straight-Line
–Asset’s book value is reduced in uniform annual
amounts over its estimated useful life
Annual amount to be depreciate d 
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 depreciati on percentage 
Fundamentals of Operations Management 4e
Year
Sum of years' digits
© The McGraw-Hill Companies, Inc., 2003
S5–19
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.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–20
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 McGraw-Hill Companies, Inc., 2003
S5–21
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 McGraw-Hill Companies, Inc., 2003
S5–22
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.
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–23
Application of Excel to Determine Net Present
Value and Internal Rate of Return
Exhibit S5.6
Fundamentals of Operations Management 4e
© The McGraw-Hill Companies, Inc., 2003
S5–24