Production and Inventory Management

Production and Inventory Management Production and Inventory Management Understand Cost Relationships Economic efficiency (profits) Understanding of relationships helps managers Effective production decisions Managers are Better Able to Meet Financial Objectives Management Information Systems MIS provides 1. Accurate and timely production Cost information All phases of business 2. Data in proper form needed 3. Accounting information that allow accurate and quick development of business financial documents 4. Efficiently and effectively monitoring and controlling business production costs 1

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 Cost Concepts Controllable and Uncontrollable Costs Incremental, Avoidable, and Sunk Costs Total Cost = Total Fixed + Total Variable Costs Costs Total Fixed Cost () Total Variable Cost (TVC) Total Cost (TC) 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 2

The Contribution Concept Selling Price/Unit = $200 100% Minus: Variable Cost/unit = -$120-60% Contribution to Fixed Costs = $ 80 40% and Profit/Unit We can use this information to make pricing decisions 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] $120 = [1 0.40] * Selling price per bag $200 = Selling price per Bag Shutdown Point 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 3

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 Are we better off to harvest the crop or just leave it in the field? Shutdown Point In-Class Exercise Harvest the crop! From Casavant, Infanger, & Bridges, pg 96 The Answer 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 In the short run do not worry about the sunk costs Look only at incremental revenue and cost 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 4

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 Output Costs 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 - = P*Y - VC*Y - = (P-VC) Y - = (P-VC) Y Y = = Break-Even Point in Units (P-VC) Calculating The Break-Even Point in Dollars Where: BEP$= Break-even point in dollars = Total fixed costs CMP = Contribution Margin Percentage For example, $750,000 0.40 CMP $1,875,000 = the Break-Even Point in Dollars 5

Production Costs Meeting Profit as Percentage of Sales Objective Using Break-Even Analysis RPP = Required Profit Percentage (CMP RPP) For example, $750,000 (0.40 0.10) = $2,500,000 (or 20,000 bags at $125 per bag) 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 Change in Fixed Costs For example: $1.00 0.40 = $2.50 = minimum increase in dollar sales needed to break-even for each new dollar spent on fixed costs 6

Determining a Selling Price Using Break Even Analysis Selling Price/Unit = Contribution + Variable Cost/Unit Determining a Selling Price Using Break Even Analysis If Variable Cost/Unit is known, all needed is Contribution Y = Contribution Determining a Selling Price Using Break Even Analysis Determine contribution by rearranging terms of the break-even equation Contribution = Y = P VC Y + VC = P Y 7

Inventory Management Reasons to hold inventory 1. Matching supply with demand 2. Prevent stockouts 3. Lower purchasing costs Reasons Not to hold inventory 1. High maintenance cost 2. High protection cost 3. Depreciation and obsolescence 4. Taxes Impact of Inventory on Profits Inventory Value = $100,000 Inventory Carrying Cost = $25,000 (25 percent) Each $1,000 reduction In Inventory = + $250 Profits Each $1,000 reduction In Inventory = +$5,000 in Sales Why It Pays to Keep Inventories Low! Basic Inventory Management Model Total cost of inventory (TC) Ordering costs sum (OC) Carrying costs (CC) TC = CC + OC 8

Managers Goal Managers determines 1. Economic Order Quantity (EOQ): Number of items to order each time Minimizes total cost 2. Reorder Point (ROP): When to reorder more Stockouts minimized Basic Inventory Model 9