Production and Inventory Management

Chapter 11

Why It Is Important to Understandthe Cost Relationships in

Production and Inventory Management

• They affect the economic efficiency (profits) of the firm.

• An understanding of these relationships helps managers make more effective production decisions.

As a result, managers are better able to meettheir financial objectives

Management Information Systems

MIS provides1. Accurate and timely production and cost

information on all phases of the business2. Data in the proper form needed for decision

making3. Accounting information that will allow fast,

accurate development of business financial documents

4. A means for efficiently and effectively monitoring and controlling business production costs

Cost Concepts• Cost: what is given up to acquire a good or

service

• Opportunity cost: the return (as measured by the highest value) that is given up in a foregone use

• Implicit cost: costs that do not include cash payments but need to be included in the calculation of the total cost of product

Cost Concepts

• Controllable and Uncontrollable Costs

• Incremental, Avoidable, and Sunk Costs

• Total Cost = Total Fixed Cost + Total Variable Costs

• Total Fixed Cost (TFC)

• Total Variable Cost (TVC)

• Total Cost (TC)

The Costs of Production

The Contribution Concept

• Contribution equals selling price/unitminus variable cost/unit

• The contribution per unit is used first to payfixed costs and later profits

• 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

Using the Contribution Concept toEstablish the Selling Price of a

New Product

TotalVariable CostsPer Unit

= [1 – Contribution Margin Percentage]

×[Selling PricePer Unit]

For example,

$120 = [1 – 0.40] × Selling Price/ Bag

$120

0.60= Selling Price per Bag

$200 = Selling Price per Bag

If the contribution/unit is 40% of the selling price/unit, the selling price/unit would be:

The Shutdown Point Short-term versus Long-term Pricing

• In the short term, a firm with idle capacity can take a job where the price does not cover all the total cost as long as the contribution is positive(P – AVC > 0).

• If the contribution is negative (P – AVC < 0)the firm is better off shutting down.

• Over the long term, all costs must be covered.

Break-Even Analysis

• Break-even analysis helps managers find the combination of costs, output, and selling price that permits the firm to break even, with no profits and losses

Selling Price

Output Costs

Calculating theBreak-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 – TFC0

= P × Y – VC × Y – TFC

= (P – VC) Y – TFC

TFC = (P – VC) Y

TFC

(P – VC) Y = = Break-Even Point in Units

Calculating the Break-Even Point in Dollars

Where: BEP$= Break-Even Point in DollarsTFC = Total Fixed Costs

CMP = Contribution Margin Percentage

TFC

CMPBEP$ =

For example,

BEP$ = $750,000

0.40

BEP$ = $1,875,000 = The Break-Even Point in Dollars

Meeting a Profit as a Percentage of Sales Objective Using Break-Even Analysis

TFC

(CMP – RPP)BEP$ =

For example,

BEP$ = (0.40 – 0.10)

$750,000

= $2,500,000 (or 20,000 bags at $125 per bag)

RPP = Required Profit Percentage

Evaluating Changes in Fixed CostsUsing Break-Even Analysis

Change in Fixed Costs

Contribution Margin Percentage=

Minimum Changein Dollar Sales Neededto Break Even for the Change in Fixed Costs

For example,

$1.00

0.40= $2.50 = the minimum increase in dollar sales needed to break even for each new dollar spent on fixed costs

Determining a Selling PriceUsing Break-Even Analysis

Selling Price/Unit = Contribution + Variable Cost/Unit

TFC

Contribution= Y

TFC

Y= Contribution

Contribution can be determined by rearranging the terms of the break-even equation

If Variable Cost/Unit is known, all that is needed is Contribution

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

Value of Inventory = $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!

The Basic Inventory Management Model

• The total cost of inventory (TC) equals the sum of ordering costs (OC) and carrying costs (CC)

TC = CC + OC

Managers’ goal is to minimize total cost. A manager needs to determine:

1. Economic Order Quantity (EOQ): the number of items to buy in each order that will minimize total cost, and

2. Reorder Point (ROP): when to reorder to minimize the chances of stockouts

The Basic Inventory Model

Discussion Questions

1. Explain why an agribusiness manager needs to understand production and inventory management. Give two examples of situations in which cost management made a difference.

2. Describe the relationship between the firm’s accounting system and its management information system. Give a definition for each. Explain which one is most important to management.

3. What is opportunity cost? Is it relevant to business decision making? Explain your answer. Give an example that shows its impact.

4. Describe the relationship between implicit and explicit costs. Describe how they are measured. Explain their role in production and pricing decisions in an agribusiness. Describe, using an example, how failure to properly account for them can get an agribusiness into trouble.

5. Explain how agribusiness managers use avoidable and sunk costs in their decision making. Why is this decision-making process called incremental analysis? Define economic efficiency and show with an example how incremental analysis helps firms increase their economic efficiency.

6. Draw a simple graph showing the total cost, fixed costs, and variable costs as production increases. Explain why each line looks the way it does.

7. Define the term “contribution” as used in this chapter. Give an example of how it could be used to price a new product.

8. Explain why a firm would take a job that does not give it a chance to make a profit. Explain when it would not accept this opportunity. Use a numerical example to explain why it is important for managers to know the difference between the two.

9. Using the break-even equations, describe and explain the relationship between cost, selling price, and output. Use a numerical example to make your points.

10. Describe and explain the importance of good inventory management of the firm’s overall objective of maximizing its long-term profits. What is the role of supply chain management and information technology in this process? Use a numerical example to make your points