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 provides1. Accurate and timely production

• Cost information • All phases of business

2. Data in proper form needed3. Accounting information that allow accurate and

quick development of business financial documents

4. Efficiently and effectively monitoring and controlling business production costs

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 (TFC) 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

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 PricePer 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

Are we better off to harvest the crop or

just leave it in the field?

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

In the short run do not worry about the sunk costsLook only at incremental revenue and cost

Shutdown Point In-Class Exercise From Casavant, Infanger, & Bridges, pg 96 The Answer

Harvest the crop! 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

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

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 lossesSelling Price

Output Costs

Calculating The Break-Even Pointin 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 TFC- -

= 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

TFC

CMPBEP$ =

Where: BEP$= Break-even point in dollars TFC = Total fixed costs

CMP = Contribution Margin Percentage

For example,

BEP$ =

$750,000

0.40

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

Production Costs

Meeting Profit as 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 Costs Using Break Even Analysis

Change in Fixed Costs

Contribution Margin Percentage=

Minimum Changein Dollar Sales Neededto Break-Even forChange 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

Determining a Selling PriceUsing Break Even Analysis

Selling Price/Unit = Contribution + Variable Cost/Unit

Determining a Selling PriceUsing Break Even Analysis

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

TFC

Y= Contribution

Determining a Selling PriceUsing Break Even Analysis

Determine contribution by rearranging terms

of the break-even equation

TFC

Contribution= Y

____TFC___ = P – VC

Y

____TFC__ + VC = P

Y

Inventory Management

Reasons to hold inventory1. Matching supply with demand2. Prevent stockouts3. Lower purchasing costs

Reasons Not to hold inventory1. High maintenance cost2. High protection cost3. Depreciation and obsolescence4. 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

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