Cost Volume Analysis- can be a valuable tool for comparing capacity alternative, if
certain assumptions are satisfied.
1. One product is involved.
2. Everything produced can be sold.
3. The variable costs per unit is the same regardless of the volume.
4. Fixed costs do not change with volume changes, or they are step changes
5. The revenue per unit is the same regardless of volume.
6. Revenue per unit exceeds variable cost per unit.
Cost volume analysis
works best with one product or a few products that have the same cost characteristics.
A notable benefit of cost-volume considerations is the conceptual framework. It
provides for integrating cost, revenue, and profit estimates into capacity decisions. If a
proposal look attractive using cost-volume analysis, the next step would be develop
cash flow models to see how it fares with the addition of time and more flexible cost
functions.
Financial Analysis
A problem that is universally encountered by managers is how to allocate scarce funds.
A common approach is to use financial to rank investment proposals.
Two important terms in financial analysis are called cash flow and present value.
Cash flows refers to the difference between the cash received from sales ( of goods
and services) and other sources ( sale of equipment) and the cash outflow for labor,
materials, overhead, and taxes.
Present value- expresses in current value the sum of all future cash flows of an
investment proposal.
The three most commonly used methods of financial analysis are payback,
present value, and internal rate of return.
1. Payback- is a crude but widely used method that focuses on the length of time it
will take for an investment to return its original cost. For example, an investment
with an original cost of 6,000 and a monthly net cash flow of 1,000 has a payback
period of six months. Payback ignores the time value of money. Its use is easier
to rationalize for short term than for long- term project.
2. Present Value –(PV) methods summarizes the initial cost of an investment, its
estimated annual cash flows, and any expected salvage value in a single value
called equivalent current value, taking into account the time value of money
( interest rates).
3. Internal Rate of Return- (IRR) summarizes the initial costs, expected annual
cash flows, and estimated future salvage value of an investment proposal in an
equivalent interest rate. In other words, this method identifies the rate of return
that equates the estimated future returns and the initial cost.
These techniques are appropriate when there is a high degree of certainty
associated with estimates of future cash flows. In many instances, however,
operations managers and other managers must deal with situations better
described as risky or uncertain. When conditions of risk or uncertainty are
present. Decision theory is often applied.
Decision theory- is a helpful tool for financial comparison of alternative under
conditions of risk or uncertainty. It is suited to capacity decisions and to a wide
range of other decisions managers must take.
Waiting –line analysis- analysis of line is often useful for designing service
systems. Waiting lines have a tendency to form in a wide variety of service
systems (airport ticket counters, telephone calls to a cable television company,
hospital emergency rooms. The line are symptoms of bottleneck operations.
Analysis is useful in helping managers choose a capacity level that will be cost
1providing additional capacity. It can aid in the determination of expected costs
for various levels of service capacity.
Decision that lend themselves to a decision theory approach tend to be
characterized by these elements.
1. A set of possible future conditions exists that will have a bearing on the
results of the decision.
2. A list of alternatives for the manager to choose from.
3. A known payoff for each alternative under each possible future condition.
To use this approach, a decision maker would employ this process:
1. Identify the possible future conditions (e.g demand will be low, medium, or
high; the number of contracts awarded will be one, two, or three, the
competitor will or will not introduce a new product).These are called states
of nature.
2. Develop a list of possible alternative, one which may be o do nothing.
3. Determine or estimate the payoff associated with each alternative for
every possible future condition.
4. If possible, estimate the likelihood of each possible future condition.
5. Evaluate alternatives according to some decision criterion (e.g., maximize
expected profit), and select the best alternative.
Causes of poor decisions
Bounded Rationality – The limitations on decision making caused by costs, human
abilities, time, technology, and availability of information.
Sub Optimization – The result of different departments each attempting to reach a
solution that is optimum for that department.
Decision Environments
Certainty – Environment in which relevant parameters have known values.
Risk – Environment in high certain future events have probable outcomes.
Uncertainty – Environment in which it is impossible to assess the likelihood of various
future events.
Consider these situations:
1. Profit per unit is 5.You have an order for 200 units. How much profit will you
make? ( this is an example of certainty since unit profits and total demand are
known.).
2. Profit is 5 per unit. Based on previous experience, there is a 50% chance of an
order
Decision making under uncertainty
1. Maximin - choose the alternative with the best of the worst possible payoffs.
2. Maximax- choose the alternative with the best possible payoff.
3. Laplace- choose the alternative with the best average payoff of any of the
alternatives.
4. Minimax regret- choose the alternative that has the least of the worst regrets.
