operation management module 2

8/10/2019 operation management Module 2

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MODULE 2

Introduction and Break even Analysis


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BREAK EVEN ANALYSIS:

It is necessary for a firm to plan its Profits. Therefore, it has to understand the

relationship between Cost, Price and Profit. The most important method of

determining this is Break-Even Analysis.

Also called Profit Analysis or Cost-volume-profit (CVP) analysis.

Meaning of Break-even Analysis:

Break-even Pointis the point at which the contribution margin is able to cover the

total fixed costs. At Break-even Point, the organization will have no-profit, no loss,

but would have covered all the fixed costs invested in the system.

Every individual unit sells at a price 'P' and has incurred a variable cost of 'V', the

difference between the two is the excess over the variable cost that could cover thefixed costs. This quantity is known as the Contribution Margin (C).

Break-even Sales refers to the number of units to be sold at the Break-even Point.

BEPsales = F/C


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Direct variable costsare those which can be directly attributable to the production

of a particular product or service and allocated to a particular cost center. Raw

materials and the wages of those working on the production line are good examples.

Indirect variable costscannot be directly attributable to production but they do

vary with output. These include depreciation (where it is calculated related to output

- e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs

Whilst the distinction between fixed and variable costs is a convenient way of

categorizing business costs, in reality there are some costs which are fixed in naturebut which increase when output reaches certain levels. These are largely related to

the overall "scale" and/or complexity of the business. For example, when a business

has relatively low levels of output or sales, it may not require costs associated with

functions such as human resource management or a fully-resourced financedepartment. However, as the scale of the business grows (e.g. output, number people

employed, number and complexity of transactions) then more resources are required.

If production rises suddenly then some short-term increase in warehousing and/or

transport may be required. In these circumstances, we say that part of the cost is

variable and part fixed.


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The Break-Even Chart

In its simplest form, the break-even chart is a graphical representation of costs at

various levels of activity shown on the same chart as the variation of income (or sales,

revenue) with the same variation in activity. The point at which neither profit nor lossis made is known as the "break-even point" and is represented on the chart below by

the intersection of the two lines:

In the diagram, the line OA

represents the variation of

income at varying levels of

production activity ("output").OB represents the total fixed

costs in the business. As output

increases, variable costs are

incurred, meaning that total

costs (fixed + variable) alsoincrease. At low levels of output,

Costs are greater than Income.

At the point of intersection, P,

costs are exactly equal to

income, and hence neither profit

nor loss is made.


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Assumptions of Break Even Analysis.

1) Fixed costs are constant, only variable costs change.

2) The firm produces only one product, or if it is multiple products the sales

mix does not change.

3) Selling price remains constant, does not change with volume of scale.

4) Constant technology.

5) Costs and revenue change with changes in sales volume.


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BEP is defined as that point of activity (sales volume) at which the total

revenues equal the total cost and the net income is zero. Point of zero

profit.

Determination of BEP

BEP can be determined in terms of physical units (products) to be produced,

or in terms of money (sales value in rupees) or as a % of full capacity.

Q = Physical output of the firm.QBEP = Output at BEP.

BEP = Break even point.

P = Price per unit or average revenue.

TR = Total revenue = P * Q.

TFC = Total fixed cost.TVC = Total variable cost.

TC = Total Cost = TFC + TVC.

AFC = Average Fixed Cost (or fixed cost per unit).

AVC = Average Variable Cost (or variable cost per unit).

AC = Average Cost = AFC + AVC.


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Break even analysis in terms of Physical Units:

Break-even volume is the number of units of a product which

must be sold in order to cover all the expenses.

BEP = Fixed Cost

________________

Selling Price Variable Cost per unit


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Break even analysis in terms of Sales Value:

Break-even volume is the number of units of a product which mustbe sold in order to cover all the expenses.

BEP = Fixed Cost________________

P/V Ratio

P/V Ratio = Contribution

_______________

Sales


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Break even analysis as a Percentage of Full Capacity:

The Full Capacity of a manufacturing plant is defined as themaximum possible volume attainable with the firms existing

fixed equipment, operating policies and procedures. Here, BEP is

usually expressed as a percentage of full capacity.

BEP(as a % of capacity) = Fixed Cost

___________

Total Contribution

(Or)

Break-even Sales

______________Capacity Sales


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Break-even Analysis for Multi-Product Firms

The unit so far has assumed that the company produces and sells a single product.

However, most companies produce and sell more than one product. Each of the

products has its own contribution margin, and any changes in one product'scontribution margin will affect the total contribution margin.

In multi-product situations, the break-even point is calculated by dividing the total

fixed costs of the company by the average contribution margin ratio of all products:

Break-even point = F_______________________

Summation[(1-Vi/Pi) * Wi]


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This average contribution margin ratio assumes a constant sales mix ofproducts. When a change in the mix of sales occurs, a change in the

average contribution margin ratio will result - unless all products carry

the same contribution margin. This will affect both the break-evenpoint and the profit.

Where the sales mix changes in favor of a product having a high

contribution margin ratio, then the average CM ratio will increase(improve) and so will profits. Conversely, when there is a decrease in

sales of a high contribution product, the average contribution ratio will

decrease (worsen) and so will profits.

It is essential, therefore, when doing break-even analysis wheremultiple products are involved, that the mix of sales is taken into

account. Before the average contribution margin ratio can bedetermined, it is necessary to know the sales mix of the products

that is, the ratio that sales of each product bears to the total sales.


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Capacity Extension Decisions:

There are two other issues that should be addressed before making capacity decisions, that is,

when to adjust capacity levels and by how much. These two things are related, that is, if demand isincreasing and the time between increments increases, the size of the increments must also

increase.

The following two extreme strategies may be helpful if you are looking to expand your capacity:

The expansionist strategy and The wait-and-see strategy.

Expansionist strategy

The expansionist strategy involves staying ahead of demand and therefore minimising the chance

of sales lost to insufficient capacity. This strategy is often favoured as it can result ineconomies of scale, allowing an organisation to reduce its costs and compete on price.

Implementing this strategy can either result in increasing your overall market share or act as a

form of pre-emptive marketing. For example, if you decide to make a large capacity expansion or

at least announce that you have plans to do so, you can pre-empt the expansion of otherorganisations.As a result, your competitors must sacrifice some of their market share or risk burdening the

industry with overcapacity.

However, in order for this strategy to be successful, you must have the credibility to persuade

your competitors that you actually have the resources to go ahead with your proposed expansionand you must announce it before they can act.


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Wait-and-see strategy

The wait-and-see strategy involves lagging behind demand and using short-term options

such as overtime, temporary workers, and subcontractors to deal with any shortfalls.

The aim of this strategy is to expand capacity in smaller increments, such as renovatingexisting facilities rather than building new ones.

By following demand, the risk of over expansion based on overly optimistic demand

forecasts, obsolete technology, or inaccurate assumptions regarding your competitors

are significantly reduced.

However, this is not to say that the wait-and-see strategy does not have any risks of

its own. If you decide to adopt this approach, you may be

pre-empted by a competitor

or may not be able to respond to sudden and unexpected high levels of demand. This

strategy is more suited to businesses that are focused on the short-term. As an

operations manager, you will have to select the most appropriate strategy for your

organizations needs. Although the above mentioned strategies are extreme and may not

be suited for everyone, there are other strategies in between that may be adopted.

Such a strategy is the follow the leader' strategy, which basically involves expanding

capacity when your competitors do so. This way, if they are right, then so are you and

nobody gains a competitive advantage, but if they make a mistake, then so do you, which

means that everyone has to deal with overcapacity.


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MAKE or BUY DECISIONS:

The act of choosing between manufacturing a product in-house or purchasing

it from an external supplier. In a make-or-buy decision, the two mostimportant factors to consider are COST & AVAILABILITY OF

PRODUCTION CAPACITY.

An enterprise may decide to purchase the product rather than producing it, if

is cheaper to buy than make or if it does not have sufficient productioncapacity to produce it in-house. With the phenomenal surge in global

outsourcing over the past decades, the make-or-buy decision is one that

managers have to grapple with very frequently.

Factors that may influence a firm's decision to buy a part rather thanproduce it internally include lack of in-house expertise, small volume

requirements, desire for multiple sourcing, and the fact that the item may not

be critical to its strategy. Similarly, factors that may tilt a firm towards

making an item in-house include existing idle production capacity, better

quality control or proprietary technology that needs to be protected.


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MAKE or BUY DECISIONS:

- Available Capacity.

- Expertise.- Quality.

- Nature of Demand.

- Cost (Availability & Reliability of Suppliers, Control of Design Secrets,

Availability of R & D, Lead time procurement versus in house manufacture,

Delivery Schedules, Employee preferences).

When to Make?

- Higher purchase price per unit.

- Timely availability.- Required facilities and capacities in house.

- Better control of quantity.

- To preserve trade secrets.

- Save on transportation costs.

- Long term requirement of product Stability & Demand.


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EQUIPMENT SELECTION DECISIONS:

Process type indicates the equipment suitable for production: a job shop

requires general purpose machines to produce a variety of products,

whereas an assembly operation requires special purpose dedicated

machines to produce large quantities efficiently. Factors that influences

selection of equipment are : Price, Ease of use, Output rate and quality,

availability of parts, skill and training requirements. Break-even analysis

is also considered.

Equipment Selection Decisions are made while adding resources to existing

operations or replacing existing resources. The type of equipment which is

capable of producing at the lowest cost to meet the anticipated demand is

the preferred alternative if the focus is on economic criterion.


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Production Process Selection Decision:

The types of Production processes/systems are classified on the basis of:

- Product/Output Variety

&- Product/Operations/Output Volume.

Based on the extent to which a factory has the Flexibility to produce a

variety of products:

They are broadly classified as:

- Continuous Production Process.

a) Process/Flow Production.

b) Mass Production.

- Intermittent Production Process.

a) Batch Production.

b) Job-Shop Production.

c) Project Production.


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Project

Job-ShopProductionProcess

MassProductionProcess

BatchProduction

Process

FlowProductionProcess

IntermittentProductionSystem

ContinuousProduction

System

VOLUME

VARIETY


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Production Processes/Manufacturing Operations may broadly be

divided into three Categories:

- Made to Stock Production Process.

These firms make items that are completed and placed instock before customer order is received.

- Made to Order Production Process.

These complete the end item only after receiving a

customer order. This is because the manufacturer cannot anticipatewhat each customer wants.

- Assemble to Order Production Process.

The company produces standard modules and assembles

these modules, according to the customer order specifications.Example: PVC Window Assemblers, Modular Kitchen Board

Assemblers.


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Basis of Comparison of Production Processes:

Manufacturing Cost.Capital Investment.

- Plant.

- Inventory.

Size of Plant.

Technical Requirements.Organizational Structure.

Flexibility of Production.

Types of Products produced.

Material Handling.

Equipment Usage.Security of Job.

- To workers & Employees.


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MANAGERIAL USES OF BREAK-EVEN ANALYSIS:

1) What happens to overall profitability when a new product is introduced?

2) Level of Sales required to cover all costs and earn profits.3) What happens to overall profitability of a firm, if the company purchases

new capital equipment or incurs higher or lower fixed or variable cost.

4) Between two alternative investments, which one offers the greater margin

of safety/profit?

5) What are the revenue and cost implication of changing the process ofproduction?

6) Should one Make, Buy or Lease, Capital Equipment?

7) Helps in determining the optimum level of output below which it would not

be profitable for a firm to produce. (Economies of Scale)

8) The firm can determine minimum cost for a given level of output.9) Plant expansion and contraction decisions.

10) Helps in determining the Selling price which would be most profitable for

the firm.

11) Helps in establishing the point at which the firm can start payment of

dividends to the shareholders


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LIMITATIONS OF BREAK-EVEN ANALYSIS:

1) All costs resolved into fixed or variable.

2) Variable costs fluctuate in direct proportion to volume.

3) Fixed costs remain constant over the volume range.

4) The selling price per unit is constant over the entire volume range.

5) The company sells only one product, or mix of products tends to remain

constant.

6) Volumetric increase is the only factor affecting costs.

7) The efficiency in the use of resources will remain constant over the period.

operation management module 2

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