March 31, 2015

Financial Analysis for Operations Management Decisions - Review Notes

Operations managers has to do engineering economic analysis and financial analysis of their project and expenditure proposals.

Chapter Outline of

Richard B. Chase, F. Robert Jacobs, Nicholas J. Aquilano, Operations Management for Competitive Advantage, 10/e, McGraw-Hill Higher Education, 2004

Concepts and Definitions

Fixed Costs
Variable Costs
Sunk Costs
Opportunity Costs
Avoidable Costs

Expected Value
Economic Life and Obsolescence

Straight-Line Method
Sum-of-the-Years' Digits (SYD) Method
Declining-Balance Method
Double-Declining Balance-Method
Depreciation-By-Use Method

Activity-Based Costing
The Effects of Taxes

Choosing Among Investment Proposals

Determining the Cost of Capital

Interest Rate Effects
Compound Value of a Single Account
Compound Value of An Annuity
Present Value of A Future Single Payment
Present Value of An Annuity
Discounted Cash Flow

Methods of Ranking Investments

Net Present Value
Internal Rate of Return

Ranking Investments with Uneven Live

Relevant Costs for Decision Making

Financial Analysis for Operations Management Decisions - Summary for Revision

Financial analysis tools and concepts are important for OM.

These tools include the types of costs, activity-based costing, risk, and expected value, and depreciation for more periodic operating decisions. When the focus of OM decisions is capital investment, issues of cost-of-capital calculations and methods of ranking investment proposals are important.

Fixed costs are any expenses that remain constant regardless of the level of output of production.

Variable costs, conversely, vary directly with changes in output levels.

Sunk costs are past expenses or investments that have no salvage value and therefore should not be taken into account when considering investment alternatives.

Opportunity costs are the benefits lost that result from choosing one action over another action.

Avoidable costs are expenses not incurred if an investment is made but that must be incurred if the investment is not made. Avoidable costs becomes the cost savings, for the proposed projects and hence enter into financial or economic analysis as positive cash flows against the negative cash flows due to investment in the project.

Expected value is the sum of expected outcomes multiplied by the probability of their occurrence. Expected values result because there is risk inherent in any investment decision.

The life of a machine or other income-producing assets is estimated and for accounting purposes, the asset is depreciated over this period. Depreciation is a method for allocating costs of capital equipment. Methods of depreciation include the straight-line method, the sum-of-the-years' digits method, the declining-balance method, the double-declining -balance method, and the depreciation-by-use method.

Activity based costing is an important accounting concept for OM and it is the practice of allocating overhead to better reflect actual proportions of overhead consumed by the production activity. Causal factors or cost drivers are identified and are used as the basis for overhead allocation as direct labor is not the best basis for allocating all overheads.

When choosing among investment proposals, investments are generally ranked according to the return they yield in excess of their cost of capital. Investment decisions can include the purchase of new equipment or facilities, replacement of existing equipment or facilities, make-or-buy decisions, lease-or-buy decisions, temporary shutdowns or plant abandonment decisions, or the addition or elimination of a product or product line.

Other financial decisions include determine the cost of capital, tax issues, and interest rate effects on OM decisions. Ways to rank investments include the net present value method, payback period, and the internal rate of return.

Costs relevant to aggregate production planning include basic production costs to costs associated with changes in the production rate, inventory holding costs, and backordering costs.

Important Operations Decisions Requiring Financial Analysis

1. Purchase of new equipment or Facilities
2. Replacement of existing equipment or facilities
3. Make or buy decisions (components)
4. Lease or buy decisions (equipment)
5. Temporary shutdowns or total plant closure decisions
6. Addition or elimination of a product or product line

Richard B. Chase, F. Robert Jacobs, Nicholas J. Aquilano, Operations Management for Competitive Advantage, 10/e, McGraw-Hill Higher Education, 2004

Originally posted at

Full material from the book

Updated 27 March 2015, 9 Dec 2011

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