Financial Analysis for Operations Management Decisions

Financial Analysis for Operations Management Decisions 

Financial analysis tools and concepts are important for OM. Many operating decisions are to be taken after financial analysis.

Financial analysis tools include the types of costs, activity-based costing, risk, 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.

Types of costs

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

Depreciation

Depreciation: 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

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.

Summary Financial Measures for Equipment Investments

Summary Financial Measures for Investments: 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 determination of 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.

Financial Analysis for Production Quantity, Capacity and Inventory Planning

Costs relevant to aggregate production planning include basic production costs to costs associated with changes in the production rate, inventory holding costs, and back-ordering 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


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