PRPC 28 Analysis of Production Systems and IE Lab

1
Syllabus
Engineering Economy and costing: Elementary cost accounting
and methods of depreciation; break-even analysis, techniques for
evaluation of capital investments.
Production planning: Forecasting techniques – causal and time
series models, moving average, exponential smoothing, trend and
seasonality.
Capacity and aggregate production planning; Master production
scheduling; MRP and MRP – II, scheduling and priority
dispatching.
Inventory – functions, costs, classifications, deterministic and
probabilistic inventory models, quantity discount; perpetual and
periodic inventory control systems.
Engineering 2

Economy and
Costing
Introduction – Product & Process Decision and Design
3
 New products and services – vital to economic survival of
business organization.

 Most companies continually redesign existing product - to

reflect market demands, changing technologies and other
inputs.

 Created by new improved process.

 Important functions in organization and greatly affect

operations system.
Product Life Cycle
4
 Continued introduction of new products or services –
assures maintenance of sales volume over a period of time.

 It relates the volume of sales of a product – to time that has

elapsed since its introduction into market place.

 Product life cycle involves 4 stages,

Introduction
Acceptance
Maturity
Decline
Product life cycle
5
Stages of product life cycle
6
 Stage 1 – Introduction stage (Product A)
- new and unknown to public
- field troubles call for redesign or production changes
- high priced.

 Stage 2 – Acceptance stage

- product improved
- sales volume increases at accelerated pace
- price decreases
- production efficiencies and reduced costs.
 Stages of product life cycle
7
 Stage 3 – Maturity stage
- Product – dependable and trade name becomes accepted.
- Company should decide on, design and start marketing new and different
product – to sustain production capacity and sales volume.
- Product B – entering stage 2 while A entering stage 3

 Stage 4 – Decline stage

- product – faced with new competition
- benefited from new technological breakthroughs
- popularity and sales volume decline.
- company involved in R & D of new products.
- Product B entering stage 3 while A entering stage 4).
New product decision and design
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Economic Analysis
 It determines the economic viability of the business organization.
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Break even analysis

 Minimum volume of sales must be produced and sold to break even after paying all
expenses.
Min. Volume – Break-even point (BEP)

 Producing and selling more than BEP – to make profit.

 Fixed cost: remain constant regardless of volume of products (rent, property taxes,
depreciation, insurance, salaries to staff)

 Variable cost: fluctuate directly with changes in the output volume of products.
BEP = Fixed cost / (unit selling price – variable cost per unit)
Break-even analysis 10
 11
Break even analysis
 In simple terms, the break-even point is the juncture where total cost
and total sales (revenue) are equal. This point is important for every
company to know because, from this point, the company starts to
become profitable. If total cost and total revenue are equal at this point,
that means the units produced would generate zero profit.
 That means at this point,
Revenue – Total Cost = 0

N = Fixed Cost / (Price per unit – Variable Cost)

 Total cost = Variable Cost * N + Fixed Cost

 Revenue = Price per unit * N
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Contribution Margin
 Break-even analysis also deals with the contribution margin of
a product. The excess between the selling price and total
variable costs is known as contribution margin.
 It represents the revenue collected to cover the fixed costs.

Note: In the calculation of the contribution margin, fixed costs are

not considered.
Problem 13

General Electric is considering the production of new, energy saving

light bulb. The selling price is $10.00, and variable cost is about
$2.00 per light bulb. If total fixed costs are $20 million, the break-
even point, in units of output sold, or light bulbs is

BEP = $20,000,000 / ($10.00 - $2.00) = 2,500,000

That is, if GE produces 2,500,000 light bulbs, total costs equal total
revenue

Total costs: $20,000,000 + $2(2,500,000) = $25,000,000

Total revenue: $10 x 2,500,000 = $25,000,000
 14
In the same problem what will happen if selling price of bulb
is $12.00?

Obviously, BEP will be lower.

BEP = $20,000,000 / ($12.00 - $2.00) = 2,000,000 bulbs

Selling price is subject to market constraints – cannot be raised.

BEP – lowered by – reducing production costs (through reduced

scrap, more efficient use of machine and labour)
Break Even Point Example 1 15
Details of the two companies are given in the below table.

In $ Company X Company Y
Fixed Cost 30000 50000
Price per unit 100 90
Variable Cost per
40 30
unit

Find the Break-even point (units) of both Company X and

Company Y?

BEP = FC / (Price – VC)

 Putting the data in the formula, we get – 16
In $ Company X Company Y
Price per unit 100 90
Variable Cost per unit 40 30
Contribution
60 60
Margin/unit

 Now, the BEP would be –

In $ Company X Company Y
Fixed Cost (A) 30000 50000
Contrib. Margin/unit (B) 60 60
BEP (A / B) 500 833.33

That means beyond 500 units, Company X and beyond 833.33 units,
Company Y would be able to make profits.
Break Even Point Example 2

In order to facilitate a faster return of rented cars. Hertz Rent-A-

Car has installed a special express counter with a capability of
handling 60 car returns/hour. The fixed costs involved are $5,000.
The variable cost of direct labor, depreciation, and material
(including computer terminal charges) amounts to $1.30/car return.
The surcharge to the customer using this express counter is
$1.40/car return.
a) What is the break-even point, expressed in number of returns?
b) What is the break-even point in hours?
Solution

a) Break Even point = $5000/($1.4-$1.3)

= 50000 cars

b) BEP in hours = 50000/60

= 833.33 hours
Break Even Point Example 3

Details of the two companies are given in the table below.

Calculate the Fixed Cost ?

In $ Company X Company Y
Fixed Cost ? ?
Price per unit 120 140
Variable Cost per unit 60 70
BEP (units) 500 600
Solution

In $ Company X Company Y

Contrib. Margin/unit (A) 60 70

BEP (B) 500 600

Fixed Cost (A * B) 30000 42000

Depreciation
Causes of depreciation
Depreciation

Due to Physical Conditions, Due to functional conditions

• Wear and tear • Inadequacy

• Physical decay • Obsolescence
• Accident
• Poor maintenance
 Depreciation
Straight Line Method (Fixed instalment method)

 Amount of depreciation is distributed over the useful life of the machine in

equal periodic instalments.
(Cost – Salvage)
 Depreciation, D=
Estimated life of machine in years

 It doesn’t consider the maintenance and repair charges.

A drilling machine is purchased for Rs. 45,000 and the assumed life in 10 years.
The scrap value is taken as Rs. 5,000. Calculate the yearly depreciation by straight
line method.
C – Rs. 45,000, n – 10 years, S – Rs. 5,000
Yearly depreciation cost,
D = (45000 – 5000)/10 = Rs. 4,000
 Depreciation

Double-declining balance method

 Annual rate of depreciation is derived by –

doubling the straight line rate and applying it, year by year to the portion of
asset value still not depreciated.

 With 10 year depreciation period – depreciation rate would be 2(1/10) = 0.20.

2(𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒)
 Double-declining balance depreciation =
𝐿𝐼𝑓𝑒𝑡𝑖𝑚𝑒
Book value – value of asset less the accumulated depreciation.
Calculation is done for each year over the lifetime of the asset.
 Depreciation
Double-declining balance method
A new machine costs $20,000 and has a depreciable (accounting) life of 5 years,
with a salvage value of $5,000. What are the values of the annual double-declining
depreciation?
Year Depreciation Beginning Depreciation Accumulated Ending
Ratio Book value Charge Depreciation Book Value
1 2/5 = 0.40` x 20,000 = 8000 8000 12000
2 2/5 = 0.40 x 12,000 = 4800 12800 7200
3 2/5 = 0.40 x 7,200 = 2200 15000 5000
4 0 x 5,000 = 0 15000 5000
5 0 x 5,000 = 0 15000 5000
Total = 15000
 In this method, one does not depreciate beneath the salvage value.
 Machine is fully depreciated by the third year, depreciation must be 0 in years 4
and 5
 Depreciation
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Double-declining balance method

Problem:
ABC Limited purchased a Machine costing $12500 with a useful life
of 5 years. The Machine is expected to have a salvage value of
$2500 at the end of its useful life. Let’s calculate the depreciation
using the Double Declining Balance method.
 Depreciation
26

Year Dep. Beginning Dep. Charge ($) Accumulated Ending

Ratio Book Dep. ($) Book
Value ($) Value
($)
1 2/5 = 0.4 x 12500 = 5000 5000 7500
2 2/5 = 0.4 x 7500 = 3000 8000 4500
3 2/5 = 0.4 x 4500 = 1800 9800 2700
4 2/5 = 0.4 x 2700 = 200 (not 1080, due to 10000 2500
Salvage Value: 2500)
5 0 2500 0 10000 2500
Total = 10000
 Capital Budgeting Techniques
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Investment decisions are generally called capital budgeting decisions

 Net present value considers – “Time value of money”

 Money grows over time, when it earns interest.
 Money in hand today is worth more than a money in future.

Discounted Cash Flow (DCF)

Investment decisions made by – taking into account the interest that the
money in hand can earn if invested in a bank or somewhere else.

Non-Discounted Cash Flow (NDCF)

 Interest is not taken into consideration.
 Time value of money is not considered.
 Capital Budgeting Techniques
29

• NPV – Net Present Value

Discounted cash flow
• IRR – Internal Rate of Return

Non – discounted cash flow Payback Period

 Present value
Example 30
1. If Rs. 120 is to be received after 1 year, What is the Present Value (PV) of
Rs. 120 today?
2. If Rs. 120 is to be received after 5 year, What is the PV of Rs. 120 today?
3. If Rs. 120 is to be received after 15 year, What is the PV of Rs. 120 today?
Note: Discounted rate is 6% per year

Solution:
Future Value (FV) = 120 k = 6 % = 6/100 = 0.06
1 FV
PV= FV x (1 + k)n = (1 + k)n

120
1. PV (n=1): PV = = 113.2
(1 + 0.06)1
120
2. PV (n=5): PV = = 89.67
(1 + 0.06)5
120
3. PV (n=15): PV = = 50.07
(1 + 0.06)15
31
 Net Present Value Method (NPV)
32
Problem:
The initial cost of a project is Rs 4,000. The forecast of year end cash
inflows is Rs 1900, Rs 1600, Rs 1400, Rs 1200 and Rs 1100
respectively during the 5 years of its life. If the rate of interest is
10%, determine the net present value of the project.
Solution:
Initial cost = Rs. 4,000 Interest rate (k) = 10% = 0.1 Period (n) = 5 years
Cash inflow (1st year) = Rs. 1,900 Cash inflow (4th year) = Rs. 1,200
Cash inflow (2nd year) = Rs. 1,600 Cash inflow (5th year) = Rs. 1,100
Cash inflow (3rd year) = Rs. 1,400

cash inflows are different in each and every year.

FV
Present value of cash inflows, PV=
(1 + k)n
 Net Present Value Method (NPV)
33
Total present value for 5 years,
1900 1600 1400 1200 1100
= + + + +
(1 + 0.1)1 (1 + 0.1)2 (1 + 0.1)3 (1 + 0.1)4 (1 + 0.1)5

= 1,727 + 1,322 + 1,052 + 820 + 682

= Rs. 5,603

NPV = (Total present value of cash inflows

– Total present value of cash outflows)

NPV = 5,603 – 4,000 = Rs. 1,603

(Note: If NPV is positive, project should be accepted otherwise it should be rejected)
 34

Note:
For constant rate of cash inflow for every year, IRR can be
calculated with the help of a formula.
For uneven rate of cash inflows for every year, IRR can be
calculated by little trial & error adjustments.
35
Internal Rate of Return Method (IRR)
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An engraving machine (project proposal) costs Rs. 64, 800. It has an economic life
of 3 years and is expected to generate cash inflows a detailed in table.
Year 1 2 3
Cash inflow 32000 28000 24000
Find the internal rate of return (IRR) for the project proposal

Solution
Initially, let us set a rate of return as 20% and calculate NPV
1
Rate = 20%, Present Value Factor (PVF) =
(1+k)𝑛
Year (a) Cash inflows (b) PVF at 20% Present value of cash inflow

1 32000 0.833 26,656

2 28000 0.694 19,432
3 24000 0.579 13,896
Total present value of cash inflows 59,984
NPV = 59984 – 64800 = - 4816
 Internal Rate of Return Method (IRR)
37
 NPV is negative, rate assumed is higher. Therefore, try for lower rates (16%
and 14%)
 NPV for 16% = - 1028, NPV for 14% = 996
 NPV = 0 lies between 16% and 14%
 Rate 15% - NPV is zero.
 The internal rate of return of the project is 15%
Payback period
38
 An investment project is accepted or rejected on the basis of
payback period.
 Period of time that a project requires to recover the money
invested in it.
 Unlike NPV and IRR, this method does not take into account the
time value of money.
 Payback period of a project is shorter than or equal to the
management’s maximum desired payback period – the project is
accepted, otherwise rejected.
Payback period – even cash flow
Same cash flow for every period,

*Incremental cash flow if an old asset (e.g., machine or equipment)

is replaced by a new one.
Example:
The ABC company is planning to purchase a machine known as machine X.
Machine X would cost $24,000 and would have a useful life of 10 years with zero
salvage value. The expected annual cash inflow of the machine is $11,000.
Compute payback period of machine X and conclude whether or not the machine
would be purchased if the maximum desired payback period of company is 3 years.
Solution:
Annual cash inflow is even in this project,
Payback period = $24,000/$11,000 = 2.18 years
purchase of machine X is desirable because its payback period is 2.18 years which
is shorter than the maximum payback period of the company.
 Payback period – even cash flow
40
Example
Due to increased demand, the management of XYZ Company is considering to
purchase a new equipment to increase the production and revenues. The useful life of
the equipment is 10 years and the company’s maximum desired payback period is 4
years. The inflow and outflow of cash associated with the new equipment is given
below:
Initial cost of equipment: $36,500
Annual cash inflows:
Sales: $70,000
Annual cash Outflows:
 Cost of ingredients: $42,000
 Salaries expenses: $12,500
 Maintenance expenses: $1,000
Non cash expenses:
Depreciation expense: $6,000
Use payback method and decide whether the company should purchase the new
equipment or not.
 Payback period – even cash flow
41
Solution
 Computation of net annual cash inflow (by deducting the total of
cash outflow from the total of cash inflow associated with the
equipment)
$70,000 – ($42,000 + $12,500 + $1,000) = $14,500
 Payback period of the equipment
= $36,500/$14,500 =2.52 years
 Depreciation is a non-cash expense and has therefore been
ignored while calculating the payback period of the project.
 The equipment should be purchased because the payback period
of the equipment is 2.52 years which is shorter than the maximum
desired payback period of 4 years.
 Payback period – Advantages and Disadvantages
42
Advantages
 Investment project (with short payback period) promises - quick inflow of
cash - useful capital budgeting method for cash poor firms.
 Project with short payback period - improve the liquidity position of the
business quickly.
 Investment with short payback period - makes the funds available soon to
invest in another project.
 Short payback period reduces - risk of loss caused by changing economic
conditions and other unavoidable reasons.
 Payback period is very easy to compute.
Disadvantages
 Time value of money – not take into account.
 useful life of the assets and cash inflow after payback period - not considered.
 Net Present Value Method (NPV)
43

Problem:
Calculate NPV for a Project X initially costing Rs. 2,50,000. It has
10% cost of capital. It generates following cash flows, Rs. 90,000,
Rs. 80,000, Rs. 70,000, Rs. 60,000 and Rs. 50,000 respectively
during the 5 years of its life.
 Net Present Value Method (NPV)
44
Solution:
Initial cost = Rs. 2,50,000 Interest rate (k) = 10% = 0.1 Period (n) = 5 years
Cash inflow (1st year) = Rs. 90,000 Cash inflow (4th year) = Rs. 60,000
Cash inflow (2nd year) = Rs. 80,000 Cash inflow (5th year) = Rs. 50,000
Cash inflow (3rd year) = Rs. 70,000

cash inflows are different in each and every year.

FV
Present value of cash inflows, PV=
(1 + k)n
 Net Present Value Method (NPV)
45
Total present value for 5 years,
90,000 80,000 70,000 60,000 50,000
= + + + +
(1 + 0.1)1 (1 + 0.1)2 (1 + 0.1)3 (1 + 0.1)4 (1 + 0.1)5

= 81818.18 + 66115.702 + 52592.04 + 40980.807 + 31046.066

= Rs. 2,72,552.795

NPV = (Total present value of cash inflows

– Total present value of cash outflows)

NPV = 22,552.795
(Note: If NPV is positive, project should be accepted otherwise it should be rejected)
 Internal Rate of Return Method (IRR)
46

Problem:
A project costs Rs. 32,000 and is expected to generate cash inflows
of Rs. 16,000, Rs.14,000 and Rs. 12,000 at the end of each year for
next 3 years. Calculate IRR.
Internal Rate of Return Method (IRR)
47
Solution
Initially, let us set a rate of return as 10% and calculate NPV
1
Rate = 10%, Present Value Factor (PVF) =
(1+k)𝑛

Year (a) Cash inflows (b) PVF at 10% Present value of cash inflow

1 16,000 0.9091 14,546

2 14,000 0.8264 11,570
3 12,000 0.7513 9,016
Total present value of cash inflows 35,132

NPV = 3,132
 Internal Rate of Return Method (IRR)
48
 NPV is positive, rate assumed is lower. Therefore, try for higher rates (18%)
 NPV for 18% = - 1082
 NPV = 0 lies between 10% and 18%
 Rate 15.78% ≈ 16 % - NPV is zero.
 The internal rate of return of the project is 16%