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Why It Is Important to Understand the Cost Relationships in Production and Inventory Management
They affect the economic efficiency (profits) of the firm. An understanding of these relationships helps managers make more effective production decisions. As a result, managers are better able to meet their financial objectives
Cost Concepts
Cost: what is given up to acquire a good or service Opportunity cost: the return (as measured by the highest value) that is given up in a foregone use
Implicit cost: costs that do not include cash payments but need to be included in the calculation of the total cost of product
Cost Concepts
Controllable and Uncontrollable Costs
Incremental, Avoidable, and Sunk Costs Total Cost = Total Fixed Cost + Total Variable Costs
Total Fixed Cost (TFC) Total Variable Cost (TVC) Total Cost (TC)
Using the Contribution Concept to Establish the Selling Price of a New Product
If the contribution/unit is 40% of the selling price/unit, the selling price/unit would be: Total Variable Costs Per Unit For example, $120 = [1 0.40] Selling Price/ Bag = Selling Price per Bag = Selling Price per Bag
= [1 Contribution Margin
Percentage]
$120 0.60
$200
Break-Even Analysis
Break-even analysis helps managers find the combination of costs, output, and selling price that permits the firm to break even, with no profits and losses
Selling Price
Output
Costs
= (P VC) Y TFC
TFC CMP
BEP$= Break-Even Point in Dollars TFC = Total Fixed Costs CMP = Contribution Margin Percentage
$750,000
0.40 $1,875,000 = The Break-Even Point in Dollars
TFC
(CMP RPP)
RPP = Required Profit Percentage For example, $750,000 BEP$ = (0.40 0.10)
= $2,500,000 (or 20,000 bags at $125 per bag)
Minimum Change = in Dollar Sales Needed to Break Even for the Change in Fixed Costs
For example, $1.00 0.40 = $2.50 = the minimum increase in dollar sales needed to break even for each new dollar spent on fixed costs
Contribution
TFC = Contribution Y
Inventory Management
Reasons to hold inventory 1. Matching supply with demand 2. Prevent stockouts 3. Lower purchasing costs Reasons not to hold inventory 1. High maintenance cost 2. High protection cost 3. Depreciation and obsolescence 4. Taxes
+ $250 Profits
+$5,000 in Sales
Discussion Questions
1. Explain why an agribusiness manager needs to understand production and inventory management. Give two examples of situations in which cost management made a difference.
2.
Describe the relationship between the firms accounting system and its management information system. Give a definition for each. Explain which one is most important to management.
What is opportunity cost? Is it relevant to business decision making? Explain your answer. Give an example that shows its impact. Describe the relationship between implicit and explicit costs. Describe how they are measured. Explain their role in production and pricing decisions in an agribusiness. Describe, using an example, how failure to properly account for them can get an agribusiness into trouble.
3.
4.
5.
Explain how agribusiness managers use avoidable and sunk costs in their decision making. Why is this decision-making process called incremental analysis? Define economic efficiency and show with an example how incremental analysis helps firms increase their economic efficiency. Draw a simple graph showing the total cost, fixed costs, and variable costs as production increases. Explain why each line looks the way it does.
6.
7.
Define the term contribution as used in this chapter. Give an example of how it could be used to price a new product.
8.
Explain why a firm would take a job that does not give it a chance to make a profit. Explain when it would not accept this opportunity. Use a numerical example to explain why it is important for managers to know the difference between the two. 9. Using the break-even equations, describe and explain the relationship between cost, selling price, and output. Use a numerical example to make your points. 10. Describe and explain the importance of good inventory management of the firms overall objective of maximizing its long-term profits. What is the role of supply chain management and information technology in this process? Use a numerical example to make your points