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SUPPLEMENT

Decision Making
Learning Goals
After reading this supplement, you will be able to . . .
1. apply break-even analysis, using both the graphic and algebraic approaches, to evaluate new products and services and different process methods. 2. evaluate decision alternatives with a preference matrix for multiple criteria. 3. construct a payoff table and then select the best alternative by using a decision rule such as maximin, maximax, Laplace, minimax regret, or expected value.

4. calculate the value of perfect information.
5. draw and analyze a decision tree.

managers make many choices as they deal with various decision O perationsChapter decision makingwith Operations”). Although the specifics areas (see
1, “Competing
of each situation vary,
generally involves the same basic steps:
(1) recognize and clearly define the problem, (2) collect the information needed to analyze possible alternatives, and (3) choose and implement the most feasible alternative.
Sometimes hard thinking in a quiet room is sufficient. At other times reliance on more formal procedures is needed. Here, we present four such formal procedures: break-even analysis, the preference matrix, decision theory, and the decision tree. ❐ Break-even analysis helps the manager identify how much change in volume or demand is necessary before a second alternative becomes better than the first one.

❐ The preference matrix helps a manager deal with multiple criteria that cannot be evaluated with a single measure of merit, such as total profit or cost. ❐ Decision theory helps the manager choose the best alternative when outcomes are uncertain. ❐ A decision tree helps the manager when decisions are made sequentially— when today’s best decision depends on tomorrow’s decisions and events.

A.2

supplement a .

Decision Making

BREAK-EVEN ANALYSIS

break-even point The
volume at which total
revenues equal total
costs.
break-even analysis The
use of the break-even
point; can be used to
compare production
methods by finding the
volume at which two
different processes have
equal costs.

variable cost The portion
of the total cost that varies
directly with volume of
output.
fixed cost The portion of
the total cost that remains
constant regardless of
changes in levels of
output.

To evaluate an idea for a new product or service or to assess the performance of an existing one, determining the volume of sales at which the product or service breaks even is useful. The break-even point is the volume at which total revenues equal total costs. Use of this technique is known as break-even analysis. Break-even analysis can also be used to compare production methods by finding the volume at which two different processes have equal total costs.

EVALUATING PRODUCTS OR SERVICES
We begin with the first purpose: to evaluate the profit potential of a new or existing product or service. This technique helps the manager answer questions such as the following:
❐ Is the predicted sales volume of the product or service sufficient to break even (neither earning a profit nor sustaining a loss)?
❐ How low must the variable cost per unit be to break even, based on current prices and sales forecasts?
❐ How low must the fixed cost be to break even?
❐ How do price levels affect the break-even volume?
Break-even analysis is based on the assumption that all costs related to the production of a specific product or service can be divided into two categories: variable costs and fixed costs.
The variable cost, c, is the portion of the total cost that varies directly with volume of output: costs per unit for materials, labor, and usually some fraction of overhead. If we let Q equal the number of units produced and sold per year, total variable cost cQ. The fixed cost, F, is the portion of the total cost that remains constant regardless of changes in levels of output: the annual cost of renting or buying new equipment and facilities (including...
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