Decision Making

Management 122
Michael Williams

Capacity
This is the amount of product you can produce.
It is a function of your fixed costs. More
capacity requires higher cost.
Example: A milling machine can only prepare
1,000 parts per day, even if run 24 hours.
In the long run, capacity is flexible. You can
always buy more machines.
In the short run, capacity is fixed.
The key decision is how to best use the limited
capacity.

Use of capacity
All businesses have limited resources.
These resources are often shared by
multiple product lines.
When a resource is fully utilized, an increase
in one products volume can only be
achieved by reducing another products
volume.
This means that each product imposes an
opportunity cost on the other products by
tying up the scarce resource.

Use of capacity (examples)

Machinery, such as a mash tun in a
brewery. These can be used for one
product at a time.
Inspection/quality control. There are a
limited number of employees that must
test all products.
Shelf space in a store.

Use of capacity (analysis)

The opportunity cost imposed by each product (Si) is based on
the following equation:

Si

Vi

i.
Resource U
Resource
i
Vi

Mi is the contribution margin per unit (as before) and Ui is the

utilization rate (how much of the scarce resource is used by each
unit of the product).
The overall opportunity cost for a resource (S) is the maximum
value of the Sis across all products that use the resource. S is
called the resources shadow cost.
For each product, the shadow cost should be treated as a variable
cost. S x Ui is added to Ci (variable cost per unit).

Cross-Elasticities
Substitutability

Complementarity

Demand

Cannibalism

Loss leader
Foot in the door

Supply

Joint capacity

Synergy
Joint cost

Price

Add

Drop

Demand
Substitutability

Demand
Complementarit
y

Supply
Substitutability

Supply
Complementarit
y
(synergy)

Supply
Complementarit
y
(joint cost)

Not a viable decision

Intertemporal Decision
Making
Convert all differential cash flows to present value:

Add present values to determine differential profit (NPV).

Discount rate is d = i + b + r + s.

i is the risk-free interest rate.

b is the default premium for the firm.
r is the projects risk premium.
s is a scarcity premium due to limited funds.

Coping with Cash Constraints on

Investment
Ideally, you want to choose s appropriately. Otherwise:
Short run constraint
Net Present Value Index (NPVI) = NPV / Investment.
Set d = i + b + r.
Long run constraint
Internal Rate of Return (IRR) = rate at which NPV = 0.

Coping with Cash Constraints on

Investment
Two projects costing $100 each (d = 20%):
A generates $30 per year for 15 years.
B generates $150 after 1 year only.

NPVI

IRR

0.403

29.4%

0.25

50%