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Lava Rock Bicycles: Use of JIT (just in time) inventory management; fixed costs

Scenario:
Lava Rock Bicycles, headquartered in San Miguel, California builds bikes for novice to mid-level cyclists, triathletes, and world-class athletes interested in cross-training. Lava Rock is beginning its 6th year of business. It continues to grow its product line and target customer market and it recently became a public company by issuing shares of stock in the NASDAQ exchange.

Each bike is made of a frame, a seat, a set of handlebars, gears & shifting system, brake system, aero bars, 2 wheels, and 2 tires. The selling price varies by model and specific components used to build the bike. Variable costs commonly include:
? component parts, packaging, etc.
? production labor
? sales commissions (percentage or per unit basis)
? other costs allocated on a per unit basis
Lava Rock produces 3 models of bikes (mid-level triathlon (Kona model), entry-level triathlon (Hilo model), and mid-level road cycle (Paris model)). The mid-level models have a greater profit margin but lower sales volume than the popular entry-level triathlon bike. Its bikes are sold directly by Lava Rocks and through independent distributors (typically bike shops and mail-order companies).

Lava Rock Bicycles tries to produce approximately the same number of bicycles it expects to sell in a given period of time. However, it cannot always accurately predict the market. If it manufactures too few cycles, it loses sales. However, because each cycle model improves each year, when Lava Rock Bicycles manufactures too many bikes, it may not be saleable. Lava Rock Bicycles may have to sell its products at a discount or even at a loss to liquidate its inventory. To reduce inventory costs, management is considering implementing a "Just In Time"(JIT) inventory management.

Goals for the next year are to grow the business to other regions, increase profit margin, and expand its product line.
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You have been studying the 'fixed' costs. You learn that a number of 'fixed' costs are actually mixed costs (variable and fixed). Write a 2 paragraph memo to your manager to explain how you can determine the fixed and mixed portion of each cost (such as utility costs, maintenance costs) and why it is relevant to more accurately understand the types of costs.
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Lava Rocks would like to implement a JIT inventory system. You are to make a presentation at this afternoon's meeting on the pros and cons of JIT, as well as, how it can be applied at Lava Bikes. Use the cybrary to research articles on JIT inventory systems at another company for supporting material.

You decide to refresh your memory on JIT by reading the article from Information Week (May 7 ,2001) on Just-in-Time Inventory (http://www.informationweek.com/836/collaborate5_side.htm)

Solution Preview

MIX OF FIXED COST AND VARIABLE COST AT LAVA ROCKS
FIXED COSTS are costs that do not change with activity base fluctuations. Importantly, fixed cost per unit will decline as volume increases.

Although we think of fixed costs as not changing with volume changes, careful analysis reveals that TOTAL FIXED COSTS CAN CHANGE. If volume increases significantly, additional fixed costs may be incurred (e.g., needing to add additional machinery). However, such increases may be beyond the relevant range of activity. Therefore, we tend to think of fixed costs as being fixed over the relevant range of expected activity.

Fixed costs can be further divided into COMMITTED AND DISCRETIONARY FIXED COSTS. Committed fixed costs arise from an organization's commitment to engage in operations and include such items as depreciation, rent, insurance, property taxes, and the like. These costs are not easily adjusted with changes in business activity. Discretionary fixed costs originate from top management's yearly spending decisions; proper planning can result in avoidance of these costs. Examples of discretionary fixed costs include advertising, employee training, and so forth.

Aside from the manner in which they originate, THE UNDERLYING DIFFERENCES between committed and discretionary fixed costs are important. Committed fixed costs relate to the desired long-run positioning of the firm, whereas discretionary fixed costs have a short-term orientation. Discretionary fixed costs are based on management expectations for the upcoming periods. Committed fixed costs are important because they cannot be avoided in lean times; discretionary fixed costs can be altered with proper planning. In summary, a company should be careful to avoid "painting themselves into a corner" by incurring excessive committed fixed costs.

A trend in corporate America is toward INCREASED FIXED COSTS. This results from items like long-term labor contracts, higher levels of automation, and so forth. These factors tend to cause certain manufacturing costs (which have traditionally been variable in nature) to become fixed.

Many costs contain both variable and fixed components. For example, utility bills often consist of a base (or fixed amount) plus an additional amount related to usage. These costs are termed MIXED (SEMIVARIABLE) COSTS. A mixed cost changes in response to fluctuations in volume. However, because of the fixed cost element, the change is not directly proportional to the change in volume.

While understanding variable, fixed, and mixed costs is not difficult, performing COST ANALYSIS does require careful study to determine how an individual cost really behaves.

A SCATTERGRAPH is a graphical representation of the observed relationship between cost and activity level. Such a graph includes the activity level on the horizontal axis and the cost incurred on the vertical axis. By plotting the specific observations and drawing a line which approximately passes through the points, one can visually determine the fixed component (the point where the line intersects the vertical axis) and the variable component (how the cost increases in comparison to increases in volume). The scattergraph is somewhat imprecise because of the manner in which the cost line is determined.

A more precise mathematical derivation of the scattergraph is the METHOD OF LEAST SQUARES. This statistical technique minimizes the sum of the squared distances between individual points and the line which would pass through this grouping of points. Once the appropriate line is determined, its intersection with the vertical axis represents fixed cost, and the slope (or rate of change as volume increases) determines the variable cost. The details of least square are reserved for more advanced courses.

Another simple but imprecise method for determining which portion of a mixed cost is fixed and which portion is variable is the HIGH-LOW METHOD. The highest and lowest levels of activity are identified for a period of time. From these two points a generalization is made regarding the fixed and variable costs. Simply, the difference in cost between the highest and lowest level of activity represents the variable cost associated with the change in activity. This difference is divided by the difference in activity to determine the variable cost for each additional unit of activity. The fixed cost can be calculated by subtracting variable cost (per-unit variable cost multiplied by the activity level) from total cost. The high-low method is subject to criticism because the entire analysis is based on only two observations.

Once variable and fixed costs are determined, COST-VOLUME-PROFIT ANALYSIS can be undertaken. There are numerous uses for cost-volume-profit analysis. One of the most highly publicized and important elements is break-even analysis (the determination of the level of activity where revenues and expenses are equal).

The EQUATION APPROACH relies on a mathematical calculation of the break-even point. Mathematically, sales minus variable and fixed costs equal zero. Restated, sales equal variable costs plus fixed costs. If one knows variable (as a percentage of sales) and fixed costs, one is then able to solve for the break-even sales.

A similar approach is the CONTRIBUTION APPROACH; the key difference being that the contribution approach focuses on unit profitability. The contribution margin is the selling price per unit minus the variable cost per unit. It represents the contribution of each unit toward covering fixed costs and generating income. Mathematically, the break-even point in units can be calculated by dividing fixed costs by the contribution margin per unit.

The break-even relationships can be demonstrated by A GRAPHICAL REPRESENTATION. This graph includes several important lines; specifically, (1) a fixed cost line which is horizontal, (2) a total cost line sloping upward to the right and beginning at the fixed cost point, (3) a total revenue line which begins at the origin of the graph and slopes upward to the right, (4) the break-even point where the total revenue line crosses the total cost line, and (5) a net income or loss area represented by the distance between the total cost and total revenue lines.

TARGET INCOME is the desired income level. The volume necessary to achieve this level can be calculated in much the same manner as the break-even point. The only modification is that net income must be treated like a fixed cost. That is, to achieve the target income, fixed cost and target income must both be recovered. The calculation of the required sales in units to achieve target income is: fixed cost plus target income, divided by unit contribution margin.

Obviously, time results in OPERATING CHANGES. Management must carefully analyze changes in operating conditions to determine the impact on profitability. Cost-volume-profit analysis is very important in this regard.
If a CHANGE IN FIXED COSTS occurs, the determination of the new break-even level requires that the new total fixed cost be divided by the contribution margin.

If there are CHANGES IN FIXED COSTS AND VARIABLE COSTS, the new fixed costs must be divided by the new unit contribution margin to determine the new break-even level. Such analysis is important to evaluate whether an increase in fixed costs is justified, the extent to which sales must increase to cover the additional fixed costs, whether sales prices need to be increased, and so forth.

Sometimes CHANGES IN FIXED COSTS AND SALES VOLUME accompany one another. For example, additional advertising (fixed cost) may attract additional customers. To determine whether the ...

Solution Summary

The solution presents a comprehensive discussion of the differences in costs: variable, fixed and mixed. Several techniques for identification are included. A section on CVP analysis is introduced and integrated into the solution, as is JIT for inventory management.

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