1.

Introduction to Manufacturing Systems

1.1. Definitions
Manufacturing system: series of value-adding manufacturing processes converting the raw materials
into more useful forms and eventually finished products.

Production rate: number of parts produced per unit time [num/h].

Work-in-process (WIP): number of parts that have been released to the shop floor for manufacturing
but have not yet been completed [num].
At each process/operation there are three types of WIP

Waiting to be processed
Currently being processed
Completed, but not yet passed on

Waiting to
be processed

Currently in
process

Completed,
but not yet
passed on

WIP

WIP
Process 1

WIP
Process 2

Process 3

WIP at Process 2

WIP is a high cost item and its volume should be reduced.

Inventory: stock that a company keeps at its premises (or at other locations) that are ready or will be
ready to be made into products for sale. It serves as a buffer between manufacturing and order
fulfilment. There are three types of inventory:

Raw materials
Work-in-Progress products
Finished goods

Inventory is part of the companys assets (usually classified as short-term assets).

Product life cycle: The engineering of a product undergoes a 'life cycle', starting with the realisation
of the need for the product through to servicing, maintenance, withdrawal and replacement. The
major phases within a product life cycle are:

Requirements Analysis
Design
Development
Manufacture
Test
Installation / commissioning
Maintenance / Service
Replacement/Disposal

1.2. Types of production based on flow direction

1.2.1. Push type production system

A node performs order planning for the succeeding node.

Information flow is in the same direction as flow of goods.
Products are pushed through the channel from production to customer.
Production level is set using forecasting and historical ordering patterns (make-to-stock).
Example: Materials Requirement Planning

Process 1

Goods
Information

Disadvantages of push systems:

Forecasts are often inaccurate.

Sales can be unpredictable.
Increased inventory level.

Usage of push systems:

Process 2

Process 3

For products with small demand uncertainty.

For large, complicated items where a pull system may not be able to react to demands.

1.2.2. Pull type production system

Succeeding node makes order request for preceding node.
Preceding node reacts by producing the order.
Information flow is in opposite direction to flow of goods.
Production is demand driven (make-to-order).
Production is initiated by the customer.
Example: kanban systems (see JIT)

Process 1

Process 2

Process 3

Goods
Information

Advantages of pull systems

No excess inventory.
Can react better to demand uncertainties.

Disadvantages of pull systems

Needs timely delivery from suppliers.

Increased lead time for large, complicated products (they are only started to be
manufactured when an order arrives).

1.2.3. Hybrid type production system

Combination of push and pull systems: some operations are push type, others are pull type. It
combines the advantages of both systems.
Example: Dell computers.
1.3. Types of production based on batch size
1.3.1. Job shop production (jobbing)

Producing parts/products of a wide variety in very small quantities.

Equipment is general-purpose.

Workers are with high skill level.

The parts spend most of the time waiting or moving and only 5% on the machine.

Example: production of special purpose large machines, prototypes, servicing.

1.3.2. Batch production

Components and products are produced in batches (10-10,000 at a time).

After the batch is produced the equipment can be set up to produce other
components/products.

Example: production of small machines of wide variety.

1.3.3. Mass production

Products are produced continuously in very large quantity.

Equipment is designed (composed) especially for producing one product.

Low-cost products through large scale manufacturing.

Example: bolts, bearings.

1.3.4. Mass customisation

Mass customisation is a paradigm shift from the traditional mass production (like the old Ford
system).

Product family planning enables manufacturers to share certain common components across
the products in the family so that economy of scale is achieved at the component level.

Manufacturers design the basic product architecture and options while customers are
allowed to select the assembly combination that they prefer most.

Flexible and reconfigurable manufacturing systems are utilised to create high variety in the
final assembly through combinational assembly.

Equipment is flexible, but allows continuous flow.

Provides large variety and individual customisation.

 Nearly everyone gets exactly what they want.

Price is comparable with that of standard goods.

Example: BMW 7 Series.

Mass
Mass

production

Quantity

customisation
Batch
production

Jobbing

Product variety
1.4. Types of manufacturing systems based on machines
1.4.1. Individual machines

Standard, general-purpose machines with manual or CNC control.

They can produce any variety of parts.

Very flexible.

Due to the use of universal equipment and lack of automated materials handling system the
production rate is low.

Machines are usually laid out by type.

Machining workshop
Lathes

Milling machines

Presses

Drilling machines

Shaping machines
S

Sheet metal workshop

Bending machines
B

1.4.2. Manufacturing cells

A group of CNC machines.

Minimised intercellular material handling (with robots or manual).

The cell is oriented to manufacture a part family.

Machining cell
Lathe

Robot

Drilling
machine
D

L
R

M
Milling
machine

Storage

G
Grinding
machine

1.4.3. Flexible manufacturing systems (FMS)

Automated factory with limited operator presence (tool and pallet setup, supervision).

Mid-volume and mid-variety production.

About 75% of discrete parts manufacturing fall into this category.

Wide range of manufacturing activities: machining, welding, sheet metal processing,

assembly, inspection, washing, packaging, etc.

Flexible automatic material handling with AGV, conveyors, robots.

1.4.4. Automatic production lines

Fixed automation manufacturing system with dedicated processing and material- handling
equipment.

Product flow factory layout

Mainly used in mass production of standard parts (bolts, bearings, etc.).

Production rates are high due to the specialised equipment, but the flexibility is very low
(often there is no flexibility at all; the line only produces one item).

Automatic

Number of products

Production
Lines
Flexible
Manufacturing
systems
Manufacturing
cells
General purpose
machines

Variety of products
1.5. Management Philosophy
A management philosophy is a set of principles that are used to try and reduce costs.
Therefore a management philosophy should:
(1). Identify the costs to be reduced.
(2). Prioritise these costs.
(3). Identify how these costs can be reduced.
Main management philosophies studied in MM354:

TQM
JIT
Lean Manufacturing
6 Sigma

2.

Financial Calculations

2.1. Cost Analysis

2.1.1. Gross Profit
The general profit function is:

GP gross profit
TR Total revenue
TC Total cost
Gross profit (= Sales profit).
Revenue (= Sales = Turnover): income that a business has from its normal business activities,
usually from the sale of goods and services to customers.
Break-even is the point of balance making neither a profit nor a loss (Gross profit = 0).

2.1.2. Variable and Fixed Costs

There are two types of costs: fixed costs and variable costs.
Fixed costs (FC): costs that do not depend on the production volume. Fixed costs are calculated
overall for a period of time [/period].

Rent of facilities, property tax

Indirect energy (heating, lighting)
Depreciation of equipment
Maintenance costs (repairs)
Indirect labour (administration)
Advertising
Office expenses (stationery)
IT costs (software licenses)

Variable costs (VC): costs that depend on the production volume. Variable costs are calculated for
each produced unit [/unit].

Direct material costs (materials from which the products are made)
Direct energy (energy to produce a product)
Direct labour cost (salaries of workers who produce the parts)
Packaging, freight

Some costs can be in both categories. For example, equipment depreciation may or may not depend
on the production volume. Some part of the energy consumption (e.g. electricity, heating of offices)
does not depend on the production volume, while energy consumed by machine tools depends on
the number of parts produced. It is necessary to be able to split costs between the two categories.
In its simplest form, the total cost TC to produce n units (parts) is:
( )
This graph looks like:

TC

FC

n
High-Low Method
The simplest way to split the total cost into variable and fixed costs is to use the High-Low method.
It uses the total cost at the highest and lowest volume of production. It is assumed that at both
points of activity the total amount of fixed costs is the same. Therefore, the change in the total costs
is assumed to be the variable cost rate times the change in the number of units produced.
In order to split the total cost into variable and fix costs, the company needs to record the total cost
and production volume for a number of years:
Year

Overall Production Volume

(thousand units)

Total Cost
(million euros)

Then we draw a scatterplot of the total cost vs. the production volume for each year of the
production:

Total cost, TC

TCmax
TCmin

FC

nmin

nmax

Production volume, n
(

This means that the slope of the total cost production volume line equals the variable cost VC.
Once VC is found, the fixed cost FC is calculated. The line passes through the two furthermost
points (hence the name High-Low method) and crosses the ordinate at FC (at n = 0 VC = 0).
Lets use the point at maximum production volume nmax:

From here:

Once VC and FC are known, the cost function is:

( )

Least Squares Regression Method

The high-low method is relatively unreliable because it only takes into account the two extreme
production volumes. For more accurate calculations, the Least Squares Regression Method can be
used. It mathematically fits a straight cost line over a scatter-chart of a number of production
volume and total-cost pairs in such a way that the sum of squares of the vertical distances between
the scattered points and the cost line is minimised. The term least-squares regression implies that
the ideal fitting of the regression line is achieved by minimising the sum of squares of the distances
between the straight line (with parameters FC and VC) and all the N points on the graph:

)]

The following formulas can calculate the parameters of the best fit straight line (best VC and FC):

) (
) (
( )
(
)

Total cost, TC

The best fit cost line looks like this:

FCbest

20

40

60

80

100

Production volume, n

2.1.3. Unit Cost

In order to compare the prices of competitors, unit cost can be used. It is the cost of one unit.
( )

( )

Unit cost, UC

Production volume, n
From this figure it can be seen that as the production volume increases, the unit cost decreases. This
is known as economies of scale.
2.1.4. Economies and Diseconomies of Scale
Economies of scale: cost advantage that companies obtain due to size, output or scale; unit cost
generally decreasing with increasing scale as fixed costs are spread out over more units of output.
Example: M8 bolt; it is produced in mass production, so the equipment cost is spread out over
millions of parts.
Note: although economies of scale are generally connected with fixed costs, they can also happen
due to decreased variable costs. Example: raw materials ordered in large quantities may be cheaper.
Diseconomies of scale: it is the opposite of economies of scale. It forces companies to produce
products with increased unit cost when the production volume increases. This happens when
economies of scale have limits.

Unit cost, UC

Economies of
scale

Diseconomies of
scale
Production volume, n

Some factors that can cause diseconomies of scale:

Exceeding the limits of nearby raw material supply: raw materials have to be transported
from further away.
Saturation of local markets: produced goods have to be transported further away.
Duplication of effort: in a company with many thousands of workers it is very likely that
similar projects are taken on by several teams. Example: General Motors CAD/CAM
systems.
Self-competition: the own products of a large company may compete with each other.
Example: Buick and Oldsmobile.
Slow response time: it is more difficult for larger companies to react quickly to changed
customer demands. They need to re-build highly specialised production lines as opposed to
SMEs with flexible manufacturing.
Inertia (unwillingness to change): old, large, successful companies are less willing to change
on the basis that they have been doing things a certain way and have always been successful.
Example: Polaroid Corporation. Example: Kodak.
Public and government opposition: the behaviour of large multinational corporations may be
seen as anti-competitive and monopolistic thread and their growth is often limited by law.
Example: Microsoft.
Large market share: A small company with only a 1% market share could potentially double
market share, and hence revenues, in a year. A large company with 90% market share will
find it difficult to do so well, as this would require that they control 180% of the original
market. Unless the total market size is increasing rapidly, this isn't possible.

2.1.5. Marginal Cost, Marginal Revenue, Marginal Profit

Marginal cost (MC): it is the change in the total cost that arises when the quantity produced is
incremented by one unit, that is, it is the cost of producing one more unit of a good.
Example:

TC ()
10,000
10,455
10.700
10.842

Production volume n
100
101
102
103

MC
455
245
142

If we have a formula (continuous function) of TC(n) in terms of the production volume n, then
( )

( )

Total cost, TC

TCi+1
MCR

TCi

MCC

ni

ni+1

Production volume, n

Suppose at production volume ni the total cost is TCi. In order to produce ni+1 parts the total cost is
TCi+1. Thus the cost of producing an extra part, which is the marginal cost, is:

Since TC(n) is a continuous function, at each production volume ni it is possible to calculate MCC
by defining the slope of the tangent.

which is the derivative of the TC function at ni. Note that since we cannot produce less than one unit
the calculated marginal cost (MCC) is slightly different from the real one (MCR). However, this is a
good approximation of the marginal cost.
If at a certain production volume n the sale price of the product is less than the marginal cost the
company should not produce the product because it will generate negative profit.
Example: in the ideal situation, when
of scale:
( )

and

and there are no diseconomies

( )

( )

Marginal revenue (MR): it is the additional revenue that will be generated by increasing product
sales by one unit.
( )

( )

TR Total revenue
Marginal profit (MP): it is the additional profit that will be generated by increasing product sales by
one unit. Marginal profit is the difference between the marginal revenue and the marginal cost of
producing one additional unit of output.
(

( )

( )

( ))

( )

( )

GP Gross profit
Under the marginal approach to profit maximisation, to maximise profits, a company should
continue to produce a product up to the point where marginal profit is zero.
Explanation: if marginal revenue is greater than marginal cost at some production volume, marginal
profit is positive and thus a greater quantity should be produced, and if marginal revenue is less than
marginal cost, marginal profit is negative and a lesser quantity should be produced. At the
production volume at which marginal revenue equals marginal cost, marginal profit is zero and this
quantity is the one that maximises profit. Since total profit increases when marginal profit is
positive and total profit decreases when marginal profit is negative, it must reach a maximum where
marginal profit is zeroor where marginal cost equals marginal revenueand where lower or
higher output levels give lower profit levels.
Thus, for maximum profit:
( )
( )

( )

( )

( )

This means that maximum profit occurs when the marginal revenue is equal to the marginal cost.
In the ideal situation, when

and

and there are no diseconomies of scale:

( )
( )
( )
( )

( )

( )

for all production volumes n, so n can be increased to infinity.

However, when at a certain production volume diseconomies of scale start to occur, n has to be
defined so that
( )

( )

When this condition is true, the production volume is optimum (nopt) and profit is maximum.

Marginal Cost (MC)

Negative
MP

Costs

Marginal Revenue (MR)

Positive Marginal Profit
(MP)

Negative, or nonoptimal positive profit

Negative, or nonoptimal positive profit

nopt

Production volume, n

Gross Profit (GP)

decreases

Gross Profit (GP) increases

2.1.6. Break-even Analysis

The simplest total revenue (TR) function for a product with sale price SP:
( )
Here we assume that the number of sold units is the same as the number of units produced (no
unsold items). Putting this into the usual total profit and total cost functions:
( )

( )

( )

The profit-volume chart shows the total profit as a function of the production volume.

Gross profit, GP

Production volume, n
FC

Break-even point

The break-even point is where GP is zero. This is at:

Finding the break-even point is part of cost-volume-profit (CVP) analysis.

Note: the profit-volume function could be more complex than linear (e.g. quadratic).

2.1.7. Revenue as a Function of Demand

So far we have used the simple revenue function:
( )
The amount sold (n) is also called the demand (D).

Here we assume that the demand is independent of the sale price (SP) of the product and other
factors. In reality, this is NEVER the case. The most important factors that influence demand:

Price of the product: There is an inverse relationship between the price of a product and the
amount of that product consumers are willing and able to buy; the lower the price, the higher
the demand (and vice versa). This is called The Law of Demand.
The price of related products: example: accessories for a product. If the price of the related
product goes up, demand for the original product decreases.
The income of the consumer: this can have both direct and inverse relationship with
demand. For products that are called normal goods demand increases when the consumers
income increases. Most products are like these. However, there are products called inferior
goods for which demand decreases with increased consumer income (e.g. low-spec cars,
junk food).
Tastes, fashion, endorsement by celebrities,
Expectations, forecast: example: if it is expected that a new product with better
characteristics comes out soon, demand for the current product may drop.

The number of consumers on the market: example: seasonal demand.

For simplicity lets assume that sale price (SP) is the only factor affecting demand (D), so
(

The form of this function is not known in advance, but there are two assumptions:
as

as

The simplest function with these two properties is a power-law function of the form:
(

Demand, D

The plot of this function looks like this:

Sale price, SP

The revenue function:

Suppose, as before, that we can sell all that we can produce. Then the demand equals production
volume (n):

Then the power-law demand function is:

(

from here:

( )

( )

Then the revenue function is:

( )

( )

( )

Total Revenue, TR

The revenue function at power-law demand is shown below. This curve is different from the linear
revenue function.

TR(n) = SPn

Power-law demand

Production volume, n
From this curve it follows that it is very difficult to maximise revenue. In order to increase profit, it
is usually easier to minimise the total cost. This is the task of operations management.

2.2. Project Evaluation

Before investing into a project that promises future payments or savings, it has to be evaluated
financially. We are going to evaluate projects using three methods: Net Present Value, Internal Rate
of Return, and Payback.
2.2.1. Productivity
Instead of using the unit cost as a measure of effectiveness of an operations management (OM)
strategy, the more traditional approach is to measure how efficiently inputs are being converted into
outputs. The simplest such measure is productivity (efficiency):
(

Output: volume or value of goods produced.

Input: Input depends on context.

Productivity: measures the efficiency of a person, machine, factory, manufacturing system, etc. in
converting inputs into outputs.
Some common productivity measures:

The productivity measure used should be based on the strategy adopted for competing in the
marketplace. E.g. a company that competes based on speed would probably measure productivity as
units produced/time.
Examples:
(1). Value of weekly output = 10,200; value of weekly inputs = 8600.

Note that productivity here is unitless because the units of both output and input are the same.
(2). A bakery produces 346 pastries in 4 hours.
[

Note that productivity here has a unit.

(3). Output = 382 and labour and material costs are 168 and 98 respectively.

Note that you can only combine inputs with identical units.

Productivity has meaning only when it is compared with a similar productivity measure or when
it is measured over time.

2.2.2. Capital Inputs

Capital is one of the most important inputs into a manufacturing system. It is necessary to minimise
costs associated with capital.
Typical capital-related problems:

A company can buy a machine by paying 100,000 now or 50,000 now and 60,000 in a
year. Which option is better, i.e., cheaper?
How to compare future capital payments of various lengths?
What is a future payment worth today, i.e., what is its present value?

Key concept: present value of a future payment (PV). The higher the PV, the better. PV (also known
as present discounted value) is the value of an expected income stream determined as of the date of
valuation. PV is always less than or equal to the future value (FV) because money has interestearning potential (assuming the interest rate is positive). PV is sometimes called the principal.

If the total period of payment is longer than one, interest is paid upon interest, so compound interest
should be calculated.
Present value of a (future) lump sum
If the future payment (value) only consists of one lump sum, its present value is:
( )

PV present value
FV future value
i interest rate for one period (e.g. one year)
n number of interest periods (e.g. number of years the payment is made)
( )

is called Discount Factor.

So the present value is:

( )

( )

To compare the change in purchasing power, the real interest rate (nominal interest rate minus
inflation rate) should be used. Most actuarial calculations use the risk-free interest rate which
corresponds to the minimum guaranteed rate provided by a bank's saving account; then inflation
rate should be subtracted.
The interest rate in capital-related problems is traditionally called the cost of capital.
Discounting: Calculating the PV (based on FV).
Capitalising: Calculating the FV (based on PV).

Present value of a (future) stream of cash flow: Net Present Value

If the future value (FV) is not a lump sum but a stream of cash flow (from N future values), the Net
Present Value (NPV) is the sum of the present values from each individual (jth) future value:

N number of future values

j counter of future values

2.2.3. Project Evaluation using Net Present Value

The equation is the same as calculating the present value of a future stream of cash flow, but the
Initial Investment (INV) is included in the sum as a negative value. Since the investment is being
made at the moment, its present value is not discounted, so its discount factor is 1.
(

FVj an individual future value (future payment, future saving)

i interest rate for one period (e.g. one year)
n number of interest periods (e.g. number of years the payment is made)
( )

discount factor of the jth payment.

If

, invest.

If

, dont invest.

2.2.4. Project Evaluation using Internal Rate of Return

Internal Rate of Return (IRR), also called Economic Rate of Return (ERR): the discount rate at
which the net present value (NPV) of all cash flows (both positive and negative) from a particular
investment equals to zero, or, in other words, the rate at which an investment breaks even. IRR can
also be defined as the discount rate at which the present value of all future cash flow is equal to the
initial investment.

n period of cash flow (usually measured in years)

r rate of return
Cash flow of the nth period
N total number of periods
A rate of return for which this function is zero is the IRR.
The higher a project's IRR, the more desirable it is to undertake the project. In general, if the IRR of
an investment is higher than the cost of capital (the minimum guaranteed interest rate from a bank),
the investment should be made.
Cash flows with one initial investment
Of particular interest are projects where there is an initial investment (outflow, negative) followed
by multiple inflows (positive) occurring at equal periods (usually annually). In this case the NPV vs
Return rate is a convex, strictly decreasing function with a single solution for IRR.
Example:
Year (n)
0
1
2
3
4

Cash flow (Cn)

-60,000
15,000
10,000
25,000
30,000

Type of cash flow

Initial investment
Cash inflow
Cash inflow
Cash inflow
Cash inflow

The function of NPV vs Return rate is:

( )

Net Present Value, NPV []

20,000

10,000

-10,000
IRR = 0.1078
-20,000

0.05

0.1

0.2

0.15

Return Rate, r
At

the net present value,

, so

How to approximate IRR

The longer the investment period, the more complex the polynomial function of NPV becomes, and
the more difficult it is to solve it analytically. There are several ways of solving the NPV function:

Using a solver. Example: MS Excel has an IRR() function that can calculate Internal Rate of
Return.
Build the NPV function by calculating many points on it and intersect it with the
horizontal line.
Approximation of the NPV function near the IRR value with a straight line.
In order to approximate the NPV function with a straight line, we need to find two points on it on
either side of the
horizontal line with a positive and negative NPV value.

Net Present Value, NPV []

IRR
Return Rate, r

We connect the two points with a straight line segment, and this segment intersects the
horizontal line it defines the approximate value of the IRR.
Note: the closer the two points are to the
approximation.

horizontal line, the more accurate the

Cash flows with multiple changes of sign

When cash flows of a project change sign more than once, there will be multiple IRRs. In this case
it is not clear which return rate is best, so it is best to compare projects based on Net Present Values.
Example:
Year (n)
0
1
2

Cash flow (Cn)

-10,000
21,000
-11,000

The function of NPV vs Return rate is:

(

Type of cash flow

Initial investment
Cash inflow
Cash outflow

Net Present Value, NPV []

50

-50

-100

-150

0.15

0.1

0.05

0.2

Return Rate, r
In this case there are two solutions for IRR: 0% and 10%.
A typical example: power plant.
Comparison of Net Present Value and Internal Rate of Return:
NPV: measures magnitude of return of an investment
IRR: measures the rate of return of an investment
IRR should not be used to rate mutually exclusive projects, but only to decide whether a single
project is worth investing in. This is because a project with lower IRR may still have higher NPV
(which is the total increase of wealth).
Example:
Year (n)
0
1
2

Cash flow A (Cn)

-60,000
50,000
30,000

The functions of NPVs vs Return rate are:

(

Cash flow B (Cn)

-90,000
70,000
45,000

A only

A better

B better

Neither

25,000

Net Present Value, NPV []

20,000
15,000
10,000

5,000
0
A

-5,000
-10,000
-15,000
-20,000
0

IRRB = 0.196
r = 0.115

0.05

0.1

IRRA = 0.237
0.15

0.25

0.2

0.3

0.35

0.4

Return Rate, r
Although A has a higher IRR than B, at certain return rates (
NPV, so it should be preferred.

) B produces higher

2.2.5. Project Evaluation using Payback

Payback (or payoff) tells the number of years for an investment to pay for itself.
[

Operating advantage: improvement in cash flows from increased income or

decreased costs or both.
Salvage value: the estimated resale value of an asset at the end of its useful life.
It is assumed that the investment occurs entirely at the beginning of the project and
the annual cash flows are (relatively) uniform.

The shorter the payback period, the better, because the investors initial investment is
at risk for a shorter period of time.
Advantages of the Payback method:
Simple method.
Gives a quick estimate of a project.
Disadvantages of the Payback method:
Time value of money: is not considered (cash generated later is worth less than
cash at the moment).
Multiple investments: the method does not work well if cash investments are
required at several stages.
Profitability: the method focuses upon the time required to pay back the initial
investment; it does not calculate the ultimate profitability of the project. It can
happen that a project with short payback period generates very little (or not at
all) profit.
Asset life span: If an assets useful life expires immediately after it pays back
the initial investment, then there is no opportunity to generate profit. Since the
payback method does not incorporate any assumption regarding asset life span,
there is no way to tell what profit is generated.
Cash flow after the payback period: the method does not consider additional
cash flows after the payback period.
Incorrect averaging: if the annual cash flows are not uniform, averaging them
may suggest incorrect payback periods.
Example: After an initial investment of 100,000 the project will bring in cash
flows:
Cash flow []
10,000
20,000
200,000

Year
1
2
3

The total cash flow for 3 years is 230,000 which averages at 76,666. The
payback period is then calculated as:
[

However, looking at the balance sheet of the company:

Year
0
1
2
3

Cash flow []
-100,000
+10,000
+20,000
+200,000

Balance []
-100,000
-90,000
-70,000
+130,000

After year 2 the project still has a negative balance, so the real payback period
obviously cannot be 1.3 years (it is between 2-3 years).
Summary: the payback method should not be used as the sole criterion for project
evaluation, but can be used for quick comparisons.