© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Accounting: What The Numbers Mean Tenth Edition Marshall, McManus, and Viele

Costs for Decision Making Chapter 16 Costs for Decision Making Chapter 16: Costs for Decision Making PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA

Relevant Cost Information LO 1 Relevant costs are differential costs that will differ according to alternate activities being considered. Opportunity costs represent income foregone by choosing one alternative over another. Irrelevant costs are allocated costs, common costs that have been arbitrarily assigned to a product or activity. Sunk costs are costs that have already been incurred and will not change. 16-3

The Special Pricing Decision LO 3 The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. Learning Objective 3: Analyze relevant costs for the following decisions: sell or process further, special pricing, target costing, make or buy, continue or discontinue a segment, and product mix. The decision to accept additional business should be based on incremental costs and incremental revenues. Incremental amounts are those amounts that occur if the company decides to accept the new business. 16-4

The Make or Buy Decision LO 3 Should I continue to make the part, or should I buy it? What will I do with my idle facilities if I buy the part? Should I continue to make the part, or should I buy it? What will I do with my idle facilities if I buy the part? 16-5

The Make or Buy Decision LO 3 The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier. Decision rule: Costs avoided must be greater than outside supplier’s price to consider buying the component. The relevant cost of making a component is the cost that can be avoided by buying the component from an outside supplier. A decision rule is that costs avoided must be greater than outside supplier's price to consider buying the component. 16-6

Short-Term Allocation of Scarce Resources Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. Managers often face the problem of deciding how scarce resources are going to be utilized. Usually, fixed costs are not affected by this particular decision, so management can focus on maximizing total contribution margin. 16-7

Capital Budgeting Large amounts of money are usually involved. LO 4 Outcome is uncertain. Large amounts of money are usually involved. Capital budgeting: Analyzing alternative long- term investments and deciding which assets to acquire or sell. Capital budgeting involves analyzing alternative long-term investments and deciding which assets to acquire or sell. Capital budgeting analysis outcome is uncertain; large amounts of money are usually involved; investment involves a long-term commitment; and decisions may be difficult or impossible to reverse. Decision may be difficult or impossible to reverse. Investment involves a long-term commitment. 16-8

Investment Decision Special Considerations LO 5 Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time. Learning Objective 5: Explain why present value analysis is appropriate and use it in capital budgeting. Business investments extend over long periods of time, so we must recognize the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time. 16-9

Cost of Capital LO 6 The firm’s cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. Learning Objective 6: Define the cost of capital and demonstrate its use in capital budgeting. The firm's cost of capital is usually regarded as the most appropriate choice for the discount rate used to calculate the present value of the investment proposal being analyzed. The cost of capital is the average rate of return the company must pay to its long-term creditors and stockholders for the use of their funds. 16-10

Net Present Value (NPV) LO 7 A comparison of the present value of cash inflows with the present value of cash outflows Learning Objective 7: Illustrate the use of and differences between various capital budgeting techniques: net present value, present value ratio, and internal rate of return. Net present value is a comparison of the present value of cash inflows with the present value of cash outflows. 16-11

Net Present Value (NPV) LO 7 Chose a discount rate – the minimum required rate of return. Calculate the present value of cash inflows. Calculate the present value of cash outflows. To calculate net present value (NPV), choose a discount rate (the minimum required rate of return), calculate the present value of cash inflows, calculate the present value of cash outflows, and subtract the cash outflows from the cash inflows. NPV =  –  16-12

Net Present Value (NPV) LO 7 If the net present value is positive, the project is acceptable, since it promises a return greater than the cost of capital. If net present value is zero, it is acceptable, since it promises a return equal to the cost of capital. If the net present value is negative, it is not acceptable, since it promises a return less than the cost of capital. 16-13

Internal Rate of Return (IRR) LO 7 The actual rate of return that will be earned by a proposed investment. The interest rate that equates the present value of inflows and outflows from an investment project – the discount rate at which NPV = 0. The internal rate of return is the actual rate of return that will be earned by a proposed investment. It is also the interest rate that equates the present value of inflows and outflows from an investment project -- the discount rate at which NPV equals zero. 16-14

Some Analytical Considerations LO 8 Sensitivity analysis and post audits are helpful in dealing with estimates. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows are assumed to occur at the end of the year. Some projects will require additional investments over time. Learning Objective 8: Describe how issues concerning estimates, income taxes, and the timing of cash flows and investments are treated in the capital budgeting process. Some analytical considerations: Sensitivity analysis and post audits are helpful in dealing with estimates. Cash flows far into the future are often not considered because of uncertainty and a small impact on present values. Cash flows are assumed to occur at the end of the year. Some projects will require additional investments over time. 16-15

Some Analytical Considerations LO 8 Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project’s life. Least cost projects, often required by law, will have negative NPV’s. Additional considerations: Often, after-tax cash flow can be estimated by adding back depreciation expense (a noncash item) to net income. Increased working capital is initially treated as an additional investment (cash outflow) and as a cash inflow if recovered at the end of the project's life. Least cost projects, often required by law, will have negative NPVs. 16-16

Managers prefer investing in projects with shorter payback periods. LO 9 The payback period of an investment is the number of years it will take to recover the amount of the investment. Managers prefer investing in projects with shorter payback periods. Learning Objective 9: Calculate the payback period of a capital expenditure project. The payback period of an investment is the number of years it will take to recover the amount of the investment. Managers prefer investing in projects with shorter payback periods. 16-17

Accounting Rate of Return LO 10 The accounting rate of return focuses on accounting income instead of cash flows. Accounting Operating income rate of return Average investment = Learning Objective 10: Calculate the accounting rate of return of a project and explain how it can be used most appropriately. The accounting rate of return focuses on accounting income instead of cash flows. Accounting rate of return equals operating income divided by average investment. 16-18

End of Chapter 16 End of Chapter 16. 16-19