Cost Analysis for Decision Making CHAPTER 14 Cost Analysis for Decision Making

Overview Cost concepts used in the decision making process Relevant costs The special pricing decision The make or buy decision Product mix decision with scarce resources Capital budgeting Cost of capital Capital budgeting techniques Analytical considerations Qualitative factors in the investment decision PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Decision making Short run Long run Decision making involves the entire planning and control cycle. Short run Allocation of resources for discretionary items Long run Strategies for products and prices Capital budgeting PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Cost Classifications for Other Analytical Purposes Cost concepts used in the decision making process: PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Short-run Investment Decisions Decisions affecting the next few days, weeks or months, for example: • utilisation of resources not otherwise active • the opportunity to reduce costs by outsourcing the production of components • ability to improve profits by selling a product at a certain point in the production process. Relevant costs - future costs that represent differences between the decision alternatives. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Special Pricing Decision Will you sell us your product at a lower price? The special pricing decision requires an understanding of where the firm is operating relative to its capacity. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Special Pricing Decision Micro Tech sells laptop computers Current selling price: $2,400 each Sales commission: 5% Budgeted production: 4,400 units Production capacity: 5,000 units PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Special Pricing Decision World University offers to buy 500 laptops from Micro Tech at $1,800 each. At first glance, Micro Tech should reject the offer as the cost of each laptop is $2,120 ($2,000 plus $120 commission). But what are the relevant costs for Micro Tech? PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Special Pricing Decision Relevant costs Irrelevant costs Micro Tech has 600 units of idle capacity, so it is able to consider adding the extra 500 units without incurring additional fixed costs. Sales commission would not be paid on the sale. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Special Pricing Decision per unit 500 units @ The special order will add $150,000 to operating profit and should be accepted. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision Of course, we should buy. Should we make or buy? Our production costs are $350, but we can buy for $300, plus delivery of $5. In a make or buy decision, the relevant cost is the cost that can be avoided by outsourcing. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision MicroTech currently makes the motherboards used in its laptop computers. It is also able to buy them from an outside supplier, Integrated Technology. There is no other use for the production resources being used. 20% of the fixed overhead represents the cost of a production manager who would not be retained if motherboards were not produced. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision Manufacturing costs need to be analysed to identify avoidable and unavoidable costs. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision The avoidable costs should then be compared with the cost of buying the product. In this case there is an advantage to make the product. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision If MicroTech buys the motherboards from the outside supplier, the idle facilities could be used to expand production of flat screen monitors that have a contribution margin of $50 each. Does this information change MicroTech’s decision? PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Make or Buy Decision The opportunity cost of facilities changes the decision. The real question to answer is, “What is the best use of MicroTech’s facilities?” PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Short-term Allocation of Scarce Resources Managers often face the problem of deciding how scarce resources are going to be utilised. Usually, fixed costs are not affected by this particular decision, so management can focus on maximising total contribution margin. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Short-term Allocation of Scarce Resources Integrated Technologies produces two products and selected data is shown below: If 120 hours of processing time are available, which product should be produced? PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Short-term Allocation of Scarce Resources Let’s calculate the contribution margin per hour of processing time. In this case, profitability will be maximised with the production and sale of product 2. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Long-run Investment Decisions Capital Budgeting Process of analysing proposed capital expenditures, such as the purchase of new equipment and introduction of new products. Will the investment generate a large enough return to contribute to the overall ROA objectives of the firm? PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Investment Decision Special Considerations Business investments extend over long periods of time, so we must recognise the time value of money. Investments that promise returns earlier in time are preferable to those that promise returns later in time. Qualitative factors will also need to be considered (e.g. competitive risks of expansion). PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Cost of Capital The firm’s cost of capital is the discount rate used to determine the present value of the investment proposal being analysed. The cost of capital is the ROA that must be earned to permit the firm to meet its interest obligations and provide expected return to its owners. That is, an indication of the appropriate minimum rate of return that creditors and owners are expecting. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Capital Budgeting Techniques Methods that use present value analysis: Net present value (NPV) Internal rate of return (IRR) Methods that do not use present value analysis: Payback Accounting rate of return PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Net Present Value (NPV) A comparison of the present value of cash inflows with the present value of cash outflows, usually the initial investment. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Net Present Value (NPV) General decision rule . . . PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Ranking Investment Projects Alternative projects with different investment amounts: At first glance, Project B would be selected as it has a higher NPV. However, need to consider present value ratio or profitability index. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Ranking Investment Projects Present value of cash inflows Investment required Present value ratio = The higher the present value ratio, the more desirable the project. Thus, Project A would be selected. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Internal Rate of Return (IRR) 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. If the IRR is equal to or greater than the company’s required rate of return, the project is acceptable. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Some Analytical Considerations The validity of PV calculations will depend on estimates. Post audits are helpful in evaluating 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. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Some Analytical Considerations Cash flows of projects should consider income tax. Often, after-tax cash flow can be estimated by adding depreciation to 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. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Managers prefer investing in projects with shorter payback periods. 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. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Payback Period Advantage: • Simplicity. Disadvantages: • Ignores the time value of money. • Ignores cash flows after the payback period. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Accounting Rate of Return The accounting rate of return focuses on accounting income instead of cash flows. Accounting Operating profit rate of return Average investment = Flaws: Ignores the time value of money. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

The Investment Decision Management evaluation of projects will also include qualitative factors, for example: • commitment to a segment of a business that requires capital investment to achieve competitiveness • regulations requiring investments to meet certain requirements • technological developments may require new facilities Most decisions are influenced by management values and experiences. PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd

Integration of the Capital Budget with Operating Budgets Contribution margin increases and cost savings from projects Cash disbursements for capital projects Capital expenditure Income statement budget Cash budget Budgeted balance sheet PowerPoint Slides t/a Accounting: What the Numbers Mean Marshall, McCartney, van Rhyn, McManus, Viele Slides prepared by Sandra Chapple Copyright  2005 McGraw-Hill Australia Pty Ltd