chapter 14 cost analysis for decision making. powerpoint slides t/a accounting: what the numbers...

CHAPTER 14

Cost Analysis for Decision Making

PowerPoint Slides t/a Accounting: What the Numbers MeanMarshall, McCartney, van Rhyn, McManus, VieleSlides prepared by Sandra Chapple Copyright 2005 McGraw-Hill Australia Pty Ltd

14-2

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


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Decision making

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


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Cost Classifications for Other Analytical Purposes

Relevant Irrelevant

Differential Cost -- will differ Allocated Cost -- a common cost thataccording to alternative activities has been arbitrarily assigned to abeing considered. product or activity.

Opportunity Cost -- income foregone Sunk Cost -- has already been incurredby choosing one alternative over and will not change.another.

Relevant Irrelevant

Differential Cost -- will differ Allocated Cost -- a common cost thataccording to alternative activities has been arbitrarily assigned to abeing considered. product or activity.

Opportunity Cost -- income foregone Sunk Cost -- has already been incurredby choosing one alternative over and will not change.another.

Cost concepts used in the decision making process:


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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.


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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.


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Micro Tech sells laptop computers

Current selling price: $2,400 each

Sales commission: 5%

Budgeted production: 4,400 units

Production capacity: 5,000 units

Current manufacturing costs Direct materials 800$ Direct labour 450 Variable overhead 250 Fixed overhead 500 Total unit cost 2,000$



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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?


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Current manufacturing costs Direct materials 800$ Direct labour 450 Variable overhead 250 Fixed overhead 500 Total unit cost 2,000$ Sales commission 5%


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.


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Special price $1,800

Relevant costs Direct materials 800$ Direct labour 450 Variable overhead 250

1,500$

Contribution margin 300$


500 units @

The special order will add $150,000 to operating profit and should be accepted.

per unit


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The Make or Buy Decision

Should we make or buy? Our production costs are $350, but we can buy for $300, plus delivery of $5.

Of course, we should buy.

In a make or buy decision, the relevant cost is the cost that can be avoided by outsourcing.


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• 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.


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Manufacturing costs need to be analysed to identify avoidable and unavoidable costs.

Manufacturing costs need to be analysed to identify avoidable and unavoidable costs.

Unit Costs

Avoidable costs

Unavoidable costs

Direct Material 120$ 120

Direct Labour 80 80

Variable Overhead 50 50

Fixed Overhead 100 20 80

Total 350$ 270 80



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The avoidable costs should then be compared with the cost of buying the product.

The avoidable costs should then be compared with the cost of buying the product.

Make BuyPurchase costsMotherboard cost 300Freight inwards cost 5

Avoidable cost to make 270

Total unit cost 270 305

Advantage to make 35

In this case there is an advantage to make the product.


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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?



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The real question to answer is, “What is the best use of MicroTech’s

facilities?”

Disadvantage of buying ( $305 - $270 ) 35$

Opportunity cost of facilities: Monitor contribution margin 50

Advantage of buying part 15$

The opportunity cost of facilities changes the decision.



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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.

Short-term Allocationof Scarce Resources


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Integrated Technologies produces two productsand selected data is shown below:

Products1 2

Selling price per unit $ 300 $ 200 Less: variable expenses per unit 150 100 Contribution margin per unit 150$ 100$

Processing time required (hours) 2 1


If 120 hours of processing time are available,which product should be produced?


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Let’s calculate the contribution marginper hour of processing time.

Products

1 2

Contribution margin per unit $ 150 $ 100

Time required to produce one unit ÷ 2 hours ÷ 1 hour

Contribution margin per hour 75$ 100$


In this case, profitability will be maximised with the production and sale of product 2.


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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?


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• 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).

Investment Decision Special Considerations


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• The firm’s cost of capital is the discount rate used to determinethe 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.

Cost of Capital


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Capital Budgeting Techniques

Methods that use present value analysis:• Net present value (NPV)• Internal rate of return (IRR)

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

Methods that do not use present value analysis:• Payback• Accounting rate of return


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A comparison of the present value of cash inflows with the present value of cash

outflows, usually the initial investment.

A comparison of the present value of cash inflows with the present value of cash

outflows, usually the initial investment.

Net Present Value (NPV)


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General decision rule . . .

If the Net Present Value is . . . Then the Project is . . .

Positive . . . Acceptable, since it promises a return greater than the cost of

capital.

Zero . . . Acceptable, since it promises a

return equal to the cost of capital.

Negative . . . Not acceptable, since it

promises a return less than the cost of capital.

Net Present Value (NPV)


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Ranking Investment ProjectsAlternative 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.

Project

Present Value of

Cash Flows InvestmentNet Present

Value

$ $ $

A 22800 20000 2800

B 34000 30000 4000


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Ranking Investment ProjectsPresent value of cash inflows

Investment required=

The higher the present value ratio, the more desirable the project. Thus, Project A would be selected.

The higher the present value ratio, the more desirable the project. Thus, Project A would be selected.

Project

Present Value of

Cash Flows InvestmentNet Present

Value

Present Value Ratio

$ $ $ $

A 22800 20000 2800 1.14

B 34000 30000 4000 1.13

Present value ratio


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• 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.

Internal Rate of Return (IRR)

If the IRR is equal to or greater than the company’s required rate of return, the project is acceptable.


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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.

• 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.


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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.

• 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.


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Payback Period

The payback period of an investmentis the number of years it will take to

recover the amount of the investment.

The payback period of an investmentis the number of years it will take to

recover the amount of the investment.

Managers prefer investing in projects

with shorter payback periods.


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Payback Period

Advantage:

• Simplicity.

Advantage:

• Simplicity.

Disadvantages:

• Ignores the time value of money.• Ignores cash flows after the

payback period.

Disadvantages:

• Ignores the time value of money.• Ignores cash flows after the

payback period.


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The accounting rate of return focuses onaccounting income instead of cash flows.

Accounting Rate of Return

Accounting Operating profitrate of return Average investment

Accounting Operating profitrate of return Average investment=

Flaws: Ignores the time value of money.


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The Investment DecisionManagement 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.


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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

chapter 14 cost analysis for decision making. powerpoint slides t/a accounting: what the numbers...

Documents

viele slides

powerpoint slides

decision making slide

investment decision

special pricing decision

van rhyn

decision product mix

decision alternatives