After reading this chapter, you should be able to answer the following questions: What are the meaning and application of the following “cost” terms: differential, allocated, sunk, and opportunity? How are costs determined to be relevant for short-run decisions? What is the special pricing decision when a firm is at full vs. idle capacity?...
CHAPTER 16 COST ANALYSIS FOR DECISION MAKING McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What are the meaning and application of the following “cost” terms: differential, allocated, sunk, and opportunity? How are costs determined to be relevant for short-run decisions? What is the special pricing decision when a firm is at full vs idle capacity? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What are the attributes of capital budgeting that make it a significantly different activity from operational budgeting? Why is present value analysis appropriate in capital budgeting? What is the concept of the cost of capital, and why is it used in capital budgeting? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives What are the uses of and differences between various capital budgeting techniques: net present value, present value ratio, and internal rate of return? How are issues concerning estimates, income taxes, and the timing of cash flows and investments treated in the capital budgeting process? How is the payback period of a capital expenditure project calculated? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objectives 10 How is the accounting rate of return of a project calculated, and how can it be used most appropriately? 11 Why are not all management decisions make strictly on the basis of quantitative analysis techniques? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objective • What are the meaning and application of the following “cost” terms: differential, allocated, sunk, and opportunity? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Revisit Plans Strategic, Operational, and Financial Planning Planning and Control Cycle Performance Analysis: Plans vs Actual Results (Controlling) McGrawHill/Irwin Implement Plans Data Collection and Performance Feedback Executing Operational Activities (Managing) âTheMcGrawưHillCompanies,Inc.,2002 Cost Classifications for Other Analytical Purposes ã A differential cost is one that will differ according to the alternative activity selected • Allocated costs are those that have been assigned to a product or activity using some sort of arithmetic process – Do not arbitrarily allocate costs because costs may not behave the way assumed in the allocation method McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã How are costs determined to be relevant for short-run decisions? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Relevant Costs • Short-run decisions may affect only a few days or weeks • Can involve: – The utilization of resources not otherwise active – The opportunity to reduce costs by adjusting the mix of resources – The ability to improve profits by further processing a product McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Variables Used in Capital Budgeting Methods • All methods use the amount to be invested • The amount of cash generated by the investment is used in the NPV, IRR, and payback methods • The accounting rate of return uses accrual accounting net income resulting from the investment McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objective • What are the uses of and differences between various capital budgeting techniques: net present value, present value ratio, and internal rate of return? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Net Present Value • Net present value method involves calculating the present value of the expected cash flows from the project using the cost of capital as the discount rate • Then the net present value result is compared to the amount of investment required • NPV often referred to as the hurdle rate McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Internal Rate of Return ã The IRR method solves for the actual rate of return that will be earned by the investment • The IRR is the discount rate at which the present value of the cash flows from the project will equal the investment in the project McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã How are issues concerning estimates, income taxes, and the timing of cash flows and investments treated in the capital budgeting process? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Some Analytical Considerations • Estimates – the validity of the present value calculations will depend on the accuracy of the cash flow projections • Cash flows far in the future – due to uncertainty, usually not consider cash flows more than ten years in the future • Timing of cash flows within the year – present value factors assume cash flows are received at the end of the year, but usually received throughout the year McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Some More Analytical Considerations • Investment made over a period of time – payments on the project may be made over a period of time, so interest on cash disbursements needs to be considered • Income tax effects of cash flows from the project – must include income tax expenditures in cash flow projections McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Still More Analytical Considerations ã Working capital investment – working capital needs will increase due to increases in accounts receivables and inventories and is treated like an additional investment • Least cost projects – some expenditures are required by law, so need to choose the project with the lowest net cost McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objective • How is the payback period of a capital expenditure project calculated? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Payback Method ã The payback method is used to evaluate proposed capital expenditures by determining the length of time necessary to recover the amount of the investment • Add up the cash inflows until the total equals the investment • Then determine how many years it has taken to recover the investment • Very simple method, but does not consider the time value of money McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objective 10 • How is the accounting rate of return of a project calculated, and how can it be used most appropriately? McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Accounting Rate of Return • Accounting rate of return focuses on the impact of the investment project on the financial statements • Done on a year-by-year basis • Drawback is time value of money is not considered • Often computed so stockholders will know the effect of the project on the financial statements McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Learning Objective 11 • Why are not all management decisions make strictly on the basis of quantitative analysis techniques? McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 The Investment Decision ã Both quantitative and qualitative factors are considered • Qualitative factors may include: – Commitment to a segment – Regulations that require an investment – Technological developments – Limited resources – Management’s judgments about the accuracy of the estimates used McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 Integration of Capital Budget with Operating Budgets • Several aspects of the capital budget interact with the development of the operating budget: – Contribution margin increases and cost savings need to be included in the income statement budgets – Cash disbursements need to be included in the cash budget – Capital expenditures need to be included in the balance sheet budget McGrawHill/Irwin ©The McGrawHill Companies, Inc., 2002 ... Objectives What are the meaning and application of the following ? ?cost? ?? terms: differential, allocated, sunk, and opportunity? How are costs determined to be relevant for short-run decisions? What is the. .. Relevant costs are: – Differential costs – Opportunity costs • Irrelevant costs are: – Allocated costs – Sunk costs McGrawưHill/Irwin âTheMcGrawưHillCompanies,Inc.,2002 Learning Objective ã What is the. .. of Return • The IRR method solves for the actual rate of return that will be earned by the investment • The IRR is the discount rate at which the present value of the cash flows from the project