Differential Cost Analysis for PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology

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1 CHAPTER 7 Differential Cost Analysis for PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology Operating Decisions 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managerial Accounting 11E Maher/Stickney/Weil 1

2 CHAPTER GOAL This chapter explains how managers can use differential analysis to examine the effects on profits. Differential analysis helps managers answer relevant questions such as: What activities differ between the alternatives? How does that difference affect costs and profits? 2

3 LO 1 DIFFERENTIAL ANALYSIS: Definition Is the analysis of differences among particular alternative actions. 3

4 U E M EXAMPLE: Ullman Educational Media LO 1 Ullman Educational Media (UEM) is a company that produces tutorial videos for primary and preschool use. UEM developed the following estimates: Units made and sold Maximum production and sales capacity 800 per month 1,200 units per month Selling price $ 30 Continued 4

5 U E M ACTIVITY & COSTS LO 1 Ullman Educational Media provides the following information about activities and costs: VC per unit FC per month Manufacturing $ 17 $ 3,060 Marketing and Administrative 5 1,740 Total costs $ 22 $4,800 Continued 5

6 U E M LO 1 Profit decreases by $1,000. EXHIBIT 7.2 6

7 LO 1 CASH FLOW Differential analysis focuses on cash flow because Cash is the medium of exchange in business Cash is a common objective measure of the costs and benefits of alternatives 7

8 MANAGERS WANT TO KNOW! LO 2 Customer Demands Competitors Actions Will raising prices lose customers to a competitor or cause them to substitute cheaper goods? Pricing Decisions Managers must consider competitors actions both nationally and internationally. Cost of Products Internal focus on continuous improvements is key to cutting costs. 8

9 U E M MANAGERS WANT TO KNOW! SPECIAL ORDERS LO 2 Ullman has an opportunity for a one-time only special order to sell 100 units at $25 each. The regular price is $28. Should they accept the special order? Continued 9

10 U E M LO 2 EXHIBIT 7.3 Yes! Since normal operations should be used to cover FC, not special orders, this special order adds $300 to the bottom line. 10

11 U E M LO 2 Full cost, used for long run decisions, is the total cost of producing and selling a unit. EXHIBIT

12 LO 2 PRICING DECISIONS Use of full cost in pricing decisions is justified because In the long run, prices must cover all costs to survive Long term contractual agreements must cover all costs Prices in regulated industries are often based on full cost Although full cost + profit may be used initially, short term adjustments may reflect market conditions. 12

13 LO 2 PRODUCT LIFE CYCLE: Definition Covers the time from initial research and development to time support to customer is withdrawn. 13

14 LO 2 Predatory pricing: Definition Is when a business deliberately prices below its costs to drive out competitors. Dumping: Definition Occurs when a foreign company sells a product in the U.S. at a price below the market value in the country of its creation. 14

15 LO 3 What is target cost? Target cost is the target price less the target profit. 15

16 LO 3 Value engineering is a systematic evaluation of all aspects of the business. EXHIBIT

17 LO 4 Customer cost USING ACTIVITY-BASED COSTING: Analyze Profitability Activities Cost to acquire customer Cost to provide goods and services Cost to maintain customers Cost to retain customers Promote product; campaign to win lost customers; run advertising campaign Process order; deliver product; process returns Bill customers; process payments; issue refunds Follow-up calls 17

18 LO 6 THEORY OF CONSTRAINTS The theory of constraints (TOC) acknowledges that businesses often have constraints or limits on what can be done. TOC encourages managers to identify where constraints arise and to develop methods to manage them. Three factors predominate: 1. Throughput contribution 2. Investments 3. Other operating costs 18

19 LO 6 BOTTLENECK: Definition Is an operation in which the work to be performed equals or exceeds the available capacity. 19

20 MANAGING THE LO 6 BOTTLENECK Recognize that the bottleneck resource determines throughput contribution of product Search for, find bottleneck Resource with large quantities of inventory waiting to be worked on Subordinate all non-bottleneck resources to the bottleneck resource Increase bottleneck efficiency, capacity Repeat 4 steps for any new bottleneck 20

21 LO 7 MAKE-OR-BUY The make-or-buy decision is one where the firm must decide whether to meet its needs internally or to acquire goods or services externally. Both cost and nonquantitative factors are considered. 21

22 MANAGERS WANT TO KNOW! LO 8 JOINT PRODUCTS In some circumstances, multiple products can be produced from a single production process. The question for management is: What is the effect of additional processing/production on profits? 22

23 LO 8 SPLITOFF POINT: Definition Is the point up to which all costs are joint and after which additional processing costs are identified with other products. 23

24 MANAGERS WANT TO KNOW! LO 9 ADD OR DROP Managers must decide when to add or drop products; when to open or abandon sales territories. The differential principle involved can be stated: If differential revenue from selling exceeds differential costs of product, the product is profitable and the firm should continue production. Click the button to skip Example 24

25 MANAGERS WANT TO KNOW! LO 10 INVENTORY MANAGEMENT Inventory has a direct affect on profit and must be carefully managed. Key questions for managers are: 1. How many units should be on hand for use or sale? 2. How often should the firm order an item and what is the optimal order size? 25

26 LO 10 JUST-IN-TIME (JIT) JIT is a philosophy, not a tool, that dovetails with total quality management (TQM) in that TQM requires reliable processing systems and disallows defective units. Flexible manufacturing that reduces both setup and inventory levels also enhances JIT. 26

27 LO 11 LINEAR PROGRAMMING Linear programming: (a) finds the product mix that will maximize profits given the constraints, (b) provides opportunity costs of constraints, and (c) allows for sensitivity analysis. 27

28 ECONOMIC ORDER LO 12 QUANTITY (EOQ) The economic order quantity (EOQ) model is a mathematical model that gives the optimal amount of goods to order when demand reduces inventory to a level called the reorder point. 28

29 CHAPTER 8 Capital Expenditure PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology Decisions 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managerial Accounting 11E Maher/Stickney/Weil 29

30 CHAPTER GOAL This chapter explains how the differential principle applies to long-term decisions where the focus is on changes in operating capacity over several future time periods. Present value analysis, also called discounted cash flow (DCF), provides analysts with the appropriate technique. 30

31 LEARNING OBJECTIVE 1 Explain the reasoning behind the separation of the investing and financing aspects of making long-term decisions. 31

32 LO 1 CAPITAL BUDGETING: Definition Involves deciding which longterm investments to take involving capital (long-term) assets. 32

33 LEARNING OBJECTIVE 2 Explain the role of capital expenditure decisions in the strategic planning process. 33

34 LO 2 STRATEGIC PLANNING In strategic planning, an organization decides on major programs and the resources to devote to them. Strategic planning provides the context for capital expenditure decisions. 34

35 LO 2 BENEFITS: Long-Term Investments Reducing potential to make mistakes improves product Making goods, delivering services that competitors cannot Reducing cycle time to make product Permanently reducing costs to provide such an advantage that competitors cannot afford to enter market Click the button to skip Exercise 6 35

36 LO 2 EXERCISE 6 If an investment does not fit with an organization s strategic plan, it is probably not a good idea, even if the net present value (NPV) is positive. Under what conditions would this statement be true? False? The statement is generally true for projects that fit the strategic plan. In certain special cases, a firm might depart from its strategic plan. Press Enter or click left mouse button for answer. 36

37 LO 2 MANAGERIAL APPLICATION Environmental accounting presents a major challenge for companies. What are some of the benefits? Benefits include providing cash flow benefits by reducing fines, legal costs and cleanups. 37

38 LEARNING OBJECTIVE 3 Describe the steps of the net present value method for making long-term decisions using discounted cash flows, and explain the effect of income taxes on cash flows. 38

39 LO 3 DISCOUNTED CASH FLOW (DCF): Definition Aids in evaluating investments involving cash flows over time where there is a significant difference between cash payment and receipt. 39

40 LO 3 What is the discount rate? The discount rate is the interest rate that analysts use in computing the present value of future cash flows. 40

41 LO 3 ELEMENTS OF DISCOUNT RATE The choice of a discount rate should consider the following A pure rate of interest that reflects the productive capability of capital assets A risk factor reflecting the riskiness of the project An increase reflecting inflation expected to occur over the life of the project. 41

42 LO 3 RISK-FREE RATE: Definition Is the pure interest rate plus expected inflation. 42

43 LO 3 What is the real interest rate? The real interest rate is the pure interest rate plus a premium for risk but no increase for inflation. 43

44 LO 3 NOMINAL INTEREST RATE: Definition Includes all three factors: pure interest, risk premium, and expected inflation. 44

45 LO 3 DECISION RULE Estimate the amounts of future cash inflows and future cash outflows in each period for each alternative Discount the future cash flows to the present using the project s discount rate. If the present value of future cash inflows exceeds the present value of future cash outflows for a proposal, The firm should accept the project with the largest NPV. Reject any negative PV. 45

46 LO 3 CASH FLOW VARIETIES Initial cash flows: Occur at beginning of project Periodic cash flows Occur during life of project Terminal cash flows Occur at end of project 46

47 J E P EXAMPLE: JEP Realty Syndicators JEP Reality Syndicators, Inc. (JEP) is considering acquisition of computer hardware with a 5-year life. Disposal of current hardware occurs in Year 0 with no gain or loss and no tax consequences. Cost $ 100,000 Market value of present equipment $ 10,000 Scrap value $ 5,000 LO 3 Continued 47

48 J E P LO 3 EXHIBIT 8.1 Projected cash flows over life of project. 48

49 J E P Year 0 & Year 1 LO 3 EXHIBIT 8.2 Depreciation is subtracted before tax 49

50 J E P Year 0 & Year 1 LO 3 Pretax net cash inflow (outflow) tax payable = Net cash inflow (outflow) X PV factor (12%) = NPV EXHIBIT

51 J E P LO 3 = EXHIBIT Projected cash flows over life of project is positive $12,469. >>>ACCEPT 51

52 LO 3 WARNING! The only time analysis need recognize working capital occurs when cash sits idle as condition of investment. 52

53 LEARNING OBJECTIVE 4 Explain how spreadsheets help the analyst to conduct sensitivity analyses of capital budgeting. 53

54 THREE ESTIMATES for LO 4 Calculating NPV The calculation of NPV for a proposed project requires three types of projections Amount of future cash flows Timing of future cash flows Discount rate Note: errors in predicting amounts of future cash flows will likely have the largest impact. 54

55 J E P LO = $350,000 in revenues Base case EXHIBIT

56 J E P LO = $344,000 in revenues, less than projected Amount of future cash flows EXHIBIT

57 J E P LO = $350,000 in revenues, not received as expected. Timing of future cash flows EXHIBIT

58 J E P LO = $350,000 in revenues, but discount rate changed. Discount rate changed to 13% EXHIBIT

59 LO 4 Which change had the greatest effect on NPV? 59

60 LEARNING OBJECTIVE 5 Describe the internal rate of return method of assessing investment alternatives. 60

61 LO 5 INTERNAL RATE OF RETURN (IRR): Definition Is the discount rate that equates the NPV of the series to 0. (Also called the time-adjusted rate of return.) 61

62 LO 5 DECISION RULE The decision to accept or reject an investment proposal can be made using either the internal rate of return method or the net present value method under most circumstances. Net Present Value Method 1. Compute the investment s net present value, using the organization s cost of capital adjusted for project-specific risk as the discount rate (hurdle rate). 2. Undertake the investment if its net present value is positive. Reject the investment if its net present value is negative. Internal Rate of Return Method 1. Compute the investment s internal rate of return. 2. Undertake the investment if its internal rate of return is equal to or greater than the organization s cost of capital adjusted for project-specific risk (hurdle rate). If not, reject the investment. 62

63 J E P LO 5 JEP s hurdle rate is 12%. Should they accept this project? Click the button to skip Exercise 15 EXHIBIT

64 LO 5 EXERCISE 15 Some people claim, The IRR is more difficult to compute than the NPV of a project. The IRR method can never give a better answer then the NPV method. Why do you suppose that so many people use the IRR method? The IRR decision is easier because it is easier to compare (and understand) interest rates (IRR) than to compare net present values (NPV). Press Enter or click left mouse button for answer. 64

65 LEARNING OBJECTIVE 6 Explain why analysts will need more than cash flow analysis to justify or reject an investment. 65

66 LO 6 JUSTIFYING INVESTMENTS Investments in computer-integrated manufacturing are often difficult because of difficulties in applying discounted cash flow methods Hurdle rate too high Should be cost of capital Bias toward incremental projects Uncertainty about operating cash flows Exclusion of benefits that are difficult to quantify More flexibility Shorter cycle and lead times Reduction of non-value-added costs 66

67 LO 6 LONG-TERM INVESTMENTS Three types of long term capital investments are: Replacement and minor improvements Expansion Strategic moves 67

68 LEARNING OBJECTIVE 7 Explain why the capital investment process requires audits. 68

69 LO 7 AUDITING Auditing to compare estimates of capital budgeting projects to actual results provides advantages: Audits identify which estimates were wrong to correct in future Managers can use audits to reward good planning Audits create environment that removes the temptation to inflate estimates and benefits 69

70 LEARNING OBJECTIVE 8 Identify the behavioral issues involved in capital budgeting. 70

71 LO 8 BEHAVIORAL ISSUES Planners have a desire to implement a project, meet performance measures. This can influence their objectivity in making estimates. Additionally, conflicts may arise between criteria used to evaluate individual projects and criteria used to evaluate an organization s overall or unit performance. 71