Cost Data in Decision Making

Cost Data in Decision Making

Cost Data for Decision Making Overview Capital Investment Make vs Buy Production Capacity Product Mix

Capital Budgeting Considering Acquiring Equipment Long-term Decision: Cost reduction through new equipment Expansion increase capacity Equipment replacement (when replace old) Equipment selection (A vs B vs C) Lease vs Buy Decision should be based/supported by analysis

Capital Investment Analysis Make the right selection, employ resources wisely: Net Present Value Payback Period Rate of Return Compare capital projects against each other

Net Present Value Cost of the equipment Present value of cost savings/cash inflows at targeted return rate If PV of cash inflows exceed initial cash outflow then proceed with project Positive cash inflow indicates project return exceeds targeted return level Negative value indicates project return is less than targeted return level Focus on cash flow not net income!

Net Present Value Cash Outflows: Initial investment - Cost of the equipment Increased working capital needs Repairs and maintenance Incremental operating costs (labor, overhead) Cash Inflows: Incremental revenues Salvage value Release of working capital

Net Present Value Choosing discount rate: In capital budgeting, hurdle rate (target rate) is the minimum rate that a company expects to earn when investing in a project. In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate. Firm s cost of capital (LT borrowing rate, equity, bond) or Return on Assets

Net Present Value CASH FLOW ITEM YEAR (s) AMOUNT PV Purchase of Equipment Now $ (450,000) $ (450,000) Working Capital Needs Now (100,000) (100,000) Overhaul of Equipment 4 (3,000) (1,715) Annual Net Cash Inflows from Sales of Product 1-5 130,000 435,780 Salvage Value of Equipment 5 175,000 87,006 Working Capital Released 5 100,000 49,718 Net Present Value $ 20,789 Rate 15% Assume Company requires assets to return a minimum of 15%. This project would be accepted because the NPV is positive project returns greater than 15%

Payback Period Advantages (Usefulness): Time it takes for an investment project to recoup its own initial cost from the cash flows it generates More quickly recovered, more desirable Compare capital projects against each other Payback period =Investment/Net Annual Cash flow Disadvantages: Doesn t consider useful life of equipment Ignores time value of money Not a measure of profitability

Payback Period Example Basic Formula (1) (2) (1)/(2) Cash Flow Payback Option Cost Reduction Period (Yrs) A $ 150,000 $ 50,000 3.0 B $ 120,000 $ 50,000 2.4 Formula is simple, must determine cash flow, not profitability (add back non-cash expense (depreciation)

Payback Period Example Uneven Cash Flows (1) (2) (3) (4) (5) (1) - (2) (3) - (4) Beginning Total Ending Unrecovered Additional Unrecovered Cash Unrecovered YR Investment Investment Investment Inflow Investment 1 $ 400,000 $ 0 $ 400,000 $ 30,000 $ 370,000 2 370,000 0 370,000 45,000 325,000 3 325,000 0 325,000 75,000 250,000 4 250,000 60,000 310,000 90,000 220,000 5 220,000 0 220,000 90,000 130,000 6 130,000 0 130,000 90,000 40,000 7 40,000 0 40,000 50,000 0 8 0 0 0 0

Rate of Return Method Why is it important: Cost of capital = hurdle rate, however can evaluate a project to the desired or forecast ROA (what are other assets/projects returning) Interest yield on a project Rate of return that will cause NPV to equal $0 Use IRR function in Excel on cash flows/outlays Compare IRR to hurdle rate, if equal or greater accept project

Choose Between Projects NPV: Higher NPV, project provides greater cash flows IRR: Higher IRR, project delivers higher return Payback: Shorter payback, project recoups investment quickest

Comprehensive Example Project: $1.6M investment, 8 yrs, no salvage, generates the following profit Item Amount Sales $ 3,000,000 Less variable expenses 1,800,000 Contribution Margin 1,200,000 Less: Fixed expenses $ 700,000 Depreciation 200,000 Total fixed expenses 900,000 Net Income $ 300,000

Comprehensive Example Project: $1.6M investment, 8 yrs, no salvage, target rate of 18% NPV Investment $ (1,600,000) PV of Cash Flows $ 2,038,783 NPV $ 438,783 IRR 26.5% Payback Investment $ 1,600,000 Net Annual Cash Flow $ 500,000 Payback Period Yrs 3.2

Relevant Costs Avoidable costs can be eliminated Focus on truly differential costs, costs avoidable, costs that can be eliminated as a result of choosing one alternative Cost data remove costs that are not avoidable (sunk costs, or future costs that will be incurred regardless) Sunk costs already incurred, cannot be avoided Some variable or allocated costs are not differential costs because they would be incurred regardless. Depreciation on equipment that was already purchased and will not be disposed is not a differential costs. Variable labor that will be retained is not a differential cost.

Relevant Costs Old Machine Amount Proposed New Machine Amount Original cost $ 175,000 List price new $ 200,000 Remaining book value $ 140,000 Expected life 4 Remaining life 4 Disposal 4 yrs 0 Disposal now $ 90,000 Annual variable operating exp $ 300,000 Disposal 4 yrs 0 Annual revenue $ 500,000 Annual variable operating exp $ 345,000 Annual revenue $ 500,000

Relevant Costs Total Cost and Revenue Next 4 Yrs Keep Old Purchase Item Machine Differential New Machine Sales $ 2,000,000 $ - $ 2,000,000 Variable expenses (1,380,000) 180,000 (1,200,000) Cost of new machine - (200,000) (200,000) Book value old machine (140,000) - (140,000) Disposal value old machine 90,000 90,000 Net Income over 4 years $ 480,000 $ 70,000 $ 550,000

Selecting Profitable Products We don t make any money on this product We can buy it cheaper than the cost to make it Limited resources/capacity issues Deciding which products to make and which to dump/discontinue Contribution Margin Throughput Costing

Make vs Buy Qualitative Produce Internally: Specialized design ( made in America ) Specialized designs and mfg skills Fits within the firm s core competencies Quantitative: Fully loaded costs inflates internal cost of production Only incremental costs should be considered Fixed and unavoidable costs should be excluded If at 100% Capacity Decide between Multiple Parts: Determine capacity of factory Calculate incremental cost of each item Choose to produce the items with the greatest incremental savings over purchase until plant capacity if filled, outsource the remaining

Make vs Buy Favor manufacturing in-house: Less expensive to make the part Use of excess plant capacity Control over quality Control of lead time Greater assurance of continual supply Favor purchasing externally: Higher quality from supplier Less expensive Insufficient capacity Item not essential to the firm's strategy

Item Make vs Buy Production Cost Per Unit Per Unit Differential Costs Make Buy Direct materials $ 6.00 $ 6.00 Direct labor 4.00 4.00 Variable overhead 1.00 1.00 Supervisor's salary 3.00 3.00 Depreciation on equipment 2.00 0 Allocation of general overhead 5.00 0 Outside purchase price $ 19.00 Total cost $ 21.00 $ 14.00 $ 19.00 Difference - in favor of make $ 5.00 Avoidable costs are less then purchase price produce in-house

Contribution Margin Contribution Margin = Sales less all variable costs (mfg. and sga), represents the margin to cover fixed costs This amount contributes to covering fixed expenses, then adds to profits Illustrates what happens to profits as volume changes Not applicable for external reporting Also called Variable or Direct Costing

Contribution Margin ACCOUNT Variable Costing Sales $ 1,200,000 Less: Variable Expenses Variable Production Costs $ 200,000 Variable Selling 60,000 Variable Admin 40,000 300,000 Contribution Margin 900,000 Less: Fixed Expenses Fixed Production 400,000 Fixed Selling 25,000 Fixed Admin 15,000 440,000 Operating Income $ 460,000

Special Orders Special order 10,000 units @ $8 Per Unit Item Amount Sales $ 12.50 Manufacturing Costs: Variable $ 6.25 Fixed 1.75 8.00 Gross Profit 4.50 Admin Expenses: Variable $ 1.80 Fixed 1.45 3.25 Operating Income $ 1.25 Profit $17,500 (10,000 units x ($8 sp -$6.25 vc)) Variable admin no additional work required on special order Assume available capacity exists

Throughput Costing Theory of Constraints: Constraint sets the pace for the entire process Identify the constraint (bottleneck) Determine the most profitable product mix given the constraint Maximize the flow through the constraint Increase capacity at the constraint Redesign manufacturing process for greater flexibility & speed Throughput Margin (Sales Direct Material): Only direct materials are variable, DL & OH are fixed costs Calculate TM per unit of time spent at constraint Profit maximized by keeping bottleneck busy with highest TM Prioritize production in order of highest TM item, based on demand

Throughput Costing Theory of Constraints: Highest margin per time spent in the bottleneck Product Product Item A B Sales Price $ 25.00 $ 30.00 Variable Cost per Unit (Materials) 10.00 18.00 Throughput Margin per Unit 15.00 12.00 Throughput Margin Ratio 60% 40% Time in Machining (minutes) 2 1 TM per Machining minute $ 7.50 $ 12.00 Units that can be processed in an hour 30 60 TM per hour $ 450.00 $ 720.00

Throughput Costing Capacity = 150 hours/month for final assembly Monthly demand in units 12 6 22 Product Product Product Item A B C Sales Price $ 2,000.00 $ 6,000.00 $ 3,000.00 Variable Cost per Unit (Materials) 1,000.00 4,000.00 2,500.00 Throughput Margin per Unit 1,000.00 2,000.00 500.00 Throughput Margin Ratio 50% 33% 17% Time in Final Assembly (hours) 4 10 5 TM per Final Assembly Hour $ 250.00 $ 200.00 $ 100.00 Hours Available 150 102 42 Demand in Units 12 6 22 Hours in Final Assembly 4 10 5 Hours Required 48 60 110 Margin Earned: A, B, C (remaining hrs) 12,000.00 12,000.00 4,000.00 C, B (remaining hrs) 0 8,000.00 11,000.00 C, A (remaining hrs) 10,000.00 0 11,000.00

Cost Volume Profit Analysis Interrelationship between cost, volume & profit: Price of products Volume/level of activity Per unit variable costs Total fixed costs Mix of products sold What products to produce & sell, pricing policy, production facility decisions

CVP Break even point = point at which all fixed costs are covered & operating income is $0 Breakeven point in units = Fixed costs/unit contribution margin Breakeven point in sales = Fixed costs/contribution margin ratio Target income ratios

CVP Multi-Product Break Even Break even point multi-products Sales= VC+Fixed Costs A & B account for 60% of 40% of total sales. VC % of product sales, A 60% B 85%, Fixed costs $150,000 S=FC+VC S=$150,00+.6(.6S)+.85(.4S).3S=$150,000 S=$500,000

CVP Target income ratios target $ income To determine how many units must be sold to generate a certain operating profit Units (volume) = Fixed costs + Target Income Unit Contribution Margin After tax: Units (volume) = Fixed costs + Target Income/(1.0-tax rate) Unit Contribution Margin

CVP Target income ratios target % income To determine how many units must be sold to generate a certain operating income percentage Operating income = Sales-VC-Fixed Costs (Sales price $6, variable costs $2, fixed costs $37,000 how many units sold for 15% operating income $.90xQ=($6xQ)-($2xQ)-$37,000 Q=12,097 units

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