1 Differential Cost Analysis for Operating Decisions CHAPTER 7 © 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. PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology Managerial Accounting 11E Maher/Stickney/Weil

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? ☼☼

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

4 EXAMPLE: Ullman Educational Media Ullman Educational Media (UEM) is a company that produces tutorial videos for primary and preschool use. UEM developed the following estimates: LO 1 Continued Units made and sold800 per month Maximum production and sales capacity1,200 units per month Selling price$ 30 UEMUEM

5 ACTIVITY & COSTS Ullman Educational Media provides the following information about activities and costs: LO 1 Continued VC per unitFC per month Manufacturing$ 17$ 3,060 Marketing and Administrative51,740 Total costs$ 22$4,800 UEMUEM

6 LO 1 EXHIBIT 7.2 UEMUEM Profit decreases by $1,000.

7 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 LO 1

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

9 SPECIAL ORDERS 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? LO 2 MANAGERS WANT TO KNOW! UEMUEM Continued

10 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. UEMUEM

11 LO 2 EXHIBIT 7.5 Full cost, used for long run decisions, is the total cost of producing and selling a unit. UEMUEM

12 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. LO 2

13 PRODUCT LIFE CYCLE: Definition Covers the time from initial research and development to time support to customer is withdrawn.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

14 Predatory pricing: Definition Is when a business deliberately prices below its costs to drive out competitors. LO 2 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.

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

16 LO 3 EXHIBIT 7.5 Value engineering is a systematic evaluation of all aspects of the business.

17 Customer cost Activities Cost to acquire customerPromote product; campaign to win lost customers; run advertising campaign Cost to provide goods and servicesProcess order; deliver product; process returns Cost to maintain customersBill customers; process payments; issue refunds Cost to retain customersFollow-up calls USING ACTIVITY-BASED COSTING: Analyze Profitability LO 4

18 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 LO 6

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

20 MANAGING THE 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 LO 6

21 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 non- quantitative factors are considered. LO 7

22 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? LO 8 MANAGERS WANT TO KNOW!

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

24 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. LO 9 MANAGERS WANT TO KNOW! Click the button to skip Example

25 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? LO 10 MANAGERS WANT TO KNOW!

26 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. LO 10

27 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. LO 11

28 ECONOMIC ORDER 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.” LO 12

29 Capital Expenditure Decisions CHAPTER 8 Managerial Accounting 11E Maher/Stickney/Weil PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 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.

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. ☼☼

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

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

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

34 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. LO 2

35 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 LO 2 Click the button to skip Exercise 6

36 EXERCISE 6 Press “Enter” or click left mouse button for answer. “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? LO 2 The statement is generally true for projects that fit the strategic plan. In certain special cases, a firm might depart from its strategic plan.

37 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. LO 2 MANAGERIAL APPLICATION

38 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. LEARNING OBJECTIVE

39 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. LO 3

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

41 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. LO 3

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

43 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. LO 3

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

45 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. 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.

46 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 LO 3

47 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. LO 3 Continued Cost$ 100,000 Market value of present equipment$ 10,000 Scrap value$ 5,000 JEPJEP

48 LO 3 EXHIBIT 8.1 Projected cash flows over life of project. JEPJEP

49 LO 3 EXHIBIT 8.2 JEPJEP Depreciation is subtracted before tax Year 0 & Year 1

50 LO 3 EXHIBIT 8.2 JEPJEP Pretax net cash inflow (outflow) – tax payable = Net cash inflow (outflow) X PV factor (12%) = NPV Year 0 & Year 1

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

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

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

54 THREE ESTIMATES for 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. LO 4

55 LO 4 JEPJEP EXHIBIT 8.3 = $350,000 in revenues ++++ Base case

56 LO 4 JEPJEP EXHIBIT Amount of future cash flows = $344,000 in revenues, less than projected

57 LO 4 JEPJEP EXHIBIT 8.3 = $350,000 in revenues, not received as expected. + Timing of future cash flows +++

58 LO 4 JEPJEP EXHIBIT Discount rate changed to 13% + = $350,000 in revenues, but discount rate changed.

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

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

61 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.) LO 5

62 LO 5 DECISION RULE Net Present Value Method Internal Rate of Return 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. 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. 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.

63 LO 5 EXHIBIT 8.4 JEP’s hurdle rate is 12%. Should they accept this project? JEPJEP Click the button to skip Exercise 15

64 EXERCISE 15 Press “Enter” or click left mouse button for answer. 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? LO 5 The IRR decision is easier because it is easier to compare (and understand) interest rates (IRR) than to compare net present values (NPV).

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

66 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 LO 6

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

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

69 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 LO 7

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

71 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. LO 8