Cost Modeling Final Summary PDF

Cost Estimation Steps in Cost Estimation 1 There are six steps in the cost estimation process: 1. Define the Cost Object. 2. Determine the Cost Drivers. The most important step: specification of underlying causal factors of a cost. 3. Collect Consistent and Accurate Data. Consistent means that the d...

Cost Estimation Steps in Cost Estimation 1 There are six steps in the cost estimation process: 1. Define the Cost Object. 2. Determine the Cost Drivers. The most important step: specification of underlying causal factors of a cost. 3. Collect Consistent and Accurate Data. Consistent means that the data are calculated on the same accounting basis and all transactions are recorded in the proper period. Accuracy refers to the reliability of the data. Cost Estimation 1 4. Graph the Data. To identify unusual patterns, possible nonlinearities, and any outlier observations. 5. Select and Employ the Estimation Method. The high-low method. Linear regression. 6. Assess the Accuracy of the Cost Estimate. One measure of the accuracy of the estimation method is the mean absolute percentage error (MAPE). Regression analysis is generally regarded as more accurate than the high-low method. Cost Estimation 2 The high-low equation is as follows: Y = a + (b × X) Where Y = the value of the estimated cost a = the intercept, a fixed quantity for the value of Y when X = 0 b = the slope of the line (unit variable cost) X = the cost driver, the number of operating hours Pros: Requires the study of a graph of the data to identify outliers and nonlinearity. Cons: Relies on only two points, and the selection of those two points requires judgment (that is, it discards most of the data). Cost Estimation 3 Cost Allocation A production department (sometimes called an operating department) is a unit of the manufacturing company that is involved directly in producing the company’s product or service; A service department is a unit of the organization that performs one or more support tasks for production departments. Overhead Allocation: Three General Approaches The volume-based approach allocates overhead from a single cost pool The departmental approach allocates overhead to production departments, and then from production departments to products The activity-based approach allocates overhead to production activities, and then from production activities to products Cost Allocation 4 Cost Allocation Joint products are products from a joint production process that have relatively substantial sales values. Products whose total sales values are minor in comparison to the sales value of the joint products are classified as by-products. The point in a joint production process at which individual products can be identified for the first time is called the split-off point. Joint costs include all manufacturing costs incurred prior to the split-off point. Cost Allocation 5 Method 1: The physical measure method The greater the output (however measured), the greater the share of joint costs allocated to the product. Advantages 1. Easy to use. 2. The criterion for the allocation of the joint costs is objective. Disadvantages 1. Ignores the revenue- producing capability of individual products. 2. Each product can have its own unique physical measure. Cost Allocation 6 Method 2: Sales Value at Split-off Method This method can only be used when joint products can be sold at the split-off point. Advantages 1. Easy to calculate. 2. Costs are allocated according to the individual product’s revenue. Disadvantages 1. Market prices for some industries change constantly. 2. Sales price at split-off might not be available because additional processing is necessary for sale. Cost Allocation 7 Method 3: The Net Realizable Value (NRV) Method The Net Realizable Value (NRV) method can be used when joint products cannot be sold at split-off. The net realizable value (NRV) of a product is the product’s estimated sales value at the split- off point. Cost Allocation 8 Strategy and the Analysis of Capital Investments Capital budgeting: The process of identifying, evaluating, selecting, and controlling capital (That is, long-term) investments. Capital investments: Projects that involve a large expenditure of funds and expected future benefits over a number of years. Capital budget: Part of the organization’s master budget that deals with the current period’s planned capital investment outlays. Independent projects: Projects whose cash flows are not affected by the cash flows of other projects. Mutually exclusive projects: An extreme form of project interdependence: the acceptance of one investment alternative precludes the acceptance of one or more other alternatives. Strategy and the Analysis of Capital Investments 9 Net working capital: Current assets (other than cash), less current liabilities. Discounted cash flow (DCF) decision models: Capital budgeting decision models that incorporate the present value of future cash flows. Non-discounted cash flow (non-D CF) decision models: Capital budgeting decision models that do not incorporate the time-value-ofmoney. Weighted-average cost of capital (W ACC): Under normal circumstances, the discount factor used in D CF capital-budgeting decision models. Estimated as a weighted average of the cost of obtaining capital from various sources (For Example, equity and debt). Discount rate: A generic term that refers to the rate used in capital budgeting for converting future cash flows to a present-value basis. 10 Strategy and the Analysis of Capital Investments Making the Decision: The NPV Model Discount all future cash inflows to present value using the WACC as the discount rate. Discount all future cash outflows to present value using the WACC as the discount rate. If NPV > 0, accept the project (that is, the project adds to the value of the company). If NPV < 0, reject the project (that is, the project does not add value to the company). Strategy and the Analysis of Capital Investments 11 Internal Rate of Return (IRR) Model IRR represents an estimate of the “true” (That is, “economic”) rate of return on a proposed investment project. IRR is calculated as the rate of return that results in a NPV of zero. If IRR > WACC, then the proposed project should be accepted (That is, its anticipated rate of return > the cost of invested capital for the firm). If IRR < WACC, the proposed project should be rejected (That is, its NPV will be < 0). Strategy and the Analysis of Capital Investments 12 Modified Internal Rate of Return (MIRR) The MIRR is IRR adjusted to account for an assumed rate of return associated with interim project cash inflows. The MIRR assumes that all positive interim cash flows are reinvested at the W ACC for the remaining life of the project. MIRR is a more conservative estimate of a project’s rate of return. Payback Period Payback period = length of time (in years) required for the cumulative cash inflows from an investment to recover the initial (net) investment outlay. When cash inflows are expected to be equal, the payback period is determined as: (Net) initial investment ÷ Annual after-tax cash inflows Strategy and the Analysis of Capital Investments 13 Strengths of the Payback Decision Model Easy to compute. Easy to understand. Payback period can serve as a rough measure of risk – the longer the payback period, the higher the perceived risk. Weaknesses The model fails to consider returns over the entire life of the investment. In its unadjusted state, the model ignores the time value of money. The decision rule for accepting/rejecting projects is ill-defined (ambiguous or subjective). Use of this model may encourage excessive investment in short-lived projects. Strategy and the Analysis of Capital Investments 14 Discounted Payback Model Discounted payback = the length of time (in years) required for the cumulative present value of after- tax cash inflows to recover the initial investment outlay Note: if the discounted payback period is less than the life of the project, then the project must have a positive NPV Strength: Takes into consideration the time value of money. Weaknesses: Can motivate excessive short-term investments. Returns beyond the payback period are ignored. Decision rule for project acceptance is ambiguous/ subjective. Strategy and the Analysis of Capital Investments 15 Accounting (Book) Rate of Return (ARR) ARR = Average annual net operating income ÷ Average investment Advantages: Readily available data. Consistency between data for capital budgeting purposes and data for subsequent performance evaluation. Disadvantages: No adjustment for the time value of money (undiscounted data are used). Decision rule for project acceptance is not well defined. The ARR measure relies on accounting numbers, not cash flows (which is what the market values). Strategy and the Analysis of Capital Investments 16