AC 4104 Strategic Cost Management PDF

AC 4104 – OVERVIEW OF STRATEGIC COST MANAGEMENT  OVERVIEW OF STRATEGIC COST MANAGEMENT Strategy – is a set of policies, procedures and approaches to business that produce long-term success. It is a set of goals and specific action plans that if, achieved, provide the desired competitive advant...

AC 4104 – OVERVIEW OF STRATEGIC COST MANAGEMENT  OVERVIEW OF STRATEGIC COST MANAGEMENT Strategy – is a set of policies, procedures and approaches to business that produce long-term success. It is a set of goals and specific action plans that if, achieved, provide the desired competitive advantage. Strategic Management – involves the development of a sustainable competitive position in which the firm’s competitive advantage spells continued success. It involves identifying and implementing these goals and action plans Strategic Cost Management – involves the development of cost management information to facilitate the principal management function which is strategic management. It is the process that aims to strengthen a company’s strategic position by carefully controlling costs according the company’s broader objectives. Cost Management Information – is the information that the manager needs to effectively manage the firm, profit oriented as well as not-for-profit organization. This includes financial information about cost and revenues as well as relevant nonfinancial information about productivity, quality and other key success factors for the firm.  Cost Management – is the practice of accounting in which the accountant develops and uses cost management information. For competitive success, it is enough to emphasize only on financial information. This could lead management to stress cost reduction (a financial measure) while ignoring or even lowering quality standards (a nonfinancial measure). This decision could be a critical mistake which could lead to the loss of customers and market share in the long run. Uses of Cost Management Information: 1. Strategic Management. Management must make sound strategic decisions regarding the choice of products, manufacturing methods, marketing techniques and channels and other long-term issues. 2. Planning and Decision Making. Cost management information is needed to support recurring decision such as managing cash flows, budgeting raw material purchases, scheduling production, etc. Planning and decision-making involves budgeting and profit planning, cash flow management and other decision related to the firm’s operation such as deciding whether to lease or buy a facility, whether to replace or just repair an equipment, when to change a marketing plan or when to begin new product development.  3. Management and Operational Control. Cost management information is needed to provide a fair and effective basis for identifying inefficient operations and to reward and motivate the most effective managers. Operational control – takes place when mid-level managers (e.g., product managers, regional managers) monitors activities of operating-level managers and employees (e.g., production supervisors, department heads). Management control – is the evaluation of mid-level managers by upper-level manager (e.g., Controller or the Chief Financial Officer). 4. Reportorial and Compliance to Legal Requirements. Require management to comply with the financial reporting requirements to regulatory agencies such as the Securities and Exchange Commission (SEC), Bureau of Internal Revenue (BIR), and other relevant authorities and agencies.The financial statement information also serves the other three management functions as these information is often as important part of planning and decision making, control and strategic management.  Management Accountant’s Role in Strategic Cost Management Management Accounting – involves the application of appropriate techniques and concepts to economic data so as to assist management in establishing plans for reasonable economic objectives and in the making of rational decision with a view towards achieving these objectives. It is the process of identification, measurement, accumulation, analysis, preparation, interpretation and communication of financial information, which is used by management to plan, evaluate and control activities within an organization. Management accountants – are concerned with providing information to managers, that is, people inside the organization who direct and control the operations. They are accounting professionals who develop and analyze cost management and other information. Administrative functions that must be performed by management accountant to provide a system which allows management to receive the necessary information: a. Planning – which involves setting of goals for the firm, evaluating the various ways to meet the goals and picking out what appears to be the best way to meet the goals.  b. Controlling – which involves the evaluation of whether actual performance conforms with plan goals; and c. Decision making – which involves determination of predictive information (e.g. relevant costs) for making important business decisions. Relationship Between Cost Accounting and Cost Management Cost accounting – is a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services. It includes methods for recognizing, classifying, allocating, aggregating and reporting such costs and comparing them with standard costs. Cost Management – needs the output of cost accounting and its purpose is to provide managers with information which aids decision. The accounting report should be tailored to the needs of the decision and the decision maker.  Strategic Decision Making and the Cost Management Accountant Basic Cost Management Perspectives: a. Strategic Management Perspective – The enterprise generates profits by attracting customers willing to pay for the goods and services it offers.. The key to company’s success is creating value for customers while differentiating itself from the competitors. Customer value fall into three (3) broad categories, namely: customer intimacy, operational excellence, and product leadership. b. Enterprise Risk Management Perspective – is a process use by an entity to identify those risks and develop responses. c. Corporate Social Responsibility (CSR) Perspective – is a concept where business organizations consider the needs of all stakeholders when making decisions. They are responsible not only not only for creating strategies that produce financial results that satisfy shareholders but also to serve other stakeholders such as customers, suppliers, employees among others whose interest are tied to the company’s performance.  d. Process Management Perspective – Most companies organized themselves as functional departments such as Marketing Department, Research and Development Department, and the Accounting department. Effective managers, however, understand that business processes, more than functional departments serve the needs of the company’s most important stakeholders – its customers. A business process is a series of steps that are followed in order to carry out some tasks in a business. The term value chain is often used to describe how an organization’s functional departments interact with one another to form a business process. A Value chain consists of the major business functions that add value to a company’s products and services. e. Leadership Perspective – To achieve success, organizational leaders must able to unite the behaviors of the fellow employee who have diverse needs, beliefs and goals to the workplace. Leaders need to understand how the following factors influence human behavior: 1. Internal motivation –refers to motivation that comes from within one’s self. A leader who is perceived by employees as credible and respectful of their values to the company can increase the extent to which those employees are intrinsically motivated to pursue strategic goals. 2. External incentives – such as bonus compensation are given by many organizations to highlight important goals and to motivate employees to achieve them.  3. Cognitive Bias – leaders should be aware that all people (including themselves) should possess cognitive bias or distorted thought processes such as promoting false assertion that can adversely affect planning, controlling and decision making. To reduce if not totally eliminate cognitive biases, a leader may routinely appoint independent team of employees to assess the credibility of recommendation set forth by other individuals and groups. F. An Ethics Perspective – without fundamental trust in the integrity of the business, the economy would operate much less efficiently. Therefore for the benefit of everyone, including profit-making companies, it is vitally important that the business be conducted within the ethical framework that builds and sustain trust. Professional management accountants have developed and implemented a set of Ethical Standards for practitioners Advantages of Strategic Cost Management Strategic Cost Management provides number of benefits to different organizations. It has provided the business with an improved understanding of its sources of profits. Some benefits are given below: 1. It has developed a framework for reviewing the strategic allocation of resources across the business based on core business processes and activities.  2. It has improved the business understanding of its cost drivers leading to improved articulation of its strategic plans in cost terms. 3. It has enabled the business to assess, at a high level, how activity-based techniques can be deployed at different levels in the business to improve its cost management process, such as in budgeting and in process improvement. Uses of Cost Management Information Cost management information is needed for each of the following management functions, namely: 1. Strategic Management. Involves the development of a sustainable competitive position in which the firm’s competitive advantage spells continued success. It involves identifying and implementing these goals and action plans. Management must make sound strategic decisions regarding the choice of products, manufacturing methods, marketing techniques and channels and other long-term issues. The strategic emphasis requires an integrated approach which combines skills from all business functions, namely: marketing< production< finance and accounting/controllership, is necessary in a dynamic and competitive environment Due to increasing strategic issues, cost management has moved from a traditional role of product costing and operational control to a broader strategic focus: strategic cost management.  2. Planning and Decision-making. Cost management information is needed to support recurring decision such as replacing and maintaining equipment, managing cash flows, budgeting raw material purchases, scheduling production, pricing and managing distribution of products to customers, etc. Planning and decision-making involves budgeting and profit planning, cash flow management and other decision related to the firm’s operation such as deciding whether to lease or buy a facility, whether to replace or just repair an equipment, when to change a marketing plan or when to begin new product development. 3. Management and Operational Control. Cost management information is needed to provide a fair and effective basis for in identifying inefficient operations and to reward and motivate the most effective in managing. Operational control – takes place when mid-level managers (e.g., product managers, regional managers) monitors the activities of operating-level managers and employees such as product supervisors, department heads. Management control – is the evaluation of mid-level managers by upper-level managers such as Controller or the Chief Financial officer (CFO).  4. Reportorial and Compliance to Legal Requirements. Reportorial and compliance responsibilities require management to comply with the financial reporting requirements to regulatory agencies such as the SEC, BIR and other relevant government authorities and agencies. The financial statement preparation role has recently received a renewed new focus and interest as accounting scandals have shown how crucial and important accurate financial information is for investors. Financial statement information also serves the other three management functions as this information is often an important part of planning and decision making, control and strategic management. Traditional Cost Management Traditional cost management is an accounting method used to determine the cost of making products to make profit, and it is based on allocating overhead (or indirect) manufacturing costs. This system relies on calculating predetermined overhead rates and applying the rates to a given metric. Traditional costing system use estimated overhead rates for specific cost driver. A cost driver is an element of the manufacturing process that may incur costs, such as: managerial expenses. Packaging, machine hours, etc.  The traditional costing system in accounting is the allocation of factory overhead to products which is based on the volume of consumed production resources. Companies using this method will apply overhead to either the number of machine hours used or the direct labor hours which were consumed. Under traditional costing, one would add an average overhead rate to the direct costs of manufacturing goods or providing services. It is applied on the basis of cost driving, reflecting what is required to produce finished products. Limitations of Traditional Cost Management The following are the disadvantages of the Traditional Cost System: 1. It offers limited accuracy, even in the best of situations. 2. It wants to ignore unexpected circumstances 3. It is not always a helpful system 4. Its simplicity may be too simple 5. It does not account for non-manufacturing cost  Ethical Standards for Practitioners of Management Accounting and Financial Management Practitioners of management accounting and financial management have responsibility to: 1. Competence. (a) Maintain an appropriate level of professional competence by ongoing development of their knowledge and skills; (b) Perform their professional duties in accordance with relevant laws, regulations, and technical standards; (c) Prepare complete and clear reports and recommendations after appropriate analysis of relevant and reliable information. 2. Confidentiality. (a) Refrain from disclosing confidential information acquired in the course of their work except when authorized, unless legally obligated to do so; (b) Inform subordinates as appropriate regarding the confidentiality of information acquired in the course of their work and monitor their activities to assure the maintenance of that confidentiality; (c) Refrain from using or appearing to use confidential information acquired in the course of their work for unethical or illegal advantage either personally or through third parties. 3. Integrity. (a) Avoid actual or apparent conflict of interest and advise all appropriate parties of any potential conflict; (b) Refrain from engaging in any activity that would prejudice their ability to carry out their duties ethically;  (c) Refuse any gift, favor, or hospitality that would influence or would appear to influence their actions; (d) Refrain from either actively or passively subverting the attainment of the organization’s legitimate and ethical objectives; (e) Recognize and communicate professional limitations or other constraints that would preclude responsibility judgment or successful performance of an activity; (f) Communicate unfavorable as well as favorable information and professional judgment or opinions; and (g) Refrain from engaging in or supporting any activity that would discredit the profession. 4. Objectivity. (a) Communicate information fairly and objectively; and (b) Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations presented.  Contemporary Business Environment The business environment in recent years has been characterized by increasing competition and relentless drive for continuous improvement. These changes include: 1. An increase in global competition; 2. Advances in manufacturing technologies; 3. Advances in information technologies, the Internet, and e-commerce; 4. Greater focus on the customer; 5. New forms of management organizations; and 6. Changes is social, political, and cultural environment of business. A Greater Focus on Customers To succeed in this area, customer value is the focus that businesses of all types must concerned with. Producing value for the customers has changed the orientation of managers from low-cost production of large quantities to quality service, faster delivery and ability to respond to the customer’s desire for specific features.  Generally, firms choose a strategic position corresponding to one of two general strategies: a) Cost leadership b) Superior product through differentiation Successful pursuit of cost leadership and/or differentiation strategies requires an understanding of a firm’s value chain (internal) and supply chain (external). Strategic Focus of Cost Management Phases of the development of cost management systems should consider the following: Stage 1: Cost management systems are basic transaction reporting systems. Stage 2: Cost management systems focus on external financial reporting. The objective is reliable financial reports, accordingly, the usefulness for cost management is limited. Stage 3: Cost management systems track key operating data and develop more accurate and relevant cost information for decision making; cost management information is developed. Stage 4: Strategically relevant cost management information is an integral part of the system.  Implementing Strategy Balanced Scorecard – translates an organization’s mission and strategy into a set of performance measures that provides the framework for implementing the strategy. The balance scorecard the non-financial objectives that an organization must achieve to meet its financial objectives. It measures an organization’s performance from four (4) perspectives: 1. Financial perspective. Measures of profitability and market value among others, as indicators of how well the firm satisfies its owners and stockholders. 2. Customer Satisfaction. Measures of quality service and low cost, among others, as indicators of how well the firm satisfies its customers. 3.Internal Business Processes. Measures of the efficiency and effectiveness with which the firm produces the product or service. 4. Innovation and Learning. Measures of the firm’s ability to develop and utilize human resources to meet the strategic goals now and into the future.  Strategic Measures of Success The strategic cost management system develops strategic information, including both financial and non-financial information. Financial performance measures include among others: a. Growth in sales and earnings b. Cash flows c. stock price They show the impact of the firm’s policies and procedures in the firm’s current financial position and therefore, its current return to the stockholders. Non-financial measures of operation include among others a. Market share b. Product quality c. Customer satisfaction d. Growth opportunities  The nonfinancial factors show the firm’s current and potential competitive position as measured from three additional perspective, namely: 1. the customer; 2. internal business process; and 3. innovation and learning Strategic financial and nonfinancial measures of success are also commonly called Critical Success Factors (CSFs). COMPETITIVE STRATEGIES For a firm to sustain a competitive position, it must purposefully or as a result of market forces, arrive at one of the two competitive strategies, namely: 1. Cost Leadership – this is a competitive strategy in which a firm succeeds in producing products or services at the lowest cost in the industry. A firm that is a cost leader makes sustainable profits at lower prices, thereby limiting the growth of competitions in the industry through its success in undermining the profitability of competitors.  2. Product Differentiation – this strategy is implemented by creating a perception among consumers that the product or service is unique in some important way, usually by being of high quality, features or innovation. This perception allows the firm to charge higher prices and outperform the competition in profits without reducing costs significantly. CONTEMPORARY COST MANAGEMENT TECHNIQUES Managers commonly used the following tools to implement the firm’s broad strategy and to facilitate the achievement of success on critical success factors: a) Total Quality Management. To survive in an increasingly competitive environment, firms realize that they must produce high-quality products. As a result , an increasing number of companies have instituted total quality management programs to ensure that their products are of the highest quality and that production processes are efficient. Total quality management (TQM) – is a technique in which management develops policies and practices to ensure that a firm’s products and services exceed customer expectations. Most companies with TQM develop a company that stresses listening, making products right the first time, reducing defective products that must be reworked and encouraging workers to continuously improve their production process.  b) Just-In-Time (JIT). Is the philosophy that activities are undertaken only as needed or demanded. JIT is a product system also known as pull-it-through approach, in which materials are purchased and units are produced only as needed to meet actual customer demand. In a JIT system, inventories are reduced to the minimum and in some cases, zero. Just-In-Time JIT) production –is a system in which each component on a production line is produced immediately as needed by the next step in the production line. In a JIT production line, manufacturing activity at any particular work station is prompted by the need for that station’s output at the following station. c) Process Reengineering Reengineering – is a process for creating competitive advantage in which a firm reorganizes its operating and management functions, often with the result that jobs are modified, combined or eliminated. It is defined as “fundamental rethinking and radical redesign of business process to achieve dramatic improvements in critical contemporary measures of performance, such as cost, quality, service and speed. Process reengineering – is a radical approach where a business process is diagrammed in detail, questioned and then completely redesigned in order to eliminate unnecessary steps, to reduce opportunities for errors and to reduce costs.  A business process – is any series of steps that are followed in order to carry out some task in a business. The main objective of this approach is the simplification and elimination of wasted effort and the central idea is that all activities that do not add value to product or service should be eliminated. d) Benchmarking. Is a process by which a firm determines its critical success factors, studies the best practices of other firms (or other units within a firm) for achieving these critical success factors, and implements improvements in the firm’s processes to match or beat the performance of those competitors. e) Mass Customization. Many manufacturing and service firms increasingly find that customers expect product and services to be develop for each customer’s unique needs. Mass customization – is a management technique in which marketing and production processes are designed to handle the increased variety that results from delivering customized products and services to customers.  f) Balanced Scorecard. Is an accounting report that includes the firm’s critical success factors in four areas, namely: a) financial performance, b) customer satisfaction, c) internal business process, and d) innovation and learning. The concept of balance captions the intent of broad coverage, financial and non financial of all factors that contribute to the success of the firm in achieving its strategic goals. g) Activity-based Costing and Management Activity analysis – is used to develop a detailed description of the specific activities performed in the operation of the firm. Many firms have found that they can improve planning , product costing operational control, and management control by using activity analysis to develop a detailed description of the specific activities performed in the firm’s operations. It provides the basis for activity-based costing and activity- based management. Activity-based costing (ABC) – is used to improve the accuracy of cost analysis by improving the tracing of costs to product or to individual customers.  Activity-based management (ABM) – uses activity analysis to improve operational control and management control. ABC and ABM are key strategic tools for many firms specially those with complex operations, or great diversity of products. h) Theory of Constraints (TOC). Is a sequential process of identifying and removing constraints in a system. The theory of constraints emphasizes the importance of managing the organization’s constraints or barriers that hinder or impede progress toward an objective. The Theory of Constraints approach is a perfect complement to Total Quality Management and Process Reengineering – it focuses improvement efforts where they are likely to be more effective. i) Life Cycle Costing. Is a management technique to identify and monitor the costs of a product throughout its lifecycle. It consists of all steps from product design and purchase of raw materials to delivery of and service of the finished product  J.Target Costing. Involves the determination of the desired cost for a product or the basis of a given competitive price so that the product will earn a desired profit. The basic relationship that is observed in this approach is: Target cost = Market determined price – Desired profit The entity using target costing must often adopt strict cost-reduction measures to meet the market price and remain profitable. This is a common strategic approach used by intensely competitive industries where even small price differences attract customers to the lowest-priced product. k) Computer-Aided Design and Manufacturing. Most companies are using computer-aided design (CAD) and computer- aided manufacturing (CAM) to respond to changing customer tastes more quickly. Computer-aided design (CAD) – is the use of computers in product development, analysis and design modification to improve the quality and performance of the product, whereas, Computer-aided manufacturing (CAM) – is the use of computers to plan, implement, and control production.  l) Automation. Involves and requires a relatively large investment in computers, computer programming, machines, and equipment. Many firms add automation gradually, one process at a time. A flexible manufacturing system (FMS) – is a computerized network of automated equipment that produces one or more groups of parts or variations of a product in a flexible manner. Computer-integrated manufacturing (CIM) – is a manufacturing system that totally integrates all office and factory functions within a company via a computer-based information network to allow hour- by-hour manufacturing management. m) E-Commerce. This E-Commerce business model has also attracted many investors to pursue the use of Internet in conducting business. Established companies will undoubtedly continue to expand into cyberspace – both business-to-business transactions and for retailing.  n) The Value Chain. It refers to the sequence of business functions in which usefulness is added to the products or services of a company. The term value refers to the increase in the usefulness of the product or service and a result its value to the customer. The value chain is an analysis tool that firms use to identify the specific steps required to provide a product or service to the customer. The key idea of this concept is that the firm studies each step in its operation to determine how each contributes to the firm’s competitiveness and profits. Analyzing the firm’s value chain helps management discover which steps of activities are not competitive, where costs can be reduced, or which activity should be outsourced, and how to increase value for the customer at one or more of the steps of the value chain. When properly implemented, these approaches can (a) enhance quality, (b) reduce costs, (c) increase output, and (d) eliminate delays in responding to customers. Internal value chain – is the set of activities required to design, develop, produce, market and deliver products or services to customers.  CAPITAL INVESTMENT DECISIONS Capital investment decisions – are concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets. Because capital investment decisions place large amounts of resources at risk for long periods of time and simultaneously the future development of the firm, they are among the most important decisions managers make. Capital budgeting is the process of making capital investment decisions Categories of Capital Investments. The 2 general types of capital investment decisions are: Independent projects – are projects that, if accepted or rejected, do not affect the cash flows of other projects. Acceptance or rejection of one product line does not require the acceptance or rejection of the other product line. Thus, the investment decisions for the product lines are independent of each other. Mutually exclusive projects – are those projects that, if accepted, preclude the acceptance of all other competing projects. Once a project is chosen, the other is excluded; they are mutually exclusive. These are projects which require the company to choose from among specific alternatives. The project to be acceptable must pass the criteria of acceptability set by the company and be better than other investment alternatives.  Elements of Capital Budgeting: The elements or factors to be considered in evaluating capital investment proposals are: 1.The net amount of the investment – represents the initial cash outlay that is required to obtain future returns or the net cash outflow to support a capital investment project. 2.The operating cash flows or returns from the investment – are the inflows of cash expected from a project reduced by the cash cost that can be directly attributed to the project. 3.The minimum acceptable rate of return on the investment/ Cost of capital – the average rate of return that the company will earn from alternative investment opportunities or the cost of capital which is the average rate of return that the firm must pay to attract investment fund.  Process of Capital Budgeting The capital budgeting can be divided into seven significant phases: 1. Finding Investment Opportunities. Since the long-term profitability of most companies depends on the nature and quality of their capital investments, these investment opportunities should be carefully analyzed and evaluated. 2. Collect Relevant Information about Opportunities. To effectively evaluate any investment opportunity, the expected cash flows from the projects must be estimated and the total cash outlay necessary to place the investment in operative form must be determined. 3. Select Discount Rate. Before the cash flow can be evaluated, the discount (cost of capital) must be established if the discounted cash flow approach is to be applied 4. Financial Analysis of Cash Flows. The techniques of capital budgeting are applied to the estimated cash flows developed in the second phase.  5. Decision. Many factors, qualitative as well as quantitative, should be given consideration before the final decision is made to as to the selection of a particular investment.They will include among others, relationship of this opportunity to other aspects of company’s operations and long-term goals, the timing of the cash flows, the availability of funds for investment purposes, etc. 6. Project Implementation. Once a decision has been made to invest funds, more detailed plans for making the project operational are developed. 7. Project Evaluation and Appraisal. This last phase involves the assessment of how effective the investment actually is. The evaluation may be in the form of continuous monitoring of the project, so that corrective action can be taken. Not only the effectiveness of the project be determined, but that the overall decision-making process be appraised for possible improvement.  Payback and Accounting Rate of Return: Non-discounting Methods Nondiscounting models ignore the time value of money, whereas discounting models explicitly considers it. Payback Period Payback period – is the time required for a firm to recover its original investment. When the cash flows of a project are assumed to be even, the following formula can be used to compute the project’s payback period: Payback period = Original investment / Annual cash flows If the cash flows are uneven, the payback period is computed by adding the annual cash flows until such time as the original investment is recovered. Decision Rule: The desirability of the project is determined by comparing the project’s payback period against the maximum acceptable payback period as predetermined by management. The project with shorter payback period will be accepted: Thus, if PB period < Maximum allowable PB then, accept; If PB period is > Maximum allowed PB period, reject.  Illustration: Suppose that a company is considering two different and mutually exclusive projects (A Answers: and B), where both have a five-year life and require an investment of P2,100,000. The cash flow patterns for each project are given below: (1) PB period for Project A: Project A: Even cash flows of P700,000 per year P2,100,000 / P700,000 = 3.0 years Project B: P1,200,000, P1,000,000, P900,000, P500,000, and P300,000 (2) PB period for Project B (uneven CFs): Required: (1) Calculate the payback period for project A, (2) Calculate the payback period for Annual Time needed project B. Which project should be accepted based on payback analysis; and (3) What if a third mutually exclusive project, Project C became available with the same investment and annual cash flows Cash flow for payback of P1,000,000? Now which project would be chosen? Yr. 1: P2,100,000 1,200,000 1.0 year Yr. 2: 900,000 1,000,000 0.9 year PB period 1.9 years Project B should be accepted because it has a shorter payback period. (3) PB period for Project C: P2,100,000 / 1,000,000 = 2.1 years Project B still has the better payback of 1.9 yrs. Accounting Rate of Return Accounting rate of return (ARR) – is the second commonly used nondiscounting model. The ARR measures the return on a project in terms of income, as opposed to using project’s cash flow. It is computed by the following formula: Accounting rate of return (ARR) = Average income / Original Investment Average income is computed by summing annual income over the life of the project and then dividing by the number of years of the project. Unlike the payback period, the accounting rate of return (ARR) does consider a project’s profitability; like the payback period, it ignores the time value of money. Ignoring the time value of money is a critical deficiency and can lead a manager to choose investments that do not maximize profits. Discounting models use discounted cash flows, which are future cash flows expressed in terms of their present value. The use of discounting models requires an understanding of the present value concepts.  Decision Rule: Under the ARR method, choose the project with the highest rate of return. Accept the project if the ARR is greater than the cost of capital. Thus: If: ARR > Required rate of return; Accept If: ARR < Required rate of return; Reject Required rate of return – is the minimum acceptable rate of return. It is also referred to as the discounted rate or the hurdle rate and should correspond to the cost of capital. Cost of capital – is the weighted average of the costs from various sources, where the weight is defined as the relative amount from each source.  Illustration: Assume that an investment requires an initial Answers: outlay of P3,000,000 with no salvage value. The life of the investment is five years with the following yearly cash flows (in 1. Average income: chronological sequence): P900,000, P900,000, P1,200,000, N/I (5,400,000 – 3,000,000) = P2,400,000 P900,000, and P1,500,000 A/I (P2,400,000 / 5 years = P480,000 Required: 2. ARR = Ave. income / Original investment 1. Calculate the average income. = P480,000 / P3,000,000 = 16% 2. Calculate the accounting rate of return. 3. The second project has an identical ARR of 16%, thus the 3. What if a second competing project had the same outlay and metric would say there is no difference between the two salvage value but had the following cash flows (in chronological projects. However, the second project would be preferred even sequence): P1,500,000, P1,200,000, P900,000, P900,000, and though it provides the same total cash because it returns P900,000. Using the ARR metric, which project should be larger amount of cash sooner than the first project. selected, the first or the second? Which project is really the better of the two?  The Net Present Value Method Net present value (NPV) – is the difference in the present value of the cash inflows and outflows associated with a project. It is the excess of the present value of cash inflows generated by the project over the amount of the initial investment. This is computed as follows: Present value of cash inflows computed based on minimum desired discount rate P xx Less: Present value of investment xx Net present value (NPV) P xx Decision Rule: For independent project proposal, accept it if NPV is positive or zero and reject if NPV is negative. In short: If: NPV > 0; Accept If: NPV < 0; Reject  Illustrative Example 1: (Uniform Cash Inflows) ABC wants to invest in a machine costing P80,000 with a useful life of six years and no salvage value. The machine will be depreciated using the straight-line method and is expected to produce annual cash inflow from operations, net of income taxes, of P22,000. Assuming that ABC wants a minimum rate of return of 10%, what is the net present value of the proposed investment? Is the project acceptable? Solution: PV of annual cash inflows for six periods at 10% (P22,000 x 4.355) P 95,810 Less: Present value of net investment 80,000 Net present value P 15,810 Decision: Yes, the ABC Company should invest in the new machine because it could earn more than the minimum return that they desire as indicated by the positive net present value.  Illustrative Example 2: (Uneven Cash Inflow) Detdet Corp. plans to invest in a four-year project that will cost P750,000. Detdet’s cost of capital is 8%. Additional information on the project is as follows: Year Cash Flow from Operations, net of taxes PV of 1 at 8% Solution 1 P 200,000 0.926 P 185,200 2 220,000 0.857 188,540 3 240,000 0.794 190,560 4 260,000 0.735 191,100 P 755,400 Less: Present value of net investment 750,000 Excess of net present value P 5,400 Required: Using the present value method, determine whether the project is acceptable or not. Decision: The project is acceptable because it will yield a return exceeding the minimum desired rate of 8%.  Discounted Rate of Return / Internal Rate of Return Discounted rate of return, also known as internal rate of return (IRR) – is the rate which equates the present value of the future cash inflows with the cost of the investment which produces them. It is the discount rate that forces a project’s NPV to equal zero. Decision Rule: Accept the proposal investment if DCR or IRR is equal to or greater than minimum desired rate of return or cost of capital. Reject the proposal if IRR is lower than the minimum desired rate of return. In short: If: IRR = or > Required rate of return; Accept If: IRR < Required rate of return; Reject Steps in the computation of the discounted rate of returns: A. Cash flows are evenly received during the life of the project: 1. Compute the PVF by dividing Net Investment by annual cash returns. 2. Trace the PV factor in the Table for Present Value of P1 received annually using the life of the project as point of reference.  3. The column that gives the closest amount to the PV factor is the “Discounted rate of return”. 4. To get the exact Discounted rate of return, interpolation is applied. Illustrative example: (Uniform Cash Returns) An investment of P50,000 will yield an average annual cash return of P7,500 a year for a period of 10 years. What is the discounted rate of return? Solution: 1. PV Factor = P50,000 / P7,500 = 6.6667 2. Referring to the table for Present Value of P1 received annually for 10 years, the column that gives the nearest value of 6.6667 is the column for 8% 3. To get the exact rate of return, interpolate between 8% and 10%. 8% - 6.710 ? - 6.667 0.043 10% - 6.145 0.565 Exact discount rate of return = 8% + (0.043 / 0.565 x 2%) = 8% + 0.15% = 8.15%  B. Cash inflows are not evenly received: The steps in computing for the discounted rate of return are: 1. Compute the average annual Cash Returns by dividing the sum of the returns to be received during the life of the project by the total economic life of the project. 2. Divided Net Investment by the Average Annual Cash Returns to get the Present Value Factor. 3. Refer to the Table for Present Value of P1 received annually to determine the rate that will give the closest factor to the computed present value factor. 4. Using the rate obtained in Step No. 3, refer to the Table for Present Value of P1. If the returns are increasing, use a discount rate lower than the rate obtained in Step No. 3, if the returns are decreasing, use a higher rate. Compute the present value of the annual cash returns. 5. Add the present value of the annual returns and compare with the Net Investment.  6. If the result in Step No. 5 does not give equality of present value of returns and net investment, try another rate. 7. Interpolate to get exact discounted rate of return. Illustrative Example: ( Uneven Cash Returns) An investment amounting to P100,000 is expected to yield cash returns as follows: Year Amount 1 P 40,000 2 50,000 3 60,000 Required: Compute the discounted rate of return. Solution: 1. Average cash returns = P150,000 / 3 years = P50,000 2. PV Factor = P100,000 / 50,000 = 2  3. Referring to the Table for Present Value of P1 received annually period 3, the column that will give the nearest value to 2 is the column for 22%. 4. Using the Table for Present Value of P1, column 22%, the cash returns are discounted as follows: Trial at 22%____ Year Amount of Cash Returns PV Factor PV of Cash Returns  Discounted Payback Period Discounted payback method – is a method that recognizes the time value of money in a payback context.This is used to compute the payback in terms of discounted cash flows received in the future. That is, the periodic cash flows are discounted using an appropriate cost of capital rate. The payback period is computed using the discounted cash flow values rather than actual cash flows. Decision Rule: If the project’s discounted payback (DPB) is shorter than the maximum allowable discounted payback set by the company, the project should be accepted. If the project’s DPB is longer than the maximum allowable DBP set by the company, the project should be rejected.  Illustration – Payback / Discounted Payback A project requiring an investment of P170,000 is expected to generate the following cash flows: Year 1 60,000 Year 2 60,000 Year 3 60,000 Year 4 60,000 Year 5 60,000 Required: a) What is the payback period? 2.833 years b) If the cost of capital is 15%, what is its discounted payback period? 4 years c) Should the project be accepted if the maximum allowable DPB is 3 years? Rejected  Illustration: Net Present Value (NPV) ABC wants to invest in a machine costing P80,000with a useful life of six years and no salvage value. The machine will be depreciated using the straight-line method and is expected to produce annual cash inflow from operations, net of income tax, of P22,000. The present value of an ordinary annuity of 1 for 6 periods at 10% is 4.355. The present value of P1 for six periods at 10% is 0.564. Required: a) Assuming that ABC wants a minimum rate of return of 10%, what is the net present value of this proposed investment? b) Is the proposal acceptable? Solution: a) PV of annual cash inflows (P22,000 x 4.355) = P95,810 Less: PV of net investment = 80,000 Net present value P15,810 b) Yes, the proposal is acceptable because the proposal could earn more than the minimum return that the firm desires as indicated by the positive net present value.  COST-VOLUME-PROFIT (CVP) ANALYSIS Basic Concepts for CVP Analysis The fundamental concept underlying CVP analysis is that the firm’s costs can be broken down into variable and fixed costs. A useful tool for organizing the firm’s costs into fixed and variable categories is the contribution-margin-based income statement. Illustration: The company plans to sell 10,000 snowboards at P400 each in the coming year. Product costs include: direct materials per snow board is P80; direct labor per snow board is P125; and variable overhead per snow board is P15. Total fixed factory overhead is P800,000.Variable selling expense is a commission of 5% of price and fixed selling and administrative expenses total P400,000. Required: a) Variable product cost per unit; b) Selling expense per unit; c) Variable cost per unit; d) Contribution margin per unit; e) Contribution margin ratio; and f) Total fixed expense.  Solution: a) Variable product cost per unit = DM + DL + VO = P80 + 125 + 15 = P220 b) Selling expense per unit = P400 x 5% = P20 c) Variable cost per unit = DM + DL + VO + VSE = P80 + 125 + 15 + 20 = P240 d) Contribution margin per unit = Price – Variable cost per unit = P400 – 240 = P160 e) Contribution margin ratio = (Price – Variable cost per unit) / Price = (P400 – 240) / P400 = 0.40 = 40% f) Total fixed expense = P800,000 + 400,000 = P1,200,000  Cos-Volume-Profit Analysis – refers to the determination of the changes in revenue, costs and expenses in relation to changes in volume. Breakeven (BEP) Point Computation Breakeven point refers to the level of activity at which there is no profit nor loss. In other words, it refers to the level of operations at which a loss is avoided (or revenue is just enough to cover costs and expenses.Therefore, the equation for sales at breakeven point is as follows: BEP sales = Fixed costs and expenses + Variable costs and expenses Contribution Margin (CM) Approach in BEP Computation The term contribution margin per unit refers to the difference between unit selling price and unit variable costs and expenses.  The formula for contribution margin per unit and contribution margin percentage are as follows: CM per unit = Unit selling price – Unit variable cost CM or (P/V) % = CM per unit / Unit selling price BEP sales volume = Fixed costs and expenses / Contribution margin per unit BEP peso sales = Fixed costs and expenses / Contribution margin % Sales with Desired Profit. The computation for sales resulting in a desired profit using the CM approach is based on the fact that contribution margin per unit is the unit contribution to absorption of fixed costs and expenses and to profit. In other words, any excess of total contribution margin over fixed costs and expenses is profit. Thus, to realize a desired profit, the total contribution margin must be equal to fixed costs and expenses plus the desired profit.  *Sales volume with desired profit = (Fixed costs and expenses + Desired profit) / CM per unit *Peso sales with desired profit = (Fixed costs and expenses + Desired profit) / CM ratio Illustration 1: If competitive selling price per unit is P4 and variable cost per unit is P3 and fixed costs and expenses of P20,000.What is the BEP sales volume and BEP peso sales? Solution: BEP sales volume = P20,000 / P1 = 20,000 units BEP peso sales = P20,000 / (P1/P4) or 25% = P80,000 Illustration 2: Based on the preceding example, if the entity wants a desired profit of P10,000.What is the sales volume and peso sales? Solution: Sales volume = (P20,000 + P10,000) / P1 = 30,000 units Sales amount = (P20,000 + P10,000) / (P1/P4) or 25% = P120,000  Margin of Safety. This term refers to the amount by which sales may decline and still enable a business firm to avoid losses. Thus, it is the difference between a specified sales figures (actual, budgetary or merely assumed) and breakeven point sales. Margin of safety = Sales – BEP sales Net income = Margin of safety x CM% Sales with Desired Profit after Income Tax. If the desired profit figure is after income tax, income before income tax is computed and the formula for sales volume and peso sales would be similar to the ones used in foregoing illustrations. Profit before income tax = Desired profit after income tax / (1- Tax rate)  Illustration 1: Assuming the desired profit is P6,500 after income taxes of 35% for the company. What is the profit before income tax? Solution: Profit before income tax = Desired profit after income tax / (1 – Tax rate) = P6,500 / (1 – 35%) = P10,000 Illustration 2: Assuming the competitive selling price per unit is P4 and variable cost per unit is P3 and fixed costs and expenses of P20,000. Desired profit after income tax is P6,500. What is sales volume and peso sales? Solution: Sales volume with desired = Fixed costs and expenses + [Desired profit after income tax / (1- Tax rate)] profit after income tax Contribution margin per unit = P20,000 + [P6,500 / (1 – 35%)] = 30,000 units P1  Peso sales with desired = Fixed costs and expenses + [Desired profit after income tax / (1 – Tax rate)] profit after income tax Contribution margin % = P20,000 + [P6,500 / (1- 35%) = P120,000 25% Sales Resulting in a Loss. Fixed costs and expenses must exceed total contribution margin for a loss to be incurred.The formula is as follows: Sales volume resulting in a loss = (Fixed costs and expenses – Loss) / CM per unit Illustration: Based on the preceding example, if the company incur a loss of, say, P5,000, what is the sales volume? Solution: Sales volume = (P20,000 – 5,000) / P1 = 15,000 units