accounting #3!
selling price equation
(1+ Markup Percentage) x Cost
profit
(p(selling price)-variable costs)xQ (unit sales)
factors in determining the markup percentage using the absorption costing approach to cost plus pricing include
1. absorption costing unit product cost 2. selling, general and administrative expenses 3. adequate return on investment
strengthen the chain
1. identify the weakest link 2. do not place a greater strain on the system than than the weakest can handle 3. concentrate improvement efforts on strengthening the weakest link 4. if successful find the next weakest link
product costs 500 dollars and company applies 50% MARKup, selling price is
500/2=250 250+500=750!!!!
markup percentage on absorption cost
=((Required ROI × Investment) +Selling and administrative expenses)) / ( Unit product cost × Unit sales )
cost plus pricing
A pricing method in which a predetermined markup is applied to a cost base to determine the target selling price.
activity-based costing can be used to help identify potentially relevant costs for decision-making purposes.
Activity-based costing improves the traceability of costs by focusing on the activities caused by a product or other segment.
using external suppliers
By pooling demand from a number of companies, a supplier may be able to enjoy economies of scale. These economies of scale can result in higher quality and lower costs than would be possible if the company were to attempt to make the parts or provide the service on its own. A company must be careful, however, to retain control over activities that are essential to maintaining its competitive position.
finding if it should be dropped
Contribution margin and fixed expenses difference. if : CM= 20000 Fixed exp= 15000 Financial disadvantage= 5000, should not be discontinued unless a more profitable use can be found for the floor and counter space that it is occupying.
contribution margin per unit by the amount of the constrained resource required to make a unit of that product equation
DIVIDE a products CM per unit by the amount of the constrained resource required to make a unit of that product
key concept number 1
Every decision involves choosing from among at least two alternatives. Therefore, the first step in decision making is to define the alternatives being considered. EX: if a company is deciding whether to make a component part or buy it from an outside supplier, the alternatives are make or buy the component part. Similarly, if a company is considering discontinuing a particular product, the alternatives are keep or drop the product.
using absorption costing to cost plus pricing
First, a company needs to calculate its unit product costs (including direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead). Second, it needs to determine its markup percentage on absorption cost. Third, it needs to multiply a product's unit product cost by the sum of one plus the markup percentage to determine the product's selling price.
A product's differentiation value can arise in either of two ways.
First, a product may differentiate itself by enabling customers to generate more sales and contribution margin than the best available alternative. Second, a product may differentiate itself by enabling customers to realize greater cost savings than the best available alternative.
isolating relevant costs is desirable for two reasons:
First, only rarely ***will enough information be available to prepare a detailed income statement for both alternatives. Assume, for example, that you are asked to make a decision relating to a portion of a single business process in a multidepartment, multiproduct company. Under these circumstances, it would be virtually impossible to prepare an income statement of any type. You would have to rely on your ability to recognize which costs are relevant and which are not in order to assemble the data necessary to make a decision. Second, ***mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is really critical. Furthermore, the danger always exists that an irrelevant piece of data may be used improperly, resulting in an incorrect decision. The best approach is to ignore irrelevant data and base the decision entirely on relevant data. Irrelevant costs may be used incorrectly in the analysis.
to make the sell or process further decision, 3 steps:
First, they should always ignore all joint costs, which include all costs incurred up to the split-off point. These costs should be ignored because they remain the same under both alternatives—whether the manager chooses to sell a joint product at the split-off point or process it further. The second step is to determine the incremental revenue that is earned by further processing the joint product. This computation is performed by taking the revenue earned after further processing the joint product and subtracting the revenue that could be earned by selling the joint product at the split-off point. The third step is to take the incremental revenue from step two and subtract the incremental costs associated with processing the joint product beyond the split-off point. If the resulting answer is positive, then the joint product should be processed further and sold for a higher price. If the answer is negative, then the joint product should be sold at the split-off point without any further processing.
key concept number 5
Future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process.
Competitors have an important effect on a company's pricing decisions because they provide reference prices that influence the price elasticity of demand.
If a company wants to charge higher prices than its competitors, then the company must differentiate its products or services from competing choices in a manner that motivates its customers to accept higher prices.
Before making a decision, managers must still decide which of the potentially relevant costs are actually avoidable.
Only those costs that are avoidable are relevant and the others should be ignored.
Some companies control all of the activities in the value chain from producing basic raw materials right up to the final distribution of finished goods and provision of after-sales service.
Other companies are content to integrate on a smaller scale by purchasing many of the parts and materials that go into their finished products
Once the seller computes the EVC, it seeks to negotiate a value-based selling price with the customer that falls within the following range:
Reference value≤Value-based price≤EVC
key concept number 2
The key to choosing among alternatives is distinguishing between relevant and irrelevant costs and benefits. Relevant costs and relevant benefits should be considered when making decisions. Irrelevant costs and irrelevant benefits should be ignored when making decisions. This is an important concept for two reasons. First, being able to ignore irrelevant data saves decision makers tremendous amounts of time and effort. Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives.
key concept number 3
The key to effective decision making is ***differential analysis—focusing on the future costs and benefits that differ between the alternatives. Everything else is irrelevant and should be ignored. A future cost that differs between any two alternatives is known as a differential cost. Differential costs are always relevant costs. Future revenue that differs between any two alternatives is known as differential revenue. Differential revenue is an example of a relevant benefit.
It is important to recognize that if a company prices all of its products above the price floor, it does not guarantee the company will earn a profit.
This is because the total sales revenue earned minus incremental costs may not cover the company's fixed costs. A company increases its likelihood of covering all of its costs and maximizing profits if it is capable of choosing optimal prices based on customer demand data rather than computing prices that are arbitrarily chosen without the benefit of customer feedback.
the capacity of a bottleneck can be effectively increased in a number of ways
Working overtime on the bottleneck. Subcontracting some of the processing that would ordinarily be done at the bottleneck. Investing in additional machines at the bottleneck. Shifting workers from processes that are not bottlenecks to the process that is the bottleneck. Focusing business process improvement efforts on the bottleneck. Reducing defective units. Each defective unit that is processed through the bottleneck and subsequently scrapped takes the place of a good unit that could have been sold.
Sunk costs are
a cost that already has been incurred and cannot be changed based on a managers decision -don't effect future cash flows
Make or buy decision
a decision to carry out of the activities in the value chain internally rather than to buy externally from a supplier.
differential cost
a difference in cost between two alternatives
bottleneck
a machine or some other part of a process that limits the total output of the entire system
it is assumed under the __________ approach that customers are required to buy a product at whatever price the seller deems appropriate
absorption costing
some products have
an established market price Consumers will not pay more than this price and there is no reason for a supplier to charge less—the supplier can sell all that it produces at this price.
joint costs incurred prior to the split off point ----- relevant in decisions regarding what do from the split off point
are not
the benefits of relaxing the constraint
are often enormous and easily quantified
potential advantages of dropping a product line or segment include
avoiding more fixed costs than the company loses in CM and an overall increase in net operating income
incremental cost (1) and avoidable cost (2)
both often used to describe differential costs. 1) increase in cost between 2 alternatives (better things that and the cost that comes with choosing the deluxe version of a car over the standard model) 2)a cost that can be eliminated by choosing one alternative over another
when companies do not have enough capacity to produce all the products and sales volumes demanded by their customers
companies must trade off, or sacrifice production of some products in favor of others in an effort to maximize profits
a decision can also be reached using
comparative format
good way to answer sell or process further questions
compare the incremental revenues and incremental costs for each of the joint products
when a constraint exists, companies need to focus on maximizing
contribution margin per unit of constraint
irrelevant costs
costs that do not differ between alternatives (includes sunk costs)
demand for a product or service is said to be inelastic if a change in price has little effect on the number of units sold
demand for a product or service is elastic if a change in price has a substantial effect on the volume of units sold
key to effective decision making is
differential analysis
when done correctly these two provide the same answer
differential approach and total cost approach
a company must make a volume trade off decision when they
do not have enough capacity to satisfy the demand for all of its products and must trade off units of one product for units of another due to limited production capacity
value based pricing
establish selling prices based on the economic value of the benefits that their products and services provide to customers
True or false? Depreciation of existing assets is relevant to decisions
false
when making a volume trade off decision managers should ignore
fixed costs
differential cost approach
focuses solely on the relevant costs and benefits
example joint products
from crude oil comes: gas, jet fuel and home heating oil
differential revenue
future revenue that differs between any two alternatives
What makes information relevant?
if information can influence decision making, then it is relevant; information is more relevant when it is more timely, consistent, comparable, and understandable Happens in future and it is not sunk.
price floor is determined by
incremental costs The price floor represents the lowest price that a company can charge and still make incremental profit on the sales transaction
when is it profitable to continue processing a joint product after the split off point?
it is profitable when the incremental rev exceeds the incremental processing cost
costs incurred up to the split off point in a process in which two or more products are produced from a common input are called
joint costs
one approach to value based pricing
known as the economic value to the customer (EVC). A product's economic value to the customer is the price of the customer's best available alternative plus the value of what differentiates the product from that alternative. The price of the best available alternative is known as the reference value, whereas the value of what differentiates a product from the best available alternative is known as the differentiation value
vertical integration provides for certain advantages like
less dependent on other suppliers and ensures a smoother flow, better quality,
one of the great dangers in allocating common fixed costs is that such allocation can make a product line
look less profitable
differential costs and benefits that should be considered in a decision
may be qualitative or quantitative
price elasticity of demand
measure the degree to which a change in price affects unit sales. a measure of degree to which a change in price effects the unit sales of a product or service.
key concept number 6
opportunity cost needs to be considered when making your decision.
when planning a trip and deciding whether to drive or fly, the _______ is a sunk cost and should be ignored
original cost of the car
the costs provided by a well designed activity based costing system are ______ relevant to a decision
potentially
comparative format
preparing income statements showing the effects of either keeping or dropping the product line
customers and competitors play important role in determining the
price ceiling for a co products and services
Product abc has a CM per unit of 10 dollars and 5 min of machine time, product xyz has a CM per unit of 15 and 10 min in machine time. IF companys constraint is machine hours, they should fill demand for
product ABC co should fill demand for product with the highest CM per unit of the constrained resource. ABC's is 2$ per min or machine time (10/5) while XYZ's is 1.50 (15/10).
managing organizations constraints is key to increased
profits
economic value to the customer
reference value + differentiation value
when a manager increases the capacity of the bottle neck it is called
relaxing (or elevating) the constraint
constraint
s anything that prevents you from getting more of what you want. Every individual and every organization faces at least one constraint, so it is not difficult to find examples of constraints
A decision as to whether a joint product should be sold at the split-off point or processed further is known as a
sell or process further decision
when making a decision, qualitative differences between alternatives
should not be ignored
microsoft excel
solver
companies can define the cost base that they use for cost plus pricing in a variety of ways
some companies may use absorption costing to define a cost base that includes direct materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead whereas other companies may rely on a product's variable cost as the cost base. Furthermore, companies can use various types of cost systems, such as normal costing or standard costing, when quantifying the cost base. If a company uses normal costing for its absorption approach, it would calculate unit product costs based on actual direct materials and direct labor costs plus applied overhead. A company that uses standard costing for its absorption approach would derive unit product costs based on standard direct materials and direct labor costs per unit plus the amount of applied overhead that is allowed per unit produced.
what should not be included in the analysis when decision making?
sunk costs and non differential costs
calculating whether product lines or other segments of a company should be dropped
takes careful analyzation
markup
the difference between its selling price and its cost and is usually expressed as a percentage of cost
when making a decision, only relevant items are included in the analysis of the alternatives when using
the differential cost approach only
in general, a special order should be accepted if
the incremental revenue from the special order exceeds the incremental costs of the order. However, it is important to make sure that there is indeed idle capacity and that the special order does not cut into normal unit sales or undercut prices on normal sales. For example, if the company was operating at capacity, opportunity costs would have to be taken into account, as well as the incremental costs that have already been detailed above.
oppurtunity cost
the loss of potential gain from other alternatives when one alternative is chosen.
in general the less sensitive customers are to price the higher
the optimal selling price will be
If a company is using a resource that could be used for some other purpose, the opportunity cost of that resource is
the profit from the best alternative use of the resource
if line is dropped
the salaries expense is down, advertising expense is down, utilities expense , depreciations expense, rent expense, insurance expense, general admin expense are all down
companies are forced to make volume trade-off decisions when
they do not have enough capacity to produce all the products and sales volumes demanded by their customers
relevant costs
those costs and revenues that differ across alternatives
joint products
two or more products that are produced from a common output
less dependance on suppliers is an advantage of
vertical integration
when a company is involved in more than one activity in the entire value chain it is
vertically integrated
Effectively managing an organization's constraints is a key to increasing profits.
when a constraint exists in the production process, managers can increase profits by producing the products with the highest contribution margin per unit of the constrained resource. However, they can also increase profits by increasing the capacity of the bottleneck operation
split off points
where joint products can be recognized as separate products
here is no such loss of contribution margin if time is lost on a machine that is not a bottleneck
—such machines have excess capacity anyway.
if it is bottleneck
focus on the contribution margin per unit by the amount of the constrained resource required to make a unit of that product
salvage value
funds gained from the sale of a capital asset
concept #5 example
So, continuing with the movie example, assume that you plan to buy a Papa John's pizza after watching a movie. If you are going to buy the same pizza regardless of your movie-watching venue, the cost of the pizza is irrelevant when choosing between the theater and the rental. The cost of the pizza is not a sunk cost because it has not yet been incurred. Nonetheless, the cost of the pizza is irrelevant to the choice of venue because it is a future cost that does not differ between the alternatives.
key concept number 4
Sunk costs are always irrelevant when choosing among alternatives.
managers should exercise caution against reading more into this "traceability" than really exists. People have a tendency to assume that if a cost is traceable to a segment, then the cost is automatically an avoidable cost.
That is not true because the costs provided by a well-designed activity-based costing system are only potentially relevant.
reasons for using target costing
The first is that many companies have less control over price than they would like to think. The market (i.e., supply and demand) really determines price The second observation is that most of a product's cost is determined in the design stage. Once a product has been designed and has gone into production, not much can be done to significantly reduce its cost.
managers may choose to retain an unprofitable product line because it
helps sell other products and attracts customers
total cost approach
includes all costs and benefits, relevant or not
typical capital budgeting cash outflows include
initial equipment investments, installation costs and working capital invested
Internal Rate of Return
investment required/annual net cash inflow
Internal Rate of Return
rate of return of an investment project over its useful life discount rate that equates the present value of a projects cash outflows with the present value of its cash inflows the internal rate of return is the discount rate that results in a net present value of zero.
capital budgeting decisions
require a great deal of analysis prior to acceptance and involve an immediate cash outlay in order to obtain a future return
Typical Cash Outflows
require an immediate cash outflow in the form of an initial investment in equipment, other assets, and installation costs. Any salvage value realized from the sale of old equipment can be recognized as a reduction in the initial investment or as a cash inflow. Second, some projects require a company to expand its working capital
The net present value of one project cannot be directly compared to the net present value of another project
unless the initial investments are equal
establishing selling prices based on the economic worth of benefits their goods and services provide to customers is the basis of
value-based pricing
cash outflow
working capital is tied up for project needs
This technique can be used in other situations in which future cash flows are difficult to estimate.
For example, this technique can be used when the salvage value is difficult to estimate.
a one time order that is not considered part of the company's normal ongoing business is a
special order
value chain
from development to production to after sales service is part of
cost of capital serves as
a screening device
future cash flows expected from investment projects
can be difficult to estimate
managers evaluate whether a
special order should be accepted and the price that should be charged
a new machine requires an investment of 630,000 and will generate 100,000 in cash inflows for 7 years, at ehich time the salvage value of the machine will be 130,000. Using a discount rate of 10%, the net present value of the machine is
-76,510 cash inflows of 486,000 (100,000x4.868)=66690 (130000x.513 (pv of 1 dollar in 7 periods at 1-% - cash outflows of 630,000 (cost + qorking capital) = that
assumptions used when performing net present value analysis
1.they assume that all cash flows other than the initial investment occur at the end of periods. This assumption is somewhat unrealistic because cash flows typically occur throughout a period rather than just at its end; however, it simplifies the computations considerably. 2. managers assume that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the rate used to discount the future cash flows, also known as the discount rate. If this condition is not met, the net present value computations will not be accurate.
farm central is considering the purchase of a larger combine to increase productivity. Combine a costs 210,000$ and has a useful life of 10 years. The combine will reduce labor costs by 25,000$ per year. The payback period of the combine is
8.4 years
Simple Rate of Return Formula
= Annual incremental net operating income / Initial investment
The project profitability index is an application of the techniques for utilizing constrained resources discussed in an earlier chapter. In this case, the constrained resource is the limited funds available for investment, and the project profitability index is similar to the contribution margin per unit of the constrained resource.
A few details should be clarified with respect to the computation of the project profitability index. The "Investment required" refers to any cash outflows that occur at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment. The "Investment required" also includes any investment in working capital that the project may need.
A positive net present value indicates that the project's return exceeds the discount rate.
A negative net present value indicates that the project's return is less than the discount rate
simple rate of return
Annual incremental net operating income/Initial investment the initial investment shown in the denominator should be reduced by any salvage value realized from the sale of old equipment.
target cost
Anticipated Selling Price - Desired Profit
if the company's minimum required rate of return is used as the discount rate, a project with a positive net present value has a return that exceeds the minimum required rate of return and is acceptable.
Conversely, a project with a negative net present value has a return that is less than the minimum required rate of return and is unacceptable.
Typical capital budgeting decisions include:
Cost reduction decisions. Should new equipment be purchased to reduce costs? Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity and sales? Equipment selection decisions. Which of several available machines should be purchased? Lease or buy decisions. Should new equipment be leased or purchased? Equipment replacement decisions. Should old equipment be replaced now or later?
factor of the internal rate of return
Factor of the internal rate of return = Investment required/Annual net cash inflow
typical cash inflows
First, a project will normally increase revenues or reduce costs. a reduction in costs is equivalent to an increase in revenues. Second, cash inflows are also frequently realized from selling equipment for its salvage value when a project ends, although the company actually may have to pay to dispose of some low-value or hazardous items. Third, any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time. Working capital is released, for example, when a company sells off its inventory or collects its accounts receivable.
net present value v internal rate of return
First, both methods use the cost of capital to screen out undesirable investment projects. Second, the net present value method is often simpler to use than the internal rate of return method, particularly when a project does not have identical cash flows every year Third, the internal rate of return method makes a questionable assumption. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flows
the simple rate of return suffers from two important limitations
First, it focuses on accounting net operating income rather than cash flows. Thus, if a project does not have constant incremental revenues and expenses over its useful life, the simple rate of return will fluctuate from year to year, thereby possibly causing the same project to appear desirable in some years and undesirable in others. Second, the simple rate of return method does not involve discounting cash flows. It considers a dollar received 10 years from now to be as valuable as a dollar received today.
If the internal rate of return is equal to or greater than the required rate of return, then the project is acceptable.
If the internal rate of return is less than the required rate of return, then the project is rejected
The difference between target costing and other approaches to product development is profound. .
Instead of designing the product and then finding out how much it costs, the target cost is set first and then the product is designed so that the target cost is attained
one dollar earned today is worth
More than one dollar earned at a future point in time
Clearly, if the intangible benefits are large enough, they could turn this negative net present value into a positive net present value. In this case, the amount of additional cash flow per year from the intangible benefits that would be needed to make the project financially attractive can be computed as follows:
Negative net present value to be offset, $226,000/Present value factor, 5.650 = $40,000
profitability index
Net Present Value / Investment Required
Project Profitability Index formula
Project profitability index = Net present value of the projectInvestment required higher the better
payback period
The length of time that it takes for a project to fully recover its initial cost out of the net cash inflows that it generates. length of time it takes for the project to recover its initials cost from the net cash inflows generated
Any tendency to inflate the benefits or downplay the costs in a proposal should become evident after a few postaudits have been conducted.
The postaudit also provides an opportunity to reinforce and possibly expand successful projects and to cut losses on floundering projects.
target costing
The process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure.
Capital Budgeting
The process of planning significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of a new product.
Project Profitability Index
The ratio of the net present value of a project's cash flows to the investment required.
if a project was approved on the basis of a net present value analysis, then the same procedure should be used in performing the postaudit. However, the data used in the postaudit analysis should be actual observed data rather than estimated data.
This gives management an opportunity to make a side-by-side comparison to see how well the project has succeeded. It also helps assure that estimated data received on future proposals will be carefully prepared because the persons submitting the data knows that their estimates will be compared to actual results in the postaudit process.
whenever the NPV of a project is postitive
Whenever the net present value of a project is positive, the project will recover the original cost of the investment plus sufficient excess cash inflows to compensate the organization for tying up funds in the project.
assumption underlying net present value analysis
all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate
in total cost app
all cash inflows and all cash outflows are included in the solution under each alternative.No effort has been made to isolate those cash flows that are relevant to the decision and those that are irrelevant. The inclusion of all cash flows associated with each alternative gives the approach its name—the total-cost approach. also Second, notice that a net present value is computed for each alternative. This is a strength of the total-cost approach because an unlimited number of alternatives can be compared side by side to determine the best option.
total cost approach and differential approach methods give same answer
always
which of the following are ways in which to calculate the benefit of selecting one alternative over another?
an analysis that just looks at the relevant costs and benefits, the diff between the net operating income for the two alternatives and an analysis that looks at all costs and benefits and identifies those that are differential
a series of equal cash flows is an
annuity
an investment that pays the investor 1000 per year for the next 10 years is an example of
annuity
the time that it takes for an investment to pay for itself
another def for pay period
out of pocket costs
are actual cash outlays for salaries, advertising, and other operating expenses
average costs
are often misleading and contain sunk costs
When the cash flows associated with an investment project change from year to year, the simple payback formula that we outlined earlier cannot be used. Instead, the payback period can be computed as follows
assuming that cash inflows occur evenly throughout Page 637the year): Payback period = Number of years up to the year in which the investment is paid off + (Unrecovered investment at the beginning of the year in which the investment is paid off ÷ Cash inflow in the period in which the investment is paid off).
when computing the simple rate of return, the annual incremental net operating income in the numerator should
be reduced by the investments depreciation charges
net present value and internal rate of return methods not only focus on cash flows
but they also recognize the time value of those cash flows
which of the following is true regarding time value of money
by collecting a projects return quickly you can re invest it quicker and projects that provide earlier returns are preferable to those that promise later returns
some companies use the simple rate of return to evaluate
capital investment proposals
know how to make
cash basis income statement and operating income statement
payback method focuses on
cash flows
the net present value assumes that
cash flows are not reinvested
when making a product line decision, a company may focus on lost __ __ and avoidable fixed costs or prepare comparative income statements.
cm
net present value method
compares the present value of a project's cash inflows to the present value of its cash outflows. The difference between the present value of these cash flows, called the net present value, determines whether or not a project is an acceptable investment.
when a product has an established market price
consumers will not pay more than the established price and there is no reason for suppliers to charge less than the established price
Working Capital
current assets - current liabilities When a company takes on a new project, the balances in the current asset accounts often increase
net present value
diff between the present cal of cash inflows and present call of cash outflows for a project AND used in determining whether or not a project is an acceptable capital investment
internal rate of return and net present value method uses
discounted cash flows
finding the present value of a future cash flow is called
disocounting
price of a customers best available alternative plus the value of what differentiates the product from that alternative is the products
economic value to the customer
to effectively deal with constraint
efforts should be focused on the weakest link and improvement should focus on the constraint
payback method is good for
finding proposals that are in the ball park -the payback method is sometimes used in industries where products become obsolete very rapidly—such as consumer electronics.
the simple rate of return
fluctuates from year to yar along with fluctuations in revenue and expense and ignores the time value of money
when a product is past the split off point but is yet a finished product it is called
intermediate product
committing funds today with the expectation of earning a return on those funds in the future in the form of additional cash flows is required when a company makes an
investment
in an equipment capital budgeting decision, recovering the original investment means that the
investment has generated enough cash inflows to completely cover the cost of the equipment
payback period formula
investment required/annual net cash inflow
postaudit
involves checking whether or not expected results are actually realized.
compound interest means that interest
is paid on interest
when the outcomes of the net present value method and the internal rate of return method do not agree
it is best to rely on the net present value method
the payback period id not true of the profitability of an investment
it simply tells a manager how many years are required to recover the original investment
the term capital budgeting is used to describe how managers plan significant investments in projects that have
long term
the required rate of return is the _________________ rate of return a project must yield to be acceptable
minimum
Net Present Value formula
net present value of future cash inflects- investment costs
least total cost
no revenue involved, deciding between leasing and buying
allocated common costs are
only relevant to decisions if they are avoidable
a shorter payback period doesn't always mean
payback period does not always mean that one investment is more desirable than another.
capital budgeting methods that focus on cash flows rather than incremental operating income are
payback, net present value and internal rate of return
if the original investment in a capital project has been recovered, the net present value will be
positive or zero
designing product that can be made for no more than the target cost is given to
product development team
the cost of capital may be used to screen out undesirable
projects
conducting a postaudit
provides an opportunity to cut losses on floundering projects, provides an opportunity to reinforce and possibly expand successful projects, flags any managers attempts to inflate benefits or downplay costs in a project proposal
Sometimes preference decisions are called
rationing decisions, or ranking decisions. Limited investment funds must be rationed among many competing alternatives. Hence, the alternatives must be ranked.
a products differentiation value can arise by enabling customers to _________ the best available alternative
realize greater cost savings than generate more sales and contribution margin than
payment method does not
recognize the time value of money. treats a dollar received todays as being equal to a dollar received in the future
time value of money
recognizes that a dollar today is worth more than a dollar a year from now if for no other reason than you could put the dollar in a bank today and have more than a dollar a year from now. Because of the time value of money, capital investments that promise earlier cash flows are preferable to those that promise later cash flows.
a products economic value to the customer is based on the ____ value and and the ____ value
reference and differentiation
preference decisions
relate to selecting from among several acceptable alternatives. To illustrate, a company may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is a preference decision.
screening decisions
relate to whether a proposed project is acceptable—whether it passes a preset hurdle. For example, a company may have a policy of accepting projects only if they provide a return of at least 20% on the investment. The required rate of return is the minimum rate of return a project must yield to be acceptable
A company is considering buying a component part that they currently make. Which of the following items related to the equipment currently being used to make the component are relevant to the decision?
salvage value and alternative uses for new equitment
typical capital budgeting cash inflows include
salvage value, working capital released, cost reductions
Capital budgeting decisions fall into two broad categories
screening and preference decisions
the process of determining the maximim allowable cost for a product and developing a profitable prototype is called
target costing
cost of capital
the average rate of return a company must earn in order to meet the demands of its lenders and expectations of its equity holders
when using the internal rate of return method
the cost of capital is used as the hurdle rate
when the net present value method is used
the discount rate equals the hurdle rate
the more frequently interest is compounded
the faster the balance grows
Postaudit
the follow-up after a project has been approved and implemented to determine whether expected results were actually realized key part of the capital budgeting process because it helps keeps managers honest in their investment proposals.
the target costing approach was developed because
the market really determines prices and most of a products cost is determined in the design stage
the higher the internal rate of return
the more desirable the project
total cost approach
the most flexible method for comparing competing projects
Simple Rate of Return
the rate of return computed by dividing a project's annual incremental accounting net operating income by the initial investment required often referred to as the accounting rate of return or the unadjusted rate of return.
when using the simple rate of return the initial investment should be reduced by
the salvage value of old equipment
If new equipment is replacing old equipment,
then any salvage value to be received when disposing of the old equipment should be deducted from the cost of the new equipment, and only the incremental investment should be used in the payback computation. In addition, any depreciation deducted in arriving at the project's net operating income must be added back to obtain the project's expected annual net cash inflow
these two methods use a technique called discounting cash flows to
translate the value of future cash flows to their present value.
a project with a positive NPV will recover the original cost of the investment plus sufficient cash inflows to compensate for tying up funds
true
the net present value method automatically provides for return of the orginal investment
true
cash inflow
working with capital is released for use elsewhere within the co
