Managerial exam 4
internal rate of return calculation
(when the net cash inflow is the same every year) investment required / annual net cash inflow
avoidable cost
a cost that can be eliminated in whole or in part by choosing one alternative or another (are relevant costs)
least cost decisions
a cost that doesnt involve money (choosing to buy or lease a jet). the most desirable alternative is the one with the least total cost from the present value perspective, can use both cost approachs. because this is the lease cost decision, the present values are negative for both alternatives.
sunk cost
a cost that has already been incurred and cannot be avoided regardless of what the manager decides to do, always the same no matter what alternatives are being considered , therefore irrelevant and should be ignored
make or buy decision
a decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier (depreciation on already purchased machines are irrelevant because they are sunk but if there is salvage value to the machinery then it becomes relevant or if it could be used to make other products)
relaxing or elevating the constraint
a manager to increase the capacity of the bottleneck (no loss of CM if the time is lost on a machine that isnt working that is not a bottleneck because it has excess capacity anyway
special order
a one time order that is not considered part of the companies normal ongoing business, a special order is profitable if the incremental revenue from the special order exceeds the incremental costs of the order (if the company is at capacity then opportunity costs would need to be taken into account as well as incremental costs
discount rate
a positive net present value indicates that the projects returns exceeds the discount rate (acceptable). a negative net present value indicates that the projects returns is less than the discount rate(unacceptable).
out of pocket costs
actual cash outlays for salaries, advertising, other operating exp.'s
postaudit
after the project has been approved and implemented. checking whether or not expected results are actually realized. keeps managers honest to their investment proposals. provides opportunities to reinforce or possibly expand successful project and cut losses on floundering projects. when calculating, use the same method used earlier/ use the actual observations in this calculation
why do managers consider decisions
an investment today in the hope of realizing future profit
simple rate of return calculation
annual incremental net operating income / initial investment
opportunity costs
are not included in the organizations general ledger because they do not represent an actual dollar amount, rather they represent economic benefits that are forgone as a result of pursuing some course of action
cost of capital
average rate of return the company must pay to its long-term creditors and shareholders for the use of their funds rate of return is < cost of capital: doesnt earn enough to compensate creditors/shareholders (should be rejected) acts as a screening device
differential cost
avoidable cost, differential cost, incremental cost, and relevant cost mean the same thing
external supplier advantages
by pooling demand from multiple companies they may be able to enjoy economies of scale (higher quality and lower costs but must keep in mind the importance of maintaining its competitive position)
simple rate of return
capital budgeting technique that doesnt involve discounting cash flows, focuses on accounting net operating income rather than cash flows. depreciation charges resulting from the investment should be deducted when determining the annual incremental net operating income. the initial investment should be reduced by any salvage value realized from the sale of old equipment.
recovery of investment
cash inflow (per month, quarter..) - return on investment
discount rate
co.'s cost of capital or an opportunity rate of return
typical CBD's
cost reduction (new equip. to reduce current costs) expansion (new plant, warehouse, factory to increase capacity/sales) equipment selection decisions (which machine) lease or buy decision (new equip. be bought/leased) equipment replacement decisions (old equip. replaced now or later) [projects promising earlier returns are more preferable than those promising later returns]
relevant cost
costs that differ between alternatives. only those costs and benefits that differ in total between alternatives are relevant in a decision (relevant in one decision or circumstance doesn't mean it is relevant in all, managers need different costs for different purposes)
working capital
current assets - current liabilities
value of money technique
discounting cash flows
steps in deciding relevancy
eliminate costs and benefits that do not differ between alternatives. there irrelevant costs consists of sunk costs and future costs that do not differ between alternatives use the remaining costs and benefits that do differ between alternatives in making the decision. the costs that remain and the differential, or avoidable costs. (isolating the relevant costs or using the relevant and irrelevant costs will get you the same answer)
payback method
focuses on the payback period. the length of time that it takes from a project to recover its initial cost from the net cash inflows that it generates. rule: the more quickly that the costs can be recovered, the more desirable the investment is. the payback period is expressed in years, when the annual net cash inflow is the same every year. not a true measure of the profitability of an investment, rather it tells the manager how many years it will take to recover the investment. ignores all cash flows that occur after the payback period. doesnt consider the time value of money. salvage value of old equipment should be deducted from the cost of new equipment
differential costs and benefits column
if it is positive the new alternative is preferred if it is negative the old alternative is preferred if it is zero then there is no difference between the alternatives (this is why costs and benefits that do not differ between alternatives are irrelevant and can be ignored [cancel each other out when compared to alternatives])
irrelevant cost
if the total cost will be the same regardless of the alternative then the decision has no effect on the cost and can be ignored (unavoidable costs are irrelevant costs) A L W A Y S I R R E L E V A N T -Sunk costs -future costs that do not differ between alternatives per unit, per direct labor hour, per machine hour may all be misleading because some of the included costs may be fixed or sunk and are irrelevant
simple rate of return criticisms
ignores time value of money (dollar today, dollar in a year) misleading if the alternatives has different cash flow patterns many projects dont have constant incremental revenues and expenses over their useful lives, fluctuating year to year. provides a single number to summarize all of cash flows over the entire useful life of the project
cost of capital screening methods
internal rate of return method: used as the internal rate of return (hurtle) that a project must clear for acceptance (if it can't clear: its rejected) net present value: the cost of capital is the discount rate (yielding negative value is rejected unless it can be justified)
return on investment
investment outstanding for the year x the percentage required back on any project
payback method calculation
investment required / annual net cash inflow
Why distinguishing between relevant costs and irrelevant costs are important
irrelevant costs can be ignored (saving time and effort) bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives . managers must be able to tell the difference between relevant and irrelevant costs and correctly use the data to make decisions
managing constraints
key to making a profit involves selecting the most profitable product mix and finding ways to increase the capacity of the bottleneck operation, the most profitable product mix is one in which has the highest CM/unit of the constrained resource and should lead to increased sales and production usually in almost immediate increase in profit
vertical integration advantages
less dependent on its supplier may be able to ensure a smoother flow of parts and production than a non-integrated company can control quality better bu producing their own parts and materials rather than relying on others quality realizes profits from their parts and materials as well as their other operations
total cost approach
most flexible for comparing competing projects unlimited number of alternatives can be compared side by side to decide which is best
typical cash outflows
most projects have at least these three types. often require an immediate cash outflow in the form of an initial investment in equip., other assets, and installation costs. (any salvage value realized from sale of old equip. can be recognized as a reduction in the initial investment or as cash inflow) require a company to expand its working capital many projects also require periodic outlays for repairs, maintenance, and additional operating costs -initial investment (including instillation costs) -increased working capital needs -repairs and maintenance -incremental operating costs
typical cash inflows
most projects have at least three types. projects normally increases revenues or reduce costs (either way this amount should be treated as cash inflow for CB purposes; reduction in cost is equivalent to an increase in revenue) cash inflow is often realized from selling equip for its salvage value when the project ends, although the co may have to pay for the disposal. and any working capital tied up by the project can be released elsewhere and is treated as a cash inflow (ex. sells off inv. or collects a/r) -incremental rev. -reduction in costs -salvage value -release of working capital
cash flows
net income, accrual based, doesnt matter when cash flow occurs capita; budgeting, timing of cash flow matters, the present value of a cash flow depends on when it occurred
project profitability index
net present value of the project / investment required. rule: the higher the project profitability index, the more desirable the project. (meant to utilize constrained resources) investment required: any cash outflow that occurs at the beginning of the project, reduced by any salvage value recovered from the sale of old equipment and includes any investment in working capital that the project may need.
net present value
positive- acceptable, the return is greater than the required rate of return zero- acceptable, promises return equal to the required rate of return negative- not acceptable, promises less than the required rate of return (underestimate the cost [3,838] or overestimate the net present value of future cash savings)
why is it desirable to isolate the relevant costs
rarely will enough info be given to complete an income statement for the two approaches mingling relevant and irrelevant costs can become confusing and distract from the critical info, irrelevant data may be used improperly resulting in improper decision making. relevant cost analysis paired with contribution approach provide a powerful took for decision making
internal rate of return
rate of return promised by an investment project over its useful life. this is the discount rate that results in a net present value of zero the IRoR is compared to the co.'s min required rate of return (which is usually the co.'s cost of capital) if the IRoR >= required rate of return (acceptable) (or less than: unacceptable)
costs that are avoidable
salaries advertising insurance (if carried on inventory)
capital budgeting falls into 2 categories
screening decisions (comes first to decide acceptability) preference decisions (which decision is best)
preference decisions
selecting from several acceptable alternatives (which of many machines to buy to replace the old one)
comparative format
showing the effects of keeping or dropping the product line
net present value advantages
simple makes a more realistic assumption about the rate of return that can be earned on cash flows from the project
steps to providing a product (value chain)
software must be developed (needing highly skilled software engineers/ project management effort) must be put into a deliverable format to customers (burning the application onto a cd or dvd, applying a label, and packaging (by an employee) must be distributed to stores then the product must be sold after purchase services (may include several or one company in all of this production process)
simplifying assumptions in net present value analysis
that all cash flows other than the initial investment occur at the end of each period and that all cash flows generated by an investment project are immediately reinvested at a rate of return equal to the discount rate (these must be met or the net realizing value wont be accurate)
minimum required rate of return
the cost of capital is usually the min.
joint cost
the costs incurred up until the split-off point
net present value
the difference between the inflows and outflows of a projects cash flow and determines if the project is an acceptable investment
bottleneck
the machine or process that is limiting overall production output is the constraint. divide the product CM/ unit by the amount of the constrained resource required to make one unit of the product
split-off point
the point in the manufacturing process at which the joint products can be recognized as separate products
net present value method
the present value of projects cash inflows is compared to the present value of the projects outflows. automatically provides for return of the original investment
intermediate product
the product is not yet finished
comparing competing investment projects
total cost approach incremental cost approach all cash inflows and outflows are included in each alternative: no relevant, irrelevant categorizing)
joint products
two or more products that are produced from a common input
capital budgeting
used to describe how managers plan significant investments in projects that have long term implications (i.e. new equipment, intro of new products) any decision involving an outlay now in order to obtain a future return is a CBD (capital budgeting decision)
internal rate of return
used to rank competing investment projects. rule: the higher the internal rate of return, the more desirable the project
costs that are not avoidable
utilities depreciation rent general administrative (common costs are irrelevant costs because they do not differ between alternatives) idle space that has no alternative has an opportunity cost of zero but if it does have use then its opportunity cost is equal to the segment margin that could be used from the best alternative use of space
vertically integrated
when a company is is involved in more than one activity in the entire value chain (vary common,
constraint
when a limited resource of some kind restrict the companies ability to satisfy demand, fixed costs excluded, they should choose the action maximizing contribution margin PER UNIT of the constrained resource
incremental cost approach
when two alternatives are being compared. more simple and direct route to a decision, only the costs and rev that differ between two alternatives are included in the analysis
screening decisions
whether a proposed project is acceptable --- passes a current hurtle (accepting only projects returning at least 20% on the investment)
santa maria wool corp process
wool/ seperating process => joint cost undyed course; fine; and superfine wool => intermediate products dying different colors =>separate product costs dyed course; fine; and superfine wool => end product
how to increase the capacity of a bottleneck
working overtime on the bottleneck subcontracting some of the processing that would be done at the bottleneck investing in additional machines at the bottleneck shifting workers from processes that are not bottlenecks to the processes that are bottlenecks focuses business process improvement efforts such as six sigma on the bottleneck reducing defective units, each unit that is processed through the bottleneck and subsequently scrapped takes the place of a good unit that could have been sold (all part of the theory of constraints and three are attractive because they are free)
