UW Principles of Accounting Final Exam
allocated general overhead
assume that these types of allocated common costs are irrelevant to the decision unless you are explicitly told otherwise assuming that these allocated costs are common to all items produced in the factory and would continue unchanged even if the shifters were bought from an outside supplier.
least-cost decisions
in decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective
same capital budgeting method should be used
in the postaudit as was used in the original approval process. That is, 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
Discount rate
interest we used to find this present value
present value
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.
major advantages of decentralization include:
1) By delegating day-to-day problem solving to lower-level managers, top-level managers can concentrate on bigger issues, such as overall strategy. 2) Empowering lower-level managers to make decisions puts the decision-making authority in the hands of those who tend to have the most detailed and up-to-date information about day-to-day operations. 3) By eliminating layers of decision making and approvals, organizations can respond more quickly to customers and to changes in the operating environment. 4) Granting decision-making authority helps train lower-level managers for higher-level positions. Empowering lower-level managers to make decisions can increase their motivation and job satisfaction.
Typical capital budgeting decisions include:
1) Cost reduction decisions. Should new equipment be purchased to reduce costs? 2) Expansion decisions. Should a new plant, warehouse, or other facility be acquired to increase capacity and sales? 3) Equipment selection decisions. Which of several available machines should be purchased? 4) Lease or buy decisions. Should new equipment be leased or purchased? 5) Equipment replacement decisions. Should old equipment be replaced now or later?
major disadvantages of decentralization include:
1) Lower-level managers may make decisions without fully understanding the company's overall strategy. If lower-level managers make their own decisions independently of each other, coordination may be lacking. 2) Lower-level managers may have objectives that clash with the objectives of the entire organization.2 For example, a manager may be more interested in increasing the size of his or her department, leading to more power and prestige, than in increasing the department's effectiveness. 3) Spreading innovative ideas may be difficult in a decentralized organization. Someone in one part of the organization may have a terrific idea that would benefit other parts of the organization, but without strong central direction the idea may not be shared with, and adopted by, other parts of the organization.
Although ROI is widely used in evaluating performance, it is subject to the following criticisms:
1) just telling managers to increase ROI may not be enough. -Managers may not know how to increase ROI; they may increase ROI in a way that is inconsistent with the company's strategy; or they may take actions that increase ROI in the short run but harm the company in the long run (such as cutting back on research and development). -This is why ROI is best used as part of a balanced scorecard, as discussed later in this chapter. A balanced scorecard can provide concrete guidance to managers, making it more likely that their actions are consistent with the company's strategy and reducing the likelihood that they will boost short-run performance at the expense of long-term performance. 2) A manager who takes over a business segment typically inherits many committed costs over which the manager has no control. These committed costs may be relevant in assessing the performance of the business segment as an investment but they make it difficult to fairly assess the performance of the manager. 3) a manager who is evaluated based on ROI may reject investment opportunities that are profitable for the whole company but would have a negative impact on the manager's performance evaluation.
Chapter 12
Differential Analysis: The Key to Decision Making
sell or process further decision
A decision as to whether a joint product should be sold at the split-off point or processed further To make these decisions, managers need to follow a three step process
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 Quite often these decisions involve whether to buy a particular part or to make it internally. Make or buy decisions also involve decisions concerning whether to outsource development tasks, after-sales service, or other activities.
present value concepts
A dollar received today is more valuable than a dollar received a year from now for the simple reason that if you have a dollar today, you can put it in the bank and have more than a dollar a year from now. Because dollars today are worth more than dollars in the future, cash flows that are received at different times must be valued differently.
differential cost
A future cost that differs between any two alternatives Differential costs are always relevant costs the terms incremental cost and avoidable cost are often used to describe differential costs
annuity
A series of identical cash flows
postaudit
After an investment project has been approved and implemented, a postaudit should be conducted. A postaudit involves checking whether or not expected results are actually realized. This is a key part of the capital budgeting process because it helps keep managers honest in their investment proposals. 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.
net book value drawbacks
An asset's net book value decreases over time as the accumulated depreciation increases. This decreases the denominator in the ROI calculation, thus increasing ROI. Consequently, ROI mechanically increases over time. Moreover, replacing old depreciated equipment with new equipment increases the book value of depreciable assets and decreases ROI. Hence, using net book value in the calculation of average operating assets results in a predictable pattern of increasing ROI over time as accumulated depreciation grows and discourages replacing old equipment with new, updated equipment. An alternative to using net book value is the gross cost of the asset, which ignores accumulated depreciation. Gross cost stays constant over time because depreciation is ignored; therefore, ROI does not grow automatically over time, and replacing a fully depreciated asset with a comparably priced new asset will not adversely affect ROI.
Vertical integration provides certain advantages
An integrated company is less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials for production than a nonintegrated company some companies feel that they can control quality better by producing their own parts and materials, rather than by relying on the quality control standards of outside suppliers. In addition, an integrated company realizes profits from the parts and materials that it is "making" rather than "buying," as well as profits from its regular operations.
Simple rate of return
Annual incremental net operating income/Initial investment The annual incremental net operating income included in the numerator should be reduced by the depreciation charges that result from making the investment. Furthermore, the initial investment shown in the denominator should be reduced by any salvage value realized from the sale of old equipment.
capital budgeting decision
Any decision that involves a cash outlay now to obtain a future return fall into two broad categories—screening decisions and preference decisions
advantages of 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.
Elements of Return on Investment (ROI)
CGS, Selling Exp, Admin Exp ----> Sales - Expeses -----> Net Operating Income / Sale ----> Margin Cash, Ac Receivable, Inventories ----> Current Assets Plants and Equipment, Other Assets ---> Noncurrent Assets Current Assets+Noncurrrent Assets ----> Sales/ Av Operating Assets ----> Turnover Margin x Turnover = ROI
Chapter 13
Capital Budgeting Decisions
volume trade-off decisions
Companies are forced to make volume trade-off decisions when they do not have enough capacity to produce all of the products and sales volumes demanded by their customers. In these situations, companies must trade off, or sacrifice production of some products in favor of others in an effort to maximize profits. The key questions become: how should companies manage those trade-offs? Which products should they produce and sell and which sales opportunities should they intentionally bypass?
Adding and Dropping Product Lines and Other Segments
Decisions relating to whether product lines or other segments of a company should be dropped and new ones added are among the most difficult that a manager has to make. In such decisions, many qualitative and quantitative factors must be considered. Ultimately, however, any final decision to drop a business segment or to add a new one hinges primarily on its financial impact. To assess this impact, costs must be carefully analyzed. LO12-2
Key Concept #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.
The Mathematics of Interest
F1 = P(1 + r) where F1 = the balance at the end of one period, P = the amount invested now, and r = the rate of interest per period.
Most projects also have at least three types of cash inflows
First, a project will normally increase revenues or reduce costs. Either way, the amount involved should be treated as a cash inflow for capital budgeting purposes. Notice that from a cash flow standpoint, 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
Comparison of the Net Present Value and Internal Rate of Return Methods
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.
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.
olating relevant costs is desirable for at least two reasons.
First, only rarely will enough information be available to prepare a detailed income statement for both alternatives. 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.
When performing net present value analysis, managers usually make two important assumptions
First, they assume that all cash flows other than the initial investment occur at the end of periods Second, 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
Most projects have at least three types of cash outflows
First, they often 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 Third, many projects require periodic outlays for repairs and maintenance and additional operating costs.
1) Joint cost
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.
volume trade-off decisions will proceed in three steps
First, we'll define the meaning of a constraint. Second, we'll explain how to determine the most profitable use of a constrained resource. Third, we'll discuss how to determine the value of obtaining more of a constrained resource and how to manage constraints to increase profits.
determine the balance in an account after n periods of compounding using the following equation:
Fn = P(1 + r)^n where n = the number of periods of compounding.
Key Concept 5
Future costs and benefits that do not differ between alternatives are irrelevant to the decision-making process. it has not yet been incurred
differential revenue
Future revenue that differs between any two alternatives relevant benefit.
traceability
However, 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. 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.
Tying Compensation to the Balanced Scorecard
Incentive compensation for employees, such as bonuses, can, and probably should, be tied to balanced scorecard performance measures. However, this should be done only after the organization has been successfully managed with the scorecard for some time—perhaps a year or more. -Managers must be confident that the performance measures are reliable, sensible, understood by those who are being evaluated, and not easily manipulated. -As Robert Kaplan and David Norton, the originators of the balanced scorecard concept point out, "compensation is such a powerful lever that you have to be pretty confident that you have the right measures and have good data for the measures before making the link."
compound interest
Interest paid on interest previously earned; credited daily, monthly, quarterly or semiannually Interest can be compounded on a semiannual, quarterly, monthly, or even more frequent basis. The more frequently compounding is done, the more rapidly the balance will grow.
rounded discount factors
It bears reemphasizing that the net present values may be calculated using the rounded discount factors from Appendix 13B.
manufacturing cycle efficiency (MCE).
MCE is computed by relating the value-added time to the throughput time. The goal is to increase this measure and the formula for computing it is as follows: MCE= Value-added time (Process time)/Throughput (manufacturing cycle) time helps companies to reduce non-value-added activities and thus get products into the hands of customers more quickly and at a lower cost.
to calculate average operating assets
Most companies use the net book value (i.e., acquisition cost less accumulated depreciation) of depreciable assets it is consistent with their financial reporting practices of recording the net book value of assets on the balance sheet and including depreciation as an operating expense on the income statement. In this text, we will use the net book value approach unless a specific exercise or problem directs otherwise.
Key Concept 2
Once you have defined the alternatives, you need to identify the criteria for choosing among them. The key to choosing among alternatives is distinguishing between relevant and irrelevant costs and benefits
Key Concept 6
Opportunity costs also need to be considered when making decisions. An opportunity cost is the potential benefit that is given up when one alternative is selected over another. not usually found in accounting records, but they are a type of differential cost that must be explicitly considered in every decision a manager makes.
we know the future value of some amount but we do not know its present value?
P =Fn/(1 + r)^n Fn = $200 (the amount to be received in the future), r = 0.05 (the annual rate of interest), and n = 2 (the number of years in the future that the amount will be received).
formula can be used to compute the payback period:
Payback period = Investment required/Annual net cash inflow The payback period is expressed in years. When the annual net cash inflow is the same every year
the financial advantage (disadvantage) of the special order would be computed as follows:
Per Unit ; Total 100 Bike Incremental revenue (a)$558 ; $55,800 Less incremental costs: Variable costs: Direct materials 372 ; 37,200 Direct labor 90; 9,000Variable manufacturing overhead 12 ; 1,200 Special modifications 34 ; 3,400 Total variable cost $508 ; 50,800 Fixed cost: Purchase of stencils 2,400 Total incremental cost (b) 53,200 Financial advantage of accepting the order (a) − (b) $ 2,600
Chapter 11
Performance Measurement in Decentralized Organizations
net present value of one project cannot be directly compared to the net present value of another project unless the initial investments are equal
Project profitability index = Net present value of the project/Investment required
rationing decisions, or ranking decisions
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. Either the internal rate of return method or the net present value method can be used in making preference decisions. However, as discussed earlier, if the two methods are in conflict, it is best to use the net present value method, which is more reliable.
Computation of the Payback Period
Step 1: Compute the annual net cash inflow. Because the annual net cash inflow is not given, it must be computed before the payback period can be determined: Net operating income $20,000 Add: Noncash deduction for depreciation 10,000 Annual net cash inflow $30,000 Step 2: Compute the payback period. Using the annual net cash inflow from above, the payback period can be determined as follows: Cost of the new equipment $80,000 Less salvage value of old equipment 5,000 Investment required $ 75,000 𝖯𝖺𝗒𝖻𝖺𝖼𝗄 𝗉𝖾𝗋𝗂𝗈𝖽 = 𝖨𝗇𝗏𝖾𝗌𝗍𝗆𝖾𝗇𝗍 𝗋𝖾𝗊𝗎𝗂𝗋𝖾𝖽 /𝖠𝗇𝗇𝗎𝖺𝗅 𝗇𝖾𝗍 𝖼𝖺𝗌𝗁 𝗂𝗇𝖿𝗅𝗈𝗐 = $𝟩𝟧,𝟢𝟢𝟢/$𝟥𝟢,𝟢𝟢𝟢 = 𝟤.𝟧 𝗒𝖾𝖺𝗋𝗌
Key concept 4
Sunk costs are always irrelevant when choosing among alternatives. A sunk cost is a cost that has already been incurred and cannot be changed regardless of what a manager decides to do. Sunk costs have no impact on future cash flows and they remain the same no matter what alternatives are being considered; therefore, they are irrelevant and should be ignored when making decisions.
Chapter 13A
The Concept of Present Value
Delivery cycle time
The elapsed time from when a customer order is received until the finished goods are shipped is called delivery cycle time. The goal is to reduce this measure and the formula for computing it is as follows: Delivery cycle time= Wait time+Throughput time
Throughput (manufacturing cycle) time
The elapsed time from when production is started until finished goods are shipped to customers is called throughput time, or manufacturing cycle time. The goal is to continuously reduce this measure and the formula for computing it is as follows: Throughput (manufacturing cycle) time= Process time+Inspection time+Move time+Queue time
Why keep a product line that is showing a loss?
The explanation for this apparent inconsistency lies in part with the common fixed costs that are being allocated to the product lines. One of the great dangers in allocating common fixed costs is that such allocations can make a product line (or other business segment) look less profitable than it really is.
two methods for evaluating this aspect of an investment center's performance
The first method, covered in this section, is called return on investment (ROI). The second method, covered in the next section, is called residual income.
From Strategy to Performance Measures: The Balanced Scorecard
The idea underlying these groupings (as indicated by the vertical arrows is that learning is necessary to improve internal business processes; improving business processes is necessary to improve customer satisfaction; and improving customer satisfaction is necessary to improve financial results.
Key Concept 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.
Profit Center
The manager of a profit center has control over both costs and revenue, but not over the use of investment funds. For example, the manager in charge of a Six Flags amusement park would be responsible for both the revenues and costs, and hence the profits, of the amusement park, but may not have control over major investments in the park. Profit center managers are often evaluated by comparing actual profit to targeted or budgeted profit.
Investment Center
The manager of an investment center has control over cost, revenue, and investments in operating assets. -responsible for earning an adequate return on investment For example, General Motors' vice president of manufacturing in North America would have a great deal of discretion over investments in manufacturing—such as investing in equipment to produce more fuel-efficient engines. Once General Motors' top-level managers and board of directors approve the vice president's investment proposals, he is held responsible for making them pay off. investment center managers are often evaluated using the return on investment (ROI) or residual income measures.
split-off point
The point in a manufacturing process where joint products (such as gasoline and jet fuel) can be recognized as separate products Quite often joint products can be sold at the split-off point or they can be processed further and sold for a higher price.
Discounting
The process of finding the present value of a future cash flow Discounting future sums to their present value is a common practice in business, particularly in capital budgeting decisions.
2) determine the incremental revenue
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.
Factor of the internal rate of return
The simplest and most direct approach when the net cash inflow is the same every year is to divide the investment in the project by the expected annual net cash inflow. This computation yields a factor from which the internal rate of return can be determined. The formula is as follows: Factor of the internal rate of return = Investment required/Annual net cash inflow
3) incremental revenue from step two and subtract the incremental costs associated with processing the joint product beyond 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.
If the Net Present Value Is ... Zero
Then the Project Is ...Acceptable because its return is equal to the required rate of return.
If the Net Present Value Is ... Positive
Then the Project Is ...Acceptable because its return is greater than the required rate of return.
If the Net Present Value Is ... Negative
Then the Project Is ...Not acceptable because its return is less than the required rate of return.
discounting cash flows
These two methods use a technique called discounting cash flows to translate the value of future cash flows to their present value.
vertically integrated
When a company is involved in more than one activity in the entire value chain
relaxing (or elevating) the constraint
When a manager increases the capacity of the bottleneck If a bottleneck machine breaks down or is ineffectively utilized, the losses to the company can be quite large
Payback and Uneven Cash Flows
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 the 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).
cost of capital serves as a screening device
When the cost of capital is used as the discount rate in net present value analysis, any project with a negative net present value does not cover the company's cost of capital and should be discarded as unacceptable.
net present value method automatically provides for return of the original investment
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
The capacity of a bottleneck can be effectively increased in a number of ways, including:
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.
avoidable cost
a cost that can be eliminated by choosing one alternative over another always relevant
value chain.
a network of value-creating activities activities, from development, to production, to after-sales service
Special order
a one-time order that is not considered part of the company's normal ongoing business Managers must often evaluate whether a special order should be accepted, and if the order is accepted, the price that should be charged
Economic Value Added (EVA®)
an adaptation of residual income that has been adopted by many companies Under EVA, companies often modify their accounting principles in various ways. For example, funds used for research and development are often treated as investments rather than as expenses. These complications are best dealt with in a more advanced course; in this text we will not draw any distinction between residual income and EVA.
incremental cost
an increase in cost between two alternatives always relevant
Constraint, or bottleneck
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 determined by the step that limits total output because it has the smallest capacity
Throughput time, which is a key measure in delivery performance, can be put into better perspective
by computing the manufacturing cycle efficiency (MCE).
Differential
can be qualitative or quantitative in nature. While qualitative differences between alternatives can have an important impact on decisions, and therefore, should not be ignored; our goal in this chapter is to hone your quantitative analysis skills. Therefore, our primary focus will be on analyzing quantitative differential costs and benefits—those that have readily measurable impacts on future cash flows.
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
residual income approach has one major disadvantage
can't be used to compare the performance of divisions of different sizes. Larger divisions often have more residual income than smaller divisions, not necessarily because they are better managed but simply because they are bigger.
The simple rate of return method
capital budgeting technique This method also is often referred to as the accounting rate of return or the unadjusted rate of return.
Separate companies may
carry out each of the activities in the value chain Other companies are content to integrate on a smaller scale by purchasing many of the parts and materials that go into their finished products
single company may
carry out several. 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
The net present value method
compares the present value of a project's cash inflows to the present value of its cash outflows
Balance scorecard
consists of an integrated set of performance measures that are derived from and support a company's strategy. top management translates its strategy into performance measures that employees can understand and influence.
Exhibit 13B-2
contains the present value of $1 to be received each year over a series of years at various interest rates when computing the present value of a series of equal cash flows that begins at the end of period 1, Exhibit 13B-2 should be used. This table should be used to find the present value of a series of identical cash flows beginning at the end of the current period and continuing into the future.
balanced scorecard approach
continual improvement is encouraged. If an organization does not continually improve, it will eventually lose out to competitors that do.
nonfinancial performance measures
critical to success in many organizations—throughput time, delivery cycle time, and manufacturing cycle efficiency (MCE)
Working capital
current assets (e.g., cash, accounts receivable, and inventory) less current liabilities
In a decentralized organization
decision-making authority is spread throughout the organization rather than being confined to a few top executives. out of necessity all large organizations are decentralized to some extent. Organizations do differ, however, in the extent to which they are decentralized. In strongly centralized organizations, decision-making authority is reluctantly delegated to lower-level managers who have little freedom to make decisions. In strongly decentralized organizations, even the lowest-level managers are empowered to make as many decisions as possible. -Most organizations fall somewhere between these two extremes.
A Company's Strategy and the Balanced Scorecard
each company must decide which customers to target and what internal business processes are crucial to attracting and retaining those customers. Different companies, having different strategies, will target different customers with different kinds of products and services. If the balanced scorecard is correctly constructed, the performance measures should be linked together on a cause-and-effect basis.
An investment can be viewed in two ways
either in terms of its future value or in terms of its present value
The residual income approach
encourages managers to make investments that are profitable for the entire company but that would be rejected by managers who are evaluated using the ROI formula. Generally, a manager who is evaluated based on ROI will reject any project whose rate of return is below the division's current ROI even if the rate of return on the project is above the company's minimum required rate of return. In contrast, managers who are evaluated using residual income will pursue any project whose rate of return is above the minimum required rate of return because it will increase their residual income. Because it is in the best interests of the company as a whole to accept any project whose rate of return is above the minimum required rate of return, managers who are evaluated based on residual income will tend to make better decisions concerning investment projects than managers who are evaluated based on ROI.
financial advantage
exists if pursuing an alternative passes the cost/benefit test. In other words, it exists if the alternative's differential benefits (i.e., its future cash inflows) exceed its differential costs (i.e., its future cash outflows)
financial (disadvantage)
exists when an alternative fails the cost/benefit test—its differential benefits are less than its differential costs.
key to maximizing the total contribution margin
favor the products that provide the highest contribution margin per unit of the constrained resource unit contribution margin alone is not enough; the contribution margin must be viewed in relation to the amount of the constrained resource each product requires.
Performance measures used in balanced scorecards tend to fall into the four groups
financial, customer, internal business processes, and learning and growth
The payback method of evaluating capital budgeting projects
focuses on the payback period. The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment.
Idle space
has no alternative use has an opportunity cost of zero. But what if the space now being used to make shifters could be used for some other purpose? In that case, the space would have an opportunity cost equal to the segment margin that could be derived from the best alternative use of the space.
balanced scorecard lays out a theory
how the company can take concrete actions to attain its desired outcomes
managers may choose to retain an unprofitable product line
if it helps sell other products, or if it serves as a "magnet" to attract customers.
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
Margin and turnover
important concepts in understanding how a manager can affect ROI. All other things the same, margin is ordinarily improved by increasing selling prices, reducing operating expenses, or increasing unit sales. Increasing selling prices and reducing operating expenses both increase net operating income and therefore margin. Increasing unit sales also ordinarily increases the margin because of operating leverage. because of operating leverage, a given percentage increase in unit sales usually leads to an even larger percentage increase in net operating income. Therefore, an increase in unit sales ordinarily has the effect of increasing margin. Some managers tend to focus too much on margin and ignore turnover. However, turnover incorporates a crucial area of a manager's responsibility—the investment in operating assets. Excessive funds tied up in operating assets (e.g., cash, accounts receivable, inventories, plant and equipment, and other assets) depress turnover and lower ROI. In fact, excessive operating assets can be just as much of a drag on ROI as excessive operating expenses, which depress margin.
Average operating assets
include cash, accounts receivable, inventory, plant and equipment, and all other assets held for operating purposes. Examples of assets that are not included in operating assets (i.e., examples of nonoperating assets) include land held for future use, an investment in another company, or a building rented to someone else. -These assets are not held for operating purposes and therefore are excluded from operating assets. The operating assets base used in the formula is typically computed as the average of the operating assets between the beginning and the end of the year.
Another method of decision analysis, called the total cost approach
includes all of the costs and benefits—relevant or not. When done correctly, the two methods always provide the same correct answer.
Net operating income
income before interest and taxes and is sometimes referred to as EBIT (earnings before interest and taxes). Net operating income is used in the formula because the base (i.e., denominator) consists of operating assets. To be consistent, we use net operating income in the numerator.
depreciation of special equipment
is an irrelevant cost because the equipment has already been purchased; thus, the cost incurred to buy the equipment is a sunk cost. If the equipment could be sold, its salvage value would be relevant. Or if the equipment could be used to make other products, this could be relevant as well.
Return on Investment (ROI)
is defined as net operating income divided by average operating assets: ROI=Net operating income/Average operating assets The higher a business segment's return on investment (ROI), the greater the profit earned per dollar invested in the segment's operating assets.
Strategy
is essentially a theory about how to achieve the organization's goals.
advantages of the balanced scorecard
it continually tests the theories underlying management's strategy. If a strategy is not working, it should become evident when some of the predicted effects (i.e., more car sales) don't occur. Without this feedback, the organization may drift on indefinitely with an ineffective strategy based on faulty assumptions.
method of decision analysis is called the differential approach
it focuses solely on the relevant costs and benefit
payback method is not a true measure of the profitability of an investment
it simply tells a manager how many years are required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another. it does not consider the time value of money.
Effectively managing an organization's constraints
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.
Managers should focus much of their attention on managing the bottleneck.
managers should emphasize products that make the most profitable use of the constrained resource. They should also make sure that products are processed smoothly through the bottleneck, with minimal lost time due to breakdowns and setups. And they should try to find ways to increase the capacity at the bottleneck.
ROI can also be expressed in terms
of margin and turnover as follows: ROI=Margin×Turnover where Margin=Net operating income/Sales and Turnover=Sales/Average operating assets
future cash flows
often uncertain or difficult to estimate. A number of techniques are available for handling this complication. Some of these techniques are quite technical—involving computer simulations or advanced mathematical skills—and are beyond the scope of this book. However, we can provide some very useful information to help managers deal with uncertain cash flows without getting too technical.
payback method focuses
on cash flows, it does not recognize the time value of money. In other words, it treats a dollar received today as being of equal value to a dollar received at any point in the future.
improvement efforts must be focused
on the constraint. A business process, is like a chain. If you want to increase the strength of a chain This simple sequential process provides a powerful strategy for optimizing business processes.
Only one of these four activities adds value to the product
process time The other three activities—inspecting, moving, and queuing—add no value and should be eliminated as much as possible.
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. an important capital budgeting concept
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 also includes any investment in working capital that the project may need.
Preference decsions
relate to selecting from among several acceptable alternatives
Screening Decisions
relate to whether a proposed project is acceptable—whether it passes a preset hurdle
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. Actual results that are far out of line with original estimates should be carefully reviewed.
Relevant cost and benefits
should be considered when making decisions
irrelevant cost and benefits
should be ignored when making decisions. 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.
Appendix 13B
shows the discounted present value of $1 to be received at various periods in the future at various interest rates we want to know the present value of $x rather than just $1, we need to multiply the factor in the table by $x This table should be used to find the present value of a single cash flow (such as a single payment or receipt) occurring in the future.
Decisin Making
six key concepts that you need to understand to make intelligent decisions
Queue time
the amount of time a product spends waiting to be worked on, to be moved, to be inspected, or to be shipped.
Inspection time
the amount of time spent ensuring that the product is not defective
Process time
the amount of time work is actually done on the product
cost of capital
the average rate of return that the company must pay to its long-term creditors and its shareholders for the use of their funds. If a project's rate of return is less than the cost of capital, the company does not earn enough to compensate its creditors and shareholders. Therefore, any project with a rate of return less than the cost of capital should be rejected.
simple rate of return method influences
the behavior of investment center managers who are evaluated and rewarded based on their return on investment (ROI).
Wait time
the elapsed time from when a customer order is received until production of the order is started. This is a non-value-added activity that should be reduced or eliminated. When companies succeed in drastically reducing or eliminating wait time plus the non-value-added components of throughput time it often enables them to increase customer satisfaction and profits
payback period.
the length of time that it takes for a project to recover its initial cost from the net cash inflows that it generates. This period is sometimes referred to as "the time that it takes for an investment to pay for itself."
Cost Center
the manager of a cost center has control over costs, but not over revenue or the use of investment funds. Service departments such as accounting, finance, general administration, legal, and personnel are usually classified as cost centers. In addition, manufacturing facilities are often treated as cost centers. The managers of cost centers are expected to minimize costs while providing the level of products and services needed by other parts of the organization. For example, the manager of a manufacturing facility would be evaluated at least in part by comparing actual costs to how much costs should have been for the actual level of output during the period. Standard cost variances and flexible budget variances, such as those discussed in earlier chapters, are often used to evaluate cost center performance.
Residual Income
the net operating income that an investment center earns above the minimum required return on its operating assets. In equation form, residual income is calculated as follows: Residual income=Net operating income-(Average operating assets×Minimum required rate of return)
When residual income or EVA is used to measure performance
the objective is to maximize the total amount of residual income or EVA, not to maximize ROI. This is an important distinction. If the objective were to maximize ROI, then every company should divest all of its products except the single product with the highest ROI.
analyzing the cash flows
the payback method, the net present value method, and internal rate of return method—all focus on analyzing the cash flows associated with capital investment projects
our methods for making capital budgeting decisions
the payback method, the net present value method, the internal rate of return method, and the simple rate of return method.
using the internal rate of return method to rank competing investment projects
the preference rule is: The higher the internal rate of return, the more desirable the project internal rate of return is widely used to rank projects.
using the project profitability index to rank competing investments projects
the preference rule is: The higher the project profitability index, the more desirable the project.3 Applying this rule to the two investments above, investment B should be chosen over investment A.
The internal rate of return
the rate of return of an investment project over its useful life. The internal rate of return is computed by finding the discount rate that equates the present value of a project's cash outflows with the present value of its cash inflows. In other words, the internal rate of return is the discount rate that results in a net present value of zero.
financial measures reflect
the results of what people in the organization do, they do not measure what drives organizational performance Consequently, many organizations use a variety of nonfinancial performance measures in addition to financial measures
focuses on incremental net operating income
the simple rate of return method focuses on incremental net operating income. To better prepare you to apply the payback, net present value, and internal rate of return methods, we'd like to define the most common types of cash outflows and cash inflows that accompany capital investment projects.
Move time
the time required to move materials or partially completed products from workstation to workstation
Present Value (PV)
the value today of a future cash flow or series of cash flows also known as the discounted value
the net present value and internal rate of return methods not only focus on cash flows
they also recognize the time value of those cash flows
Joint products
two or more products, known as joint products, are produced from a single raw material input.
unrounded discount factors
use Microsoft Excel's NPV function to perform the calculations. The NPV function automatically calculates the net present value after specifying three parameters—the discount rate (0.18), the annual cash flows (C6:G6), and the initial cash outlay (+B6).
Responsibility Accounting
used for any part of an organization whose manager has control over and is accountable for cost, profit, or investments. The three primary types of responsibility centers are cost centers, profit centers, and investment centers.
Capital budgeting
used to describe how managers plan significant investments in projects that have long-term implications such as the purchase of new equipment or the introduction of new products. managers must carefully select those projects that promise the greatest future return. How well managers make these capital budgeting decisions is a critical factor in the long-run financial health of the organization
internal business processes
what the company does in an attempt to satisfy customers
