CH-13-15 Cost Management and Decision Making – Cost Management: Strategies for Business Decisions : Chapter Notes

This Document Contains Chapters 13 to 15 Chapter 13 Cost Management and Decision Making Chapter Outline A. Cost Management Challenges — Chapter 13 offers two cost management challenges. 1. How can cost management help organizations choose among competing alternative uses of the organization’s resources? 2. How to set prices to increase employment or to generate funds for internal investment. B. Learning Objectives 1. Structure business decision-making problems into objectives, alternative actions, and expected outcomes. 2. Identify both quantitative and qualitative relevant costs and benefits of decision alternatives. 3. Use decision trees to describe business decisions. 4. Use a benefit-cost approach for common decisions such as obtaining new technology or capability, outsourcing (make versus buy); or modifying, adding, or dropping a product, service, or business unit; and pricing, including special orders and life-cycle costs. C. Financial models are representations of reality in the business world. A model allows one to see how something is supposed to work. A financial model allows an organization to test the interaction of economic variables in a variety of settings. Financial models require that analysts develop a set of equations that represent a company’s operating and financial relationships. These may include things like the relation of sales to variable costs, inventory turnover, and the relative proportions of various products sold. Once a financial model is developed, it can be used to explore different combinations of the variables that interact with each other to see what outcomes to expect given different scenarios. Financial models offer several benefits to users. Once the model is developed, users can concentrate on business analysis instead of number crunching. It gives managers insight into possible business outcomes without the risk of trying them first. It is, therefore, possible to identify bad business decisions ahead of time. On a cautionary note, models are only as good as the information that goes into them. Faulty assumptions in building a model will lead to faulty predictions and bad business decisions. D. Organizations exist to achieve specific goals. The first step is to set goals and specific objectives. The next step is gathering information. An objective measurement involves accuracy, timeliness, and relevance. Next, alternatives need to be evaluated, and considering estimated costs and benefits, the best alternative needs to be chosen. The chosen alternative must then be implemented. Finally, we must obtain feedback to evaluate the merits of the route chosen. In addition, quantitative as well as qualitative factors need to be considered while choosing among alternatives. Objectivity (the degree of consensus about what to measure, how to measure it, what the observed measure is, or whether the measurement is important) is important in decision making. It includes accuracy (precision in measurement), timeliness (availability of information in timely fashion to fully consider it when making decisions), and relevant costs and benefits which are those that occur in the future and differ among competing alternatives. Past costs are considered “sunk” and are irrelevant in decision making. Cost managers need to make trade-offs between information cost and quality. Qualitative factors are considered when a choice between alternatives with numerical quantification is difficult to obtain. E. Target costing is used considering tangible objectives. A target profit which is the desired excess of periodic or project sales revenues over costs is first determined. Target profit per unit is the target profit percentage times the market price per unit. The target cost is the most that a good or service can cost and still meet both customer needs and company profit targets. Target price is what the competitors charge and the customers are willing to pay for the product. If the target cost cannot be achieved under the current conditions, management may choose to either abandon the project or redesign the product and the work force until such time that the target cost objectives can be achieved. Target costing is explained in detail in chapter four. F. Decision trees are used for describing business decisions involving several alternatives. Decision tree is a diagram of decisions and alternative outcomes expected from those decisions in a “tree, branch, and limb format. To build a decision tree, the decision alternatives in the order the decisions must be made should be diagramed. Then, the path of each decision to its ultimate outcomes with each decision path leading to alternative paths must be shown. Finally, the benefits and costs of each set of outcomes must be determined. The challenge is to choose the optimal path considering the benefits and costs of each alternative outcome. G. The CVP model is used primarily for short-term decision making. Four types of decisions for which the CVP model might provide helpful information are (1) the make-or-buy decision, (2) adding or dropping a business unit (e.g., a product line), (3) optimal use of scarce resources, and (4) accepting special orders. These decision-making problems will be discussed in more detail later in this chapter. There are other decision-making tools that can be used besides the CVP model. The characteristics of information used to make these types of management are described below. 1. Three characteristics that are critical to making decisions are relevance, accuracy, and timeliness. Information is relevant only if it is pertinent to a particular decision. When making decisions about what should be done in the future, relevant information is defined as information that differs among alternatives in the future. Information must also be accurate in order to be useful. Inaccurate information could cause cost managers to approve unwise business decisions or to reject wise ones. Relevant, accurate information has absolutely no value if it arrives too late to be used in making a decision. The degree of accuracy of information may be reduced by the need for it to be made available on a more timely basis. 2. Other types of decision-making information are qualitative rather than quantitative in nature. Although most business decisions are related in some way to meeting profit objectives, qualitative concerns must also be factored in. Qualitative information includes things like effect on employee morale, loss of control by giving work to outsourcing providers, and effects on a community or the environment. When faced with making a decision that includes hard to quantify factors such as these, managers must employ skill, experience, judgement, and ethical standards. 3. The relevance of information is one important characteristic that bears further discussion. There are many times managers are not confronted with simply making a decision. Often they must choose among alternatives. Relevant costs and revenues are costs and revenues that occur in the future and differ among alternatives. When faced with this dilemma, managers should consider the following factors. a. The first question that should be answered is, “Will the costs or benefits change as a result of selecting the alternative under study?” If the answer is “yes,” then those costs and benefits must be considered in making the decision. b. The second issue that must be considered is what time period will be affected by the decision to be made. The events of the past do not affect the decision. Only costs and benefits that will occur in the future are relevant to the decision. Costs that have already been incurred are called “sunk costs.” c. Although sunk costs are not factored into the assessment of costs and benefits to be gained in the future, past decisions should not be ignored completely. Information from past events should be looked at, at least to understand where mistakes and successes occurred. The past can be a good predictor of the future. 4. There is a distinction to be made between decision making and performance evaluation. When making a decision, past costs should only be looked at to decide what worked well and what did not. When evaluating performance, past costs and recovery of the costs through productive activity are often a primary basis for the evaluation. In fact, performance evaluation of managers may be based on the organization’s annual performance. Sometimes a decision that benefits an organization in the long run may have a detrimental effect on the organization’s current profitability. Top managers responsible for evaluating employee performance must be cognizant of the effects of long-term decisions on short-term profits and should not punish employees making such decisions. 5. Relevant costs and revenues are considered in many different situations, both inside and outside of business organizations. The use of relevant cost information must be considered in four different types of decisions to be discussed next. They are the make versus buy decision (the outsourcing question), adding or dropping a business unit, making optimal use of scarce resources, special orders, and pricing decisions. H. A make-or-buy decision is any decision by a company to acquire goods or services internally or externally. The decision to buy goods or services externally is also known as “outsourcing.” Outsourcing is more commonly associated with decisions by organizations to shift their focus toward accomplishing core activities internally and allowing outside organizations to accomplish peripheral activities. In recent years, many companies have chosen to outsource support service activities such as information systems technology, human resources, accounting, and payroll activities. The make-or-buy decision is often part of a company’s long-run strategy. Some organizations integrate vertically, meaning that they perform all activities from the beginning to the end of their value chain. Other organizations rely on outsiders for some inputs and specialize only on certain portions of the total process. In decision to outsource, usually, variable manufacturing costs, batch level costs, and product level costs (such as supervisory personnel) are relevant costs for comparison to the outsourced price. Depreciation is a sunk cost and therefore, irrelevant. Common costs are also irrelevant except for any possible reduction in common costs as a result of outsourcing a product. Opportunity costs, however, such as the possible rental revenue for the area released in case the product is outsourced, are relevant. 1. Outsourcing can sometimes result in the elimination of non-value-added activities. This is especially true when an organization does not have a lot of expertise in a particular area. 2. When making a decision to perform an activity internally or externally, the information used must be relevant, timely, and accurate. The best way to think about the decision is to consider which costs will differ based on the choice to make or to buy. I. Managers must sometimes decide whether to add or drop a business unit. A business unit may be a product, market territory, department, facility, or any other type of segment that can be identified as a distinct unit. The decision to drop a business unit may occur for a variety of reasons, including decline in market demand, obsolescence of the product, or inability to remain competitive. Companies may decide to add a business unit because of new product development, expansion to new markets, acquisition of other companies, or ability to meet demands of new customers. Making the decision to add or drop a business unit cannot be made based on segmented income statements. Financial statement information contains allocated costs that are not relevant to the decision. Cost managers deciding whether to add or drop a business unit must base their decision only on relevant costs and revenues. If a segment is dropped, what revenues will go away? What costs will go away? If the costs to be eliminated exceed the revenues, then it is probably wise to discontinue the segment. 1. One factor to consider in making the decision whether to drop or add a business is the opportunity cost associated with making one choice over another. This means that one should consider what can be done with resources that are freed up by dropping a unit, or what resources will be tied up by adding a unit? The value of the opportunities foregone by making the add or drop decision should be factored into the decision 2. Other factors to consider when deciding to close (drop) a business unit are qualitative ones. Discontinuing a business unit, while the correct financial choice is sometimes not viewed as the correct qualitative choice, especially when employees or communities are affected negatively by the decision. Completely eliminating a business unit almost always results in downsizing. Outsourcing also results in the elimination of jobs, since employees performing activities being outsourced are no longer needed. Discontinuing a segment is a difficult business decision that must, nevertheless, be made by managers. J. Trying to decide what the right price is for goods and services is not easy. Setting prices too high discourages customers from buying the product. Setting the price too low makes the profit margin smaller. 1. There are several factors that must be considered when the pricing decision is being made. Pricing must be considered from the perspective of the customer. The competitive environment may allow customers to find adequate substitutes for a product if an organization sets its prices too high. Competitors also react to prices charged. If one organization sets a high price, a competitor may offer a lower price. If an organization lowers its price, competitors may respond by lowering prices also. In an increasingly global competitive market, companies must also consider differential pricing in markets outside of their home base. 2. Costs must also be considered when setting price. In order to make profit, all costs of an organization must first be recovered through the sale of goods and services. Some industries’ prices are very heavily market-driven. Prices are based on competitive pressures. In these industries, profit is made only if costs are managed properly. In other industries, prices are set, at least partially, based on the underlying production costs. In most industries, some components of market-driven and cost-driven pricing are present. 3. In addition to customer, market, and cost considerations, companies must be aware of legal, political, and reputation issues as they relate to pricing decisions. Companies should be aware of legal issues such as price discrimination, international laws related to dumping, and activities taken to monopolize a market (antitrust violations). There may be political repercussions if a company is perceived as one that is taking unfair advantage of its customers or society as a whole (for instance, the tobacco industry). Companies also base prices on the reputation they have for high quality or low quality. High quality producers can demand higher prices than low quality producers. 4. Managers must consider short and long-run strategies in making pricing decisions. Decisions for price-setting should take into account the life cycle of products offered. Managers should also consider the effect of special, one-time orders that have no longterm implications. Product mix and volume adjustments must also be considered in a highly competitive market. a. When looking at short-run pricing decisions, there are some costs that must be factored in and others that are not relevant. As with any of the decisions discussed so far in this chapter, it is only the relevant costs that should be considered in making pricing decisions. In many short-run decisions, unit-level variable costs are the only relevant costs. In other cases, fixed costs or costs at a higher level than unit-level may be relevant. b. When used in pricing decisions, relevant costs required to sell and/or produce a good or service should be viewed as the floor — that is, the minimum selling price. Over the long-run, this pricing strategy will not work. For instance, the relevant cost of one more passenger on a bus may be close to zero. This may motivate managers to offer free rides to small children if their parents pay for their tickets. If the bus company has excess capacity, this strategy may generate additional profits because it will attract customers with small children who might not otherwise purchase the bus tickets. As capacity is used up though, the free ticket strategy becomes less useful. Paying customers may not be able to buy seats if too many passengers with small children buy tickets. c. Pricing special orders is another consideration that requires determining which costs are relevant. The most important considerations in deciding whether to accept special orders are the net benefits derived from taking the order and the amount of productive capacity that must be available to complete the order. If an organization has excess capacity and is paying for it even though it is not being used, it is to the organization’s advantage to take special orders that generate some contribution margin, even if it is lower than the margin generated from regular sales. In other words, only unit-level and batch-level costs are usually relevant in special order situations. 5. Companies that use a cost-plus pricing approach benefit from use of a good costing system and from use of activities-based management that will have identified non-valueadded costs. Companies cannot afford to use a pure cost-plus pricing strategy without first managing costs. Such a strategy coupled with out-of-control costs will result in toohigh prices and lower sales volume as a result, or lower profit margins and lower profits as a result. 6. Target costing is the cost management strategy that companies in highly competitive markets are forced to adopt. Target costing is a method used by organizations to design products and services to meet customer needs and to meet the company’s profit targets. Target cost is determined by a market-based price, from which the company’s target profit is subtracted. Companies that have adopted target costing use value engineering to assure that all production activities are value-added. Target costing is based on the elimination of any activity that does not add value to a product. Companies may adopt a related management philosophy, called “Kaizen costing.” or continuous improvement. This philosophy assumes that product and process quality and efficiencies can always be improved. This subject is discussed in chapter 4. 7. Life-cycle costs are the costs incurred for a particular product from its inception to the point at which it is no longer produced and related customer service activities end. Theoretically, prices should be charged that allow recovery of all costs associated with a particular product during its entire life. 8. Prices cannot, by law, be charged differentially to different customers for the same products (where there is intent to harm competitors). This is price discrimination. Companies in the United States must comply with antitrust laws. The Robinson-Patman Act prohibits price discrimination. Other laws — the Clayton Act, and the Sherman Act — prevent pricing that results in monopolistic or anti-competitive behavior. Another illegal pricing tactic is predatory pricing. This occurs when organizations set prices below cost temporarily to increase demand for a product, and to damage competitors’ sales of competing products. After the competitor is run out of business, the predator feels safe to increase prices to his heart’s desire! Problem 1 – Chapter 13 Choosing among alternatives Learning objectives: 1 and 4 Time needed: one hour Shahnaz Store has three departments; clothes (A) , toys (B) , accessories (C). Sales for the year amounted to $310,000, $230,000, and $140,000 for the three departments respectively. Cost of sales amounts to 50%, 40%, and 30% for the three lines of products. The departments’ other direct costs including employees salaries and benefits amount to $65,000, $60,000, and $55,000 for each department respectively. The store’s general administrative expenses including rent, utilities, accounting, and general manager’s salary amounts to $150,000. This amount is divided equally among the three departments because each department occupies the same space and requires the same level of attention and time by general management. Required: 1) Prepare a segmental income statement for the company. 2) Prepare a revised income statement considering closing of the Accessories department and renting it out for $30,000 a period. This decision will reduce general administrative expenses by 20%. 3) Prepare a revised income statement considering closing of the Accessories department and expanding the clothing department with a 40% increase in sales. 4) Prepare a revised income statement considering closing of the Accessories department and expanding the toys department by 60%. 1) A B C Total Sales 310,000 230,000 140,000 680,000 Cost of sales 155,000 92,000 42,000 289,000 Gross profit 155,000 138,000 98,000 391,000 Direct fixed costs 65,000 60,000 55,000 180,000 Segment margin 90,000 78,000 43,000 211,000 Allocated G & A 50,000 50,000 50,000 150,000 Segmental profit 40,000 28,000 (7,000) 61,000 2) A B Rental Total Sales 310,000 230,000 30,000 570,000 Cost of sales 155,000 92,000 - 247,000 Gross profit 155,000 138,000 30,000 323,000 Direct fixed costs 65,000 60,000 Segment margin 90,000 78,000 30,000 Allocated G & A 60,000 60,000 - 120,000 Segmental profit 30,000 18,000 30,000 78,000 3) A B C Total Sales 434,000 230,000 - 664,000 Cost of sales 217,000 92,000 - 309,000 Gross profit 217,000 138,000 - 355,000 Direct fixed costs 65,000 60,000 - Segment margin 152,000 78,000 - Allocated G & A 100,000 50,000 - 150,000 Segmental profit 52,000 28,000 - 80,000 4) A B C Total Sales 310,000 368,000 - 678,000 Cost of sales 155,000 147,200 - 302,200 Gross profit 155,000 220,800 - 375,800 Direct fixed costs 65,000 60,000 - Segment margin 90,000 160,800 - Allocated G & A 50,000 100,000 - 150,000 Segmental profit 40,000 60,800 - 100,800 Notes: Allocated costs are often irrelevant except for any potential decrease in those costs as a result of closing a segment. Depreciation is a sunk cost and is irrelevant in all such decisions except for any potential resale value of the equipment. Opportunity costs, where present, are always relevant. Problem 2 LO: 4 Cost Management decisions Time needed: 15 minutes Bahereh Ceramics wants to acquire a new machine to replace one of its old machines. The new machine costs $138,000 and has an estimated useful life of five years with a salvage value of $15,000. Variable operating costs would be $85,000 a year. The old machine has a book value of $75,000 and a remaining useful life of five years. Its disposal value in five years would be around $9,000. Variable operating costs of the old machine is $115,000 a year. Required: considering the five years in total, but ignoring the time value of money and income taxes, what would be the difference in operating income by acquiring the new machine as opposed to retaining the old one? Solution: Item Old $ New $ Difference New machine - 138,000 (138,000) Salvage value (9,000) (15,000) 6,000 Variable costs 575,000 425,000 150,000 Totals 566,000 548,000 18,000 The amount of $18,000 is the net advantage of the new machine . Problem 3 LO: 4 Make or buy decisions Time needed: 15 minutes Bahereh Ceramics produces and sells 30 units of Product M at a cost of $1,195 a piece including direct material of $675, direct labor of $130 and overhead charged at the rate of 300%. Forty percent of the overhead charged is variable. Fixed costs will remain the same except for $750 in total. Siena Ceramics has suggested to sell the 30 units of M to Bahereh at $975 a piece and pay a rental of $2,200 a month for the space for not producing product M. Determine if Bahereh should accept this offer. Solution to problem 3: Variable overhead per unit 130 * 300% * 40% = $156 Relevant costs of this order 675+ 130 + 156 + 25 = 986; 986 * 30 = $29,580 Cost of buying from Siena (975 * 30) – 2,000 = $27,250 Net advantage of buying from Siena 29,580 – 27,250 = $2,330.00 Problem 4 LO: 4 Accept or reject special orders Time needed: 15 minutes Arman sells product N at $195 a unit. The product has a cost of $150 – 80% of which is in variable costs. Ryan wants to buy 500 units of this product for $116 a piece. Ryan argues that Arman will save $8 a piece in sales commission alone as well as $3 a piece in packaging and extra shipping costs. Determine a) if Arman should accept this offer assuming excess capacity, b) if Arman should accept this offer assuming no excess capacity, c) if Arman should accept this offer assuming an excess capacity of 300 units. Note that in all special order decisions, it is assumed that the special order does not affect the firm’s regular market. Solution: a) Relevant cost of the special order 150 * 80% - 8 – 3 = $109.00 Extra profit from accepting the order (120 – 109) * 500 = $5,500 b) No excess capacity – Do not accept the offer ((195 – 150)-(120 – 109))*500 = $17,000 disadvantage c) With excess capacity of 300 (300 * 11) – ((200 *(45-11)) = $3,500 disadvantage Sample Quiz 1. AAA currently has a profit of $15,000 at a sales volume of 9375 units and a fixed cost which amounts to $65,625 and a selling price of $20 per unit. Variable cost per unit should be a. $12.6 b. $12.0 c. $11.4 d. $11.0 e. None of the above. Answer: c Learning Objective: 4 65,625 + 15,000 = 80,625; 80625 / 9,375 = 8.6; 20 – 8.6 = 11.4 2. A relevant cost is a cost that a. occurs in the future and is the same among competing alternatives. b. occurred in the past and is the same among competing alternatives. c. occurs in the future and is different among competing alternatives. d. occurred in the past and is different among competing alternatives. e. None of the above. Answer: c Learning Objective: 2 3. You be the judge! Should we make product X that costs $27.50 a unit with an output of 1000 units or buy it from outside (outsource) at $25 a unit and get a rent of $2,000 a period for the freed space? The indirect overhead allocated to product X amounts to $3,600 a period. a. You save $900 if you outsource. b. You lose $900 if you outsource. c. You save $4,100 if you outsource. d. You lose $4,100 if you outsource. e. None of the above. Answer: a Learning Objective: 4 Make: 27.50 – 3.6 + (2000 / 1000) = $25.9; (25.9 – 25) * 1000 = $900 4. You decide! In this general store, we have two departments — cosmetics and other goods. Cosmetics had a profit of $87,500, Other had a loss of $24,800. Forty percent of the rent of $120,000 is charged to Other. If we close Other, we can sublet the space and receive an income of $18,000 for it. a. Losses will decrease by 5,200 if we close Other. b. Losses will increase by 5,200 if we close Other. c. Losses will remain the same if we close Other. d. None of the above. Answer: b Learning Objective: 4 (120,000 * .40) – 18,000 = 30,000; Now: 87,500 – 24,800 = $62,700; then: 87,500 – 30,000 = 57,500 62,700 – 57,500 = 5,200 decrease if we close Other. 5. Saba Printing is considering accepting an order for $24,900 even though its cost amounts to $28,500 inclusive of $12,500 worth of overhead – 60% of this overhead is avoidable if the order is not accepted. The order must be a. accepted because it increases profit by $1,400. b. rejected because it decreases profit by $1,400. c. accepted because it increases profit by $3,600. d. rejected because it decreases profit by $3,600. e. None of the above. Answer: a Learning Objective: 4 12,500 * .40 = 5,000; 28,500 – 5,000 = 23,500; 24,900 – 23,500 = $1,400 6. Arman Toys is considering selling 500 units of its AA Toy, which has a total cost of $25 a unit (60% of which is variable cost), for only $19 a unit to a customer who does business in Mexico. The current selling price of the AA Toy is $29 a unit and the company has no excess capacity. Arman should a. sell the toys because it will increase its profit by $2,000. b. not sell the toys because it will decrease its profit by $2,000. c. sell the toys because it will increase its profit by $5,000. d. not sell the toys because it will decrease its profit by $5,000. e. None of the above. Answer: d Learning Objective: 4 7. Shahnaz Designs expects a profit of 20% on total cost of Mrs. Y’s job. The job cost $23,500 and supplies and shipping charges came to an additional $1,500. The job’s selling price should be a. $28,200 b. $29,375 c. $30,000 d. $31,250 e. None of the above. Answer: c Learning Objective: Ch 4 8. Honda Company has decided that a fair selling price for its model 2003 Accords is $18,960 per vehicle. The dealer markup is 20% from the net manufacturer’s price. The freight to the dealer’s shops, which is paid by the manufacturer, comes to $450 per vehicle. An Accord inclusive of freight costs the company in the neighborhood of $15,950. Honda’s cost to manufacture per unit should be reduced by _______ in order to break even. a. $150 b. $600 c. $782 d. $1,232 e. None of the above. Answer: b Learning Objective: Ch 4 9. Honda Company has decided that a fair selling price for its model 2003 Accords is $18,960 per vehicle. The dealer’s margin is 20% from the suggested selling price. If Honda wants a profit of 10% on its net invoiced price, its cost per vehicle should be a. $13,651 b. $14,220 c. $16,853 d. $17,556 e. None of the above. Answer: a Learning Objective: 2 10. Value engineering may involve a. benchmarking. b. activity-based costing. c. elimination of non-value-added costs. d. tearing apart competitive products for analysis. e. All of the above. Answer: e Learning Objective: 4 11. A fair price for this company’s briefcase is $60. From this price the retailer receives a margin of 30%. The product costs the company $42.50 in addition to $250 shipping charge for each lot of 100 units shipped. By how much should the cost be reduced in order for the manufacturer to have a profit of $2 per unit? a. $2 b. $3 c. $4 d. $5 e. none of the above Answer: d Learning objective: Ch.4 12. This lamp costs the company $25 to produce and it can be sold for $28 a unit for an annual production of 2000 units. The company has an investment of $40,000 and requires a return of 20% on investment. The target profit per unit amounts to a. $5 b. $4 c. $3 d. $2 e. none of the above Answer: b Learning objective: Ch. 4 13. This lamp costs the company $25 to produce and it can be sold for $28 a unit for an annual production of 2000 units. The company has an investment of $40,000 and requires a return of 20% on investment. The target cost per unit amounts to a. $24 b. $25 c. $26 d. $27 e. none of the above Answer: a Learning objective: Ch 4 14. This lamp costs the company $25 to produce and it can be sold for $28 a unit for an annual production of 2000 units. The company has an investment of $40,000 and requires a return of 20% on investment. The production process includes $22,000 in fixed costs that cannot be reduced. Variable costs should be ________ in order to achieve the targeted profit. a. $11 b. $12 c. $13 d. $14 e. none of the above Answer: c Learning objective: Ch 4 15. Ryan Company is considering accepting a special order for 600 units of product A which costs $25 a unit (inclusive of $3600 in common costs) for $22 a unit. Accepting this order increases fixed costs by $1200. The current selling price is $29 a unit. Ryan’s excess capacity is around 900 units. If this order is accepted, profit will a. increase by $600 b. decrease by $600 c. increase by $1,800 d. decrease by $1,800 e. none of the above Answer: a Learning objective: 4 25 – (3,600 / 600) + (1,200 / 600) = 21; 22 – 21 = 1; 1* 600 = 600 16. Ryan Company is considering accepting a special order for 600 units of product A which costs $25 a unit (inclusive of $3600 in fixed costs) for $22 a unit. Accepting this order increases fixed costs by $1200. The current selling price is $29 a unit. Ryan’s excess capacity is around 300 units. If this order is accepted, profit will a. increase by $1,400 b. decrease by $1,400 c. increase by $1,500 d. decrease by $1,500 e. none of the above Answer: d Learning objective: 4 17. Ryan Company is considering accepting a special order for 600 units of product A which costs $25 a unit (inclusive of $3600 in fixed costs) for $22 a unit. Accepting this order increases fixed costs by $1200. The current selling price is $29 a unit. Ryan has no excess capacity. If this order is accepted, profit will a. increase by $3,600 b. decrease by $3,600 c. increase by $1,500 d. decrease by $1,500 e. none of the above Answer: b Learning objective: 4 18. Arman has a drug store with two departments, drugs and supplies. The drug division had a total sales of $400,000 and a cost of sales of 40%. Supplies division had a total sales of $200,000 and a cost of sales of 70%. Each division has a direct overhead of $45,000. Common store costs inclusive of rent amount to $150,000 and are allocated to the two departments based on their sales. Supplies division’s loss amounts to a. $15,000 b. $20,000 c. $30,000 d. $35,000 e. none of the above Answer: d Learning objective: 4 19. Arman has a drug store with two departments, drugs and supplies. The drug division had a total sales of $400,000 and a cost of sales of 40%. Supplies division had a total sales of $200,000 and a cost of sales of 70%. Each division has a direct overhead of $45,000. Common store costs inclusive of rent amount to $150,000 and are allocated to the two departments based on their sales. If supplies department is closed, overall profit will a. decrease by $15,000 b. increase by $15,000 c. decrease by $35,000 d. increase by $35,000 e. none of the above Answer: a Learning objective: 4 20. Arman has a drug store with two departments, drugs and supplies. The drug division had a total sales of $400,000 and a cost of sales of 40%. Supplies division had a total sales of $200,000 and a cost of sales of 70%. Each division has a direct overhead of $45,000. Common store costs inclusive of rent amount to $150,000 and are allocated to the two departments based on their sales. Management is considering closing the supplies department and renting the space for $50,000 a period. With this decision, overall profit will a. decrease by $45,000 b. increase by $45,000 c. decrease by $35,000 d. increase by $35,000 Answer: d Learning objective: 4 21. Ariana is tempted to reject an offer to sell 500 units of a product which costs $24 a unit for $19 a unit where the regular selling price is $27 a unit. Fixed costs amounts to $31,200. Unfortunately, the current sales volume is 5,200 units whereas, the factory capacity is at 6000. Accepting this offer will a. decrease profit by $2,500 b. decrease profit by $4,000 c. increase profit by $1,000 d. increase profit by $500. Answer: d Learning objective: 4 31,200 / 5,200 = 6; 24 – 6 = 18; 19 – 18 = 1; 1 * 500 = $500. Chapter 14 Strategic Issues in Making Investment Decisions Chapter Outline A. Cost Management Challenges — Chapter 14 presents four cost management challenges. 1. What are the differences between expansion, replacement, and strategic move investment? 2. What do net present value, real option value analyses imply for the success in long-term decisions? 3. What are ethical implications in capital budgeting decisions? B. Learning Objectives 1. Describe the strategic importance of capital investments. 2. Identify external and internal information for strategic investments. 3. Learn to use forecasts of quantitative and qualitative effects of strategic investments in net present value analysis. 4. Model the impact of competitor’s actions. 5. Know when and how to apply real option analysis to evaluate strategic investments. . 6. Identify and apply ethical issues in strategic investment decisions. C. Strategic planning is the process of deciding on an organization’s major programs and the approximate resources devoted to them. Major programs consist not only of products and product lines but also major research and development projects. Strategic plans are based on an organization’s overall objectives for its existence. As such, strategic planning is done for projects that encompass long periods of time. Strategic planning must also encompass consideration of market forces and changes in one’s industry. Ongoing changes in an industry need to be incorporated into changes in an organization’s strategic planning. Capital investment decisions are a product of strategic plans. Capital investments require substantial monetary commitments that have the intended result of generating profits over periods that are typically much longer than one year. Financial decisions that have an impact or duration of one year or less are considered to be short-term decisions. Financial models are representations of reality in the business world. A model allows one to see how something is supposed to work. A financial model allows an organization to test the interaction of economic variables in a variety of settings. C. Identification of good investments can be the result of natural transitions from existing operations to operations that incorporate changes that are clearly warranted. A case in point is the decision by automobile manufacturers to shift from human labor to robotics in their assembly lines. Technology changes that improved production activities were clearly advantageous over the existing production methods. Other investment decisions are not so obvious. Furthermore, organizations that fail to respond in time to the need to shift their strategic plan and make the correct capital investment decisions run the risk of going out of business. There are three general types of long-term capital investments. These three types are presented in Chapter 14. They are (1) replacement and minor improvements, (2) expansion, and (3) strategic moves. 1. Replacements and minor improvements are just replacements of existing long-lived assets that wear out or become obsolete. This is not a major strategic decision. It usually requires that managers consider different alternatives for replacing the asset. Cost, efficiency, and time factors are all considered. 2. Expansion decisions occur as an organization works toward achieving growth. This type of capital investment may arise out of necessity because demand for a company’s products has exceeded its ability to produce or provide the product. Expansion activities to increase capacity provide an obvious incentive to grow and expand. 3. Expansion may also result from an organization’s desire to move into new markets. Expansion to other countries, into other geographical regions in a region, adding new product lines, or increasing the number of locations in the current market all are examples of expansion activities. Expansion activities that lead to operations in new locations or new production activities are considered to be strategic expansion activities or strategic moves. Strategic expansion activities are more risky than expansion to increase capacity. There are many unknown factors to address when moving to uncharted waters. Top management may rely on market studies, outside consultants, experts in the industry an organization wants to expand into, or people with knowledge of the history and cultural norms of a country being considered for market entry. Technical expertise is also sought in order to identify the actual procedures for accomplishing the proposed strategic move. Strategic moves may result from responses to market conditions (like Barnes and Noble’s recognition that it had to offer Online services to compete with Amazon.com); it might result from product innovations (like Microsoft’s combination of its operating system with an entire package of software tools); or it may result from proactive organizational planning activities. Some organizations employ strategic planners whose sole purpose is to develop strategic moves. D. Due diligence is a legal term. It is the due process or appropriate steps in an investigation. During due diligence investigations, people look for potential problems with a prospective investment. The main objective of due diligence is to ascertain that there will be no unpleasant surprises that occur after the investment has been made. Due diligence can be split into four areas. They are (1) legal, (2) environmental, (3) public relations, and (4) employee relations. 1. Before making a major investment, organizations must investigate all of the legal repercussions of the planned investment. This is especially important when companies are considering expanding to other countries. There are tax, import, and export laws that can affect the profitability of a strategic move. Some countries restrict the amount of foreign labor or have laws regarding minimum wages, amount of production materials and other resources that can be brought in from outside of the country, and even how much profit can be taken out of the country. Although bribery is illegal in the US and many other countries, it is a cultural norm in some locales. Managers must decide how to deal with all of these legal issues. 2. Due diligence may be related to environmental issues. Companies must be aware, to the extent possible, of possible environmental hazards they might later be held responsible for. They must also be aware of environmental laws in the location where they are planning to move. Investigation into the history of plant sites should include searches for information regarding environmental hazards that exist there. 3. Public relations issues arise when a company expands into new areas that have a detrimental effect on their public image. For instance, Nike became embroiled in controversy when it was learned that some of its overseas production facilities used child labor and violated child labor laws. 4. Employee relations must also be considered when a strategic move is being considered. Some strategic moves result in the transfer of employees far from their homes. Other moves may result in the elimination of jobs. Still others place existing employees in the role of managers of new employees from other cultures, and they may be inexperienced in dealing with different languages or cultural norms. E. Financial information is a critical piece of the strategic planning puzzle. Cost managers are involved in providing financial information. A key to good financial planning for capital investments is sound estimates of cash flow alternatives. Managers must identify what the cash outlays will be, estimate cash flows from the investment, and project cash flow needs for the end of the investment project (if the project does not have an indefinite life). The timing of cash flows is important because of the time value of money. A dollar today is worth more than a dollar obtained next year, because the dollar currently held could be invested for a year. The entire issue of the timing of cash flows is addressed in the appendix to this chapter and in basic texts for finance courses. There are three sources of financial information that the cost manager can access to help their fellow managers to evaluate a potential investment. They are (1) financial records, (2) interviews with operating and marketing personnel, and (3) industry data and competitor analysis. 1. Financial records are the most beneficial when an investment decision is similar to decisions made in the past. Historical financial information is a good starting point. From this information, cost managers can modify the numbers to fit the pending investment. Known differences can be incorporated into the analysis. Historical financial information can be used for replacement decisions or expansions of existing operations to meet higher demand. Financial information for strategic moves is less helpful, because it may not be applicable to the planned strategic move. If the move is into completely different products or different countries, there are many factors that will not be present in historical financial information. 2. A second source of good information is to interview operating and marketing personnel. Cost managers can obtain first-hand information about how production activities are accomplished. Operations managers can provide details, step-by-step, of the cost-causing activities that they supervise. For replacement or expansion decisions, operating managers often can suggest the best solutions to these investment problems. Marketing people are useful sources of information about the competitive environment. People with marketing expertise can advise on the potential for the success or failure of entry into new markets, addition of new products, or changes in the way existing products are offered. 3. A third useful source of information is industry data and competitor analysis. Regardless of the industry an organization is in, there is normally a wealth of published information that can help in making the investment decision. Company and industry Web sites, corporate financial statements, and other publicly available information can be used to evaluate a project’s potential. Since cost managers do not usually have this kind of expertise or first-hand knowledge of it, it is wise to hire outside consultants to aid them in making the correct decision. For a strategic move, the only source of information may be that obtained from industry data and competitor analyses. Especially useful, for strategic moves that are responses to competitors’ strategies, is identifying what worked for one’s competitors. F. Although a for-profit organization certainly would want to go forward with a profitable business venture, it must also consider some non-financial factors that could affect the overall appeal of an investment decision. These are discussed below. 1. There are non-quantifiable effects on employee morale, the community, and the environment that should be considered. Capital investment decisions can affect the security of employment, may cause employees to be relocated, or may cause other related stresses that make working for the organization undesirable. On the other hand, some capital investment decisions open up opportunities for employees that might not otherwise exist. An organization’s shift in strategy may have a positive or a negative effect on a community. A plan to shift operations overseas — to countries where labor costs are lower — could be devastating to the community where the jobs are lost but could be an economic windfall to the community where the jobs are moved. Environmental impact of a strategy change may also be positive or negative. Aside from the costs of complying with environmental laws, organizations must be good corporate citizens, who do not pollute, who do not locate undesirable facilities where members of the community do not want them, and who make visible contributions for the social good of the community. 2. Ethical issues come into play for a variety of reasons. First, what may be legal may not always be ethical based on a company’s own code of ethics. For instance, child labor laws may be more lenient than some companies are willing to tolerate in some countries. Some countries allow bribery of government officials to occur, but companies may have strict policies against that. At another level, managers may violate the ethical codes in their own organization to accomplish the objectives of the organization. It becomes difficult to enforce company ethical codes in a global organization, particularly when employees may have different cultural or ethical philosophies than those adhered to by the company. 3. Another issue to consider, even though it may be hard to quantify, is the benefit of experiences gained from the investment opportunity being embarked upon. Most strategic moves involve some sense of adventure because an organization and its employees are exploring opportunities that are new or foreign to them. Strategic moves provide opportunities for managers to learn about new ways of conducting their business. They may learn about new technologies, processes, new markets, and new kinds of markets. For instance, Ford Motor Company initially rejected a capital project that would have revolutionized production processes. Based on the discounted cash flow analysis, the project should have been rejected. The CEO of Ford argued that the non-quantifiable benefits outweighed the financial deficit and authorized the project. He believed, correctly, that Ford would learn how to apply computerized manufacturing processes by acquiring the computerized equipment. This turned out to be true. G. Managers involved in making strategic decisions are often confronted with projects that are related to technology. In addition to the complexity of technology changes, which are not likely to be well understood by cost managers, there are other barriers to making right choices when technological changes are involved. 1. Production and engineering people see the benefits of technology change. Finance and accounting people may only focus on the costs of technology. 2. In performing discounted cash flow analysis, managers make the discount rate higher when there is uncertainty. The discount rate should be the cost of capital, adjusted for risk. Cost managers may overstate the risk, causing a high-tech project to show a negative net present value (meaning the project should be rejected). 3. The length of time that benefits can be obtained from a high-tech project may also be too short. If the cash flow analysis doesn’t include enough years of benefit, the project will be rejected. 4. Discounted cash flow analysis should not be the only tool used to assess the viability of a high-tech project. The non-quantifiable benefits of accepting technology change may include more flexibility in the production process, shorter cycle times and reduced lead times, and reduction of non-value-added activities and costs. 5. Companies that do not make the technology investments when their competitors do may forego opportunities to remain competitive on product quality, production efficiency, or other dimensions I. Sensitivity analysis in the strategic planning arena is a very important step to take. Since there are so many uncertainties associated with any investment decision that lasts for long periods of time, it is a good idea to consider many possible outcomes. These different outcomes are the result of changing assumptions about different pieces of the strategic plan. Some assumptions that could be reconsidered are the amount of initial cash outlay (higher or lower); timing of cash flows over the life of the project (faster or slower, more variable than expected, longer or shorter); cost of disposing of assets at the end of the project (more costly or less costly). The scenarios should range from a worst-case scenario to a best-case scenario, with two or more scenarios in between. Usually, the investment as initially proposed falls within these two extremes. Then managers can make the decision knowing what they think is the worst possible outcome. At a minimum, four scenarios should be looked at, ranging from disaster to disappointing to expected to optimistic. In addition to sensitivity analysis, the chapter introduces the concept of “real option value – ROV”. The impact of external factors, particularly potential competition in project evaluation must be assessed and scenarios for the costs and benefits of continuing with the project or abandoning it at a certain point in the future must be carefully assessed. J. Depending on the magnitude of a capital investment, the final approval may occur at lower levels of management (for instance, for equipment replacements or repairs) to the board of directors (for strategic moves). 1. There may be biases in the process. Everyone involved in a decision to make a capital investment is a stakeholder of sorts. Some may want the project to proceed because it was their idea. Those who propose an investment project may have access to the most and best information related to it. However, the decision-makers should try to eliminate whatever bias may be in the information provided. Others may be biases against an idea. Managers who are used to doing things a certain way may believe in the old adage, “if it ain’t broke, don’t fix it.” They may try to undermine a sound analysis that a project is worthy of pursuit simply because they are not willing to change. K. Even though the analysis of the viability of a capital project can be very complex, and timeconsuming, implementing an approved project is even more complex. Both time and cost considerations weigh heavily in the implementation process. Although not as complex for replacements and improvements, project implementation can be incredibly complicated for strategic moves. Managers may have little or no guidance from the past to develop schedules and budgets for cash outlays for the investment. Companies may experience cost overruns and project delays that are more than double their worst-case scenario. Other companies discover well into the implementation that the project was a mistake and then have to admit that the huge sums spent so far are sunk costs. Further spending will not make the project successful. Capital projects in overseas markets may experience cost overruns or delays because of inexperience in dealing with workers, because of inflationary trends that are much different from the home country’s, because of political intervention, or because of poor planning. Some political risks may be hard to assess and the added uncertainty will make any educated case less than valid. L. During the project’s implementation phase and after a project is completed, managers perform audits of the project. An audit of the decision and the implementation process reveal how well the investment performed compared to expectations. The capital investment process includes a lot of estimates, forecasts, and uncertainties. It is unlikely that a project will turn out just as planned. Audits performed on an interim basis can reveal problems and provide information to improve future activities on the project. Audits on the project can also provide feedback for future projects. 1. Audits help management to identify what estimates were wrong so planners can incorporate that knowledge in future estimates to avoid making similar mistakes. 2. Audits can be used to evaluate the performance of planners who make good capital budgeting decisions. 3. Audits prevent planners from inflating estimated benefits of the project to get it approved. 4. Audits make planners accountable and, in that sense, add some degree of discipline to what can, at times, be a subjective judgmental process. M. There are three ethical issues in capital investment decisions that may occur. They are (1) misstatement of information used to make the investment decision, (2) misstatement of the results, and (3) investing in unethical projects. 1. Misstatement of information used to make the investment decision will be most likely to come from proponents of the project. Because they believe in a project, those who propose it may be less than objective in their presentation of the information needed to make the decision. Unfortunately, omission of crucial information, or manipulating the information to make the project more acceptable, may not become apparent until the company has invested millions of dollars in it. 2. Misstating results is most likely to occur when managers become so committed to it that they are willing to lie about its success. They may have the most personal of interests in the project being continued (they may lose their job if it is ended). Misstatement of results leads to even more of the company’s resources being spent on what could be a losing venture. Although audit can sometimes uncover these misstatements, that is not always the case. 3. Investing in unethical projects may occur because of the high returns that could result. This is a high-risk management strategy that can permanently damage an organization’s reputation. N. Capital investment decisions are made in non-profit and government organizations. The purpose of analysis for these organizations is not to see whether profits can be made from an investment. Instead, analyses of capital investment opportunities are usually performed because capital is limited. Efficient allocation of the resources available is necessary, and capital investment analysis is used to make sure that happens. Problem 1 – Chapter 14 Learning objectives 1and 3 and Appendix A Rank alternative sources of financial information Sensitivity analysis of capital investment decisions Time required: 45 minutes Saba Company is thinking about building a first class hotel in the city of Kabul with an estimated cost of 60 million dollars. The investment includes 40 million dollars in buildings, 9 million dollars in equipment and machinery, and 11 million dollars in furnishings. In addition, five million dollars in working capital is required. The company expects to depreciate all assets in ten years and recoup its total investment within this time period. The World Bank has agreed to a loan of 50 million dollars at 6% per year if the investors ½ of whom should be Afghan citizens can come up with the required equity. Ignore the repayment schedule in computing the annual interest payments. The company has been granted a ten year tax holiday with a mere promise of spending at least 40% of its profit (if it exceeds 5% of total equity) on philanthropic projects of its choosing within the country. There are no other first class hotels in Kabul, and the city has had a hard time accommodating dignitaries and journalists who come to town after the city was liberated from the hands of fanatic, barbaric, and brutal Talibans. There is a 90% chance of success in this endeavor, and a 10 percent chance that chaos will return to the country and very little, if anything, can be recouped. Full occupancy is estimated at 300 days per year for the one thousand rooms. The best guess is a 20% chance for full occupancy at $80 a day; 30% chance for 80% occupancy at $90 a day; and 40% chance for 60% occupancy at $100 a day. Management has discussed the pros and cons of having a flexible workforce but has decided to employ 500 wage earners at $6,000 a year, and 200 salary employees including security guards, accountants, computer experts, and managers at an average of $15,000 a year. The latter number includes 20 expatriates with substantially higher salaries, but the salary of most local hires will be at less than $10,000 a year. Supplies and all other expenses are estimated to be about three million dollars a year. Required: 1) prepare a sensitivity analysis showing the potential income or loss under the four different scenarios, 2) calculate the expected annual income and the return on investment and return on equity, 3) discuss various scenarios on how the excess profit could be spent on various philanthropic projects and why such expenditure would make good economic sense as well. Probabilities: 10% 20% 30% 40% Days 300 300 300 Number of rooms 1000 1000 1000 Average room rate 80 90 100 Occupancy rate % 100% 80% 60% Expected revenue (000) 0 24,000 21,600 18,000 Wages and salaries 6,000 6,000 6,000 6,000 Supplies 3,000 3,000 3,000 3,000 Interest 3,000 3,000 3,000 3,000 Depreciation 6,000 6,000 6,000 6,000 Total costs 18,000 18,000 18,000 18,000 Income (loss) (18,000) 6,000 3,600 - 2) Expected income (loss): [(18,000) * .10] + [6,000 * .20] + [3,600 * .30] + [0 * .40] = $480 or $480,000 per year. The expected return on equity amounts to 480,000 / 15,000,000 = 3.2% Expected return on investment: (3,000 + 480) / 65,000 = 5.35% 3) The expected numbers are not very promising. But note that such outcome is based on full employment and a 10% chance that chaos will return to the country. As time passes and completion of the project nears, management will have a better grasp of the situation and may even decide to eliminate the 10% possibility of chaos that it now anticipates. In addition, it may want to revise the expenditure list so that to adjust employment and expenditure at a less conservative basis rather than full employment under all conditions. However, note that full employment under all conditions would bring about a good sense of loyalty among the staff. Note also that we are depreciating the company assets in ten years whereas, the estimated useful life could be between 20 to 40 years. The estimated cash flow may also be sufficient to pay off the entire loan within a ten-year period. Ignoring the worst scenario, the expected profit could be in excess of 2.5 million dollars on the average. This level of income could provide a return of about 10% on owners’ equity plus approximately one million dollars a year to be spent on domestic philanthropic projects. The company can spend this money on roads, schools, hospitals, adult education, agriculture, care for the poor and the needy, and other projects in consultation with the respected elders and good citizens some of whom could be asked to serve on the board of directors. Such endeavors would not only benefit the firm through enhancing goodwill among the citizens, but can also serve as a model for other companies who want to profit and do good at the same time. The model of this company would tell the world that philanthropy, good deeds, and capital investments do not need to be viewed as separate and disjointed phenomena. They can be the facets of the same act. Perhaps, the models and our worldview have to be changed drastically if we wish to have a better and a safer world in which to live. Problem 2 LO: 1 Expected future growth Expected time: 15 minutes Saba Electronics expects its business to growth by 10 percent for the next five years. It also expects inflation rate to hover around 5% for the next several years. If the business for 2007 was around $250,000 for the year, determine the amount inclusive of inflation for the next five years. Solution: Problem 3 LO 3 Net present value analysis Expected time: 45 minutes Shahnaz Design is considering replacing its current computer system. The current system has a book value of $60,000 and a salvage value of $18,000 with a remaining useful life of five years. Operating cost of the old system is $48,000 a year. The new system will have a life of five years and cost $95,000 with additional working capital requirement of $22,000, and no salvage value. The operating cost of the new system is $17,000 a year. The desired rate of return is 8% and the tax rate is at 30%. Use straight line depreciation. Determine: a) Company’s projected payback period. b) Company’s projected net present value. c) Company’s projected internal rate of return. d) When would a company accept a project even if it cannot justify it on financial grounds? Solution: a) Payback period Cost of the computer 95,000.00 Working capital needed 22,000.00 Salvage value of old (18,000.00) Tax savings on loss of old (12,600.00) (60,000 - 18,000)*.30 Net initial cash outlay 86,400.00 Net annual cash flow 21,700.00 (48,000 - 17,000)*.70 Payback period 3.98 (101,400/21,700) b) Net present value Present value of cashflows 86,641.59 (21,700*3.9927) Net present value 241.59 PV of inflows - outflows c) Internal rate of return As PV of inflows almost equals outflows then, IRR is about 8%. d) A company may accept a project even if it cannot be totally justified financially because of legal requirements or the necessity of remaining competitive. Employee morale, better customer service, etc. could be among other reasons for such a decision. Sample Quiz 1. Your grandfather is considering paying you $5,000 a year for the next four years to help out with your college tuition or pay you a lump sum $21,000 in four years upon graduation for the purchase of your first car. Assuming that you can get a return of 10 percent at the bank, which option will you prefer and why? a. Option 1 because its present value is over $1,500 higher. b. Option 2 because its present value is over $1,500 higher. c. Option 1 because its present value is over $870 higher. d. Option 2 because its present value is over $870 higher. e. None of the above. Answer: a Learning Objective: 3 5,000 * 3.169865 = 15,849; 21,000 * .683013 = 14,345; 15,849 – 14,345 = $1,504 approx 1,500. 2. You are considering buying this taxi for $15,000. It will provide you with a cash flow of $4,800 per year, and you would have to give the car away after four years. Your desired return is 10% per year. a. Buy because you would have an NPV = $850. b. Don’t buy because you would have an NPV = -$850. c. Buy because you would have an NPV = $216. d. Don’t buy because you would have an NPV = - $216. e. None of the above. Answer: c Learning Objective: 3 3. You are considering buying this taxi for $15,000. It will provide you with a cash flow of $4,000 per year, and you would be able to sell the car for $3,200 after four years. Your desired return is 10% per year. a. Buy; NPV = $134 b. Don’t buy; NPV = - $134 c. Buy; NPV = $153 d. Don’t buy; NPV = - $153 e. None of the above. Answer: b Learning Objective: 3 4. You are considering buying this computer for $15,000. It will provide you with a cash flow of $4,500 per year, and you would be able to sell it for $2,000 at the end of its useful life of four years. You are able to depreciate $3750 per year for tax purposes. Your tax rate is at 30% and your expected return is at 10% per year. a. Buy; NPV = $423 b. Don’t buy; NPV = - $423 c. Buy; NPV = $628 d. Don’t buy; NPV = - $628 e. None of the above. Answer: d Learning Objective: 3 5. You are considering replacing your old computer which has a book value of $2,500 with a new one which costs $14,800. The old computer can be sold for $1,200. The new one has a life of four years and your expected salvage value is $2,800, which is considered in computation of your straight line depreciation for tax purposes. Your expected savings per year with the new machine is $4,200 before tax. Your tax rate is at 40% and your expected return is 10% per year. a. Replace; NPV = 624 b. Don’t replace; NPV = - 624 c. Replace; NPV = 896 d. Don’t replace; NPV = - 896 e. None of the above. Answer: a Learning Objective: 3 6. You owe $1,457 to your friend. He tells you that in consideration of full payment of this debt he expects you to pay him $500 per year for the next four years. Your friend’s expected return is a. 10% b. 12% c. 14% d. 16% e. Can’t be determined. Answer: c Learning Objective: 3 7. Your older brother has started a business and he needs cash. He tells you that, if you pay him $5,160 today, he will pay you back $10,000 in four years. He is in effect giving you a return of a. 20% b. 18% c. 16% d. 14% e. Can’t be determined. Answer: b Learning Objective: 3 8. You have borrowed $6,480 from the bank and are told that the yearly payment for four years amounts to $2,000. The bank is charging you an interest of a. 12% b. 11% c. 10% d. 9% e. None of the above. Answer: d Learning Objective: 3 9. You have agreed to an annual payment of $3,000 for four years on a loan which has an interest rate of 8%. The loan amount should be a. $12,000 b. $10,161 c. $9,936 d. $9,720 e. None of the above. Answer: c Learning Objective: 3 10. You have agreed to a lump sum payment of $5,000 in four years on a loan which has an interest of 7% per year attached to it. The loan amount should have been a. $4,275 b. $4,115 c. $3,960 d. $3,815 e. None of the above. Answer: d Learning Objective: 3 11. The best capital budgeting model is often considered to be a. discounted payback. b. discounted bailout. c. time-adjusted rate of return. d. net present value. e. None of the above. Answer: d Learning Objective: 3 12. When computing a discount rate, we must consider a. interest factors. b. riskiness of the project. c. stockholder’s expected return. d. All of the above. e. a and b Answer: d Learning Objective: 1 13. In discounted cash flow analysis, we consider the following except a. disposal value of the old asset. b. book value of the old asset. c. installation charges of the new system. d. purchase price of the new system. e. tax effect of depreciation of the new system. Answer: b Learning Objective: 3 14. In discounted cash flow analysis, we consider the following except a. future revenues of the project. b. future appreciation of the asset. c. working capital needs of the project. d. salvage value of the project. e. tax effect of depreciation of the project. Answer: b Learning Objective: 3 15. When disposing of an old asset, a. gain on sale of the old asset reduces the basis of the new asset. b. gain on sale of the old asset increases the basis of the new asset. c. loss on sale of the old asset reduces the basis of the new asset. d. loss on sale of the old asset increases the basis of the new asset. e. None of the above. Answer: e Learning Objective: 3 16. NBC Company considers a project that will generate sales of $60,000. Fixed costs will be $16,000 per year. Variable costs are 40% of sales. Depreciation of the project will be $5,000 per year (this is in addition to the fixed costs). Taxes are at 30%. The expected annual cash flow from this project will be a. $15,400 b. $15,500 c. $16,400 d. $16,500 e. None of the above. Answer: b Learning Objective: 3 17. The discount rate commonly used in present value calculations is the a. treasury bill rate. b. prime rate. c. federal reserve rate. d. shareholders’ expected return on equity. e. None of the above. Answer: e Learning Objective: 3 18. You have borrowed $2,200 plus $51 expenses for borrowing payable in one year in 12 monthly installments with an annual interest rate of 12%. The monthly payment amounts to a. $187.58 b. $200.00 c. $206.36 d. $210.09 e. None of the above. Answer: b Learning Objective: 3 19. Your father has given you a certificate of deposit amounting to $20,000 which earns an interest of 12% per year paid semiannually for two years. You deposit the interest and earn interest on it as well. Your investment after two years will grow to a. $25,000 b. $25,250 c. $26,000 d. $26,216 e. None of the above. Answer: b Learning Objective: 3 20. The internal rate of return is the a. hurdle rate. b. rate of return for which the present value of cash inflows equals the present value of cash outflows. c. weighted average cost of debt plus cost of equity. d. dividend as a percentage of stock price plus the growth expectation of the investor. e. None of the above. Answer: b Learning Objective: 3 21. Real option analysis considers a. decision trees b. expected values c. net present values d. all of the above Answer: d Learning Objective: 5 22. Ethical dimensions of strategic investments may include a. bribing foreign officials for getting the contract b. ignoring environmental factors c. bias from personal commitment to a project d. all of the above e. a and b only. Answer: d Learning Objective: 6 23. The ethical foundation of a business dealing with strategic decisions can be enhanced through a. proper hiring practices b. investment reporting and review techniques c. formulating a proper code of ethics d. internal audits as well as the above Answer: d LO: 6 Chapter 15 Budgeting and Financial Planning Chapter Outline A. Cost Management Challenges — Chapter 15 offers five cost management challenges. 1. Why do organizations need an annual budget, and what purposes are served by the budgeting process? 2. How does budgeting facilitate communication and coordination among managers, particularly top management, sales and production personnel? 3. What is a master budget, and what are the five parts of a master budget for a manufacturing firm? 4. How can top management or the board of directors use the budget to influence the future direction of a company? 5. How can participative budgeting be used as an effective management tool? B. Learning Objectives — This chapter has seven learning objectives. 1. It describes the key role that budgeting plays in the strategic planning process. 2. Chapter 15 presents and explains five purposes of budgeting systems. 3. The chapter describes and demonstrates how to prepare a master budget, including its components. 4. Chapter 15 illustrates and evaluates a typical organization’s process of budget administration. 5. The chapter discusses the behavioral implications of budgetary slack and explains the workings of a participatory budget. 6. It describes contemporary trends in the budgeting process as an element of a cost management system. 7. Use of the economic-order-quantity model and discusses the implications of JIT on inventory management (Appendix). C. Every organization exists for the purpose of accomplishing some set of goals, such as profitability or public service. In order to achieve those goals, an organization’s top management engages in strategic planning. One step toward achieving the goals of an organization is identification of critical success factors. These are key strengths felt to be most responsible for making the organization successful. Chapter 14 presented strategic planning concerns as they relate to longterm goals. The focus in the last chapter was on long-term capital investments and planning for strategic moves. Chapter 15 presents budgeting, and budgets represent managers’ strategic plan in one-year increments. 1. A strategic long-range plan consists of the steps needed to achieve intermediate and longrange goals. It is a tool used to aid in decisions as they relate to major capital investments in existing facilities, expansion projects, and strategic moves. Strategic plans may include specific objectives such as cost control, increased market share, or introduction of new products. 2. A strategic plan is detailed into year-by-year plans. These yearly guides are referred to as master budgets. A budget is basically a road map or a plan for accomplishing immediate goals. The purposes of budgeting and various types of budgets are presented next. Then the details that go into the master budget will be illustrated. D. A budget, which is a detailed plan, has five primary purposes. 1. It is a planning tool. It allows managers to quantify their plan of action. 2. A budget facilitates communication and coordination among managers and departments of an organization. 3. They help managers to see how resources should be allocated. 4. Budgets aid in managing financial and operational performance. It is used as a benchmark against which actual results can be compared. 5. Budgets can be used for performance evaluation, both for segments of an organization, managers, and the organization as a whole. E. Organizations use many types of budgets. The master budget (or profit plan) is a comprehensive set of budgets covering all phases of an organization’s operations for a specified time period. Budgeted financial statements (or pro forma financial statements) show how an organization’s financial statements will appear if operations proceed according to plan. A capital budget is a plan for acquiring capital assets. A financial budget is a plan that shows how an organization will acquire financial resources through issuing stock or incurring debt. Budgets differ also along time dimensions. Budgets may cover a month, quarter, or year (shortrange budgets). They may cover periods longer than a year (long-range budgets). Rolling budgets or revolving or continuous budgets are continuously updated, covering the same amount of time but dropping older periods which are replaced by newer time periods. F. The master budget is the main output of a budget system. It is comprised of many separate budgets that are interdependent. The various components of the master budget are outlined below. 1. The sales budget is the first budget to be completed in the master budget. Before the sales budget is even completed though, a sales forecast is completed. a. The sales forecast is a prediction of sales of goods or services. Sales forecasts are based on past sales, industry trends, general economic trends, political, legal events, pricing policies, planned advertising, planned introduction of products, market research studies, strategic moves planned for the coming year, and other known changes. b. Sources of sales forecast data are sales staff, market researchers, and econometric models (a sophisticated multiple regression time-series model that shows sales trends, given the impact of many variables). A method called the Delphi technique requires that members of a forecasting group submit individual forecasts anonymously. The group then discusses all of the results submitted as a group. This is an attempt to remove biases from the sales forecast. 2. A set of operational budgets is developed next, based on the sales budget. The components of this set of budgets vary, depending on whether the company is a manufacturer, a merchandiser, or a service provider. a. A manufacturing firm develops a production budget, which is the basis for a direct materials budget, a direct labor budget, and an overhead budget. These budgets are then used to prepare a schedule of cost of goods manufactured and cost of goods sold. A second set of budgets and schedules is for selling, general, and administrative expenses. b. A merchandising company does not need a production budget or the budgets prepared from the production budget. Instead, a merchandise purchases budget is prepared. Then, a budget for personnel, overhead, and selling and administrative expenses is prepared. c. A service provider, after preparing a sales budget, must prepare a set of budgets, showing how those services will be provided. The schedules prepared by service firms vary, depending on the types of service being provided. d. A cash budget shows the amount and timing of expected cash receipts and cash disbursements. e. A capital budget details plans for major acquisitions and disposals of assets. That portion of the capital which is planned for the coming budget period is included as part of the master budget. f. Budgeted financial statements are the final piece of the master budget to be completed. The financial statements include budgeted (pro forma) balance sheet, income statement, and statement of cash flows. g. Non-profit organizations also use master budgets with the notable omission of the sales budget, since they do not obtain their financial resources from selling products or services. They usually begin with information showing planned services that will be provided and the expected funding. G. Organizations with international operations face a number of challenges in preparing their budgets. For foreign activities, the budget process must incorporate translation of foreign currency into the currency of the home country; adjusting financial information for the inflation rate of the countries where the company operates; and other factors that might affect budget estimates, like consumer demand, costs, and availability of skilled labor, legal, and political change. H. The best way to understand the process of completing a master budget is to walk through each component, describing what goes into it and how the information is obtained. This is shown for a manufacturing company. A manufacturing firm’s budget has eight major parts to it: (1) the sales budget (2) the production budget (3) the direct materials budget (4) the direct labor budget (5) the manufacturing OH budget (6) the selling, general, and administrative budget (7) the cash budgets, including budgeted cash receipts and disbursements, and (8) the budgeted financial statements. Each of these is described in more detail below. 1. The sales budget shows projected sales in units and multiplies the number of units by price to determine sales revenue. These budgets may be shown by month instead of quarter. 2. The production budget shows the number of units of product that are to be produced during a budget period. In order to determine what production needs are, desired inventory levels must also be budgeted. The production budget is based on the following formulas: ➢ Sales in units + desired ending inventory of finished goods = total units required. ➢ Total units required – expected beginning inventory of finished goods = units to be produced. 3. The direct materials budget is the next to be prepared. This budget shows what materials are needed to produce the units budgeted. The formulas showing how many units need to be produced can also be used to show the raw materials needed: ➢ Raw material required for production + desired ending inventory of raw materials = total raw materials required. ➢ Total raw materials required – expected beginning inventory of raw materials = raw material to be purchased. The materials to be purchased must be computed for each type of material used in production. Then, estimated cost per unit of material is multiplied by the number of units needed. The direct materials budget shows total units of materials needed and the cost of those materials. a. Production and purchasing are linked because the production budget is the basis for determining materials needs. In addition, inventory must be properly managed. Although, ideally inventory levels should be minimized to save money, managers do not want to face material shortages that might delay production. 4. The direct labor budget shows the number of hours of direct labor to be used during the budget period. This budget is based on estimated units to be produced. Then the amount of labor time needed to complete production of these units is determined. Depending on the complexity of production processes, the skill levels of direct labor workers may vary. In this case, the direct labor budget must be more detailed. It must show how much labor of each skill and pay type is needed to complete production. The direct labor budget is not a separate budget if labor is included as part of conversion activity. In addition, direct labor may be treated as a facility-level cost instead of unitlevel cost if labor costs are not adjusted according to production level changes. The direct labor budget shows the total time and the total cost of direct labor. 5. The manufacturing overhead budget shows the cost of overhead expenses to be incurred in the budget process. The manufacturing overhead budget details each type of overhead cost, and each cost is categorized as unit, batch, product, customer, or facility-level. Overhead costs are also split between cash outlays and non-cash outlays (like depreciation). 6. The selling, general, and administrative budget shows the planned amounts of expenditures for these non-production costs. These costs are, like the manufacturing overhead costs, split into unit, batch, product, customer, and facility level. 7. The cash budget shows the timing and amounts of cash receipts and cash disbursements. Supplementary budgets are the cash receipt and the cash disbursement budgets. a. The cash receipts budget shows cash flows generated from sales revenues and other sources of cash. i. Especially important is the expected flow of cash from credit sales. Businesses that extend credit to customers must estimate when cash from those sales will be received. ii. Uncollectible credit sales must be estimated for those customers who fail to pay what they owe. iii. In the case where there are substantial credit sales, a sizable part of the cash receipts from one month may actually be for sales from prior periods. In a given month, the schedule of cash receipts will consist of receipts from cash sales in the current period plus cash receipts for credit sales from past periods. iv. Cash receipts may occur when a company borrows funds, sells stock, sells assets, or earns interest or dividends from investments. These receipts are shown on the cash budget, not on the cash receipts budget, which only shows receipts from operating activities. b. The cash disbursements budget details the expected cash payments for the budget period. Payments may be for materials purchases, payroll, or payment for other goods and services needed to run the business. i. Materials purchases are usually paid for over several months, so the timing of cash disbursements must also be estimated. ii. The cash disbursements budget is very detailed because it shows all of the items that disbursements are made for. Expenditures from the direct labor, direct materials, manufacturing overhead, and selling, general and administrative budgets appear on the cash disbursements budget. c. The cash budget combines cash receipts and disbursements. Combining the cash receipts and cash disbursements helps managers to see whether there is adequate cash on hand to pay for all expenditures on a timely basis. The cash budget is organized to show the cash receipts and disbursements from operations first. The change in the cash balance due to operations is an important piece of budget information. The expectation is that most of the increase to cash will be the result of profits from operations. Below the change in cash figures, other cash activity is shown. Companies may borrow money for various reasons. If there are loans outstanding, interest must be paid on the loan, and the principal must be repaid. There may be some months during which cash disbursements exceed the cash balance. In that case, the company should have an established line of credit with banks that they do business with in order to cover any shortages until cash flows increase in later months. This is a common practice in companies that have seasonal sales activity. 8. The budgeted schedule of cost of goods manufactured and cost of goods sold combines information from the direct materials, direct labor, and manufacturing overhead budgets. The cost per unit of product is based on absorption costing. This means that unit-level costs are assigned based on budgeted unit-level costs, and higher level costs are allocated based on budgeted activity. The schedule of cost of goods manufactured has the following parts. a. Direct materials. Beginning raw materials plus purchases minus raw materials ending inventory = direct materials used. Direct materials information is obtained from the direct materials budget. b. Direct labor. Obtained from the direct labor budget. c. Manufacturing overhead. Obtained for the manufacturing overhead budget. d. Total manufacturing costs. The sum of direct materials used, direct labor, and manufacturing overhead. e. Add the budgeted beginning work in process (if there is any). Deduct the budgeted ending work in process (if there is any) to get cost of goods manufactured. If there is budgeted beginning or ending work in process balances, then a separate schedule showing budgeted equivalent units and their associated costs must be completed. f. Add beginning finished goods inventory to cost of goods manufactured to get cost of goods available for sale. Budgeted beginning finished goods inventory is obtained by multiplying the desired number of units in the production budget by the absorption cost per unit calculated for the schedule of cost of goods manufactured. g. Deduct budgeted finished goods inventory from cost of goods available for sale to get budgeted cost of goods sold. Budgeted ending finished goods inventory is obtained by multiplying the desired number of units in the production budget by the absorption cost per unit calculated for the schedule of cost of goods manufactured. 9. The budgeted financial statements, also referred to as pro forma financial statements, consist of the budgeted income statement, the budgeted balance sheet, and the budgeted statement of cash flows. a. The budgeted income statement pulls together information from other budgets to derive the budgeted amount of net income. It shows sales revenue from the sales budget. Cost of goods sold, selling, general and administrative expenses, uncollectible accounts expense, and interest expense are all taken from other budgets. b. The budgeted balance sheet shows the expected end-of-period balances for the company’s assets, liabilities, and owner’s equity, assuming that planned operations are carried out. The balance sheet budgeted at the beginning of the year is adjusted to reflect all changes in the balance sheet accounts. All of the changes to the accounts are obtained from other budgets that have already been completed. i. The cash balance can be taken directly from the cash budget. ii. Accounts receivable can be determined by looking at the cash receipts budget and using the estimated percentage of credit sales still outstanding. iii. Inventory balances are obtained from the budgeted cost of goods manufactured. iv. If any capital budget items are for capital assets, the capital budget will show changes that should be made to long-lived assets. Accumulated depreciation is updated based on the amount of depreciation appearing on the manufacturing overhead budget (there might also be some depreciation for non-production equipment, on the selling, general, and administration budgets). v. The balance in accounts payable is obtained from the direct materials budget, and determining what percentage of payments for purchases is still outstanding. vi. Owner’s equity is updated by adding budgeted net income from the budgeted income statement to the beginning equity balance. 10. The master budget is based on many assumptions. Like any other estimated planning tool, it is a good idea to perform sensitivity analysis by modifying the assumptions. Financial planning models allow computerized analyses of different outcomes, based on various outcomes rather than just one set of budget outcomes. I. Responsibility for the overall budget process is usually assigned to a budget director or the controller. The budget director determines how budget data will be gathered, collects the information, and prepares the master budget. Managers responsible for preparing components of the master budget are often guided by a budget manual. Organizations may also have a budget committee to advise the budget director. Final approval of the master budget is usually the responsibility of either the board of directors or board of trustees in non-profit organizations. J. Since budgeting has an impact on virtually everyone in an organization, there are behavioral implications to budgeting that should be considered. Three behavioral issues are budgetary slack, participative budgeting, and ethical issues in budgeting. 1. Budgetary slack occurs when sales are estimated too low or costs are estimated to be too high. This provides managers with “budgetary slack.” There are three reasons for the presence of budgetary slack. a. There is the perception that performance that is better than the budget will look good. If managers are evaluated by comparing actual performance to expected (budgeted) outcomes, then this is a correct perception. If sales are set artificially low, then exceeding targeted sales goals will make it appear that salespeople have done an exceptional job, exceeding expectations. If cost managers estimate costs high and then costs fall below those estimates, then it appears that cost managers have done an exceptional job of controlling costs. b. Budgetary slack is used to deal with uncertainty. Unanticipated events beyond the control of managers may cause the budget to be unattainable. Managers prefer to pad the budget “just in case” something goes wrong. c. Managers experienced in the budget process realize that budgets are usually cut before they are finalized. Knowing this, they pad their part of the budget, hoping that the cuts will not chip away at their true resource needs. 2. Participative budgeting involves employees in the budget process. The advantage of participative budgeting is that it gives employees a sense of ownership and a sense of control over the constraints a budget imposes on them. The disadvantage of participative budgeting is that it may result in padding and can slow down the process, since it is more likely that different managers will disagree on uses of the company’s resources. 3. Ethical issues related to budgeting arise when employees’ actual performance is evaluated based on budgeted or expected performance. For instance, if bonuses are based on exceeding sales figures, then budgeted sales will be lowered to allow salespeople to exceed budget goals, thereby ensuring that bonuses will be paid. Sales employees may even be pressured by their managers to manipulate budget figures or to shift the timing of reported actual activities, if the manager stands to earn bonuses as well. K. Zero-based budgeting is a management approach to budgeting that some organizations have tried. Under zero-based budgeting, the budget for every activity starts at zero for each new budget period. Each expenditure proposed for inclusion in the budget must be justified. This forces management to rethink every phase of operations before allocating resources to them. A modification of the zero-based budgeting approach is called “base budgeting,” where each department starts with a minimal level. Any expenditures above this amount must be justified. This is in contrast to incremental budgeting, most often used by government-type agencies, where the starting point for budgets is the last year’s numbers. A percentage is then added to this base to account for inflation and other potential increases. L. Although budgeting has been and continues to be a widely used management planning tool, the budget process is transitioning from simple budgeting to more sophisticated financial planning activities that incorporate cost management concepts and value-added philosophies to the traditional budgeting process. M. Inventory management deals with the issues of an economic inventory-ordering decisions and the implications for the JIT approach to inventory management. 1. EOQ model is a mathematical tool for determining the order quantity that minimizes the cost of ordering and holding inventory. EOQ is the order quantity that minimizes the cost of ordering and holding inventory. Ordering costs include time spent in finding suppliers, clerical costs, transportation costs and receiving costs. Holding costs include cost of storage space, security, insurance, foregone interest on capital tied up as well as deterioration, theft, and spoilage. Shortage costs are the costs of lost sales, loss of quantity discounts on purchases, idle time due to lack of materials, and extra machinery setups. 2. At the EOQ level, ordering costs equals carrying costs while total costs are at the bare minimum level. The trick is to place that many orders where total of ordering costs would equal total carrying costs. This can be achieved through either a tabular approach or an equation approach. A graphic approach can also be used in solving the EOQ problem. 3. The other issues addressed are the timing of the orders. Lead time is the time required for the material to be received after an order is placed. Safety stock is the potential excess usage of material when material usage fluctuates during the lead time. 4. Under the JIT philosophy, the goal is to keep all inventories as low as possible. Any inventoryholding costs are seen as inefficient and wasteful. JIT approach argues that holding costs tend to be higher than might be apparent. N. The chapter also briefly deals with activity-based budgeting. Because ABC costing is presented elsewhere, the focus here is on budgets without further complications of ABC. Problem 1 – Chapter 15 Learning objective: 3 Master budget – comprehensive exercise Time required: one hour Rohan Company produces a perfume that sells for $580 a bottle. Sales for 2003 is estimated to amount to 450 bottles. Inventory at the end of each period should amount to 20% of the period’s production. The product includes two ingredients; two ounces of X at $9 an ounce and three ounces of Y at $20 an ounce. Eight hours of labor at $15 an hour is needed for each unit. Variable overhead amounts to 50% of direct labor cost and Fixed overhead including $23,000 of depreciation amounts to $45,000. Inventory ending of raw materials amounts to 20% of production needs. 10% of X’s purchases and 15% of Y’s purchases remain unpaid at yearend. Inventory ending of finished goods amount to 100 units. 14% of sales remain unpaid while 2% of total sales must be written off as bad debts. Sales commission amounts to 10% of sales and 20% of it remains unpaid at yearend. General administration expense inclusive of bad debts and $ 8,000 in depreciation amounts to $15,300. Interest expense for the year amounts to $8,500. Taxes amount to 30% and are to be paid within 45 days after the yearend. Dividend of $10,000 is declared and is payable in 60 days. Balance of income is not distributed. All production costs except for unpaid purchases and $27,400 of wages are paid in cash. $24,000 of new machines are purchased in November and are to be paid in December of 2003. $60,000 of long-term debts are retired during 2003. Balance sheet as of 1/1/2003 includes $3,400 in cash, $24,700 in receivables, 110 ounces of X at $9 and 350 ounces of Y at $20 an ounce. Finished goods inventory of 50 units at $340 a unit. Fixed assets amounting to $310,000. Accounts payable of $6,990, taxes payable of $3,870, long-term debt of $300,000, and capital stock of $40,000. Required: 1) Prepare a sales and production forecast. 2) Prepare a purchases budget and a payable forecast. 3) Determine cost per unit. 4) Prepare a cost of production and sales report. 5) Prepare an income statement forecast for 2003. 6) Prepare a cash flow forecast. 7) Prepare a balance sheet forecast as of 1/1/2003 Note: As an extra assignment, you can prepare a balance sheet as of 12/31/2003. 1) Sales & Production units 5) Forecasted income statement Price Total Sales 450 Sales 450 580 261000 Ending inventory 100 Cost of sales 450 347.11 156200 Beginning inventory -50 Gross profit 104801 Production 2)Purchases & payables X Y Selling expense Administration 26100 15300 Production 500 Interest expense 8500 Ingredients - ounces 2 3 Income before taxes 54901 Production needs 1000 1500 Income tax 16470 Inventory ending 200 300 Neet income 38430 Inventory beginning -110 -350 Dividends 10000 1090 1450 38810 9 20 9810 29000 5331 981 4350 33479 8829 24650 24650 87300 20880 2080 8500 6990 3870 24000 60000 Purchases To retained earnings 28430 Unit price $ 6) Cash flow forecast Purchases $ Cash receipt 219240 Accounts payable Receivable collected 24700 Cash needed Total receipts 243940 3) cost per unit Quantity Price Total Purchases cash needs Material X 2 9 18 Production needs Material Y 3 20 60 Sales commission Direct labor 8 15 120 Administration expense Variable overhead 60 Interest expense Fixed overhead 90 Accounts payable Cost per unit 348 Taxes payable 4) Cost of production and sales Purchase of equipment Production 500 348 174000 Long-term debt reduction Inventory beginning 50 340 17000 Total disbursements 238270 Inventory ending -100 348 -34800 Cash overrage 5670 Cost of sales 450 347.11 156200 Cash beginning 3400 7) Forecasted balance sheet As of 1/1/03 As of 12/31/03 Cash 3400 9070 Accounts receivable 24700 36540 Raw materials inventory 7990 7800 Finished goods inventory 17000 34800 Fixed assets 310000 334000 Accumulated depreciation -31000 Total assets Accounts payable 363090 6990 391210 4350 Taxes payable 3870 16470 Dividends payable 10000 Sales commissions payable 5220 Wages payable 24700 Long-term debt 300000 240000 Common stock 40000 40000 Retained earnings 12230 40660 Ending cash balance 9070 Problem 2 LO: 3 Production budget Estimated time: 15 minutes Ryan Fabrics has two products X and Y with an inventory beginning of 235 yards of M and 395 yards of N. Sales for the coming period are anticipated to amount to 3,900 yards for M and 4,760 yards for N. The company policy is to keep at least 20% of the period’s sales in inventory. Determine how much the company needs to produce. Solution: Description Product X Product Y Sales forecast 3,900 4,760 Desired ending inventory 780 952 Total available 4,680 5,712 Beginning inventory 235 395 Budgeted production 4,445 5,317 Problem 3 LO 3 Raw material purchases budget Estimated time: 25 minutes Namazi Fabrics has decided to produce 3,750 yards of product M and 4,760 yards of product N. Product M uses 60% nylon and 40% rayon. Product N uses 100% wool. Each yard of M weighs 2 lbs. and each yard of N weighs 2.5 lbs. The price of nylon is $3.75 per lb, rayon is $2.95 per lb, and wool is $4.85 per lb. Inventory beginning amounts to 265 yards of nylon, 145 yards of rayon, and 310 yards of wool. Inventory ending is required to be 20% of the period’s usage. Determine a) raw material usage in lbs., b) amount to be purchased in lbs. and in dollars, d) material cost per yard of M and N. a) Raw material usage Nylon usage: 3,750 yards of M * 2 = 7,500 lbs.: 7,500 * .60 = 4,500 lbs. Rayon usage: 3,750 yards of M * 2 = 7,500 lbs.: 7,500 * .40 = 3,000 lbs. Wool usage: 4,760 yards * 2.5 = 11,900 lbs. Description Nylon Rayon Wool b) amoount to be purchased: Usage per above 4,500.00 3,000.00 11,900.00 Desired ending inventory 900.00 600.00 2,380.00 Less beginning inventory (265.00) (145.00) (310.00) Total to be purchased 5,135.00 3,455.00 13,970.00 price per lb. 3.75 2.95 4.85 Total purchases in $ c) material cost per yard: 19,256.25 10,192.25 67,754.50 M usage per yard 1.20 0.80 N usage per yard 2.50 Cost per yard 4.50 2.36 12.13 Cost per yard of M =$6.86 Problem 4 LO: 3 Accounts receivable and cash receipts budget Estimated time: 25 minutes Namazi Fabrics is anticipating to sell 3,850 yards of M and 4,960 yards of N at $12.50 and $25.75 per yard in March. Sales for April are expected to be 5% higher, May 6% higher than April, and June 8% higher than May. Terms of sales are 30% cash, 50% in 30 days, and the balance in 60 days. However, 20% of the latter amount becomes uncollectible. The uncollectible amount is written off to bad debts fifteen days after the last installment is paid. Prepare a cash receipts and accounts receivable budget through the end of June. Solution: Sales March 3,850.00 4,960.00 Sales April 4,042.50 5,208.00 Sales May 4,285.05 5,520.48 Sales June 4,627.85 5,962.12 Sales price 12.50 25.75 Sales March in $ 48,125.00 127,720.00 175,845.00 52,753.50 87,922.50 28,135.20 Sales April in $ 50,531.25 134,106.00 184,637.25 55,391.18 92,318.63 29,541.96 Sales May in $ 53,563.13 142,152.36 195,715.49 58,714.65 97,857.74 Sales June in $ 57,848.18 153,524.55 211,372.72 - 63,411.82 Totals 767,570.46 52,753.50 Balance of Accounts receivable as of June 30th: From March sales 0.00 this balance is written off in mid-June From April sales 7,385.49 From May sales 39,143.10 From June sales 147,960.91 Total 194,489.50 143,313.68 179,168.47 190,811.52 Description M N Total March April May June Sample Quiz 1. A master budget is composed of a. sales budget, production budget, and operational budget. b. sales budget, operational budget, and budgeted financial statements. c. budgeted income statement, budgeted balance sheet, and budgeted cash flows. d. manufacturing budget, cost of sales budget, and cash budget. e. None of the above. Answer: b Learning Objective: 3 2. The first step in budgets is the preparation of a. the budgeted income statement. b. the budgeted statement of cash flows. c. the sales budget. d. the budgeted balance sheet. e. None of the above. Answer: c Learning Objective: 3 3. Delphi Technique is a sales forecasting method that a. allows members of the forecasting group to prepare individual forecasts and then compare and discuss those forecasts until they converge on a single best estimate. b. enters sales data into a regression model to obtain a statistical estimate of factors affecting sales. c. is prepared through summarizing of past performance and adding a percentage to cover potential future growth. d. accounts for production and research facility requirements in its analysis. e. None of the above. Answer: a Learning Objective: 4 4. M & N Company has two products M and N with an inventory beginning of 195 yards of M and 345 yards of N. Sales for the coming period is anticipated to amount to 2,900 yards of M and 3,760 yards of N. The company policy is to keep at least 15% of the period’s sales in inventory. Budgeted production of N amounts to a. 4,314 yards b. 3,979 yards c. 3,335 yards d. 3,140 yards e. None of the above. Answer: b Learning Objective: 3 Use this data to answer questions 5 through 9. M & N has decided to produce 3,200 yards of product M and 3,900 yards of product N. M uses 70% nylon and 30% rayon. N is 100% wool. Each yard of M weighs 1.5 lbs and each yard of N weighs 2 lbs. The price of nylon is $2.50 a lb., rayon $1.75 a lb., and wool 3.90 a lb. Inventory beginning amounts to 225 lbs of nylon, 135 lbs of rayon, and 185 lbs of wool. Inventory ending is required to be 20% of the period’s usage. 5. Rayon usage amounts to a. 7,800 lbs. b. 4,800 lbs. c. 3,360 lbs. d. 1,440 lbs. e. None of the above. Answer: d Learning Objective: 3 6. Wool usage amounts to a. 7,800 lbs. b. 4,800 lbs. c. 3,360 lbs. d. 1,440 lbs. e. None of the above. Answer: a Learning Objective: 3 7. Purchases of nylon amounts to a. 1,593 lbs. b. 1,728 lbs. c. 3,807 lbs. d. 4,032 lbs. e. None of the above. Answer: c Learning Objective: 3 8. Purchases of wool amounts to a. $2,787.75 b. $9517.50 c. $15,975.25 d. $35,782.50 e. None of the above. Answer: d Learning Objective: 3 9. Material cost per yard of M amounts to a. $3.41 b. $4.41 c. $6.80 d. $7.80 e. None of the above. Answer: a Learning Objective: 3 10. Shahnaz Fabrics is anticipating to sell 2,900 yards of product M and 3,760 yards of product N at $9.50 and $24.50 per yard respectively in the month of September. Terms of sales are 30% cash, 50% in 30 days, and 20% in 60 days. However, 20% of the latter amount is expected to be uncollectible. The uncollectible balance is written off to bad debts when the last installment is due. Cash receipts for September amount to a. $17,950 b. $35,901 c. $49,835 d. $59,835 e. None of the above. Answer: b Learning Objective: 3 11. Shahnaz Fabrics is anticipating to sell 2,900 yards of product M and 3,760 yards of product N at $9.50 and $24.50 per yard respectively in the month of September. Terms of sales are 30% cash, 50% in 30 days, and 20% in 60 days. However, 20% of the latter amount is expected to be uncollectible. The uncollectible balance is written off to bad debts when the last installment is due. Accounts receivable as of 10/31/xx amounts to a. $5,983 b. $23,934 c. $83,769 d. –0- e. None of the above. Answer: b Learning Objective: 3 12. A budgeting system a. comprises the procedures used to develop a budget b. is a detailed plan expressed in quantitative terms c. is a general plan expressed in monetary terms d. specifies how an organization will acquire and use resources during a particular period of time e. none of the above. Answer: a Learning objective: 2 13. Revolving budgets a. are prepared on an annual basis b. are prepared semi-annually c. are same as continuous budgets d. are updated periodically by adding a new incremental time period e. c and d. Answer: e Learning objective: 2 14. Budgetary slack is a. the intentional underestimating of the budget b. the unintentional overestimating of the budget c. the difference between the revenue or cost projection and a realistic estimate of the revenue or cost d. a and c e. b and c Answer: c Learning objective: 5 15. Zero-base budgeting sets a. the budget for each item below the prior year b. the budget slightly above the prior year’s budget c. initially the budget for virtually every activity in the organization to zero d. a and c e. none of the above Answer: c Learning objective: 5 Use the following data to answer questions 16 through 20. Namazi Fabrics is anticipating production of 3,200 yards of M and 3,900 yards of N at a cost of $6.70 per yard for M and $16.50 per yard for N. Ending inventory amounts to 20% of the period’s production. Sales amounted to 2,900 yards of M at $9.50 per yard and 3,760 yards of N at $24.50 per yard. Selling expense amounts to 10% of sales, and administration expense amounts to $4,950. Taxes are at 20% of income. Accounts receivable at the beginning of the period amounts to $21,500. Ten percent of this amount remains uncollected. Accounts receivable at the end of the period amounts to 20% of the period’s sales. Payable at the beginning of the period amounted to $14,800. Ending payable amounts to 20% of the period’s cost of sales. 25% of current taxes are paid in the current period. 16. Gross profit for M amounts to a. $5,365 b. $8,120 c. $20,868 d. $30,080 e. None of the above. Answer: b Learning Objective: 3 17. Separable income for N amounts to a. $5,365 b. $8,120 c. $20,868 d. $30,080 e. None of the above. Answer: c Learning Objective: 3 18. Company taxable income (rounded) amounts to a. $17,026 b. $18,026 c. $20,283 d. $21,283 e. None of the above. Answer: d Learning Objective: 3 19. Total cash receipts amounts to a. $101,150 b. $111,150 c. $115,086 d. $119,086 e. None of the above. Answer: c Learning Objective: 3 20. Taxes payable at the end of the period amounts to a. $4,450 b. $3,392 c. $3,250 d. $3,192 e. None of the above. Answer: d Learning Objective: 3 21. Economic order quantity is the order level where a. ordering cost equal carrying costs b. ordering cost is greater than carrying costs c. ordering cost is less than carrying costs d. any of the above. Answer: a LO: 7 22. Carrying cost is calculated by multiplying a. average inventory times carrying cost per unit b. inventory times carrying cost per unit c. ending inventory times carrying cost per unit d. beginning inventory times carrying cost per unit. Answer: a LO: 7 23. Ordering cost is calculated by multiplying a. number of orders times cost per order b. average inventory times cost per order c. ending inventory times cost per order d. beginning inventory times cost per order Answer: a LO: 7 Instructor Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533