Basics of Managerial Accounting for Dicision Making

Part A: Calculations and Explanations for Project X:

Depreciation calculation must consider the new machinery, the new factory and the patent. The question states that a policy proclaimed by Cherry PLC was designed to depreciate the equality of its non-current assconsidered to equal to a zero. That is why the depreciation (in £ millions) for every year must be: (8+9.6+3.2)/10=2.08

The formula for IRR is 11.5%+ [(the difference between two discount factors*[email protected]%) / the difference between NPV at different DF]. Thus, the calculation of IRR should be: 0.115+ [(0.25-0.115)*22.394]/[22.394-(-2.573)]=23.6% (By using the figures with DF 25%)

In order to calculate the ARR, we need to obtain the operating profit after depreciation, which means that we have to add interest payments to the profit figures provided by the question as those figures are profits after charging both interest and depreciation, e.g. for year 1, -1.6+0.45 gives us the operating profit after depreciation.

To calculate ARR, we obtain the average profit which is 78.9/10=7.89. According to the ARR formula : ARR= Avg operating profit after depreciation/initial investment, ARR=7.89/33.8=0.233

Workings of the payback period are: 4+(2.28/18.08)=4.126 years

Project X

Yr (£ millions)

0

1

2

3

4

5

6

7

8

9

10

Profit

0

-1.6

2.4

9.6

12.8

16

12.8

8

6.4

4.8

3.2

Add: Depreciation

0

2.08

2.08

2.08

2.08

2.08

2.08

2.08

2.08

2.08

2.08

Patent cost

-8

0

0

0

0

0

0

0

0

0

0

New factorial building cost

-3.2

0

0

0

0

0

0

0

0

0

0

Machinery cost

-9.6

0

0

0

0

0

0

0

0

0

0

Land cost

-11.1

0

0

0

0

0

0

0

0

0

7.8

Working capital

-1.9

0

0

0

0

0

0

0

0

0

1.9

Net cash flow

-33.8

0.48

4.48

11.68

14.88

18.08

14.88

10.08

8.48

6.88

14.98

Project Y

Workings and explanations for project Y:

The depreciation per year for project X takes into account the new machinery, the patent and the new factory and this should be added to the profit in order to obtain the correct original profits for project Y. Project Y does not need to build a new factory. (8+9.6+3.2)/10=2.08

As it states in the question that no bank loan would be necessary, thus we need to add bank loan interest because it has been deducted in the project X situation. 0.45 Million per year.

In Project X, it assumes that there will be a loss when Cherry PLC sells the land after 10 years. Therefore, when we do the cash flows for project Y, the land loss figure should be added to the cash flow for year 10. (11.1-7.8=3.3)

The calculations for IRR: 0.115+[(0.3-0.115)*28.612]/(28.612-1.487)=0.31014=31%

In order to calculate the ARR, we need to obtain the operating profit after depreciation, which means that we need to add interest payment per year and depreciation of the new factory per year to the profit figures, while we also need to deduct the annual lease payment. E.g. for year 1, -1.6+0.45+0.32-1.2=-2.03, which gives us the operating profit after depreciation.

For ARR: (73.4/10)/21.74=0.337426=0.338

Workings for the payback period: 3+ (7.35/14.13)=3.52 years.

Project Z

Workings and explanations for project Z:

The depreciation per year only takes into account the new machinery, thus it should be 6/10=0.6 per year.

Calculations for ARR: (28.3/10)/6.4=0.442

Calculations for the payback period: 1+ (3.2/3.3)=1.97 years.

Workings for ARR: 0.115+[(0.3-0.115)*14.259]/(14.259-4.795)=39.37%

Project Z

Yr (£ millions)

0

1

2

3

4

5

6

7

8

9

10

Profit

0

2.6

2.7

2.9

3.9

4.8

3.5

3.6

1.9

1.5

0.9

Add: Depreciation

0

0.6

0.6

0.6

0.6

0.6

0.6

0.6

0.6

0.6

0.6

Machinery cost

-6

0

0

0

0

0

0

0

0

0

0

working capital

-0.4

0

0

0

0

0

0

0

0

0

0.4

Net Cash Flow

-6.4

3.2

3.3

3.5

4.5

5.4

4.1

4.2

2.5

2.1

1.9

Cash Flows:

Part B

Cherry PLC investment decision will result in improvements in processing speeds due to the manufacturing of a new chip. Investment decisions are of importance to a company because of a large number of resources that need to be directed towards the project as well as being very difficult to reverse an investment decision once it has been undertaking. Therefore, management should ensure that they critically evaluate all investment options and chose the one that offers maximum returns without exposing them to a lot of risks. Management should also consider the use of a risk-adjusted discount rate which involves adding a risk premium to the risk-free rate. For the three alternatives advanced, the third option presents minimum risk and most value for the company’s shareholders.

The above decision was reached at after conducting capital budgeting evaluation on all three advanced alternatives. First the NPV of all three projects was carried out, project X has an NPV of -2.573, project Y 1.487 and project Z 4.795. The general rule of acceptance requires NPV to be greater than zero. This instantly disqualifies project X. the IRR for the three projects is as follows: 23.60%. 31%, and 39.37% respectively. The acceptance rule for IRR requires the internal rate of return to be higher than the opportunity cost which in this case is 11.5%. However, in order to make a more conclusive decision other evaluation techniques have to be considered such as the payback period. The payback period for the three projects is as follow: 4.126, 3.52, and 1.97 years. This means that project Z in comparison with the other projects is more profitable for the firm as it requires the shortest time to recover invested funds in the project. Finally we shall consider the ARR which is used to measure profitability of an investment. The general rule of acceptance is to accept the project with the highest ARR. In this case, the ARR for the three projects is as follows, 0.233, 0.338, and 0.442 respectively. Therefore, project Z is the best alternative for the company as it has minimum risks and a shorter payback period.

Sensitivity Analysis

This involves evaluating all factors that could potentially affect the long-term success of the investment project. Since Cherry PLC are considering the launch of a new product a sensitivity analysis will be carried out to analyze all potential risk factors. These factors include operating costs, the initial outlay for the machine, initial outlay for the factory, financing costs and life of the project. Sensitivity analysis, however, has a few drawbacks, this is it does not give management a real picture of the project, therefore, the final decision will be based on management’s judgment, it also does not foresee any changes that a particular factor of production will change, increase or decrease, and finally sensitivity analysis only considers one factor of production at a time while all other factors are held constant.

However, management should also consider the strengths and weaknesses of the appraisal methods used in evaluating which investment project they should undertake. For instance, the net present value NPV requires cash flows to be estimated which in some cases is a strenuous, tedious and time-consuming task. Also, computation of NPV requires the use of the opportunity cost as the discount rate. This poses difficulties as it is sometimes difficult to accurately pinpoint the opportunity cost of capital. Finally, NPV is very sensitive in relation to fluctuating discount rates. The IRR on the other hand also has some weaknesses key among them being that IRR may fail to provide the best choice between two conflicting alternatives. IRR brings forth multiple rates which makes it difficult in computing the present value of the project.

Furthermore, non-discounted cash flow methods of appraisal such as payback period do not take into account the time value of money. Also, this method completely ignores all cash flows that come to the business after the payback period. PB cannot be used as a measure of profitability as it does not offer any accurate method of estimating actual payback. Finally, the accounting rate of return ARR does not use cash flows in its computations, therefore, the average return arrived at does not show the full picture of the project. ARR also places more regard to future cash flow receipts and does not provide an objective minimum acceptable rate of return for any project.

Part C

“For decision-making purposes, the only costing method worthwhile using is marginal costing”.

A costing system is a tool used by management to determine the cost of objects such as products and services while providing a better and more accurate measurement of resources used by the above objects. Each business chooses the costing method that allows them to reach their objectives. The method, however, should allow the business to prosper and achieve profitability. For effective decision making the costing method chosen should aim to put all total costs as direct costs of the project in order to reduce the number of costs classified as indirect. Also, the costing method should classify all indirect costs as those with a similar cause and effect relationship. For instance, indirect costs are pulled together and classified as machine costs and distribution costs. Finally, the costing method chosen should have cost allocation bases. This is a base created to supplement the indirect cost pool stated above. Before deciding on which costing method should be chosen it is prudent to carefully evaluate the three costing methods available which are:

Marginal Costing

Traditional Absorption Costing

Activity Based Costing

Marginal Costing

Marginal costing refers to the variable cost of producing a product. It is defined as an accounting system that charges variable costs to cost units while writing off fixed costs. Variable costs in this context refer to costs that change as levels of output changes. This method is best used by management for decision making as it considers the changes which will be brought about by the decision in question. For any item of production its marginal cost of production is the total of direct labor costs, direct expenses and direct materials which means that if the marginal cost of production increases, total variable costs also rise in the same proportion. In this costing system, variable costs are charged under marginal costing while fixed costs are placed under period costs. Marginal costing implements the contribution concept where contribution = sales revenue- variable costs.

This concept is very important as it gives management a real sense of how much money they have left towards catering to the other operational costs of the organization. The advantages of marginal costing method are that it easy a very easy method to use and understand. Also, it provides a clear picture of the relationship between costs, sales volume and prices of actual products.

Traditional Absorption Costing

This method divides all costs into two distinct groups which are production costs and non-production costs. All other costs which are not associated with the production process such as research and development, distribution costs, marketing, design and transported are categorized under nonproduction costs. However, production costs are further classified into production overhead and direct costs. Direct costs are made up of direct labor, direct expenses and direct material. Production overhead costs are comprised of indirect expenses, indirect labor, and indirect material. This costing method is normally used in valuing inventory as well as for external reporting. This method as its name suggests is traditional and has some disadvantages which include; providing late and inaccurate information, erroneously classifying fixed and variable costs as well as poor classification of the period and product costs.

Inventory in the absorption costing method is valued at full production cost. This, therefore, means that profits stated under the marginal costing method and traditional absorption costing method are different. An increase in inventory levels under the absorption costing method will indicate a rise in profits. This is because this method carries forward all inventory held at the end of the accounting period. The advantages of this method include all overheads in the inventory value been fixed, it is a useful tool for controlling costs in a company, and finally, it provides a clear means of estimating future profits by absorbing all costs to the production process.

Activity-Based Costing

This costing method focuses on individual activities as the cost objects. An activity in this context is used to refer to any unit of work within the operations of a company, for example, distribution of products and setting up of machines. Since it is easy to categorize direct costs, activity based costing method lays a lot of emphasis on indirect costs and their assignment to various departments within an organization. This costing method, therefore, identifies and lists all activities as well as the costs associated with performing each activity. By creating a cost hierarchy that categorizes different costs into their cost pools an effective way of determining costs is arrived at.

The advantages of activity-based costing are that it provides a better tool for implementing performance management, sales strategy and decision making as it provides an accurate figure of cost per unit as compared to the other two costing methods. This costing method is best preferred when deriving realistic costs in the operational environment of a business. Also, activity-based costing can be applied to all overhead costs as opposed to the other two costing methods which mainly focus on production overheads. The disadvantages of this method are that it cannot allocate overhead costs to a specific activity which in turn makes it difficult to track that cost. Also, activity-based costing activities and cost drivers that may seem inappropriate in the long-term operations of the business.

After careful evaluation of the three costing methods, one can conclude that the student was correct in saying that for decision-making purposes the only costing method worthwhile using is marginal costing. This is because the costing function is an important aspect of every business. Each business uses the costing method that increases their chances of achieving their desired result. After analyzing the three available costing methods based on their advantages and disadvantages marginal costing remains the best tool for accurate and informed decision making. This is because marginal costing takes into account the break-even analysis, investigates the impact of variable cost on output, and analyses the contribution from each department within a company in order to know which departments are profitable.

References

Horngren, C.T., Foster, G., Datar, S.M., Rajan, M., Ittner, C. and Baldwin, A.A., 2010. Cost accounting: A managerial emphasis. Issues in Accounting Education, 25(4), pp.789-790.

Pandey, I.M., 1995. Essentials of Financial Management, 4th Edtion. Vikas publishing house.