afm102 exam aid final
TRANSCRIPT
Chapter 10Good to Know…- DM, DL, VMO, FMO variances- Overhead Cost Analysis
Management by ExceptionDefinition • System of management in which standards are set for various operating activities which are periodically compared to actual results• Significant differences (variances) = “exceptions”
Variance Analysis Cycle1) Prepare standard cost
performance report2) Analyze variances3) Identify Questions4) Receive explanations5) Take corrective actions6) Conduct next period’s operations Goal is to improve operations, not assign blame
Ideal vs. Practical Standards
Ideal Standards•Allows for no machine breakdowns or
other work interruption•Require peak efficiencyPROS
•Motivational valueCONS
•Discourages most diligent workers•Variances have little meaning
Ideal vs. Practical StandardsPractical Standards• Allows for normal machine breakdowns and
other work interruption• Attained through reasonable but highly
efficient efforts by average employeesPROS
•Used to forecast cash flows and plan inventory• Standard used for purposes of chapterCONS
• Variances need management attention
Direct Materials StandardsStandard Price per Unit (SP) – price paid for single unit of material• Includes allowances for quality, shipping, net of
discounts
Standard Quantity per Product (SQ) – amount of materials required to complete single unit of product• Includes allowances for waste, spoilage, rejects
Standard Cost of Material per Product= SP x SQ
Direct Labour StandardsStandard Rate per Hour (SR) – labour rate that should be incurred per hour• Includes employment tax, employee benefits
Standard Hours per Product (SH) – amount of labour time required to complete single unit of product• Includes allowances for breaks, machine downtime,
clean up
Standard Labour Cost per Product= SR x SH
Variable Manuf. O’head StandardsStandard Rate per Hour (SR) – variable portion of predetermined overhead rateStandard Hours per Product (SH) – amount of labour time required to complete single unit of product• SH same as in DL Variance
Standard VMO per Product= SR x SH
Variance Analysis
•Variance – Difference between standard price and quantities and actual price and quantities
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Direct Materials VarianceMaterials Price Variance= AQ (AP – SP)•Measure of difference between actual unit price and standard unit price
Responsibility•Purchasing manager
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Direct Materials VarianceMaterials Quantity Variance= SP (AQ – SQ)•Measure of difference between actual
quantity used and standard quantity allowed•Best isolated when materials placed into
production (early control)•Excess result of faulty machine, untrained
workers, poor supervisionResponsibility•Production department
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Direct Labour VarianceLabour Rate Variance= AH(AR – SR)•Measure of diff. b/w actual rate and
standard rate•Can arise from way labour used ie. High-
skilled worker doing duty of low skill or v.v.•Unfavourable variance from overtime
work @ premium rateResponsibility•Production supervisors
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Direct Labour VarianceLabour Efficiency Variance= SR(AH – SH)•Measure of diff. b/w actual hours and
standard hours allowed (measures productivity)•Most important to management•Unfavourable variance from untrained
workers, poor-quality materials, breakdowns, insufficient demand
Responsibility•Managers in charge of production
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Variable Manuf. O’head VarianceVMO Spending Variance= AH(AR – SR)•Measure of diff. b/w actual VMO cost and
standard cost•Can occur if:
a)Actual purchase price different from standard price
b)Actual quantity different from std.Responsibility•Purchasers of overhead items
Variance AnalysisActual
QuantityAt
Actual Price
Actual QuantityAt
Standard Price
Standard Quantity
AtStandard Price
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
Variable Manuf. O’head VarianceVMO Efficiency Variance= SR(AH – SH)•Measure of diff. b/w actual activity
and standard activity allowed• Indirectly measures efficiency of
activity baseResponsibility•Whoever is responsible for activity
base
Variance AnalysisAQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
FavourableAP < SPUnfavourable AP > SP
FavourableAQ < SQUnfavourable AQ > SQ
Further Analysis
AQ x AP AQ x SP SQ x SP
Total Flexible Budget Variance
Price Variance Quantity Variance
M x SP
Actual Quantity At Std. Mix & Std. Price
Mix Variance
Yield Variance
Quantity Variance
Mix Variance= SP(AQ – M)= SP(AQ – Budgeted% x Total Input)•Difference between actual mix of
materials and budgeted mix of materialsie. Mix of Materials A & B, Mix of Skilled and Unskilled Labour Types• Favourable: AQ < M•Unfavourable: AQ > M
Quantity Variance
Yield Variance= SP(M – SQ)= Mix Variance – Quantity Variance•Favourable: Mix Var. < Quantity Var.•Unfavourable: Mix Var > Quantity Var.
Quantity Variance
Process:•Calculate a Mix Variance and Yield Variance for every type of material, labour, etc…•Total Mix Variance = Sum of Mix Variances•Total Yield Variance = Sum of Yield Variances
Overhead Rates•Predetermined overhead rate=
•Variable Element=
SR used in VMO variance calculations
• Fixed Element =
•Estimates are from flexible budget
Overhead Cost Application
• In a standard cost system, total overhead cost applied based on standard hours, not actual hours•Total Overhead Cost= Predet. O’head Rate x Standard Hours•Keeps unit costs from being affected by variations in efficiency
Fixed Manuf. O’head VarianceBudget Variance= Actual FMO cost– Flexible budget FMO cost• Represents difference between how much should have been spent and how much actually spent•Favourable: Actual < Flexible•Unfavourable: Actual > Flexible
Fixed Manuf. O’head VarianceVolume Variance= Fixed Portion of Predet. O’head Rate x (Denominator Hours – Std. Hours Allowed)• Measures utilization of plant facilities•Arises when std. hours allowed differs
from denominator activity level planned•Favourable: Denom. < Standard•Unfavourable: Denom. > Standard
Graphic Analysis of FMO Variance
BudgetActualAppliedVolume Variance (F)
Budget Variance (U)
Std. HoursDenom. Hours
Applied-Cost Line
Fixed O’head Cost
Variable O’head Cost
Budgeted
Applied
Cautions in FMO Analysis
•Total fixed cost is not a variable cost, but we act as if it is•Volume variance expressed in units as opposed to $ to avoid confusion
Under/Overapplied O’head CostSum of:• VMO Spending Variance•VMO Efficiency Variance• FMO Budget Variance• FMO Volume Variance
= Total Overhead Variance• Favourable Variance: Overapplied•Unfavourable Variance: Underapplied
Management by Exception
• If Actual close to Budget/Standards Managers can focus on other issues• If Variance occurs Managers alerted of “exception”
Evaluation of Standard Costs
Advantages1. Key element in management by
exception.2. Reasonable standards can promote
economy and efficiency.3. Greatly simplifies bookkeeping;
standard costs are consistent.4. Fits naturally in “responsibility
accounting”.
Evaluation of Standard CostsDisadvantages
1. Variance reports often outdated.2. Morale may suffer if reports used to lay blame.3. Assumes output is labour-paced (but often
depends on speed of machine).4. Assumes labour hours are variable; in fact, fixed.5. In some cases, favourable is actually
“unfavourable”; ie. Harvey’s: less meat = substandard burger
6. Emphasizes meeting standards; excludes other important objectives ie. Quality
Question•Which of the following is not a possible cause
of an unfavourable variable overhead spending variance
A) Paying higher hourly wages for indirect labour than planned
B) Paying more for indirect supplies than planned
C) Using more indirect supplies than plannedD) Paying more for insurance on factory
equipment than planned
Question•Which of the following is not a possible cause
of an unfavourable variable overhead spending variance
A) Paying higher hourly wages for indirect labour than planned
B) Paying more for indirect supplies than planned
C) Using more indirect supplies than plannedD) Paying more for insurance on factory
equipment than planned
Question 10-26Haliburton Mills Inc. is a large producer of men’s and women’s clothing. The company uses standard costs for all of its products .The standard costs and actual costs for a recent period are given:Direct Materials: Standard Actual
Standard: 4.0m at $3.60/m $14.40Actual: 4.4m at $3.35/m $14.74
Direct Labour:Standard: 1.6hr at $4.50/hr $7.20Actual: 1.4hr at $4.85/hr $6.79
Variable Manufacturing Overhead:Standard: 1.6hr at $1.80/hr $2.88Actual: 1.4hr at $2.15/hr $3.01
Fixed Manufacturing Overhead:Standard: 1.6hr at $3.00/hr $4.80Actual: 1.4hr at $3.05/hr $4.27
Total Cost per unit $29.28 $28.81
Question 10-26During this period, the company produced 4,800 units of product.There was no inventory of materials on hand to start the period. During the period, 21,120 metres of materials were purchased and used in production. The denominator level of activity for the period was 6,860 hours.1. For direct materials:
a) Compute the price and quantity variances for the period.
b) Prepare journal entries to record all activity relating to direct materials for the period.
3. Compute the fixed overhead budget and volume variances.
2006 Final QuestionAnalysts at Spring Break Ltd. have gathered the following data:Budgeted direct labour mix at standard rate, for actual output achieved:Skilled labour 7,650 hours at $32 per hrUnskilled labour 2,550 hours at $24 per hrActual results:• Skilled labour 8,000 hours at $38 per hr•Unskilled labour 2,000 hours at $18 per
hr
2006 Final Question cont’d
RequiredCalculate the mix and yield variances for direct labour. (8 marks)
Chapter 11Good to Know…- Negotiated Transfer Pricing- ROI/RI calculations- 4 Cost of Quality Groups
Responsibility Centre
Definition•Any part of an organization whose manager has control over and is accountable for cost, profit or investments
Responsibility Centre3 types of responsibility centres1) Cost Centre•Evaluated using standard cost and
flexible budget variances2) Profit Centre•Evaluated by comparing actual profit to
target/budget3) Investment Centre•Evaluated using ROI or RI
Transfer Pricing
Definition• Price charged when division provides good or service to another division of organization
Transfer Pricing3 common approaches:1) Allow managers to negotiate.2) Set at cost using variable/full
absorption costing.3) Set at market price. Fundamental objective:Act in best interest of overall company
Negotiated Transfer Price
Advantages•Preserves autonomy of division.•Managers have better information about costs and benefits
Transfer Price
Selling Division
Purchasing Division≤ ≤
Upper Limit (Purchasing Division)
Transfer Price≤ Cost of buying from Supplier
• If no outside suppliers, purchasing division should be willing to pay expected revenue per unit – excluding transfer price
Lower Limit (Selling Division)
Transfer Price≥ VC/unit +
3 scenarios:1) Selling Division with Idle Capacity2) Selling Division with no Idle
Capacity3) Selling Division with some Idle
Capacity
Lower Limit (Selling Division)
Selling Division with Idle CapacityTransfer Price≥ VC/unit +
≥ VC/unit +
≥ VC/unit
Lower Limit (Selling Division)
Selling Division with no Idle CapacityTransfer Price≥ VC/unit +
≥ VC/unit +
≥ Selling Price per unit
Lower Limit (Selling Division)
Selling Division with some Idle CapacityTransfer Price≥ VC/unit +
≥ VC/unit
+
Evaluation of Negotiated Transfer Prices
• If transfer results in higher overall profits, there will always be a range of acceptable transfer prices•Sometimes managers aren’t cooperative•Most companies set transfer prices
using other methods Set transfer price at:1) Cost or 2) Market Price
Transfers to Selling Division at Cost• Set price at variable cost or full absorption
cost incurred by selling division.Major defects:•May lead to suboptimization.• Selling division will never show profit.•No incentives to control costs.Advantage:• Easily understood and convenient. cost-based transfer prices common used.
Transfers to Selling Division at MV
•Set price to match price charged on open market.•Appropriate when no idle capacity.Major defects:•When idle capacity present, purchasing division might regard market price as cost might make bad pricing decision (end product priced too high)
Evaluation of Investment Centre
• 2 methods:1) Return on Investment2) Residual Income
1) Return on Investment
ROI =
Operating Income• Earnings before Interest and Tax (EBIT)Average Operating Assets• Includes cash, A/R, inventory, P&E•Doesn’t include land, investments, rented-out
buildings Higher ROI = Greater Profit per $ invested in operating assets
1) Return on Investment
Side NoteAdvantage of calculating P&E using:•Net Book ValueConsistent with balance sheet value•Gross CostEliminates depreciation factor (ROI
as NBV due to depreciation)
1) Return on InvestmentROI = Margin x Turnover
=
• Increase in ROI must involve at least one of following:1) Increased Sales2) Reduced operating expenses3) Reduced operating assets
1) Return on InvestmentCriticisms1) Increasing ROI inconsistent with
company strategy. May increase ROI in short run but harm in
long run ie. cut R&D costs.2) Managers may inherit committed costs with
no control Difficult to assess manager against other
managers.3) Managers evaluated based on ROI may
reject profitable investment opportunities.
2) Residual Income
Residual Income= Operating Income– (Average Operating Assetsx Minimum Required Rate of Return)
2) Residual IncomeAdvantage•Encourages manager to make investment that is profitable for entire company but rejected by managers evaluated with ROI.
Disadvantage•Can’t be used to compare performance of division of different size.
2) Residual IncomeCriticisms1) Based on historical data.2) Doesn’t indicate what earnings should
be for business unit.Must compare to competitor/past
performance.3) Requires adjustments to GAAP that
increases cost of preparing information.4) Doesn’t incorporate non-financial
indicators ie. Employee motivation
Balanced Scorecard
3 Strategic Approaches to Outperforming Competitors:1) Cost Leadership2) Differentiation3) Focus/Niche
Balanced Scorecard
• Illustrates theory of how company can attain desired outcome with concrete actions.
Advantage• Can be used continually to test theories underlying manager’s strategy Needs feedback
Balanced Scorecard
Advantages of Timely Feedback• Cause can be tracked down and action taken quickly.• Managers can focus on trends. Emphasize improvement rather than standard.
Measures of Internal Business Process PerformanceDelivery Cycle Time• Amount of time required from receipt of order
to shipment of goodThroughput (Manufacturing Cycle) Time• Amount of time required to turn raw material to
complete product• Process time = value-added activity• Inspection, Move, Queue time – should be
eliminated as much as possibleManufacturing Cycle Efficiency= Value-Added Time / Throughput Time
Cost of Quality
Quality of Conformance•Degree to which product/service meets design specifications and is free of defects Objective:High Quality of Conformance
Cost of Quality4 Groupings:1) Prevention Costs – incurred to keep
defects from occurring2) Appraisal Costs – incurred to identify
defective products before shipping3) Internal Failure Costs – costs incurred
as result of identifying defective product before shipping
4) External Failure Costs – costs incurred when defect product delivered
Cost of Quality
•When quality of conformance low, cost of quality high.•Reduce cost of quality by focusing on appraisal and prevention costs.
International Standards Organization
ISO 9000 Standards• Quality control requirements issued by the ISO.
ISO 4000 Standards• Requirements for environmental management system.
QuestionWhich of the following statements is true?A) If a division’s net operating income is
positive, it’s residual income will also be positive.
B) Residual income should be used to evaluate profit center managers.
C) ROI can be used to compare divisions of different sizes.
QuestionWhich of the following statements is true?A) If a division’s net operating income is
positive, it’s residual income will also be positive.
B) Residual income should be used to evaluate profit center managers.
C) ROI can be used to compare divisions of different sizes.
QuestionVision Inc. reported actual return on investment of 24% and average operating assets of $1,500,000 for the month of September. If the required rate of return is 20%, what was Vision’s residual income in September?A) $360,000B) $300,000C) $60,000D) $0
QuestionVision Inc. reported actual return on investment of 24% and average operating assets of $1,500,000 for the month of September. If the required rate of return is 20%, what was Vision’s residual income in September?A) $360,000B) $300,000C) $60,000D) $0
11-24Galati Products Inc. has just purchased a small company that specializes in the manufacture of electronic tuners that are used as component part of TV sets. Galati Products Inc. is a decentralized company and it will treat the newly acquired company as an autonomous division with full profit responsibility. The new division called Tuner Division has the following revenue and costs associated with each tuner that it manufactures and sells:• Selling Price $20• Expenses:• Variable $11• Fixed (based on 100,000 tuners) $6 $17
• Operating income $3
11-24Galati Products also has an Assembly Division that assembles TV sets. This division is currently purchasing 30,000 tuners per year from an overseas supplier at a cost of $20 per tuner, less a 10% purchase discount. The president of Galati Products is anxious to have the Assembly Division begin purchasing its tuners from the newly acquired Tuner Division in order to “keep the profits within the corporate family.”
11-24Assume the Tuner Division can sell all of its output to outside TV manufacturers for $20.1. Are the managers of the Tuner and Assembly Division
likely to voluntarily agree to a transfer price for 30,000 tuners each year? Why or why not?
2. If the Tuner Division meets the price that the Assembly Division is currently paying to its overseas supplier and sells 30,000 tuners to the Assembly Divison each year, what will be the effect on the profits of the Tuner Division, the Assembly Division and the company as a whole?
11-24Assume the Tuner Division is currently selling only 60,000 tuners to outside TV manufacturers.3. Are the managers of the Tuner and Assembly
Divisions likely to voluntarily agree to a transfer price for 30,000 tuners each year? Why or why not.
2006 Final QuestionFolk Company’s Audio Division (AD) produces a speaker used by manufacturers of various audio products. Sales and cost data on the speaker are as follows:• Selling price per unit to external customers $60• Variable manufacturing costs per unit $40• Fixed overhead per unit (based on capacity) $ 2• Variable selling costs per unit $ 2• Fixed selling and administrative costs per unit $ 8• Total capacity 25,000 unitsThe Home Theatre Division (HTD) of Folk Company could use this speaker in one of its products. They require 5,000 speakers per year and are currently paying $57 per speaker from an external supplier. Selling costs are not incurred on internal transfers.
2006 Final Question• Selling price per unit to external customers $60• Variable manufacturing costs per unit $40• Fixed overhead per unit (based on capacity) $ 2• Variable selling costs per unit $ 2• Fixed selling and administrative costs per unit $ 8• Total capacity
25,000 units• HTD requires 5000 speakers.• HTD current pays external supplier $57 per speaker.RequiredAssuming the AD is currently selling 20,000 speakers per year to external customers, what would be the overall effect on company profits if they were to sell 5,000 speakers per year to the HTD? (4 marks)
2006 Final QuestionAssume now that the AD is currently selling 25,000 speakers per year to external customers. Further assume that the HTD will use the speaker in a product with the following details:• Selling price per unit $400• Direct material costs per unit $300 (excl. speaker cost)• Direct labour costs per unit $ 20• Variable overhead costs per unit $ 10• Fixed overhead costs per unit $ 8• Variable selling costs per unit $ 2
Also assume that the HTD can only manufacture and sell this product if they are able to buy the speaker from the AD (i.e., there is no external supplier). What would be the overall effect on company profits if the AD sells 5,000 speakers per year to the HTD? (5 marks)
Chapter 12Good to Know…- Relevant vs. Irrelevant Costs- Various Decision Analyses- Cost-Plus Pricing
Relevant vs. Irrelevant Costs
Relevant Costs• Avoidable Costs – any cost that can be
eliminated by choosing one alternative over another(aka relevant cost, differential cost)
Irrelevant Costs• Sunk Costs – any cost already incurred that
can’t be changed by decision• Future Costs that don’t differ between
alternatives
Why Isolate Relevant Costs?
1) Only rarely will enough information be available for detailed income statement.
2) Combining R and IR costs may cause confusion and distract from critical information (relevant costs).
Analysis of Decisions
1) Add or Drop Product Line2) Make or Buy3) Accept or Reject Special Order4) Sell or Process Further
1) Adding/Dropping Product Lines
Add product line if:•Avoidable Fixed Costs< Contribution MarginDrop product line if:•Avoidable Fixed Costs> Contribution Margin
2) Make or Buy Decision
Advantages of Making• Less dependent on suppliers.•Smooth flow of parts and materials
for production.•Control quality better.Advantages of External Suppliers•Suppliers enjoy economies of scale.
2) Make or Buy Decision
Consider:1) Avoidable Costs2) Opportunity Costs
2) Make or Buy Decision
Avoidable CostsMake if:•Avoidable Costs < Purchase PriceBuy if:•Avoidable Costs > Purchase Price
2) Make or Buy DecisionOpportunity Costs• If space idle, opportunity cost = 0 Make• If space used for something else,
opportunity cost = CM from best alternative use of space.•Make: Opp. Cost < Make/Buy Difference• Buy: Opp. Cost > Make/Buy Difference
3) Special Orders
Take special order if:• Idle Space:• Incremental Revenue >
Incremental Costs•No Idle Space:• Incremental Revenue >
Incremental Costs + CM forgone
4) Sell or Process Further
Keep Processing if:• Incremental Revenue > Incremental Processing Cost
Maximizing CM with Constrained ResourcesWithout Bottleneck• Choose products that have highest
unit CM.With Bottleneck• Choose products with highest
profitability index.• Profitability Index= Unit CM/Quantity of Constraint
Cost-Plus Pricing
Selling Price= Cost + (Markup % x Cost)2 Approaches:1) Absorption Costing Approach2) Variable Costing Approach
1) Absorption Costing Approach1) Compute Unit Product Cost
= DM + DL + VMO + FMO2) Markup Percentage
=
Problems•Relies on forecast of unit sales.
2) Variable Costing Approach1) Compute Unit Variable Cost
= DM + DL + VMO2) Markup Percentage
=
Advantages3) Consistent with CVP Analysis4) Avoids need to arbitrarily
allocate common fixed costs.
Target Costing•Process of determining maximum
allowable cost for developing new product.
Target Cost= Anticipated Sell Price – Desired ProfitReasoning• Many companies have little control over
price.• Most of the cost of a product determined
in the design stage.
QuestionWhich of the following items will not be relevant when deciding whether to keep or drop a product line?A) Contribution margin of the product lineB) Avoidable fixed costs of the product lineC) Depreciation on equipment used to
manufacture the productD)All of the above are relevant
QuestionWhich of the following items will not be relevant when deciding whether to keep or drop a product line?A) Contribution margin of the product lineB) Avoidable fixed costs of the product lineC) Depreciation on equipment used to
manufacture the productD)All of the above are relevant
2006 Final QuestionTanner Computing, a retailing company, has two departments, Hardware and Software. Results from the most recent month of operations are as follows:Total Hardware Software
Total Hardware Software• Sales $4,000,000 $3,000,000 $1,000,000• Variable expenses 1,300,000 900,000 400,000• Contribution margin 2,700,000 2,100,000 600,000• Fixed expenses 2,200,000 1,400,000 800,000• Operating income $500,000 $700,000 $(200,000)Analysis shows that 40% of the fixed costs in the Software department are common costs that will continue even if the department is dropped. Of the remaining fixed costs, $50,000 relates to the Software department manager, who if the department is dropped, will be assigned other duties in Tanner Computing at her existing salary. If the Software department is dropped, sales in the Hardware department will drop by 10% with no change to Hardware’s fixed costs.
2006 Final Question• Sales $4,000,000 $3,000,000 $1,000,000• Variable expenses 1,300,000 900,000 400,000• CM 2,700,000 2,100,000 600,000• Fixed expenses 2,200,000 1,400,000 800,000• Operating income $500,000 $700,000 $(200,000)• 40% of the Software Dept. fixed costs are common costs• $50,000 relates to Software Manager, who will be transferred• If the Software department is dropped, sales in the Hardware
department will drop by 10% with no change to Hardware’s fixed costs.
Required:If the Software department is dropped, what will be the effect on operating income for the company as a whole? Should the department be dropped? (7 marks)
Chapter 13Good to Know…- 3 Screening Decisions- 2 Preference Decisions- CCA tax shield calculation
Capital Budgeting
2 Broad Categories ofCapital Budgeting Decisions:1) Screening Decision – decision as to
whether proposed investment meets standard.
2) Preference Decision – decision as to which of several competing acceptable investment proposals is best.
Capital Budgeting Decisions
3 Screen Decision Approaches:1) The Payback Method2) The Simple Rate of Return3) Discounted Cash Flows
1) Net Present Value2) Internal Rate of Return
1) The Payback Method
Payback Period =Advantages• Used in industries where product
obsolete quickly• Important for “cash poor” companiesDisadvantages•Doesn’t adequately consider time
value of money•Prefer return sooner rather than later
2) The Simple Rate of ReturnSimple Rate of Return
=
•Accept: Simple Rate > Target Rate•Reject: Simple Rate < Target RateAdvantage• Information is consistent with ROIDisadvantage•Doesn’t adequately consider time value
of money.
3) Discounted Cash Flows
1) Net Present Value= PV of Cash Inflows – PV of Cash Outflows• If NPV is Positive Accept Project• If NPV is Zero Accept Project• If NPV is Negative Reject Project
3) Discounted Cash Flows
1) Net Present Value•Cash Inflows:• Incremental revenues•Reduction in costs•Salvage value•Release of working capital
3) Discounted Cash Flows1) Net Present Value•Cash Outflows:• Initial investment(depreciation not deducted)• Increased working capital(=current assets – current liabilities)•Repairs and maintenance• Incremental operating costs
3) Discounted Cash Flows
2) Internal Rate of Return• Discount rate that makes NPV = 0• Can only be calculated through trial-and-error or financial calculator• IRR compared to Required Rate of Return:• If IRR ≥ Required Accept• If IRR < Required Reject
3) Discounted Cash Flows
NPV Advantages over IRR•NPV simpler to calculate• IRR assumes internal rate is rate of
return (whereas it should be the discount rate) If NPV and IRR disagree, use NPVIRR Advantage over NPV• IRR used for comparing projects of
different sizes
Capital Budgeting Decisions
2 Preference Decisions:1) Net Present Value2) Internal Rate of Return
1) Net Present Value
• NPV can’t be compared unless investments are of equal size• Profitability Index
=
• Higher PI More desirable project
2) Internal Rate of Return
• Higher IRR More Desirable Project
Comparing Preference Rules
• Profitability Index preferred because it always gives the correct signal as to relative desirability of alternatives, even if different lives/patterns of earning• IRR preferred for short-term decisions (4-5 years)
After-tax Cost and Benefit
After-Tax Cost= Tax Deductible Cash Expense x (1 – tax rate)After-Tax Benefit= Taxable Cash Receiptx (1 – tax rate)
Capital Cost Allowance• Amount of depreciation allowed by Canada Revenue Agency for tax purposes•Undepreciated Capital Cost (UCC) – remaining book value of asset under CCA•Maximum amount that can be deducted as depreciation expense
= UCC x CCA rate
CCA Tax Shield•Present value of infinite stream of tax savings from CCA
CCA Tax Shield =where:
C = the capital cost of the assetd = CCA ratet = firm’s tax ratek = Cost of Capital
Adjustment for Salvage Value
Salvage Value =where:S = salvage valued = CCA ratet = firm’s tax ratek = Cost of Capital
PV of CCA tax shield
PV of CCA tax shield
= −
QuestionWhich of the following indicates an UNACCEPTABLE capital project?A) The internal rate of return exceeds the
cost of capital.B) The net present value of a project is 10.C) The profitability index of a project is
0.97.D)The simple rate of return exceeds the
target rate of return.
QuestionWhich of the following indicates an UNACCEPTABLE capital project?A) The internal rate of return exceeds the
cost of capital.B) The net present value of a project is 10.C) The profitability index of a project is
0.97.D)The simple rate of return exceeds the
target rate of return.
Question
Project A:Periods 0 1 2 3 4Cash flows (50) 0 0 0 100
If Project B has an IRR of 10%, which project would you prefer using the IRR method?
