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Cost Data in Decision Making
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Cost Data for Decision Making
Overview
• Capital Investment
• Make vs Buy
• Production Capacity
• Product Mix
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Capital Budgeting
Considering Acquiring Equipment – Long-term Decision:
• Cost reduction through new equipment
• Expansion – increase capacity
• Equipment replacement (when replace old)
• Equipment selection (A vs B vs C)
• Lease vs Buy
• Decision should be based/supported by analysis
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Capital Investment Analysis
Make the right selection, employ resources wisely:
• Net Present Value
• Payback Period
• Rate of Return
• Compare capital projects against each other
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Net Present Value
• Cost of the equipment
• Present value of cost savings/cash inflows at targeted return rate
• If PV of cash inflows exceed initial cash outflow then proceed with project
• Positive cash inflow indicates project return exceeds targeted return level
• Negative value indicates project return is less than targeted return level
• Focus on cash flow not net income!
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Net Present Value
Cash Outflows:
• Initial investment - Cost of the equipment
• Increased working capital needs
• Repairs and maintenance
• Incremental operating costs (labor, overhead)
Cash Inflows:
• Incremental revenues
• Salvage value
• Release of working capital
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Net Present Value
Choosing discount rate:
• In capital budgeting, hurdle rate (target rate)is the minimum rate that a company expects to earn when investing in a project.
• In order for a project to be accepted, its internal rate of return must equal or exceed the hurdle rate.
• Firm’s cost of capital (LT borrowing rate, equity, bond) or Return on Assets
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Net Present ValueCASH FLOW
ITEM YEAR (s) AMOUNT PV
Purchase of Equipment Now (450,000)$ (450,000)$
Working Capital Needs Now (100,000) (100,000)
Overhaul of Equipment 4 (3,000) (1,715)
Annual Net Cash Inflows from
Sales of Product 1-5 130,000 435,780
Salvage Value of Equipment 5 175,000 87,006
Working Capital Released 5 100,000 49,718
Net Present Value 20,789$
Rate 15%
Assume Company requires assets to return a minimum of 15%. This project would be accepted because the NPV is positive – project returns greater than 15%
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Payback Period
Advantages (Usefulness):
• Time it takes for an investment project to recoup its own initial cost from the cash flows it generates
• More quickly recovered, more desirable
• Compare capital projects against each other
• Payback period =Investment/Net Annual Cash flow
Disadvantages:
• Doesn’t consider useful life of equipment
• Ignores time value of money
• Not a measure of profitability
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Payback Period Example –
Basic Formula
• Formula is simple, must determine cash flow, not profitability (add back non-cash expense (depreciation)
(1) (2) (1)/(2)
Cash Flow Payback
Option Cost Reduction Period (Yrs)
A 150,000$ 50,000$ 3.0
B 120,000$ 50,000$ 2.4
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Payback Period Example
Uneven Cash Flows(1) (2) (3) (4) (5)
(1) - (2) (3) - (4)
Beginning Total Ending
Unrecovered Additional Unrecovered Cash Unrecovered
YR Investment Investment Investment Inflow Investment
1 $ 400,000 $ 0 $ 400,000 $ 30,000 $ 370,000
2 370,000 0 370,000 45,000 325,000
3 325,000 0 325,000 75,000 250,000
4 250,000 60,000 310,000 90,000 220,000
5 220,000 0 220,000 90,000 130,000
6 130,000 0 130,000 90,000 40,000
7 40,000 0 40,000 50,000 0
8 0 0 0 0
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Rate of Return Method
Why is it important:
• Cost of capital = hurdle rate, however can evaluate a project to the desired or forecast ROA (what are other assets/projects returning)
• Interest yield on a project
• Rate of return that will cause NPV to equal $0
• Use IRR function in Excel on cash flows/outlays
• Compare IRR to hurdle rate, if equal or greater accept project
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Choose Between Projects
NPV:
• Higher NPV, project provides greater cash flows
IRR:
• Higher IRR, project delivers higher return
Payback:
• Shorter payback, project recoups investment quickest
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Comprehensive Example• Project: $1.6M investment, 8 yrs, no salvage,
generates the following profit
Item Amount
Sales 3,000,000$
Less variable expenses 1,800,000
Contribution Margin 1,200,000
Less:
Fixed expenses 700,000$
Depreciation 200,000
Total fixed expenses 900,000
Net Income 300,000$
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Comprehensive Example• Project: $1.6M investment, 8 yrs, no salvage, target
rate of 18%NPV
Investment (1,600,000)$
PV of Cash Flows 2,038,783$
NPV 438,783$
IRR 26.5%
Payback
Investment 1,600,000$
Net Annual Cash Flow 500,000$
Payback Period Yrs 3.2
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Relevant Costs• Avoidable costs – can be eliminated
• Focus on truly differential costs, costs avoidable, costs that can be eliminated as a result of choosing one alternative
• Cost data – remove costs that are not avoidable (sunk costs, or future costs that will be incurred regardless)
• Sunk costs – already incurred, cannot be avoided
• Some variable or allocated costs are not differential costs because they would be incurred regardless. Depreciation on equipment that was already purchased and will not be disposed is not a differential costs. Variable labor that will be retained is not a differential cost.
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Relevant Costs
Old Machine Amount Proposed New Machine Amount
Original cost 175,000$ List price new 200,000$
Remaining book value 140,000$ Expected life 4
Remaining life 4 Disposal 4 yrs 0
Disposal now 90,000$ Annual variable operating exp 300,000$
Disposal 4 yrs 0 Annual revenue 500,000$
Annual variable operating exp 345,000$
Annual revenue 500,000$
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Relevant Costs
Keep Old Purchase
Item Machine Differential New Machine
Sales 2,000,000$ -$ 2,000,000$
Variable expenses (1,380,000) 180,000 (1,200,000)
Cost of new machine - (200,000) (200,000)
Book value old machine (140,000) - (140,000)
Disposal value old machine 90,000 90,000
Net Income over 4 years 480,000$ 70,000$ 550,000$
Total Cost and Revenue Next 4 Yrs
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Selecting Profitable Products• “We don’t make any money on this product”
• “We can buy it cheaper than the cost to make it”
• Limited resources/capacity issues
• Deciding which products to make and which to dump/discontinue
• Contribution Margin
• Throughput Costing
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Make vs BuyQualitative – Produce Internally:• Specialized design (“made in America”)• Specialized designs and mfg skills• Fits within the firm’s core competenciesQuantitative:• Fully loaded costs inflates internal cost of production• Only incremental costs should be considered• Fixed and unavoidable costs should be excludedIf at 100% Capacity – Decide between Multiple Parts:• Determine capacity of factory• Calculate incremental cost of each item• Choose to produce the items with the greatest incremental
savings over purchase until plant capacity if filled, outsource the remaining
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Make vs BuyFavor manufacturing in-house:
• Less expensive to make the part
• Use of excess plant capacity
• Control over quality
• Control of lead time
• Greater assurance of continual supply
Favor purchasing externally:
• Higher quality from supplier
• Less expensive
• Insufficient capacity
• Item not essential to the firm's strategy
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Make vs BuyProduction
Cost
Item Per Unit
Make Buy
Direct materials 6.00$ 6.00$
Direct labor 4.00 4.00
Variable overhead 1.00 1.00
Supervisor's salary 3.00 3.00
Depreciation on equipment 2.00 0
Allocation of general overhead 5.00 0
Outside purchase price 19.00$
Total cost 21.00$ 14.00$ 19.00$
Difference - in favor of make 5.00$
Per Unit
Differential
Costs
Avoidable costs are less then purchase price – produce in-house
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Contribution Margin• Contribution Margin = Sales less all variable costs
(mfg. and sga), represents the margin to cover fixed costs
• This amount contributes to covering fixed expenses, then adds to profits
• Illustrates what happens to profits as volume changes
• Not applicable for external reporting
• Also called Variable or Direct Costing
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Contribution MarginVariable
ACCOUNT Costing
Sales 1,200,000$
Less: Variable Expenses
Variable Production Costs 200,000$
Variable Selling 60,000
Variable Admin 40,000 300,000
Contribution Margin 900,000
Less: Fixed Expenses
Fixed Production 400,000
Fixed Selling 25,000
Fixed Admin 15,000 440,000
Operating Income 460,000$
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Special Orders• Special order 10,000 units @ $8
• Profit $17,500 (10,000 units x ($8 sp -$6.25 vc))• Variable admin – no additional work required on special
order • Assume available capacity exists
Per Unit
Item Amount
Sales 12.50$
Manufacturing Costs:
Variable 6.25$
Fixed 1.75 8.00
Gross Profit 4.50
Admin Expenses:
Variable 1.80$
Fixed 1.45 3.25
Operating Income 1.25$
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Throughput CostingTheory of Constraints:
• Constraint sets the pace for the entire process
• Identify the constraint (bottleneck)
• Determine the most profitable product mix given the constraint
• Maximize the flow through the constraint
• Increase capacity at the constraint
• Redesign manufacturing process for greater flexibility & speed
Throughput Margin (Sales – Direct Material):
• Only direct materials are variable, DL & OH are fixed costs
• Calculate TM per unit of time spent at constraint
• Profit maximized by keeping bottleneck busy with highest TM
• Prioritize production in order of highest TM item, based on demand
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Throughput CostingTheory of Constraints:
• Highest margin per time spent in the bottleneck
Product Product
Item A B
Sales Price 25.00$ 30.00$
Variable Cost per Unit (Materials) 10.00 18.00
Throughput Margin per Unit 15.00 12.00
Throughput Margin Ratio 60% 40%
Time in Machining (minutes) 2 1
TM per Machining minute 7.50$ 12.00$
Units that can be processed in an hour 30 60
TM per hour 450.00$ 720.00$
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Throughput CostingCapacity = 150 hours/month for final assembly
Monthly demand in units 12 6 22
Product Product Product
Item A B C
Sales Price 2,000.00$ 6,000.00$ 3,000.00$
Variable Cost per Unit (Materials) 1,000.00 4,000.00 2,500.00
Throughput Margin per Unit 1,000.00 2,000.00 500.00
Throughput Margin Ratio 50% 33% 17%
Time in Final Assembly (hours) 4 10 5
TM per Final Assembly Hour 250.00$ 200.00$ 100.00$
Hours Available 150 102 42
Demand in Units 12 6 22
Hours in Final Assembly 4 10 5
Hours Required 48 60 110
Margin Earned:
A, B, C (remaining hrs) 12,000.00 12,000.00 4,000.00
C, B (remaining hrs) 0 8,000.00 11,000.00
C, A (remaining hrs) 10,000.00 0 11,000.00
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Cost Volume Profit Analysis
Interrelationship between cost, volume & profit:
• Price of products
• Volume/level of activity
• Per unit variable costs
• Total fixed costs
• Mix of products sold
What products to produce & sell, pricing policy, production facility decisions
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CVP
• Break even point = point at which all fixed costs are covered & operating income is $0
• Breakeven point in units = Fixed costs/unit contribution margin
• Breakeven point in sales = Fixed costs/contribution margin ratio
• Target income ratios
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CVP
Multi-Product Break Even
• Break even point multi-products
• Sales= VC+Fixed Costs
• A & B account for 60% of 40% of total sales. VC % of product sales, A 60% B 85%, Fixed costs $150,000
• S=FC+VC
• S=$150,00+.6(.6S)+.85(.4S)
• .3S=$150,000
• S=$500,000
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CVP
Target income ratios – target $ income
• To determine how many units must be sold to generate a certain operating profit
• Units (volume) = Fixed costs + Target Income
Unit Contribution Margin
• After tax:• Units (volume) = Fixed costs + Target Income/(1.0-tax rate)
Unit Contribution Margin
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CVP
Target income ratios – target % income
• To determine how many units must be sold to generate a certain operating income percentage
• Operating income = Sales-VC-Fixed Costs
• (Sales price $6, variable costs $2, fixed costs $37,000 how many units sold for 15% operating income
• $.90xQ=($6xQ)-($2xQ)-$37,000
• Q=12,097 units
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Contact Information
Joe Mocciaro, CPA
Bowers & Company CPAs PLLC
1200 AXA Tower I – 100 Madison St.
Syracuse, New York 13202
Phone: 315-234-1179
www.bcpllc.com