Cost Data in Decision Making

Cost Data for Decision Making

Overview

• Capital Investment

• Make vs Buy

• Production Capacity

• Product Mix

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

Capital Investment Analysis

Make the right selection, employ resources wisely:

• Net Present Value

• Payback Period

• Rate of Return

• Compare capital projects against each other

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!

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

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

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%

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

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

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

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

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

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$

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

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.

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$

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

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

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

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

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

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

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$

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$

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

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$

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

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

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

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

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

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

Contact Information

Joe Mocciaro, CPA

Bowers & Company CPAs PLLC

1200 AXA Tower I – 100 Madison St.

Syracuse, New York 13202

Phone: 315-234-1179

jmm@bcpllc.com

www.bcpllc.com