When is a manufacturer not a manufacturer? When it outsources. An extension of the classic “make or buy” decision, outsourcing involves hiring other companies to make all or part of a product or to perform services. Who is outsourcing? Nike, General Motors, Sara Lee, and Hewlett-Packard, to name a few. Even a recent trade journal article for small cabinetmakers outlined the pros and cons of building cabinet doors and drawers internally, or outsourcing them to other shops.
Gibson Greetings, Inc., one of the country's largest sellers of greeting cards, has experienced both the pros and cons of outsourcing. In April one year, it announced it would outsource the manufacturing of all of its cards and gift wrap. Gibson's stock price shot up quickly because investors believed the strategy could save the company $10 million a year, primarily by reducing manufacturing costs. But later in the same year, Gibson got a taste of the negative side of outsourcing: When one of its suppliers was unable to meet its production schedule, about $20 million of Christmas cards went to stores a month later than scheduled.
Outsourcing is often a point of dispute in labor negotiations. Although many of the jobs lost to outsourcing go overseas, that is not always the case. In fact, a recent trend is to hire out work to vendors located close to the company. This reduces shipping costs and can improve coordination of efforts.
One company that has benefited from local outsourcing is Solectron Corporation in Silicon Valley. It makes things like cell phones, printers, and computers for high-tech companies in the region. To the surprise of many, it has kept thousands of people employed in California rather than watching those jobs go overseas. What is its secret? It produces high-quality products efficiently. Solectron has to be efficient because it operates on a very thin profit margin—that is, it makes a tiny amount of money on each part—but it makes millions and millions of parts. It has proved the logic of outsourcing as a management decision, both for the companies for which it makes parts and for its owners and employees.
Preview of Chapter 26
An important purpose of management accounting is to provide managers with relevant information for decision-making. Companies of all sorts must make product decisions. Philip Morris decided to cut prices to raise market share. Oral-B Laboratories opted to produce a new, higher-priced ($5) toothbrush. General Motors discontinued making the Buick Riviera and announced the closure of its Oldsmobile Division. Quaker Oats decided to sell off a line of beverages, at a price more than $1 billion less than it paid for that product line only a few years before. Ski manufacturers like Dynastar had to decide whether to use their limited resources to make snowboards instead of downhill skis.
This chapter begins with an explanation of management's decision-making process. It then considers the topics of incremental analysis and capital budgeting. The content and organization of Chapter 26 are as follows.
Making decisions is an important management function. Management's decision-making process does not always follow a set pattern because decisions vary significantly in their scope, urgency, and importance. It is possible, though, to identify some steps that are frequently involved in the process. These steps are shown in Illustration 26-1.
Accounting's contribution to the decision-making process occurs primarily in Steps 2 and 4—evaluating possible courses of action, and reviewing results. In Step 2, for each possible course of action, relevant revenue and cost data are provided. These show the expected overall effect on net income. In Step 4, internal reports are prepared that review the actual impact of the decision.
In making business decisions, management ordinarily considers both financial and nonfinancial information. Financial information is related to revenues and costs and their effect on the company's overall profitability. Nonfinancial information relates to such factors as the effect of the decision on employee turnover, the environment, or the overall image of the company in the community. (These are considerations that we touched on in our Chapter 19 discussion of corporate social responsibility.) Although nonfinancial information can be as important as financial information, we will focus primarily on financial information that is relevant to the decision.
Decisions involve a choice among alternative courses of action. Suppose you face the personal financial decision of whether to purchase or lease a car. The financial data relate to the cost of leasing versus the cost of purchasing. For example, leasing would involve periodic lease payments; purchasing would require “up-front” payment of the purchase price. In other words, the financial data relevant to the decision are the data that would vary in the future among the possible alternatives. The process used to identify the financial data that change under alternative courses of action is called incremental analysis. In some cases, you will find that when you use incremental analysis, both costs and revenues will vary. In other cases, only costs or revenues will vary.
Alternative Terminology
Incremental analysis is also called differential analysis because the analysis focuses on differences.
Just as your decision to buy or lease a car will affect your future financial situation, similar decisions, on a larger scale, will affect a company's future. Incremental analysis identifies the probable effects of those decisions on future earnings. Such analysis inevitably involves estimates and uncertainty. Gathering data for incremental analyses may involve market analysts, engineers, and accountants. In quantifying the data, the accountant is expected to produce the most reliable information available at the time the decision must be made.
The basic approach in incremental analysis is illustrated in the following example.
This example compares alternative B with alternative A. The net income column shows the differences between the alternatives. In this case, incremental revenue will be $15,000 less under alternative B than under alternative A. But a $20,000 incremental cost savings will be realized.1 Thus, alternative B will produce $5,000 more net income than alternative A.
In the following pages, you will encounter three important cost concepts used in incremental analysis, as defined and discussed in Illustration 26-3.
Incremental analysis sometimes involves changes that at first glance might seem contrary to your intuition. For example, sometimes variable costs do not change under the alternative courses of action. Also, sometimes fixed costs do change. For example, direct labor, normally a variable cost, is not an incremental cost in deciding between two new factory machines if each asset requires the same amount of direct labor. In contrast, rent expense, normally a fixed cost, is an incremental cost in a decision whether to continue occupancy of a building or to purchase or lease a new building.
It is also important to understand that the approaches to incremental analysis discussed in this chapter do not take into consideration the time value of money. That is, amounts to be paid or received in future years are not discounted for the cost of interest. Time value of money is addressed later in this chapter as well as in Appendix G.
A number of different types of decisions involve incremental analysis. The more common types of decisions are whether to:
1. Accept an order at a special price.
2. Make or buy component parts or finished products.
3. Sell products or process them further.
4. Repair, retain, or replace equipment.
5. Eliminate an unprofitable business segment or product.
We will consider each of these types of decisions in the following pages.
SERVICE COMPANY INSIGHT
That Letter from AmEx Might Not Be a Bill
No doubt every one of you has received an invitation from a credit card company to open a new account—some of you have probably received three in one day. But how many of you have received an offer of $300 to close out your credit card account? American Express decided to offer some of its customers $300 if they would give back their credit card. You could receive the $300 even if you hadn't paid off your balance yet, as long as you agreed to give up your credit card.
Source: Aparajita Saha-Bubna and Lauren Pollock, “AmEx Offers Some Holders $300 to Pay and Leave,” Wall Street Journal Online (February 23, 2009).
What are the relevant costs that American Express would need to know in order to determine to whom to make this offer? (See page 1271.)
Sometimes a company may have an opportunity to obtain additional business if it is willing to make a major price concession to a specific customer. To illustrate, assume that Sunbelt Company produces 100,000 Smoothie blenders per month, which is 80% of plant capacity. Variable manufacturing costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4 per unit. The Smoothie blenders are normally sold directly to retailers at $20 each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler) to purchase an additional 2,000 blenders at $11 per unit. Acceptance of the offer would not affect normal sales of the product, and the additional units can be manufactured without increasing plant capacity. What should management do?
If management makes its decision on the basis of the total cost per unit of $12 ($8 variable + $4 fixed), the order would be rejected because costs per unit ($12) would exceed revenues per unit ($11) by $1 per unit. However, since the units can be produced within existing plant capacity, the special order will not increase fixed costs. Let's identify the relevant data for the decision. First, the variable manufacturing costs will increase $16,000 ($8 × 2,000). Second, the expected revenue will increase $22,000 ($11 × 2,000). Thus, as shown in Illustration 26-4, Sunbelt will increase its net income by $6,000 by accepting this special order.
Two points should be emphasized. First, we assume that sales of the product in other markets would not be affected by this special order. If other sales were affected, then Sunbelt would have to consider the lost sales in making the decision. Second, if Sunbelt is operating at full capacity, it is likely that the special order would be rejected. Under such circumstances, the company would have to expand plant capacity. In that case, the special order would have to absorb these additional fixed manufacturing costs, as well as the variable manufacturing costs.
SERVICE COMPANY INSIGHT
Giving Away the Store?
In an earlier chapter, we discussed Amazon.com's incredible growth. However, some analysts have questioned whether some of the methods that Amazon uses to increase its sales make good business sense. For example, a few years ago, Amazon initiated a “Prime” free-shipping subscription program. For a $79 fee per year, Amazon's customers get free shipping on as many goods as they want to buy. At the time, CEO Jeff Bezos promised that the program would be costly in the short-term but benefit the company in the long-term. Six years later, it was true that Amazon's sales had grown considerably. It was also estimated that its Prime customers buy two to three times as much as non-Prime customers. But, its shipping costs rose from 2.8% of sales to 4% of sales, which is remarkably similar to the drop in its gross margin from 24% to 22.3%. Perhaps even less easy to justify is a proposal by Mr. Bezos to start providing a free Internet movie-streaming service to Amazon's Prime customers. Perhaps some incremental analysis is in order?
Source: Martin Peers, “Amazon's Prime Numbers,” Wall Street Journal Online (February 3, 2011).
What are the relevant revenues and costs that Amazon should consider relative to the decision whether to offer the Prime free-shipping subscription? (See page 1271.)
Special Orders
Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to make a product that normally sells for $42. A foreign wholesaler offers to buy 5,000 units at $25 each. Cobb will incur additional shipping costs of $1 per unit. Compute the increase or decrease in net income Cobb will realize by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order?
Action Plan
Identify all revenues that will change as a result of accepting the order.
Identify all costs that will change as a result of accepting the order, and net this amount against the change in revenues.
Solution
Related exercise material: BE26-3, E26-2, E26-3, and DO IT! 26-1.
When a manufacturer assembles component parts in producing a finished product, management must decide whether to make or buy the components. The decision to buy parts or services is often referred to as outsourcing. For example, as discussed in the Feature Story, a company such as General Motors Corporation may either make or buy the batteries, tires, and radios used in its cars. Similarly, Hewlett-Packard Corporation may make or buy the electronic circuitry, cases, and printer heads for its printers. Boeing recently sold some of its commercial aircraft factories in an effort to cut production costs and focus instead on engineering and final assembly rather than manufacturing. The decision to make or buy components should be made on the basis of incremental analysis.
Baron Company makes motorcycles and scooters. It incurs the following annual costs in producing 25,000 ignition switches for scooters.
Instead of making its own switches, Baron Company might purchase the ignition switches from Ignition, Inc. at a price of $8 per unit. What should management do?
At first glance, it appears that management should purchase the ignition switches for $8 rather than make them at a cost of $9. However, a review of operations indicates that if the ignition switches are purchased from Ignition, Inc., all of Baron's variable costs but only $10,000 of its fixed manufacturing costs will be eliminated (avoided). Thus, $50,000 of the fixed manufacturing costs will remain if the ignition switches are purchased. The relevant costs for incremental analysis, therefore, are as shown below.
This analysis indicates that Baron Company would incur $25,000 of additional costs by buying the ignition switches rather than making them. Therefore, Baron should continue to make the ignition switches even though the total manufacturing cost is $1 higher per unit than the purchase price. The primary cause of this result is that, even if the company purchases the ignition switches, it will still have fixed costs of $50,000 to absorb.
Ethics Note
In the make-or-buy decision, it is important for management to take into account the social impact of its choice. For instance, buying may be the most economically feasible solution, but such action could result in the closure of a manufacturing plant that employs many good workers.
The foregoing make-or-buy analysis is complete only if it is assumed that the productive capacity used to make the ignition switches cannot be converted to another purpose. If there is an opportunity to use this productive capacity in some other manner, then this opportunity cost must be considered. As indicated earlier, opportunity cost is the potential benefit that may be obtained by following an alternative course of action.
To illustrate, assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $38,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make-or-buy decision. This opportunity cost is therefore added to the “Make” column for comparison. As shown in Illustration 26-7, it is now advantageous to buy the ignition switches. The company's income would increase by $13,000.
The qualitative factors in this decision include the possible loss of jobs for employees who produce the ignition switches. In addition, management must assess how well the supplier will be able to satisfy the company's quality control standards at the quoted price per unit.
DO IT!
Make or Buy
Juanita Company must decide whether to make or buy some of its components for the appliances it produces. The costs of producing 166,000 electrical cords for its appliances are as follows.
Direct materials | $90,000 |
Direct labor | $20,000 |
Variable overhead | $32,000 |
Fixed overhead | $24,000 |
Instead of making the electrical cords at an average cost per unit of $1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy the cords at $0.90 per unit. If the company purchases the cords, all variable costs and one-fourth of the fixed costs will be eliminated.
(a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. (b) Will your answer be different if the released productive capacity will generate additional income of $5,000?
Action Plan
Look for the costs that change.
Ignore the costs that do not change.
Use the format in the chapter for your answer.
Recognize that opportunity cost can make a difference.
Solution
Related exercise material: BE26-4, E26-4, and DO IT! 26-2.
Identify the relevant costs in determining whether to sell or process materials further.
Many manufacturers have the option of selling products at a given point in the production cycle or continuing to process with the expectation of selling them at a later point at a higher price. For example, a bicycle manufacturer such as Trek could sell its bicycles to retailers either unassembled or assembled. A furniture manufacturer such as Ethan Allen could sell its dining room sets to furniture stores either unfinished or finished. The sell-or-process-further decision should be made on the basis of incremental analysis. The basic decision rule is: Process further as long as the incremental revenue from such processing exceeds the incremental processing costs.
Assume, for example, that Woodmasters Inc. makes tables. It sells unfinished tables for $50. The cost to manufacture an unfinished table is $35, computed as follows.
Woodmasters currently has unused productive capacity that is expected to continue indefinitely. Some of this capacity could be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labor). No increase is anticipated in fixed manufacturing overhead.
Should the company sell the unfinished tables, or should it process them further? The incremental analysis on a per unit basis is as follows.
Helpful Hint Current net income is known. Net income from processing further is an estimate. In making its decision, management could add a “risk” factor for the estimate.
It would be advantageous for Woodmasters to process the tables further. The incremental revenue of $10.00 from the additional processing is $1.60 higher than the incremental processing costs of $8.40.
Identify the relevant costs to be considered in repairing, retaining, or replacing equipment.
Management often has to decide whether to continue using an asset, repair, or replace it. For example, Delta Airlines must decide whether to replace old jets with new, more fuel-efficient ones. To illustrate, assume that Jeffcoat Company has a factory machine that originally cost $110,000. It has a balance in Accumulated Depreciation of $70,000, so its book value is $40,000. It has a remaining useful life of four years. The company is considering replacing this machine with a new machine. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160,000 to $125,000 annually, and the old unit could be sold for $5,000. The incremental analysis for the four-year period is as follows.
In this case, it would be to the company's advantage to replace the equipment. The lower variable manufacturing costs due to replacement more than offset the cost of the new equipment. Note that the $5,000 received from the sale of the old machine is relevant to the decision because it will only be received if the company chooses to replace its equipment. In general, any trade-in allowance or cash disposal value of existing assets is relevant to the decision to retain or replace equipment.
One other point should be mentioned regarding Jeffcoat's decision: The book value of the old machine does not affect the decision. Book value is a sunk cost, which is a cost that cannot be changed by any present or future decision. Sunk costs are not relevant in incremental analysis. In this example, if the asset is retained, book value will be depreciated over its remaining useful life. Or, if the new unit is acquired, book value will be recognized as a loss of the current period. Thus, the effect of book value on current and future earnings is the same regardless of the replacement decision.
Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product.
Management sometimes must decide whether to eliminate an unprofitable business segment or product. For example, in recent years, many airlines quit servicing certain cities or cut back on the number of flights. Goodyear quit producing several brands in the low-end tire market. Again, the key is to focus on the relevant costs—the data that change under the alternative courses of action. To illustrate, assume that Venus Company manufactures tennis racquets in three models: Pro, Master, and Champ. Pro and Master are profitable lines. Champ (highlighted in red in Illustration 26-11) operates at a loss. Condensed income statement data are as follows.
Helpful Hint A decision to discontinue a segment based solely on the bottom line—net loss—is inappropriate.
You might think that total net income will increase by $20,000 to $240,000 if the unprofitable Champ line of racquets is eliminated. However, net income may actually decrease if the Champ line is discontinued. The reason is that the fixed costs allocated to the Champ racquets will have to be absorbed by the other products. To illustrate, assume that the $30,000 of fixed costs applicable to the unprofitable segment are allocated ⅔ to the Pro model and ⅓ to the Master model if the Champ model is eliminated. Fixed costs will increase to $100,000 ($80,000 + $20,000) in the Pro line and to $60,000 ($50,000 + $10,000) in the Master line. The revised income statement is:
Total net income has decreased $10,000 ($220,000 − $210,000). This result is also obtained in the following incremental analysis of the Champ racquets.
The loss in net income is attributable to the Champ line's contribution margin ($10,000) that will not be realized if the segment is discontinued.
In deciding on the future status of an unprofitable segment, management should consider the effect of elimination on related product lines. It may be possible for continuing product lines to obtain some or all of the sales lost by the discontinued product line. In some businesses, services or products may be linked—for example, free checking accounts at a bank, or coffee at a donut shop. In addition, management should consider the effect of eliminating the product line on employees who may have to be discharged or retrained.
MANAGEMENT INSIGHT
Time to Move to a New Neighborhood?
If you have ever moved, then you know how complicated and costly it can be. Now consider what it would be like for a manufacturing company with 260 employees and a 170,000-square-foot facility to move from southern California to Idaho. That is what Buck Knives did in order to save its company from financial ruin. Electricity rates in Idaho were half those in California, workers’ compensation was one-third the cost, and factory wages were 20% lower. Combined, this would reduce manufacturing costs by $600,000 per year. Moving the factory would cost about $8.5 million, plus $4 million to move key employees. Offsetting these costs was the estimated $11 million selling price of the California property. Based on these estimates, the move would pay for itself in three years.
Ultimately, the company received only $7.5 million for its California property, only 58 of 75 key employees were willing to move, construction was delayed by a year which caused the new plant to increase in price by $1.5 million, and wages surged in Idaho due to low unemployment. Despite all of these complications, though, the company considers the move a great success.
Source: Chris Lydgate, “The Buck Stopped,” Inc. Magazine (May 2006), pp. 87–95.
What were some of the factors that complicated the company's decision to move? How should the company have incorporated such factors into its incremental analysis? (See page 1271.)
DO IT!
Unprofitable Segments
Lambert, Inc. manufactures several types of accessories. For the year, the knit hats and scarves line had sales revenue of $400,000, variable expenses of $310,000, and fixed expenses of $120,000. Therefore, the knit hats and scarves line had a net loss of $30,000. If Lambert eliminates the knit hats and scarves line, $20,000 of fixed costs will remain. Prepare an analysis showing whether the company should eliminate the knit hats and scarves line.
Action Plan
Identify the revenues that will change as a result of eliminating a product line.
Identify all costs that will change as a result of eliminating a product line, and net the amount against the revenues.
Solution
The analysis indicates that Lambert should eliminate the knit hats and scarves line because net income will increase $10,000.
Related exercise material: BE26-7, E26-8, E26-9, and DO IT! 26-3.
Companies, like individuals, face limited resources. For a retail department store, the limited resource may be floor space. For a manufacturing company, the limited resource may be raw materials, direct labor hours, or machine capacity. When a company has limited resources, management must decide which products to make and sell in order to maximize net income.
To illustrate, assume that Collins Company manufactures deluxe and standard pen and pencil sets. The limiting resource is machine capacity, which is 3,600 hours per month. Relevant data consist of the following.
The deluxe sets may appear to be more profitable since they have a higher contribution margin ($8) than the standard sets ($6). However, the standard sets take fewer machine hours to produce than the deluxe sets. Therefore, it is necessary to find the contribution margin per unit of limited resource—in this case, contribution margin per machine hour. This is obtained by dividing the contribution margin per unit of each product by the number of units of the limited resource required for each product, as shown in Illustration 26-15.
Helpful Hint CM alone is not enough in this decision. The key factor is CM per unit of limited resource.
The computation shows that the standard sets have a higher contribution margin per unit of limited resource. This would suggest that, given sufficient demand for standard sets, the company should shift the sales mix to produce more standard sets or increase machine capacity. If Collins Company is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the standard or deluxe pen and pencil sets. The total contribution margin under each alternative is found by multiplying the machine hours by the contribution margin per unit of limited resource, as shown below.
From this analysis, we see that to maximize net income, all of the increased capacity should be used to make and sell the standard sets.
Individuals make capital expenditures when they buy a new home, car, or television set. Similarly, businesses make capital expenditures when they modernize plant facilities or expand operations. Companies like Holland America Line must constantly determine how to invest their resources. Other examples: Dell announced plans to spend $1 billion on data centers for cloud computing. Exxon announced that two wells off the Brazilian coast, which it had spent hundreds of millions to drill, would produce no oil. Renault and Nissan spent over $5 billion during a nearly 20-year period to develop electric cars, such as the Leaf.
In business, as for individuals, the amount of possible capital expenditures usually exceeds the funds available for such expenditures. Thus, the resources available must be allocated (budgeted) among the competing alternatives. The process of making capital expenditure decisions in business is known as capital budgeting. Capital budgeting involves choosing among various capital projects to find the one(s) that will maximize a company's return on its financial investment.
Many companies follow a carefully prescribed process in capital budgeting. At least once a year, top management requests proposals for projects from each department. A capital budgeting committee screens the proposals and submits its findings to the officers of the company. The officers, in turn, select the projects they believe to be most worthy of funding. They submit this list to the board of directors. Ultimately, the directors approve the capital expenditure budget for the year. Illustration 26-17 shows this process.
The involvement of top management and the board of directors in the process demonstrates the importance of capital budgeting decisions. These decisions often have a significant impact on a company's future profitability. In fact, poor capital budgeting decisions have led to the bankruptcy of some companies.
Accounting data are indispensable in assessing the probable effects of capital expenditures. To provide management with relevant data for capital budgeting decisions, you should be familiar with the quantitative techniques that may be used. The three most common techniques are: (1) annual rate of return, (2) cash payback, and (3) discounted cash flow. We demonstrate each of these techniques in the following sections. To illustrate the three quantitative techniques, assume that Reno Company is considering an investment of $130,000 in new equipment. The new equipment is expected to last 5 years and have zero salvage value at the end of its useful life. Reno uses the straight-line method of depreciation for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are:
MANAGEMENT INSIGHT
Investing for the Future
Monitoring capital expenditure amounts is one way to learn about a company's growth potential. Few companies can grow if they don't make significant capital investments. Here is a list of well-known companies and the amounts and types of their capital expenditures in a recent year.
Why is it important for top management to constantly monitor the nature, amount, and success of a company's capital expenditures? (See page 1271.)
The annual rate of return method is based directly on accrual accounting data rather than on cash flows. It indicates the profitability of a capital expenditure by dividing expected annual net income by the average investment. Illustration 26-19 shows the formula for computing annual rate of return.
Expected annual net income is obtained from the projected income statement. Reno Company's expected annual net income is $13,000. Average investment is derived from the following formula.
The value at the end of useful life is the asset's salvage value, if any. For Reno Company, average investment is $65,000 [($130,000 + $0) ÷ 2]. The expected annual rate of return for Reno's investment in new equipment is therefore 20%, computed as follows.
$13,000 ÷ $65,000 = 20%
Management then compares this annual rate of return with its required rate of return for investments of similar risk. The required rate of return is generally based on the company's cost of capital. The cost of capital is the rate of return that management expects to pay on all borrowed and equity funds. The cost of capital is a company-wide (or sometimes a division-wide) rate; it does not relate to the cost of funding a specific project.
Helpful Hint A capital budgeting decision based on only one technique may be misleading. It is often wise to analyze the investment from a number of different perspectives.
The annual rate of return decision rule is: A project is acceptable if its rate of return is greater than management's required rate of return. It is unacceptable when the reverse is true. When companies use the rate of return technique in deciding among several acceptable projects, the higher the rate of return for a given risk, the more attractive the investment.
The principal advantages of this method are the simplicity of its calculation and management's familiarity with the accounting terms used in the computation. A major limitation of the annual rate of return method is that it does not consider the time value of money. For example, no consideration is given as to whether cash inflows will occur early or late in the life of the investment. As explained in Appendix G, recognition of the time value of money can make a significant difference between the future value and the discounted present value of an investment. A second disadvantage is that this method relies on accrual accounting numbers rather than expected cash flows.
DO IT!
Annual Rate of Return
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual revenue would increase by $400,000 and that annual expenses excluding depreciation would increase by $190,000. It uses the straight-line method to compute depreciation expense. Management has a required rate of return of 9%. Compute the annual rate of return.
Action Plan
Expected annual net income = Annual revenues − Annual expenses (including depreciation expense).
Annual rate of return = Expected annual net income/Average investment.
Average investment = (Original investment + Value at end of useful life)/2.
Solution
Since the annual rate of return (13.33%) is greater than Watertown's required rate of return (9%), the proposed project is acceptable.
Related exercise material: BE26-10, E26-11, and DO IT! 26-4.
The cash payback technique identifies the time period required to recover the cost of the capital investment from the net annual cash flow produced by the investment. Illustration 26-21 presents the formula for computing the cash payback period assuming equal annual cash flows.
Net annual cash flow is approximated by taking net income and adding back depreciation expense. Depreciation expense is added back because depreciation on the capital expenditure does not involve an annual outflow of cash. Accordingly, the depreciation deducted in determining net income must be added back to determine net annual cash flows.
In the Reno Company example, net annual cash flow is $39,000, as shown below.
Helpful Hint Net annual cash flow can also be approximated by net cash provided by operating activities from the statement of cash flows.
The cash payback period in this example is therefore 3.33 years, computed as follows.
$130,000 ÷ $39,000 = 3.33 years
Evaluation of the payback period is often related to the expected useful life of the asset. For example, assume that at Reno Company a project is unacceptable if the payback period is longer than 60% of the asset's expected useful life. The 3.33-year payback period in this case is 67% of the project's expected useful life. Thus, the project is unacceptable.
It follows that when the payback method is used to decide among acceptable alternative projects, the shorter the payback period, the more attractive the investment. This is true for two reasons. First, the earlier the investment is recovered, the sooner the company can use the cash funds for other purposes. Second, the risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.
The preceding computation of the cash payback period assumes equal net annual cash flows in each year of the investment's life. In many cases, this assumption is not valid. In the case of uneven net annual cash flows, the company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment.
To illustrate, assume that Chen Company proposes an investment in a new website that is estimated to cost $300,000. Illustration 26-23 shows the proposed investment cost, net annual cash flows, cumulative net cash flows, and the cash payback period.
As Illustration 26-23 shows, at the end of year 3, cumulative net cash flow of $240,000 is less than the investment cost of $300,000. However, at the end of year 4, the cumulative net cash flow of $360,000 exceeds the investment cost. The net cash flow needed in year 4 to equal the investment cost is $60,000 ($300,000 − $240,000). Assuming the net cash flow occurs evenly during year 4, we then divide this amount by the net annual cash flow in year 4 ($120,000) to determine the point during the year when the cash payback occurs. Thus, we get 0.50 ($60,000/$120,000), or half of the year, and the cash payback period is 3.5 years.
The cash payback method may be useful as an initial screening tool. It may be the most critical factor in the capital budgeting decision for a company that desires a fast turnaround of its investment because of a weak cash position. Like the annual rate of return, cash payback is relatively easy to compute and understand.
However, cash payback is not ordinarily the only basis for the capital budgeting decision because it ignores the expected profitability of the project. To illustrate, assume that Projects A and B have the same payback period, but Project A's useful life is double that of Project B's. Project A's earning power, therefore, is twice as long as Project B's. A further—and major—disadvantage of this technique is that it ignores the time value of money.
MANAGEMENT INSIGHT
Can You Hear Me—Better?
What's better than 3G wireless service? 4G. But the question for wireless service providers is whether customers will be willing to pay extra for that improvement.Verizon has already spent billions on the upgrade, but customer usage might be slow in coming. First, there aren't that many 4G-compatible devices, and coverage will be spotty. Also, most applications don't really need higher speeds. Verizon is hoping that its investment in 4G works out better than its $23 billion investment in its FIOS fiber-wired network for TV and ultrahigh-speed Internet. One analyst estimates that the present value of each FIOS customer is $800 less than the cost of the connection.
Source: Martin Peers, “Investors: Beware Verizon's Generation GAP,” Wall Street Journal Online (January 26, 2010).
Based on the potentially slow initial adoption of 4G by customers, how might the conclusions of a cash payback analysis of Verizon's 4G investment differ from a present value analysis? (See page 1271.)
DO IT!
Cash Payback Period
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Compute the cash payback period.
Action Plan
Annual cash inflows − Annual cash outflows = Net annual cash flow.
Cash payback period = Cost of capital investment/Net annual cash flow.
Solution
Related exercise material: BE26-9, E26-10, E26-11, and DO IT! 26-4.
Distinguish between the net present value and internal rate of return methods.
The discounted cash flow technique is generally recognized as the best conceptual approach to making capital budgeting decisions. This technique considers both the estimated total net cash flows from the investment and the time value of money. The expected total net cash flow consists of the sum of the annual net cash flows plus the estimated liquidation proceeds when the asset is sold for salvage at the end of its useful life. But because liquidation proceeds are generally immaterial, we ignore them in subsequent discussions.
Two methods are used with the discounted cash flow technique: (1) net present value, and (2) internal rate of return. Before we discuss the methods, we recommend that you examine Appendix G if you need a review of present value concepts.
The net present value (NPV) method involves discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment. The difference between these two amounts is referred to as net present value (NPV). Company management determines what interest rate to use in discounting the future net cash flows. This rate, often referred to as the discount rate or required rate of return, is discussed in a later section.
The NVP decision rule is this: A proposal is acceptable when net present value is zero or positive. At either of those values, the rate of return on the investment equals or exceeds the required rate of return. When net present value is negative, the project is unacceptable. Illustration 26-24 shows the net present value decision criteria.
Discounted future cash flows may not take into account all of the important considerations needed to make an informed capital budgeting decision. Other issues, for example, could include worker safety, product quality, and environmental impact.
When making a selection among acceptable proposals, the higher the positive net present value, the more attractive the investment. The application of this method to two cases is described in the next two sections. In each case, we assume that the investment has no salvage value at the end of its useful life.
EQUAL NET ANNUAL CASH FLOWS Reno Company's net annual cash flows are $39,000. If we assume this amount is uniform over the asset's useful life, we can compute the present value of the net annual cash flows by using the present value of an annuity of 1 for 5 payments (in Table 2, Appendix G). The computation at a rate of return of 12% is:
The analysis of the proposal by the net present value method is as follows.
The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive.
Helpful Hint The ABC Co. expects equal net annual cash flows over an asset's 5-year useful life.
What discount factor should it use in determining present values if management wants (1) a 12% return or (2) a 15% return?
Answer: Using Table 2, the factors are (1) 3.60478 and (2) 3.35216.
UNEQUAL NET ANNUAL CASH FLOWS When net annual cash flows are unequal, we cannot use annuity tables to calculate their present value. Instead, we use tables showing the present value of a single future amount for each net annual cash flow.
To illustrate, assume that Reno Company management expects the same aggregate net annual cash flow ($195,000) over the life of the investment. But because of a declining market demand for the new product over the life of the equipment, the net annual cash flows are higher in the early years and lower in the later years. The present value of the net annual cash flows is calculated as follows using Table 1 in Appendix G.
Therefore, the analysis of the proposal by the net present value method is as follows.
In this example, the present value of the net annual cash flows is greater than the $130,000 capital investment. Thus, the project is acceptable at a 12% required rate of return. The difference between the present values using the 12% rate under equal net annual cash flows ($140,586) and unequal net annual cash flows ($147,339) is due to the pattern of the net cash flows.
MANAGEMENT INSIGHT
Seeing the Big Picture
Inaccurate trend forecasting and market positioning are more detrimental to capital investment decisions than using the wrong discount rate. Ampex patented the VCR but failed to see its market potential. Westinghouse made the same mistake with the flat-screen video display. More often, companies adopt projects or businesses only to discontinue them in response to market changes. Texas Instruments announced it would stop manufacturing computer chips, after it had made substantial capital investments that enabled it to become one of the world's leading suppliers. The company dropped out of some 12 business lines in only a few years.
Source: World Research Advisory Inc. (London, August 1998), p. 4.
How important is the choice of discount rate in making capital budgeting decisions? (See page 1271.)
The internal rate of return method differs from the net present value method in that it finds the interest yield of the potential investment. The internal rate of return (IRR) is the interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cash flows. Because it recognizes the time value of money, the internal rate of return method is (like the NPV method) a discounted cash flow technique. The determination of the internal rate of return involves two steps.
Step 1. Compute the internal rate of return factor. The formula for this factor is:
The computation for Reno Company, assuming equal net annual cash flows,2 is:
$130,000 ÷ $39,000 = 3.3333
Step 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Table 2 of Appendix G is used in this step. The internal rate of return is the discount factor that is closest to the internal rate of return factor for the time period covered by the net annual cash flows.
For Reno Company, the net annual cash flows are expected to continue for 5 years. Thus, it is necessary to read across the period-5 row in Table 2 to find the discount factor. The row for 5 periods is reproduced below for your convenience.
In this case, the closest discount factor to 3.3333 is 3.35216, which represents an interest rate of approximately 15%. The rate of return can be further determined by interpolation, but since we are using estimated net annual cash flows, such precision is seldom required.
Once managers know the internal rate of return, they compare it to the company's required rate of return (the discount rate). The IRR decision rule is as follows: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate of return. Illustration 26-30 below shows these relationships. Assuming the required rate of return is 10% for Reno Company, the project is acceptable because the 15% internal rate of return is greater than the required rate.
The IRR method is widely used in practice. Most managers find the internal rate of return easy to interpret.
Illustration 26-31 compares the two discounted cash flow methods—net present value and internal rate of return. When properly used, either method provides management with relevant quantitative data for making capital budgeting decisions.
DO IT!
Discounted Cash Flow
Watertown Paper Corporation is considering adding another machine for the manufacture of corrugated cardboard. The machine would cost $900,000. It would have an estimated life of 6 years and no salvage value. The company estimates that annual cash inflows would increase by $400,000 and that annual cash outflows would increase by $190,000. Management has a required rate of return of 9%.
(a) Calculate the net present value on this project, and discuss whether it should be accepted.
(b) Calculate the internal rate of return on this project, and discuss whether it should be accepted.
Action Plan
Compute net annual cash flow: Estimated annual cash inflows − Estimated annual cash outflows.
Use the NPV technique to calculate the difference between net cash flows and the initial investment.
Accept the project if the net present value is positive.
Compute the IRR factor: Capital investment ÷ Net annual cash flows.
Look up the factor in the present value of an annuity table to find the internal rate of return.
Accept the project if the internal rate of return is equal to or greater than the required rate of return.
Solution
(b) $900,000 ÷ 210,000 = 4.285714. Using Table 2 of Appendix G and the factors that correspond with the six-period row, 4.285714 is between the factors for 10% and 11%. Since the project has an internal rate that is greater than 10% and the required rate of return is only 9%, Watertown should accept the project.
Related exercise material: BE26-11, BE26-12, BE26-13, E26-10, E26-11, E26-12, E26-13, and DO IT! 26-5.
Sierra Company is considering a long-term capital investment project called ZIP. The project will require an investment of $120,000, and it will have a useful life of 4 years. Annual net income for ZIP is expected to be: Year 1 $12,000; Year 2 $10,000; Year 3 $8,000; and Year 4 $6,000. Depreciation is computed by the straight-line method with no salvage value. The company's cost of capital is 12%.
Instructions
(a) Compute the annual rate of return for the project.
(b) Compute the cash payback period for the project. (Round to two decimals.)
(c) Compute the net present value for the project. (Round to nearest dollar.)
(d) Should the project be accepted? Why?
Action Plan
To compute annual rate of return, divide expected annual net income by average investment.
To compute cash payback, divide cost of the investment by net annual cash flows.
Recall that net annual cash flow equals annual net income plus annual depreciation expense.
Be careful to use the correct discount factor in using the net present value method.
Solution to Comprehensive DO IT!
(a) $9,000 ($36,000 ÷ 4) ÷ $60,000 ($120,000 ÷ 2) = 15%
(b) Depreciation expense is $120,000 ÷ 4 years = $30,000.
Net annual cash flows are: | |
Year 1 | $12,000 + $30,000 = $42,000 |
Year 2 | $10,000 + $30,000 = $40,000 |
Year 3 | $8,000 + $30,000 = $38,000 |
Year 4 | $6,000 + $30,000 = $36,000 |
Cumulative net cash flows would be $82,000 ($42,000 + $40,000) at the end of year 2 and $120,000 ($42,000 + $40,000 + $38,000) at the end of year 3. Since the cumulative net cash flows at the end of year 3 exactly equal the initial cash investment of $120,000, the cash payback period is 3 years.
(d) The annual rate of return of 15% is good. However, the cash payback period is 75% of the project's useful life, and net present value is negative. The recommendation is to reject the project.
1 Identify the steps in management's decision-making process. Management's decision-making process is: (a) identify the problem and assign responsibility, (b) determine and evaluate possible courses of action, (c) make the decision, and (d) review the results of the decision.
2 Describe the concept of incremental analysis. Incremental analysis identifies financial data that change under alternative courses of action. These data are relevant to the decision because they will vary in the future among the possible alternatives.
3 Identify the relevant costs in accepting an order at a special price. The relevant information in accepting an order at a special price is the difference between the variable costs to produce the special order and expected revenues.
4 Identify the relevant costs in a make-or-buy decision. In a make-or-buy decision, the relevant costs are (a) the manufacturing costs that will be saved, (b) the purchase price, and (c) opportunity costs.
5 Identify the relevant costs in determining whether to sell or process materials further. The decision rule for whether to sell or process materials further is: Process further as long as the incremental revenue from processing exceeds the incremental processing costs.
6 Identify the relevant costs to be considered in repairing, retaining, or replacing equipment. The factors to consider in determining whether equipment should be retained or replaced are the effects on variable costs and the cost of the new equipment. Also, any trade-in allowance or cash disposal value of the existing asset must be considered.
7 Identify the relevant costs in deciding whether to eliminate an unprofitable segment or product. In deciding whether to eliminate an unprofitable segment, determine the contribution margin, if any, produced by the segment and the disposition of the segment's fixed expenses.
8 Determine which products to make and sell when resources are limited. When a company has limited resources, find the contribution margin per unit of limited resource. Then multiply this amount by the units of limited resource to determine which product maximizes net income.
9 Contrast annual rate of return and cash payback in capital budgeting. The annual rate of return is obtained by dividing expected annual net income by the average investment. The higher the rate of return, the more attractive the investment. The cash payback technique identifies the time period to recover the cost of the investment. The formula is: Cost of capital expenditure divided by estimated net annual cash flow equals cash payback period. The shorter the payback period, the more attractive the investment.
10 Distinguish between the net present value and internal rate of return methods. Under the net present value method, compare the present value of future net cash flows with the capital investment to determine net present value. The NPV decision rule is: Accept the project if net present value is zero or positive. Reject the investment if net present value is negative.
Under the internal rate of return method, find the interest yield of the potential investment. The IRR decision rule is: Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.
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