Tag: icap

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• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Time Value of Money Overview

Discounted cash flow analysis

• It is a technique for evaluating the proposed investments to decide whether thy are financially worthwhile.
• The expected future cash flows (inflows/outflows) from the investment are all converted to a present value by discounting them at the cost of capital ‘r’
• Taking into account the concept of relevant cost.
• It is usually assumed that cash flow early during a year should be treated as a cash flow as at the end of the previous year.

Present value Formulas

Discount factor = 1/(1+r)n

where
r = cost of capital
n = number of periods

Annuity factor = ( 1 – (1+r)-n /r)

Discounted Cash Flow

Time Value of Money

Methods of Discounted Cash Flow



Net Present value (NPV)

• In Net present value (NPV) analysis, all future cash flows from a project are converted into a present value.
• NPV is the difference between present value of all costs incurred and present value of all benefits received.

Approach

1. List all cash flows from the project (initial investments, future cash inflows/outflows).
2. Discount these cash flows to present value using ‘cost of capital’ as discount rate.
3. If present value of Benefits exceeds the present value of costs, the NPV is positive and if present value of benefits is less, then NPV is negative.

• A project is worthwhile if NPV is positive.
• The project commences at time ‘0’ where the cash flows are already at present value.
• Changes in working capital included as cash flows. An increase usually at the beginning of the project in time ‘0’ is a cash outflow and reduction is a cash inflow.

Internal Rate of Return (IRR)

• It is the discounted rate of return on investment.
• It is the average annual investment return from the project.
• The NPV of the projected cash flows is ‘zero‘ when those cash flows are discounted at IRR.
• A company might establish the minimum rate of return that it wants to earn on an investment:

• • If a project’s IRR is equal or higher than minimum acceptable rate of return, it should be undertaken.
  • If IRR is lower than the minimum required return, it should be rejected.
• The following step are involved for calculation of a reliable Internal rate of return (IRR):

1. 1. Calculate NPV of the project at TWO different rates. One of the NPV should be positive and the other should be negative.
   2. Put the NPVs in the formula:

Discounted Cash Flow and Inflation

Time Value of Money

Methods of incorporating Inflation



Real cash flows

• The cash flows expressed in today’s price terms.
• They ignore the expectations of inflation.
• In order to incorporate real cash flows in NPV calculation, real cash flows should be discounted at the real cost of capital.

The following steps are involved:

• Calculate real discount rate

= money cost of capital – 1
inflation rate

• Calculate net cash flows at today’s prices.
• Discount them using real discount rate.

Money cash flows

This is the most common method used.

• Money (nominal) cash flows are cash flows that include expected inflation.
• Money cash flows should be discounted at the money cost of capital.

The following steps are involved:

1. Calculate net cash flows at today’s price.
2. Make adjustment for inflation (by doing this they will be converted into money cash flows).
3. Use money cost of capital as discount rate.

*Both approaches give same solution, with a difference of rounding off.

Read more

• Introduction to Cost and Management Accounting
• High/Low and Linear Regression Analysis
• Inventory Management
• Accounting for Inventory
• Accounting for overheads
• Absorption Costing
• Marginal Costing
• Job Batch and Service costing
• Process Costing
• Target Costing
• Variances
• Standard Costing
• Cost Volume Profit analysis
• Relevant costing and Decision-Making Techniques
• Time Value of Money (TVM)

Relevant costing and Decision Making Techniques Overview

Definitions:

Relevant cost

• A relevant cost is a future cash flow that will occur as a direct consequence of making a particular decision.
• They cannot include any cost occurred in past.
• Costs that occur whether or not a particular decision is taken are not relevant costs.
• Relevant costs are cash flows. Notional costs such as depreciation, interest costs and absorbed fixed cost are not relevant cost.

Incremental cost

• Any incremental cost, if a particular decision is taken, results in cash flow are relevant cost.

Differential cost

• A differential cost is an amount by which future costs will be higher or lower. A differential cost is a relevant cost.

Avoidable and unavoidable cost

• Avoidable costs are relevant costs
• Unavoidable costs are not relevant.

Committed costs

• Committed costs are unavoidable costs, therefore not relevant for decision making.

Sink costs

• Cost that are already incurred/or committed by an earlier decision. Such costs are not relevant costs.

Opportunity costs

• The relevant cost is the benefit that would be lost by switching to other work.

Identifying Relevant costs

Relevant costs of:



Materials

When Material currently in inventory

Are material in regular use?

• Yes

The relevant cost is the current Replacement cost.

• No

The relevant cost is the current opportunity cost.
Opportunity cost is higher of;

1. Net disposal/sales value/scrap value or;
2. Net benefit from alternative use.

When Material not currently in inventory

In this case the relevant cost is simply the purchase value.

Labour

• If the cost of labour is a variable cost and labour is not in restricted supply: The relevant cost is its variable cost.
• If labour is a fixed cost and there is spare labour time available: The relevant cost of using labour is ‘zero‘. The spare time would otherwise be paid for idle time.
• If labour is in unlimited supply: Relevant cost includes the opportunity cost of using the labour time for the decision instead of next most profitable way.

Overheads

• Normal rules of relevant costs are applied i,e Relevant costs are future cash flows.
• Fixed overheads absorption rate are irrelevant. However the variable overhead hourly rate is treated as relevant cost.
• The only overhead fixed costs that are relevant costs are the extra cash spending.

Decision Making Techniques

Types of Decisions

• The concept of relevant costs can be applied for both ‘long term’ and ‘short term’ decisions.
• The application is same for both types of decisions except for long term decisions ‘time value of money’ should be considered.

Such Types of Decisions are:

Limiting Factor Decisions

• Limiting factor are the factors that ‘restricts‘ operational capabilities, sales demand is normally the factor that sets a limit on volume of production. However the availability of scarce resources such as Direct material, skilled labour or machine capacity could be the limiting factor.
• If the company makes just one product and a production resource is in limited supply, profit is maximized by making as many units of product as possible with limited resources.
• However, if the company produces more than one product with same scarce resources then a budgeting problem is to decide how many of each product to make and sell in order to maximize Profit. In Such case select products for manufacture and sale according to the contribution per unit. The following steps are involved:

1. Calculate the contribution per unit of each good produced.
2. Identify scarce resources (e,g labour hours).
3. Calculate the amount of scarce resources used by each good produced (e,g ‘X’ no. of labour hours)
4. Now divide the contribution earned by each good by scarce resources used by that good to give the contribution per unit of scarce resources for that good.
5. Rank each good in order of contribution per unit per scarce resources (highest contribution is ranked 1st).
6. Construct a production plan based on ranking.

Assumptions of limiting factors:

• Profit is maximized by maximizing contribution.
• Variable costs are only the relevant costs.
• Fixed cost will be the same whatever decision is taken. Therefore are not relevant.

One-off contractual decisions

• The contract where the Job is once only and will not be repeated in future.
• The one-off contract is under taken if extra revenue is higher than relevant costs.
• The decision is to whether agree to do the Job at a Price offered by customer or decide a selling price (base on relevant costs).
• Profit = Revenue – Relevant cost
• One-off contract decisions might occur when a company has spare capacity and an opportunity arises to earn some extra profit.

Make-or-Buy decisions

• A decision whether: to make an item internally or buy it externally. The decision should be based on relevant cost, the preferred option from a financial view point is the one with the lowest relevant costs.
• A financial assessment of a make or buy decision involves a comparison of:

• • cost that would be saved; and
  • incremental cost of outsourcing
• A situation may arises where entity is operating in full capacity, in order to overcome some restrictions on its output and sales, the entity may outsource some products.
• The decision is about which item to outsource and which to retain in-house.
• The profit maximizing decision is to which items to outsource.
• Those items are outsource where cost of outsourcing is least.
• To identify the Least-cost of outsourcing, it is necessary to compare:

• • additional cost of outsourcing; with
  • amount of resources need to make product in-house.

Make-or-buy decision non-financial considerations

Non-financial considerations will often be relevant to make-or-buy decision:

• When work is outsourced, the entity loses some control over the work. It will rely on the external supplier. There may be some risk that external supplier will:

• • provide a lower quality.
  • fail to meet delivery on said dates.
• The entity will lose some flexibility. If it needs to increase or reduce supply of the outsourced item at short notice.
• Redundancy of employees may occur as a consequence of outsourcing affecting relations between management and other employees.

Shut-down Decisions

• A shutdown decision is whether or not to shut down a part of the operations of a company.
• From a financial view an operation should be shutdown if the benefits of shutdown exceeds relevant costs.

Example of such costs

• Fixed costs may be saved, Employee redundancy cost.

Joint Product further processing decisions

• Joint products are product manufactured from a common process.
• The entity has a choice whether:

1. 1. selling joint product as soon as it is output; or
   2. processing it further before selling (at a higher price).

• This is a short-term decision and financial assessment should be made using relevant cost and revenues. The financial assessment should compares:

1. 1. Revenue (less) selling cost from joint product as soon as it is output.
   2. The revenue that will be obtained if Joint product is processed further (less) incremental cost of further processing.