ACT4131 Management Accounting III ACT4131 MANAGEMENT ACCOUNTING III

1. ACT4131 Management Accounting IIIACT4131MANAGEMENT ACCOUNTING III APPRAISAL OF STRATEGIC INVESTMENTS

2. Investments in Advanced Technology • Innovation and adoption of Advanced technology (AT) is critical for business survival. Why? • Response to environmental changes: • Growing competition • Increasing customer requirements and needs

3. Investments in Advanced Technology (AT) • Innovation and adoption of Advanced technology (AT) is critical for business survival. Why? • AT adds value: - productivity and economic growth - increased efficiency and reduced cost • innovation and interaction with customers

4. Advanced Technology (AT) • AT has significant impact on product, process and informational aspects of system • Examples: – stand-alone system such as computer-aided design (CAD) • Intermediate system such as automatic storage and retrieval system (AS/RS) • Integrated system such as flexible manufacturing system (FMS)

5. Characteristics of AT • Long life • Investment requirements that expand several years • Increasing returns over time • Various intangible or system-wide benefits

6. Strategic Investments • Does the investment policy: • support your competitive strategy? • enhance organisational capabilities? • Need to differentiate between Strategic and Tactical investments

7. Tactical Investment • Cost-reduction/saving orientation • Benefits are easily quantifiable and are based on the cost accounting system • E.g. invest in new equipment to reduce labour cost • Technology investments require more than pure labour savings investment

8. Strategic Investments in AT • Strategic due to the technology, quality enhancement • Cash inflow includes benefits from productivity gains due to better design methods, quality improvements and reductions in cycle time, inventory and space • Strategic investment enhances organisational capabilities

9. Enhancing Organisational Capabilities • External integration - link with customers and suppliers to create high-quality product • Internal integration – communication between intra-organisational functions, fast response and quick decision-making

10. Enhancing Organisational Capabilities • Responsive and flexibility – change at low cost and rapidly • Continuous improvement – communication, knowledge, skills

11. Justifying AT Expenditure • Justifying expenditure is a challenge • WHY? - Are there limitations in the traditional accounting techniques? - Do these techniques hinder investments? - Investment analysis ignores strategic considerations?

12. Financial Evaluation • Difficult to justify financially due to: • High initial capital costs that are not easily justified through traditional methods • High hurdle rates imposed (30% return or payback less than 2-3 yrs) • High levels of risk (cannot show big profit early) • Compare with status quo – do nothing – refuse to realistically view risks and opportunity costs

13. Improper Evaluation • Inability to properly justify investments • Benefits of AT are often non-quantifiable and difficult to estimate

14. Linking to Strategy • AT proposals failed if financial justification is not linked to manufacturing and business strategy • Thus, decision-making process should link financial justifications and strategic considerations • Accounting techniques alone are not adequate

15. Effects of Taxation and Inflation • Effect of Taxes: • Accounting profits vs. taxable profits • Tax rate applicable. • Covert all pre-tax cash flows to after tax cash flows and use after-tax cost of capital as the discount factor. • Effect of Inflation: • Each cash flow needs to be adjusted by the appropriate discount rate and the expected inflation rate.

16. Common/Traditional Techniques 1. Payback Period 2. Accounting rate of return 3. Net present value 4. Internal rate of return 5. Profitability index 6. Economic value added (EVA)

17. Payback Period • Payback period = length of time (in years) required for the cumulative after-tax cash inflows from an investment to recover the initial (net) investment outlay • Number of years required to recover a project’s initial investment from the cash flow generated from the project. • When after-tax cash inflows are expected to be equal, the payback period is determined as: Number of years =Cost of investment/annual cash flow

18. Strengths of the Payback • Easy to compute • Businesspeople have an intuitive understanding of “payback” periods • Payback period can serve as a rough measure of risk—the longer the payback period, the higher the perceived risk

19. Payback Period • This method automatically favors short-term over long-term investments • It does not have a clear decision criteria as to whether to accept or reject. The cut-off point is ambiguous. • Ignores time value of money & cash flows after the payback period

20. Weaknesses of the Payback • The model fails to consider returns over the entire life of the investment • In its unadjusted state, the model ignores the time value of money • The decision rule for accepting/rejecting projects is ill-defined (ambiguous or subjective) • Use of this model may encourage excessive investment in short-lived projects

21. Mendoza Co. : Use of the Payback Method

22. Payback Period • Project A: • Payback period = 2 years • Project B: • Payback period=3years

23. Accounting Rate of Return (ARR) • is an accounting-based technique • is obtained by dividing the average accounting income (profit) by the average level of investment • ignores time value of money and suffers from deficiencies in GAAPs.

24. Accounting Rate of Return (ARR)ountingRate of Return Accounting Rate of Return = Average Annual Income/Average Annual Investment Average annual investments= RM23,300/RM70,000= 33.3%

25. Pro’s and Con’s of ARR Pros: • It takes all the years into account • It’s is easy to use and is familiar “ return on investment” or “ return on Capital employed. Cons: • It is purely based on accounting figures and not on cash flow. Thus it does not take into account the working capital requirements that are needed for the investment • can be manipulated by changing accounting methods like depreciation rates & method • There is no account of time value of money. • Having calculated the return, we still do not know whether the return is acceptable or not?

26. Net Present Value (NPV) • The sum of the present values of all cash inflows and outflows associated with the project. • Present value payback = the length of time (in years) required for the cumulative present value of after-tax cash inflows to recover the initial investment outlay

27. NPV • Positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. • Reject Negative NPV as it cannot generate a return above the cost of finance. • The present value of all the future cash flows = the present value of the initial outlay yield a NPV of zero.

28. Profitability Index • Profitability index is computed by dividing the present value of cash inflows by the present value of cash outflow or • PI = NPV/Initial capital investment outlay • The index has to be >1 for any project to be acceptable and is used for comparisons of mutually exclusive projects.

29. Internal Rate of Return (IRR) • The discount rate that makes the project’s NPV equal to zero • If the internal rate of return is less than cost of capital, do not invest in the project. • Interpolation method - take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.

30. Interpretation of IRR:If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted

31. Limitations of Accounting Techniques • All benefits and costs must be quantifiable in monetary terms. • But difficult to quantify some benefits from AT investment such as, e.g. improved quality, flexibility & speed.

32. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (1) inventory reductions Better flexibility and scheduling from new technology Thus, reduced levels of WIP and FG Holding less inventory leads to cash savings

33. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (2) reduced floor space requirements - floor space is reduced through less inventory & better grouping of machines • Space savings reduce costs of space

34. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (3) improved quality • Decline in scrap, rework and waste • Reduce in cost of quality Difficult to quantify benefits but projected savings inventory, space and quality costs has to be estimated

35. Limitations of Accounting Techniques • Favours investments with short arbitrary payoffs (e.g., payback period). • Simplistic approach such as  hurdle (discount) rate or/and shortening evaluation horizon to adjust for risk. • Ignore the cost of not investing (i.e., static base line)

36. Limitations of Accounting Techniques • Short-term and piece-meal approach – lacks strategic instead focuses on tactical issues • Deficiencies of GAAPs; e.g., asset capitalisation principle leads to bias toward higher associated investment-related costs, and volume-based cost allocation leads to inaccurate cost-savings or benefits.

37. Implications • Consider system wide benefits in analysis – product, process, customer, competitor, employee, strategy • Incorporate intangible benefits although difficult to quantify • Link financial justification to strategy • Supplement financial with other techniques

38. Behavioral Issues in Capital Budgeting • Cost escalation (escalating commitment)--decision makers may consider past costs or losses as relevant • Incrementalism (the practice of choosing multiple, small investments) • Uncertainty Intolerance (risk-averse managers may require excessively short payback periods) • Goal congruence (i.e., the need to align DCF decision models with models used to subsequent financial performance)

39. New Investment Appraisal Techniques • Judgment-based and subjective in nature, such as: • Critical success factors • Return on Management (ROM) • Multiple Objectives and Multiple Criteria (MOMC) • Need for proper matching of type/objective of ICT investment to the appraisal approach/techniques. • Traditional financial-oriented techniques: For well-tried technologies for supporting activities. • Judgment-based techniques: For strategic investments with uncertain benefits.

40. New Investment Appraisal Techniques • Indirect, strategic, qualitative, sophisticated, core, leader, Unpredictable, Ad hoc, no’s not important, infrastructure, changeable • Boundary values(BV), • Information economics (IE) - indirect • Return on management (ROM) • Direct, tactical, quantifiable, simple, support follower, Ad hoc, no’s not important, infrastructure, changeable • Multiple objective, multiple criteria (MOMC) • Experimental methods (EM)

41. New Investment Appraisal Techniques Direct, tactical, quantifiable, simple, support follower, Predictable, specification, no’s important, specific, stable ROI, Payback, Cost/Revenue Indirect, strategic, qualitative, sophisticated, core, leader, Unpredictable, Ad hoc, no’s not important, infrastructure, changeable Cost benefit analysis (CBA)