Wey_AP_9e_Ch26_Edited

Wey_AP_9e_Ch26_Edited - Chapter 26 Incremental Analysis and...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Chapter 26 Incremental Analysis and Capital Budgeting Chapter 26-1 Accounting Principles, Ninth Edition Incremental Analysis and Capital Budgeting Incremental Analysis Management’s decisionmaking process Accept special-price order Make or buy Sell or process further Chapter 26-2 Retain or replace Retain equipment Eliminate unprofitable segment segment Allocate limited resources Capital Budgeting Evaluation process Annual rate of return Cash payback Discounted cash flow: Discounted NPV and IRR NPV Management’s Decision-Making Process Im portant m anage e function m nt Doe not always follow a se patte s t rn De cisions vary in scope urge and im , ncy, portance S ps usually involve in proce include te d ss : Illustration 26-1 Chapter 26-3 SO 1: Identify the steps in management’s decision-making process. Management’s Decision-Making Process C onside both financial and non-financial inform rs ation Financial information include re nue and costs as we s ve s ll as the e ct on ove profitability ir ffe rall Non-financial information include e ct on e ploye s ffe m e t urnove thee r, nvironm nt, or ove com e rall pany im age Chapter 26-4 SO 1: Identify the steps in management’s decision-making process. Management’s Decision-Making Process Incremental Analysis Approach De cisions involvea choice am alte ong rnativeactions De choice am Financial data re vant to a de le cision arethedata that vary in the Financial future among alternatives future Both costs and re nue m vary or ve s ay Only re nue m vary or ve s ay Only costs m vary ay Chapter 26-5 SO 2: Describe the concept of incremental analysis. Management’s Decision-Making Process Incremental Analysis Proce use to ide ss d ntify thefinancial data that change Proce unde alte r rnativecourse of action s unde I de ntifie probablee cts of de s ffe cisions on future e arnings Also calle diffe ntial analysis be d diffe re causeit focuse on s Also diffe nce re s diffe Chapter 26-6 SO 2: Describe the concept of incremental analysis. How Incremental Analysis Works Basic Example Illustration 26-2 C parison of Alte om rnativeB with Alte rnativeA: I ncre e re nueis $15,000 less under Alternative B m ntal ve Incremental cost savings of $20,000 is realized Alternative B produces $5,000 more net income Chapter 26-7 SO 2: Describe the concept of incremental analysis. How Incremental Analysis Works S e e involve change that se mcontrary to intuition om tim s s s e Variablecosts som tim s do not change unde e e do r Variable alte rnative s alte Fixe costs som tim s change be e alte d e e change twe n rnative s Fixe I ncre e analysis not t hesam as C analysis m ntal e VP not Chapter 26-8 SO 2: Describe the concept of incremental analysis. S enote pagefor solution e s How Incremental Analysis Works BE26-2: Ming C pany is conside two alte om ring rnative Alte s. rnativeA will havesale of $150,000 and costs of $100,000. Alte s rnativeB will havesale of s $180,000 and costs of $120,000. C pareAlte om rnativeA to Alte rnativeB showing incre e re nue costs, and ne incom . Which alte m ntal ve s, t e rnativeshould you choose ? Chapter 26-9 SO 2: Describe the concept of incremental analysis. Types of Incremental Analysis Types Acce an orde at a spe price pt r cial Acce Makeor buy S ll or proce furthe e ss r Re or re tain placee quipm nt e Elim inatean unprofitablebusine se e ss gm nt Allocatelim d re ite source s Chapter 26-10 SO 2: Describe the concept of incremental analysis. Accept an Order at a Special Price Obtain additional busine by m ss aking a m priceconce ajor ssion to a Obtain spe custom r cific e spe Assum s that sale of products in othe m ts arenot affe d by e s r arke cte Assum spe orde cial r spe Assum s that com e pany is not ope rating at full capacity Chapter 26-11 SO 3: Identify the relevant costs in accepting an order at a special price. Accept an Order at a Special Price Example C ustom r offe to buy a spe orde of 2,000 units at $11 pe unit e rs cial r r No e ct on norm sale ffe al s No e ct on plant capacity; curre ope ffe ntly rating at 80%which is 100,000 units Curre variablem nt anufacturing cost = $8 pe unit r Curre fixe m nt d anufacturing costs = $400,000 or $4 pe unit r Norm se al lling price= $20 pe unit r Base strictly on total cost of $12 pe unit ($8 + $4), reject offe as cost d r r Base reject e e se xce ds lling priceof $11 Chapter 26-12 SO 3: Identify the relevant costs in accepting an order at a special price. Accept an Order at a Special Price Example - Continued Fixed costs do not change since within existing capacity – thus fixed Fixed costs are not relevant costs Variable manufacturing costs and expected revenues change – thus Variable both are relevant to the decision both Illustration 26-3 Decision: Accept the offer; Income increases by $6,000 Chapter 26-13 SO 3: Identify the relevant costs in accepting an order at a special price. S enote pagefor solution e s Accept an Order at a Special Price BE26-3: In Karnes Company it costs $30 per unit ($20 variable and $10 fixed) to make a product that normally sells for $45. A foreign wholesaler offers to buy 4,000 units at $23 each. Karnes will incur special shipping costs of $1 per unit. Assuming that Karnes has excess operating capacity, prepare an incremental analysis that indicates the net income (loss) Karnes would realize by accepting the special order. Should the order be accepted? Chapter 26-14 SO 3: Identify the relevant costs in accepting an order at a special price. Make or Buy Must de whe r to m thecom nt parts or to buy the from ake pone m Must cide the othe rs othe Example: The following costs are The incurre to m 25,000 switche d ake s: Alternatively, the the switches can be purchased for $8 per switch ($200,000) switch Eliminates all variable Eliminates costs of making switches costs Eliminates $10,000 of Eliminates fixed costs; however, $50,000 remain $50,000 Chapter 26-15 SO 4: Identify the relevant costs in a make-or-buy decision. Make or Buy Example - Continued Total manufacturing cost is $1 higher than purchase price Must absorb at least $50,000 of fixed costs under either option Illustration 26-5 Decision: Continue to make switches Decision: as purchasing adds $25,000 to cost as Chapter 26-16 SO 4: Identify the relevant costs in a make-or-buy decision. Make or Buy Opportunity Cost t hepotential benefit t hat thepotential m beobtaine fromfollowing ay d an alte an rnativecourseof action m beconside d in ust re incre e analysis m incre ntal Chapter 26-17 SO 4: Identify the relevant costs in a make-or-buy decision. Make or Buy Example – Continued Assume that buying the switches allows the company to use the released capacity to earned $28,000 in additional income The $28,000 lost income is an additional cost of making the switches – an opportunity cost Illustration 26-6 Decision: Buy the switches as company is $3,000 better off Chapter 26-18 SO 4: Identify the relevant costs in a make-or-buy decision. SO Sell or Process Further May haveoption to se product at a give point in production or ll n May to proce furthe and se at a highe price ss r ll r to Decision Rule: Proce furthe as long as theincre e re nuefromsuch ss r m ntal ve Proce proce ssing e e theincre e proce xce ds m ntal ssing costs Chapter 26-19 SO 5: Give the decision rule for whether to sell or process materials further. SO Sell or Process Further Example: Costs to manufacture one unfinished table: Direct materials $ 15 Direct labor $ 10 Variable manufacturing overhead $6 Fixed manufacturing overhead $4 Manufacturing cost per unit $35 Selling price of unfinished unit is $50 Use capacity to finish tables to sell for $60 per table Relevant unit costs of finishing table: Direct materials increase $2 Direct labor increase $4 Variable overhead increase $2.40 (60% of direct labor) No change in fixed overhead Chapter 26-20 SO 5: Give the decision rule for whether to sell or process materials further. Sell or Process Further Example – Continued Illustration 26-8 Decision: Process further Incremental revenue ($10) exceeds incremental processing costs Incremental ($8.40); income increases $1.60 per unit ($8.40); Chapter 26-21 SO 5: Give the decision rule for whether to sell or process materials further. S enote pagefor solution e s Sell or Process Further BE26-5: Stanton Inc. makes unfinished bookcases that it sells for $60. Production costs are $30 variable and $10 fixed. Because it has unused capacity, Stanton is considering finishing the bookcases and selling them for $72.Variable finishing costs are expected to be $8 per unit with no increase in fixed costs. Prepare an analysis on a per unit basis showing whether Stanton should sell unfinished or finished bookcases. Chapter 26-22 SO 5: Give the decision rule for whether to sell or process materials further. Retain or Replace Equipment Example: Assessment of replacement of factory machine: Old Machine New Machine Book Value $ 40,000 Cost $ 120,000 Remaining useful life four years four years Salvage value -0-0Variable manufacturing costs decrease from $160,000 to Variable $125,000 if new machine purchased $125,000 Chapter 26-23 SO 6: Identify the factors to consider in retaining or replacing equipment. Retain or Replace Equipment Example – Continued Illustration 26-9 Decision: Replace the Equipment The lower variable costs due to replacement more than offset the The cost of the new equipment cost Chapter 26-24 SO 6: Identify the factors to consider in retaining or replacing equipment. Retain or Replace Equipment Additional Considerations Thebook valueof old m achinedoe not affe the s ct The de cision. de Book valueis a sunk cost. C which cannot bechange by future osts d de cisions (sunk cost) arenot re vant in le incre e analysis. m incre ntal Howe r, any trade allowanceor cash disposal ve -in valueof thee xisting asse is re vant. t le Chapter 26-25 SO 6: Identify the factors to consider in retaining or replacing equipment. Eliminate an Unprofitable Segment Ke Focus on Relevant Costs y: Ke Focus C onside e ct on re d product line r ffe late s Fixe costs allocate to theunprofitablese e must be d d gm nt absorbed by theothe se e r gm nts absorbed Ne incom m decrease whe an unprofitablese e is t e ay decrease n gm nt e inate lim d De cision Rule : Retain the segment unless fixed costs eliminated Retain exceed contribution margin lost exceed Chapter 26-26 SO 7: Explain the relevant factors in whether to SO eliminate an unprofitable segment. eliminate Eliminate an Unprofitable Segment Example: Martina C pany m om anufacture thre m ls of te racke s e ode nnis ts: Profitableline Pro and Maste s: r Unprofitableline C p : ham C nse I ncom S m nt data: onde d e tate e Illustration 26-10 Should Champ be eliminated? Chapter 26-27 SO 7: Explain the relevant factors in whether to SO eliminate an unprofitable segment. eliminate Eliminate an Unprofitable Segment Example – Continued I f C p is e inate allocateits $30,000 fixe costs: ham lim d, d 2/3 to Pro and 1/3 to Maste r Re d I ncom S m nt data: vise e tate e Illustration 26-11 Total incom has decreased by $10,000 e decreased Chapter 26-28 SO 7: Explain the relevant factors in whether to SO eliminate an unprofitable segment. eliminate Eliminate an Unprofitable Segment Example – Continued I ncre e analysis of C p provide thesam re m ntal ham d e sults: Do Not Eliminate Champ Illustration 26-12 De asein ne incom is dueto C p’s contribution m cre t e ham argin ($10,000) t hat will not bere d if these e is discontinue alize gm nt d. Chapter 26-29 SO 7: Explain the relevant factors in whether to SO eliminate an unprofitable segment. eliminate Allocate Limited Resources Resources are always limited Floor spacefor a re firm tail Raw m rials, dire labor hours, ate ct or m achinecapacity for a m anufacturing firm Manage e m de which m nt ust cide products to make and sell to maximize net income maximize Chapter 26-30 SO 8: Determine which products to make and sell when SO resources are limited. resources Allocate Limited Resources Example: C ollins C pany m om anufacture s de and standard pe and luxe n pe se ncil ts Lim iting re source : 3,600 m achinehours pe m r onth Illustration 26-13 De se has highe contribution m luxe t r argin: $8 S tandard se take fe r m t s we achinehours pe unit r Chapter 26-31 SO 8: Determine which products to make and sell when SO resources are limited. resources Allocate Limited Resources Example: - Continued Must com putecontribution margin per unit of limited resource Illustration 26-14 S tandard se havehighe contribution m ts r argin pe unit of lim d r ite re source s Decision: Shift sales mix to standard sets or increase machine capacity Chapter 26-32 SO 8: Determine which products to make and sell when SO resources are limited. resources Allocate Limited Resources Example: - Continued Alte rnative I ncre m : ase achinecapacity from3,600 to 4,200 m achine hours Illustration 26-15 To m izene incom , all theadditional 600 hours should beuse to axim t e d producestandard se ts Chapter 26-33 SO 8: Determine which products to make and sell when SO resources are limited. resources Capital Budgeting Theproce of m ss aking capital e nditurede xpe cisions in busine is ss The known as known Capital Budgeting Theam ount of possiblecapital e nditure usually e e thefunds xpe s xce ds availablefor such e nditure xpe s C apital budge involve choosing am various capital proje ting s ong cts t o find theone that will (s) Maximize a company’s return on investment Chapter 26-34 Evaluation Process Many com s fully pre scribe proce in capital d ss Many panie follow a care budge ting. budge At le oncea ye ast ar: Proposals arere ste frome de que d ach partm nt e Thecapital budge com itte scre ns theproposals and ting m e e subm its findings to theoffice of thecom its rs pany Office se ct proje and subm list to theboard of rs le cts it dire ctors for approval Chapter 26-35 Evaluation Process Providing m m nt le Providing anage e with re vant data for capital budge de ting cisions re quire fam s iliarity with quantitativete chnique s. with Them com on te ost m chnique are s: Annual Rate of Return Cash Payback Discounted Cash Discounted Flow Flow Chapter 26-36 Evaluation Process These techniques will be illustrated using the following data for These Tappan Company: Tappan Investment in new equipment: $130,000 Useful life of new equipment: 10 years Zero salvage and straight-line depreciation The expected annual revenues and costs of the new product that will be produced from the investment are: Illustration 26-16 Chapter 26-37 Annual Rate of Return Theannual rateof re turn te chniqueis base dire on accounting d ctly The data data I t indicate theprofitability of a capital e nditure s xpe Theform is: ula Illustration 26-17 Thee cte annual ne incom is fromtheproje d I ncom xpe d t e cte e S m nt tate e Chapter 26-38 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Annual Rate of Return Theave inve e is de d fromthefollowing form rage stm nt rive ula: Illustration 26-18 For Tappan C pany theave inve e is: om rage stm nt [($130,00 + $0) ÷ 2] = $65,000 Chapter 26-39 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Annual Rate of Return Thee cte rateof re turn for Tappan C pany’s inve e in om stm nt The xpe d ne e w e ne quipm nt is: $13,000 ÷ $65,000 = 20% Thede cision ruleis: A project is acceptable if its rate of return is greater than management’s minimum rate of return. When choosing among several acceptable projects, the project with the higher rate of return is generally more attractive. Chapter 26-40 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Annual Rate of Return Principal advantage of theannual rateof re s turn te chnique : S plicity of calculations im Manage e fam m nt’s iliarity with accounting te s use in the rm d calculation Major lim itation of thete chnique : It does not consider the time value of money As note in Appe d ndix C re , cognition of thetim valueof m y can e one m a significant diffe ncebe e thepre nt and futurevalue ake re twe n se s of an inve e stm nt. Chapter 26-41 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Cash Payback I de ntifie thetim pe re s e riod quire to re r thecost of the d cove inve e stm nt Use thene annual cash flow produce fromtheinve e s t d stm nt Ne annual cash flow can beapproxim d by taking ne incom t ate t e and adding back de ciation pre Theform for com ula puting thecash payback pe is: riod Illustration 26-19 Chapter 26-42 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Cash Payback Example: Tappan C pany has ne annual cash inflows of $26,000 ( Ne om t t I ncom $13,000 + De ciation $13,000) e pre Thecash payback pe is: riod $130,000 ÷ $26,000 = 5 ye ars $130,000 Chapter 26-43 SO 9: Contrast annual rate of return and cash payback in SO capital budgeting. capital Cash Payback Example: C n C pany has une n ne annual cash inflows he om ve t Now thecash payback pe is de rm d whe thecum riod te ine n ulativene t cash flows e qual thecost of theinve e stm nt Illustration 26-21 Chapter 26-44 SO 9: Contrast annual rate of return and cash payback in capital budgeting. capital Cash Payback BE26-9: Adle C pany is conside purchasing ne e r om ring w quipm nt e f or $300,000. I t is e cte that thee xpe d quipm nt will produceannual e ne incom of $10,000 ove its 10-ye use life Annual de ciation t e r ar ful . pre will be$30,000. will Compute the cash payback period. Chapter 26-45 Cash Payback First, calculatene annual cash inflows: t Ne incom + de ciation t e pre $10,000 + $30,000 = $40,000 Second, dividecapital inve e by annual cash flows stm nt $300,000 ÷ $50,000 = 6 years Chapter 26-46 Discounted Cash Flow Discounte cash flow te d chnique ge rally re s ne cognize as be d st approach to m aking capital budge de ting cisions Te chnique conside both: s r Estim d total cash inflows, and ate Thetim valueof m y e one Two m thods ge rally use with thediscounte cash flow e ne d d te chnique are s Net Present Value Method Internal Rate of Return Method Chapter 26-47 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method NPV m thod com s thepresent value of the cash e pare inflows t o thecapital outlay required by theinve e stm nt inflows Thedifference be e thetwo am ounts is re rre to as the fe d difference twe n net present value net Theinte st rateuse to discount thecash flow is there re d quire d m umrateof re inim turn A proposal is acce ptablewhe theNPV is zero or positive n zero Thehighe thepositiveNPV, them attractivetheinve e r ore stm nt Chapter 26-48 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method Net Present Value Decision Criteria Illustration 26-22 Chapter 26-49 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method Example: Equal Annual Cash Flows Annual cash flows of $26,000 uniformove asse use life r t’s ful C alculation of pre nt valueof annual cash flows (annuity) at 2 se diffe nt discount rate re s: Illustration 26-23 Chapter 26-50 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method Example: Equal Annual Cash Flows - Continued Analysis of proposal using ne pre nt value t se s Illustration 26-24 NPV positive f or both discount rate s Accept propose capital e nditureat e r discount rate d xpe ithe Chapter 26-51 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method Example: Unequal Annual Cash Flows Diffe nt cash flows e ye ove asse use life calculation of re ach ar r t’s ful ; PV of annual cash flows at 2 diffe nt discount rate re s: Illustration 26-25 Chapter 26-52 SO 10: Distinguish between the net present value and SO internal rate of return methods. Net Present Value Method Example: Unequal Annual Cash Flows - Continued Analysis of proposal using ne pre nt value t se s Illustration 26-26 NPV positive f or both discount rate s Accept propose capital e nditureat e r discount rate d xpe ithe Chapter 26-53 SO 10: Distinguish between the net present value and SO internal rate of return methods. Internal Rate of Return Method I RR m thod finds theinte st yie of thepote e re ld ntial inve e stm nt I RR – ratethat will causethePV of thepropose capital d e nditureto equal t hePV of thee cte annual cash inflows xpe xpe d Two ste in m thod ps e 1. 2. Chapter 26-54 C putetheinte rateof re om rval turn factor Usethefactor and thePV of an annuity of 1 tableto find the I RR. SO 10: Distinguish between the net present value and SO internal rate of return methods. Internal Rate of Return Method Example: Example: Step 1: Theform for com ula puting theI RR factor: Illustration 26-27 I RR factor for Tappan C pany, assum e om ing qual annual cash inflows: $130,000 ÷ $26,000 = 5.0 Chapter 26-55 SO 10: Distinguish between the net present value and SO internal rate of return methods. Internal Rate of Return Method Example - Continued Example Step 2: I RR is thediscount factor close to theI RR factor for the st t im pe cove d by theannual cash flows. e riod re C st discount factor to 5.0 is 5.01877; thus I RR is approxim ly lose ate 15% Chapter 26-56 SO 10: Distinguish between the net present value and SO internal rate of return methods. Internal Rate of Return Method C pareI RR to m om anage e re m nt’s quire m umrateof d inim re turn Decision Rule: Accept the project when the IRR is equal to or greater than the required rate of return. Assum a m umrateof re ing inim turn for Tappan of 10% , proje is acce d sinceI RR of 15%is gre r than the ct pte ate re quire rate d. Chapter 26-57 SO 10: Distinguish between the net present value and SO internal rate of return methods. Internal Rate of Return Method Illustration 26-28 Chapter 26-58 SO 10: Distinguish between the net present value and SO internal rate of return methods. Comparison of Discounted Cash Flow Comparison Methods Methods Illustration 26-29 Chapter 26-59 SO 10: Distinguish between the net present value and SO internal rate of return methods. ...
View Full Document

Ask a homework question - tutors are online