Part A
Introduction
Almost all firms recognize that they face major uncertainties about the future, yet most firms' strategic investment decisions are primarily based on a single projection of future events. Although managers do recognize that the failure to include a consideration of uncertainty can lead to costly errors, the difficulty of such planning leads many to ignore the potential costs and hope that serious problems will not arise (Trigeorgis 1995). Suppose a company is considering a strategic decision, such as building a large now plant or embarking on a large research project. Major projects such as these require significant commitments of both capital and managerial attention. The reward from the project depends not only on its technical success, but also on the market conditions and industry structure at the time of completion. Uncertain future developments and the firm's response to these developments can turn such projects into either resounding successes or abysmal failures. However, managers are often baffled by the question of how to include uncertain future outcomes and potential future strategic responses in a prospective analysis of a capital investment project. The actual staging of capital investment as a series of outlays over time creates valuable options to default at any given stage (Trigeorgis 1995). Engaging in investment projects is vital for the growth of the firm. This part of the paper discusses the usefulness of investment appraisal techniques. This part of the paper analyzes how the methods of investment appraisal are as relevant and appropriate as the others when making investment decisions.
Investment Appraisal Techniques
From the firm’s perspective the objective of the investment appraisal process is to determine how the value of an investment is likely to affect the value of the firm. The goal is to increase the wealth of the firm by making investments which are expected to yield returns greater than their costs (Mcmenamin 1999). The investment appraisal process involves the evaluation of a prospective investment’s relevant cash flows which will occur over different time periods. In order to make a valid comparison of cash flows occurring over different time periods, it is necessary to convert them to a common base, or time period. People do this by either converting future cash flows back to their present day values, or by moving present cash flows out to a future date. The judicious application of investment appraisal techniques will enable management to select projects that will advance the organization’s objectives and plans and add to shareholder wealth. The financial techniques most commonly used to evaluate investment appraisal projects are payback method; accounting rate of return (ARR), or return on investment (ROI) and discounted cash flow (DCF) methods (Mcmenamin 1999).
In applying Discounted Cash Flow (DCF) the following techniques are commonly used: net present value (NPV); profitability index (PI); and internal rate of return (IRR). The payback method is the most popular and the most easily understood of the main appraisal techniques. It is essentially an expression of how long it will take to recover the initial cash outlay on an investment from the investment’s cash flow returns. The ARR is an unsophisticated technique. It is calculated by dividing a project’s average accounting profits by its average investment. The average profits figure is found by adding up the profits for each year of the investment and dividing by the number of years. The average investment is the sum of the initial investment or outlay plus the expected residual or realizable value of the asset, divided by two. The DCF is the incremental operating after-tax cash inflows which people use to measure the expected benefits from the project. The net present value (NPV) is the difference between the present value of future cash inflows and the present value of the initial outlay, discounted at the firm’s cost of capital. The profitability index (PI) is the ratio of the present value of all future net cash flows to the initial costs. While the NPV is an absolute measure of a project’s acceptability, the profitability index is a relative measure as it relates the benefits to the initial investment. The internal rate of return (IRR) or yield can be defined as: the discount rate which equates the present value of the expected initial cash investment, with the present value of the expected cash inflows (Mcmenamin 1999). The aim of investment appraisal techniques is not to replace the brilliant business tycoon or even to eliminate all elements of luck. Rather, it is to quantify all those factors that can be measured in order to provide management with as much information as possible about whether a project looks like adding value to the firm (Chrystal 1997). The investment appraisal techniques help in determining how the investments will create benefits or problems to a firm. The investment appraisal techniques ensure that the value of an investment will reflect on the firm’s value.
Investment decisions and investment appraisal
Even in advanced countries, technological developments, where they tend to increase the degree of complementarity between different investment decisions, may have a profound effect on market structure. There exist between the firms in a modern competitive economy complex interrelationships of ownership and control, which are abstracted from in much of more formal analysis; their justification derives, in part, from the need to co-ordinate complementarity activities (Richardson 1997). And the optimum size of the firm may be determined, not so much by the scale economies associated with any particular operation, but by the number of operations which require planned co-ordination. Nevertheless all the forces do not work in the direction of integration. The inevitable imperfection of the entrepreneur's knowledge, both about technical conditions and about the prospects of other firms, checks his willingness both to make long-term binding commitments and to throw in his lot with that of others (Richardson 1997). A company's internal context, competitive position, external opportunities, business concept, and stock of resources and capabilities available define some options or opportunities that a company has before it at any particular time. However, neither this company's growth path nor its growth rate is completely determined by such scenarios (Canals 2000).
It is the decisions as to what growth alternatives are chosen and the processes by which these decisions are made and implemented that eventually trigger the company's future growth. Of course, these decisions are closely related with the prior development of a business concept and depend upon the firm's internal and external context, and its resources and capabilities. Strategic investment decisions are often related to the development of the company's capabilities. In accordance with the resource-based view of the firm, achieving a certain market position is not only to be attributed to a lower cost structure or a better differentiation. Behind these and other qualities, there are some resources and capabilities that, when adequately combined, enable the company to achieve that competitive position. Consequently, the creation of a business concept implies a definition of what capabilities will be crucial for the company in the future and a program for developing or acquiring such capabilities. In turn, this program requires a strategic decision, and an investment of resources in a certain direction, which excludes other alternative directions (Canals 2000).
The unique nature of certain strategic investment decisions is that, in one way or another, they commit the company's future and define its growth possibilities. These decisions provide new business opportunities or give new life to existing businesses. These investments tend to be irreversible. Thus, if the project is not successful, the resources invested tend to lose value. Therefore, it would be just as bad to invest in projects without a hope of success as not to invest and let opportunities pass by. Investment decisions play an essential part in accounting for the growth process and in the continued pursuit of a certain strategy throughout a company's life. These decisions also help explain some of the difficulties faced by a company when it attempts to implement an organizational change process (Canals 2000). Economic growth and structural change come about as a consequence of innovation being injected into the productive system through investment decisions. However, the economic effects of innovation depend on how it is diffused throughout the productive fabric and what technological strategy firms employ to sustain and improve the results of their activity (Vázquez-Barquero 2002). Investment decisions are made to create a better future for a firm or any organization that wants to take it. The use of investment appraisal techniques in making investment decisions increase the chance of making appropriate decisions that results to wanted effects. Investment appraisals provide a clear financial and statistical data on what will happen to the firm’s status once it undergoes an investment decision. Investment appraisal techniques provide an outlook on what should be the main focus of an investment decision.
Conclusion
Engaging in investment projects is vital for the growth of the firm. The investment appraisal techniques help in determining how the investments will create benefits or problems to a firm. The investment appraisal techniques ensure that the value of an investment will reflect on the firm’s value. Investment appraisals provide a clear financial and statistical data on what will happen to the firm’s status once it undergoes an investment decision. Investment appraisal techniques provide an outlook on what should be the main focus of an investment decision.
Part B
Introduction
In recent times, numerous academics and practitioners have begun to question the usefulness of traditional managerial costing systems. Their arguments range from the irrelevance of traditional costing techniques in a flexible manufacturing environment to almost complete exclusion of meaningful cost data for marketing, distribution, and customer service functions. Corporate management accounting systems are inadequate for today's environment. In this time of rapid technological change, vigorous global and domestic competition, and enormously expanding information processing capabilities, management accounting systems are not providing useful, timely information for the process control, product costing, and performance evaluation activities of managers (Madu 1993). A competitive advantage can be developed and sustained once a company identifies its value chain and the cost drivers that determine the value of the activities on that value chain. This can be done by controlling and manipulating the drivers better than the competitors. Strategic cost analysis, which is the use of cost data in strategic planning, is a powerful competitive weapon. When combined with other costing methods costing strategic cost analysis can direct managers to take strategic initiatives in product designing, product cost, customer service, pricing, and automation (Madu 1993). Costing a product or service gives a company an opportunity to analyze the value of their product or service so that they can make necessary adjustments. This part of the paper focuses on evaluating the different approaches to costing products or services.
Marginal or Variable Costing
The manner in which direct costs are computed may be inconsistent with the regulations' definition of cost of production. In management accounting practices, direct costs are defined as those costs that can be traceable into and are identified specifically with a particular product or process for a particular purpose. However, direct costing, sometimes called variable costing, is a method of product costing that charges only the variable costs of manufacturing to the product. The variable costing method includes only variable manufacturing costs as the cost of a product. Product costs include direct materials, direct labor, and variable manufacturing costs. All fixed manufacturing costs are excluded from the inventoriable costs and expensed during the fiscal year in which they are incurred together with all selling and administrative expenses (Abdallah 2004). The variable or marginal approach to decision making is useful in making short-run decisions, but must be used with caution in situations that require long range commitments. In the long run all costs and expenses must be accounted for, plus a markup or profit in order to continue in business. The variable or marginal costing approach cannot be applied indiscriminately to all situations (Lewis 1993). The marginal costing approach focuses only on short term decisions because it has simplified features. The marginal costing approach shares the same ideas with break even analysis. In this approach the behavior of both costs and revenues is maintained constant throughout the relevant range of activity. In the marginal costing approach a critical scenario is the point where total revenues equal total costs.
Full or absorption costing
The cost of a product influences channel structure directly. The unit cost of a forklift truck is high and may be considered investment spending. These types of products are used over and over again for many years. Financing the purchase may be a deciding factor in influencing when to buy and what brand to buy. Major equipment products, such as forklifts, are generally sold by exclusive retailers for specific brands or by company branch retailers. Because of the high purchase price, the direct incentives offered by the manufacturer to the user are of considerable importance (McCalley 1992). In some instances, special options are offered and must be specified to the manufacturer in advance of product delivery. These market characteristics require a short line of communications, no storage or warehousing for wholesale distribution, and frequent involvement by the manufacturer with its retailers (McCalley 1992). Having different ways to assemble data for different uses is essential, particularly when a full or absorption costing system is used. When using absorption costing, then, it is essential to have available some product cost information other than just the full product cost, which includes a variety of costs that vary as to the plant, process, or batch but are fixed or non incremental at the product level (Cheatham & Cheatham 1993).
When using costs for decision making, it is necessary to be able to assemble costs that are relevant to that particular decision whether it is a decision to accept a special order, discontinue a product line, or outsource a component. Management must be able to distinguish which portions of total costs are sunk costs and are not relevant to the decisions and which are costs that will be created by the new proposal. Only the newly created costs are relevant in most cases (Cheatham & Cheatham 1993). There are costs which are incurred by the organization as a whole, and are usually apportioned to the different cost centers. There is no one method of dividing these costs, but the most simple and common is called absorption costing which is to spread all the cost into the center. Absorption costing makes sure that the full costs of an organization are absorbed at the service level, so that overhead costs are not a drain upon other incomes or reserves (Palmer & Randall 2002). It ensures that an organization can receive the maximum amount of income to cover its costs. It can lead to greater accountability of the central services of an organization to the services that are funding them. There are various problems caused by absorption costing. Absorption costing can lead to inefficiency in central services, as they have no incentive to minimize or control their costs. Competitive edge can be blunted if another company bidding for a contract has leaner costs or is not working on an absorption model. This approach can cause resentment among service managers who may feel they are supporting the central services to the detriment of their own service (Palmer & Randall 2002). The absorption costing includes all kinds of manufacturing costs. Under absorption or full costing the variable and fixed manufacturing overhead is included. This costing method makes sure that the maximum amount of income to cover its costs will be received by a firm.
Activity Based Costing
ABC drove costing very deeply into the organization by identifying the actual costs of labor, equipment, and premises associated with each activity performed by the firm rather than relying on arbitrary formulas to allocate overhead. Activity-based profitability analysis is a granular form of costing. It identifies the actual costs of labor, materials, equipment, and premises needed to deliver a product, serve the customer, and sustain the business. ABC practitioners believe that making costs known creates opportunities for savings even though ABC methodology alone does not identify savings targets. Two advantages are claimed for ABC compared to conventional costing methods. First, ABC makes all costs explicit, reducing distortions caused by arbitrary allocations of overhead to products and customers (Meyer 2002). Second, ABC traces costs back to the economic events that cause them, making it possible to judge the reasonableness of costs in light of these events. Activity-based costing is less useful when costing decisions are made without objective information about their consequences (Meyer 2002).
Activity based costing is a strategy wherein a company assigns its resource cost through activities to the products and services provided to the customers. It is used as a way for the business organization to understand and learn about customer cost and profitability. Companies use it to support decisions on pricing, outsourcing and measurement of process improvement initiatives. Activity based costing is good for companies because it makes cost specific and more understandable to the company. ABC provided assistance in helping the company determine what composes its cost and whether such cost is acceptable to the company or not. ABC is also good for the company because it can help in ascertaining whether the expenses and costs acquired by the company are acceptable or worth it. ABC provided a clearer statement of what composes the product cost thus when it is computed the result was lower rates of overhead costs. The ABC system provided a better chance for companies to reanalyze its focus and financial goals. For a company this means that the use of ABC system can help it lessens the financial worries of the company thus the company can have more chance to try to analyze their goals and achieve the new perceived goal. Another implication for the company is it can make use of such information to create a better image for itself. This will help the company’s desire for a better standing in its competitive environment.
Conclusion
The marginal costing approach focuses only on short term decisions because it has simplified features. The marginal costing approach shares the same ideas with break even analysis. Under absorption costing the variable and fixed manufacturing overhead is included. This approach makes sure that the maximum amount of income to cover its costs will be received by a firm. ABC provided assistance in helping firms determine what composes its cost and whether such cost is acceptable to the firm. ABC is good for the firm because it can help in ascertaining whether the expenses acquired by a firm are acceptable.
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