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SHORT-TERM AND LONG-TERM DECISIONS
1. Relevant Costs for Decision Making
Explain the concept of relevant costs and relevant revenues and how this is potentially
different from the notion of fixed and variable costs✔ ✔relevant costs and revenues are future costs and revenues that differ among alternatives. they are to be used in decision making. irrelevant costs are things that cannot change no matter what action you take.Usually fixed costs will be irrelevant and variable will be relevant but you must not make this assumption automatically.
Explain the importance of the time horizon in decision making and its impact on relevant
cost/revenue✔ ✔in the short term a cost is more likely to be fixed but as time goes on they will most likely become variable.
or in a short run decision a company may lack capacity or experience great demand leading to a large price spike.
Explain 'sunk costs' and why they are considered irrelevant to decisions.✔ ✔costs that are unavoidable and won't change no matter what action you take.
opportunity costs✔ ✔the contribution to operating income that is foregone or rejected by not using a limited resource in its next best alternative
avoidable costs✔ ✔variable costs that can be taken out of the equation unlike fixed costs
differential costs✔ ✔the difference in total cost between two alternatives
incremental costs✔ ✔the additional total cost incurred for an activitiy
Understand that accounts drawn up for financial accounting purposes often blend
fixed/variable, relevant/irrelevant costs, and therefore cost accounting information for
decision-making often needs to be specifically constructed for the decision at
hand.✔ ✔they are blended sometimes even though they act very differently.
e.g. if you are given a question with the total manufacturing costs you have to determine the variable and fixed components.
variable costing income statement✔ ✔Sales
Less VC
VMOH
V selling costs
Contribution margin
Less fixed costs
FMOH
Fixed admin
what is the main difference between variable and absorption costing✔ ✔variable will cost the fixed component as an expense in the current year where as absorption will treat the fixed overhead as an inventorial cost and the cost will follow the periods the inventory is used in.
what drives operating profit in variable and absorption costing✔ ✔variable = unit level of sales
-ignore unavoidable expenses
-will some expenses avoidable but you will still have to pay regardless?
-sales -avoidable costs= positive=add
-interdependencies
customer profitability✔ ✔are the customers of benefit or are they a liability?
-ignore allocated overhead
-consider opportunity cost
pricing and profitability✔ ✔select and increase products that yield the highest contribution margin of the constrained resource.
special order✔ ✔-affects output levels
-additional revenue> additional costs= accept
-capacity levels
-fixed costs must be able to cover extra units
make or buy✔ ✔-factors; quality, reputation, security, employee morale, control.
-relevant costs to make instead of buying
-relevant costs make > relevant costs to buy= buy the product.
-greater CM will cover more of the fixed costs.
-long term strategy to minimise supplier risks e.g. enter into long run contract
-constrained capacity? consider the opportunity cost
Be aware of the role of 'excess capacity' in decision-making and its significance for cost
analysis✔ ✔in relation to product mix decisions. relates to both the demand and capacity in the short run. if a companies demand is below their capacity they have the ability to run a special price or special order
value added✔ ✔if eliminated this would reduce the actual or perceived value or utility customers obtain from the use of product or service.
internal value chain✔ ✔sequence of business functions in which customer usefulness is added to the product/service.
product lifecycles✔ ✔the time span from the initial research and development to when customer service and support is no longer on offer for that product
lifecycle costs✔ ✔system that tracks and accumulates business function costs of the value chain attributable to each product.
-product or customer
cost based✔ ✔good for differentiated products and will ignore demand
cost + markup
market based✔ ✔useful in competitive markets where the process is target pricing
- Capital Budgeting Decisions
How managers plan significant investments in projects that have long term implications such as purchasing new equipment or introducing new products is
called ______. ✔ ✔capital budgeting
When computing the payback period for a new piece of equipment, the salvage value of the equipment being replaced is ______. ✔ ✔deducted from the cost of the new equipment
Working capital ______. ✔ ✔often increases when a company takes on a new project
Sandy's Soda Co. is planning to purchase new equipment that costs $56,000 and will save on operating costs for the next 5 years as follows: $21,500 in year 1; $23,100 in year 2; $19,000 in year 3; $13,900 in year 4; and $15,200 in year 5. The
payback period for the cooling equipment is ______ years. ✔ ✔After two years $44,600 ($21,500 + $23,100) will have been paid back leaving $11,400 ($56,000 - $44,600). $11,400 ÷ $19,000 = .6, so the total payback period is 2.6 years.
One dollar earned today is worth ______. ✔ ✔More than one dollar earned at a future point in time
Instead of focusing on a project's profitability, the _________ period focuses on
the time it takes for an investment to pay for itself. ✔ ✔payback
Net present value is the ______. ✔ ✔difference between the present value of a project's cash inflows and the present value of the project's cash outflows
True or false: When a capital investment decision is being made between two or more alternatives, the project with the shortest payback period is always the most desirable investment.
True false question. ✔ ✔False
If the original investment in a capital project has been recovered, the net present
value will be ______. ✔ ✔positive or zero
In an equipment capital budgeting decision, recovering the original investment
means that the ______. ✔ ✔investment has generated enough cash inflows to completely cover the cost of the equipment
True or false: When calculating the payback period, the depreciation on the
investment is excluded in the calculation of net cash flow. ✔ ✔True. Depreciation is a non-cash expense, and therefore, should not be included in the calculation of the net cash inflows of a capital investment. Thus it must be added back to determine the annual net cash flow.
Cash inflow in a working capital situation: ✔ ✔Working capital is released for use elsewhere within the company
Cash outflow in a working capital situation: ✔ ✔Working capital is tied up for project needs
The concept of the time value of money is based on the notion that a dollar today is
worth (more/less) _________ than a dollar a year from now. ✔ ✔more
The internal rate of return ______. ✔ ✔is the discount rate that makes NPV equal zero for a project
The net present value of a project is ______. ✔ ✔-the difference between the present value of cash inflows and present value of cash outflows for a project
-used in determining whether or not a project is an acceptable capital investment
Which of the following statements are true? ✔ ✔-A project with a positive NPV will recover the original cost of the investment plus sufficient cash inflows to compensate for tying up funds.
