Intangible benefits in capital budgeting

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Course Learning Outcomes for Unit VIII Upon completion of this unit, students should be able to:

7. Explain how financial information influences both short-term and long-term management decisions. 7.1 Describe the use of standard cost manufacturers and service businesses.

8. Discuss operational and capital budgets.

8.1 Describe capital budgeting methods. 8.2 Identify the use of intangible benefits in capital budgeting.

Course/Unit Learning Outcomes

Learning Activity

7.1

Unit Lesson Chapter 26, pp. 26-1 to 26-24 Webpage: Balanced Scorecard Basics Video: What is a balanced scorecard: A simple explanation for anyone Unit VIII Case Study

8.1 Unit Lesson Chapter 27, pp. 27-1 to 27-19 Unit VIII Case Study

8.2 Unit Lesson Chapter 27, pp. 27-1 to 27-19 Unit VIII Case Study

Required Unit Resources Chapter 26: Standard Costs and Balanced Scorecard, pp. 26-1 to 26-24 Chapter 27: Planning for Capital Investments, pp. 27-1 to 27-19 In order to access the following resources, click the links below. Balanced Scorecard Institute. (n.d.). Balanced scorecard basics. https://balancedscorecard.org/bsc-basics-

overview/ For the video resource below, a transcript and closed captioning are available upon accessing the video. Marr, B. (2019, June 24). What is a balanced scorecard: A simple explanation for anyone [Video]. Cielo24.

https://c24.page/2s4pmxpj2kpwnprckg6p8tcjtu

Unit Lesson

Introduction This final unit will conclude the study of managerial accounting. This lesson will share important content for managers in manufacturing, merchandising, and service companies. Content includes estimating future costs, implementing financial and non-financial performance measures, and incorporating capital budgeting. Costing requires you to make estimates. As noted in a previous unit, many people are uncomfortable with this task, as they are used to having objective numbers given to them. However, as much as the future is

UNIT VIII STUDY GUIDE

Management: Costs and Capital Investing

https://balancedscorecard.org/bsc-basics-overview/
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unpredictable, we are still required to use our experience and judgment to chart a path forward. In this unit, you will learn about standard costs. Partially based on prior period actual costs, they provide the basis for budgeting and subsequent evaluation. Management accountants, no matter the title, are integral to the development of standard costs, implementation of the balanced scorecard, and the capital budgeting process. Pay attention as you read, review, and evaluate this unit as it is almost wholly transferable to any company. Consider the following questions and how you would respond to each as you move through this unit.

 As the chief accounting officer (CAO) or chief financial officer (CFO), how will you set product, service, or process costs for upcoming periods?

 What are the factors that you will consider when planning capital investments?

 What organization performance measures will you use regarding the type of responsibility centers?

Standard Costs Costing is one of management’s major (and basic) responsibilities. Standard costing is all about establishing objectives for future periods. Standard costing puts those objectives into a written form so they can be communicated and become the basis for measurement. Standard costs are about amounts per unit. Labor, materials, and overhead are translated into a dollar amount for each unit produced. Budgets are total amounts. The amounts budgeted for different cost components for a given level of production are the total budgeted costs.

Setting Standard Costs Standards are often the subject of debate between management, professionals, and employees or their representatives. Take a look at the following four issues outlined below to help clarify who sets these standard costs and why.

 How are standard costs set? Standards for the upcoming period start with the actuals from immediate prior periods. They are then modified with planned business process changes and technology changes to be implemented. If non-value steps are removed from a process, if organizational changes enhance roles and responsibilities of process participants, or if technology improves the outcome quality (accuracy, speed), the standard will change.

 Who participates in setting standard costs? While primary responsibility may rest with a financial manager, other major participants include operating management, internal (or external) consultants, and current process participants. If one or more of these parties is not present, the acceptance of a new or changed standard will be lessened.

 How often are standard costs updated? Standards must be updated as organization, process, or

technology changes take place. While there is a balance between planning and doing, standards should be revisited at the start of every accounting (business performance) period.

 What should a standard represent? Standards set too high (i.e., an ideal or perfect performance) will not motivate those working in the process. Standards set too low will similarly demotivate managers and employees, as it will be difficult to compete with external competitors producing at a higher level. A balanced approach (i.e. normal) is best. Process participants must come to agree on the performance level for it to work. Another level that is often promoted is a stretch standard, meaning more than normal but less than ideal and accepted by the participants.

Now, what makes up the standard? As you may recall from prior unit lessons, there are three major cost components that make up a standard. These cost components are direct materials, direct labor, and manufacturing overhead. For reference, these are detailed further in the illustration below.

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 Direct materials (DM): This is the cost for one unit of the finished product (or service). Materials may

be purchased for use as an intermediate part or the final part of the production process. In either case, we can develop a cost per pound (or applicable unit of measure). The cost should include any freight or handling charges associated with the materials. Lastly, multiply by the amount of material required to make one unit to reach the standard amount. o The standard DM cost per unit is the standard DM price times the standard DM quantity.

 Direct labor (DL): The DL price standard is based on current wage rates (modified for cost of living adjustments [COLA]) and includes employer taxes and benefits. The DL quantity standard is the time required to produce one unit of product. It is the normal time required. o The standard DL cost per unit of a finished product is the standard DL rate times the standard

direct labor hours (DLH).

 Manufacturing overhead (MOH): Companies begin with a standard predetermined overhead rate (PDOH), which is the budgeted overhead divided by the expected standard activity index. In the past, most companies used a single index (i.e., DLH or machine hours). Today, many firms use activity- based costing (ABC) to incorporate multiple indices, which will produce a more accurate overhead allocation. o The standard MOH cost per unit is the PDOH rate times the activity index quantity standard.

Together, these three components become the total standard cost per unit. Specific examples of these components are further illustrated in the textbook on pages 26-5 through 26-7 (Weygandt et al., 2018).

Variances Variances are the partner that make standard costs useful. Variances are the differences between actual costs and standard costs. Just as there are components to standard costs, there are multiple variances. The total variance equals the sum of materials, labor, and overhead variances. Variances are expressed in dollar amounts and are based on the actual production volume. Each of the three components are further outlined below. The individual variances and the total may be favorable or unfavorable. Variance analysis is the first step in understanding and resolving any number of issues where variance analysis applies, such as cost, production, sales, or cash management.

 Direct materials variances are variances that come about from price or quantity differences. o The total materials variance is the sum of the actual quantity times the actual price and the

standard quantity times the standard price. o The price variance is the actual quantity times the actual price less the actual quantity times the

standard price. o The quantity variance is the actual quantity times the standard price less the standard quantity

times the standard price. What causes the variance? Examining the formulas, you can see that it comes from differences in what the firm paid for the raw materials and differences in production volumes. The root cause may be external price changes in materials, training of production employees, excessive breakdowns in equipment, etc. The following matrix outlines the DL variances, and these formulas are further defined below.

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 The DL variance calculation is much the same as with DM.

 Total labor variance is the difference between the amount paid compared to the expected. The formula is actual hours times the actual rate less the standard hours times the standard rate.

 Labor price variance is the actual hours times the actual rate less the actual hours times the standard

rate.

 Labor quantity variance is the actual hours times the standard rate less the standard hours times the standard rate.

Why is a difference seen? For price variance, the firm either paid workers at different rates than predicted, or labor was misallocated (using higher-skilled labor where lower-skilled labor was predicted). Quantity variance refers to the efficient (or inefficient) use of labor. Root causes could include training shortfalls, equipment breakdown, or poor workplace design.

 Manufacturing overhead variances: Total overhead variance is the difference between actual overhead costs and overhead predicted based on standard hours for the production level. As noted earlier, machine hours or a combination of activity indices may be used rather than labor hours. o The formula for total overhead variance is the actual overhead less the applied overhead. The

total actual overhead is the sum of variable and fixed overhead. As with DM and DL, overhead variance can be further evaluated as controllable (price) or volume (quantity). Causes of overhead variance include increased or decreased use of indirect labor, shared plant equipment, shared technology usage, and utility expense.

Variances may be presented directly in the income statement, illustrating the cost of goods sold (COGS) and gross profit (GP) using standard costs, and individual variances as additions or subtractions to arrive at the actual GP. Another way that variances can be presented is by cost-volume-profit (CVP) or through a contribution margin income statement; an illustration of this can be found on pages 26-11 and 26-12 of the textbook. When using this format, the variances are evaluated in fixed and variable cost components prior to presentation.

Balanced Scorecard The balanced scorecard was previously introduced in Unit V. You may recall that the balanced scorecard incorporates both financial and non-financial measures when evaluating a firm’s performance. When fully implemented, the balanced scorecard cascades into every job description in an organization. In doing so, it focuses every manager and employee on individual contributions to the firm’s goals and objectives.

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There are four perspectives to the scorecard; these include financial, customer, internal process, and learning and growth. These are further explained below.

1. Financial: These are measures used by most business (e.g., sales revenues, profitability). 2. Customer: This is an evaluation by the buyers of the firm’s products and services and in comparison

to competitors (e.g., price, quality, customer service, retention). 3. Internal process: This is an evaluation of business processes, including development, production,

distribution, and servicing. Measures may be innovation, inventory, and quality (waste, errors, and rework).

4. Learning and growth: These include measures of employee skills and skill development, including training programs, employee satisfaction, and communications.

Linking these perspectives pushes company goals and objectives into every manager and employee job description and evaluation. The result is a single performance measurement system where everyone has a part in the success of the firm. While much of this lesson focuses on the standard costs and measurements of manufacturers, the material is applicable across industries and organization size. No matter the industry, it is important to understand costs, what is required to produce a product or service, and how to measure all of the results. Nonprofits and government organizations will also use standard costs in their budget preparation. The remainder of this lesson will focus on capital budgeting.

Planning for Capital Investments The second half of this lesson will shift to longer-term (year or more) capital budgeting. While you may not be as formal as other consumers may, you still evaluate your capital budgeting options the same way, which may include budgeting for vehicles, appliances, and house construction. Questions that a business (and consumer) might ask when considering investments are listed below.

 How long will I need the product or service?

 How long will the product or service last?

 What are the alternatives available to me?

 What are the benefits each alternative provides?

 What are the costs for each alternative? The planning process is similar in most companies. A capital budgeting (investment) committee meets periodically (perhaps quarterly or annually). As capital investments may require large financial sums, the committee may consist of higher management, augmented by professionals representing the discipline (department) affected by the investment. Capital investment decisions can influence the firm’s performance for several years. Good outcomes will propel the firm forward; bad outcomes can lead to bankruptcy.

Capital Budgeting and Cash Payback As accounting managers, you will be tasked with answering management’s questions regarding estimates of benefits and costs of projects over an anticipated usage time. These are estimated and measured using cash flows. Recall discussions and studies you have had regarding the time value of money (TVM). A dollar today is worth a dollar. A dollar 5 years from now is worth less. You will use multiple accepted methods to take time into consideration. Decision-making considerations include funds availability, project independence or dependence, and the risk of success or failure. The most important point to remember is the significance of management and professional judgment. Without good estimates, wrongful capital allocation could take place. There are five methods in use to evaluate capital investments. Two of these methods use TVM techniques (net present value [NPV] and internal rate of return [IRR]). Look at each method below for a more detailed explanation. Cash payback is a straightforward approach to capital budgeting. An estimate is made of the net annual cash flows produced by the investment. It is compared to the cost of the investment. The breakeven time is the payback period.

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The decision rule for cash payback is as follows: The shorter the time, the more attractive the investment. This is the simplest approach but neglects TVM and the proposed project’s profitability.

NPV, also called new present value, estimates annual cash outlays and inputs, but adjusting them with TVM, which is called a discounted cash flow, for time and the firm’s cost of capital creates a much more accurate project evaluation. The decision rule for NPV is that a project is acceptable if the NPV is positive or zero. Assumptions made in the analysis are that cash flows occur at the end of the year; they are immediately reinvested in another alternative with similar returns, and that cash flow can be estimated with certainty.

Profitability index (PI) is the third approach to evaluating capital investment alternatives. This is used to solve the dilemma when multiple projects offer a positive NPV but are mutually exclusive (i.e., selecting one alternative means that another alternative should not be selected). The PI is calculated by dividing the NPV of a project’s cash flows by the initial investment, thus taking into account the size of the capital investment and the discounted cash flows. The decision rule for the profitability index is to select the project with the higher PI. IRR is the fourth approach, which also uses discounted cash flows in the IRR model. The rate is the interest rate, which causes the NPV calculation to be equal to zero. It is also called the interest yield for the investment. The decision rule is to accept a project only when the interest yield is equal to or higher than the required rate of return (normally the firm’s cost of capital). Annual rate of return is the final method to examine. Rather than using discounted cash flows, this approach uses the profitability of a project, which is based on accrual accounting. It is calculated by dividing the expected net annual net income by the average capital investment. The average investment is simply the initial investment added to the salvage value (the value at the end of the projected life) and then divided by two. The decision rule is to accept a project if the rate of return is greater than the required rate of return. Investments with a higher rate of return are chosen before those with lower rates. This approach is simple to use but does not consider TVM. Capital budgeting mathematics are important tools in running the numbers to help management prioritize capital projects. We have looked at five methods each with different mathematic challenges. The two methods that employ discounted cash flow analysis or TVM are most widely used. Additionally, for smaller projects, especially those with a timeframe of less than 2 years, the cash payback method is frequently used. Luckily, today, technological advancements have provided accounting managers with software programs, such as Microsoft Excel and financial calculators (including calculator apps for tablets), to simplify any required calculations. There are also several tutorials that can be found online (such as YouTube) that explain each method and the application of using a calculator or software program. The examples outlined in the following section can be used to answer the questions below.

1. What are the inputs into NPV, IRR, or payback? 2. What are the issues around gathering those inputs?

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A Capital Budgeting Example Assume a project has initial costs of $700,000 and a projected return of $300,000/year. The firm’s cost of capital is 15%. If the discount rate, or cost of capital, is different from 15%, then that would be entered. As noted earlier, using payback for anything over 2 years is problematic; this case stretches a little beyond.

For illustration purposes, identical timeframes for each method (3 years) is used. If the time is longer, there would be entries for Y4, Y5, etc. If the discount rate or cost of capital is different from 15%, then that would be entered.

Additional Factors for Capital Budgeting Before concluding this lesson, there are some additional factors to consider. While there are many issues that may exist in a specific firm and industry, there are three items for general consideration when allocating capital funds, which are detailed below.

 Intangible benefits may include increased quality, improved customer service, and enhanced

customer loyalty from more accurate or faster processing. Some firms choose to ignore intangibles and require investment decisions to be based solely on tangible benefits. There are two options to incorporate intangible benefits in the decision process. o Calculate the value of intangible benefits in sales, profits, etc., and compare the value to the

amount of negative NPV. o Calculate and project conservative estimates for the intangibles, and incorporate them directly

into the NPV calculation and investment assessment.

 Risk analysis is important when projecting investment capital costs and future cash flows. Managers and professionals with specific knowledge are tasked with these estimates. As noted by those making the estimate, projections may have more or less risk associated with the project. In order to take into account a project with a higher risk of attaining the outcomes, an approach is to use a higher discount rate (required rate of return). o This satisfies those concerned with the accuracy of future estimates but may cause some

projects to be rejected that offer high returns.

 A post audit is a consideration for any firm that makes a capital commitment in order to evaluate the progress and results of its investment. If the firm does not audit its capital projects, shame on them. o When a firm commits capital funds to a project that will potentially require multiple accounting

periods to fully implement and multiple accounting periods to earn the return (the economic benefits), always put in place an audit process. The process will mimic the original project evaluation. If projects on outlays and benefits are not happening as proposed, the firm must be able to either halt the project entirely or, at a minimum, make needed alterations (e.g., change personnel, processes, or technology).

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Conclusion Capital budgets implement the firm’s strategy. Evaluating, selecting, and managing the implementation of capital projects is one of management’s most important activities. Now that you have learned about costs, capital budgeting, and investing, can you answer the questions posed at the beginning of this lesson?

Reference Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2018). Accounting principles (13th ed.). Wiley.

https://online.vitalsource.com/#/books/9781119411017

Suggested Unit Resources In order to access the following resources, click the links below. For the video resources below, transcripts and closed captioning are available upon accessing the videos. You will learn about the methods used to evaluate and rank capital investment alternatives in the following video. Cambridge, T. (2017, March 11). Financial management: Capital investment [Video]. Cielo24.

https://c24.page/8ppc2n9ajb8u599x2c83jk28c6 The video below explains the use of the discounted cash flow model to value an investment. Corporate Finance Institute. (2018, June 27). Discounted cash flow (DCF) model [Video]. Cielo24.

https://c24.page/yd54w9e53jbqk45crbqkabxjg4 The following video provides examples for how to calculate standard cost. Croesus Financial Training. (2016, October 25). Standard costing [Video]. Cielo24.

https://c24.page/w7w83egemyxe78v6gbtxq7vygs The following video tutorial provides a thorough presentation of time value of money (TVM). Subjectmoney. (2014, October 21). Time value of money TVM lesson/tutorial future/present value formula

interest annuities perpetuities [Video]. Cielo24. https://c24.page/9wqxdqmc2r75dmhvdt7wnu796t

Learning Activities (Nongraded) Nongraded Learning Activities are provided to aid students in their course of study. You do not have to submit them. If you have questions, contact your instructor for further guidance and information. This is an opportunity for you to express your thoughts about the material you are studying by writing about it. Conceptual thinking is a great way to study because it gives you a chance to process what you have learned, and it increases your ability to remember it. In order to practice what you have learned, please attempt the exercises and problems below, which can be found in your textbook.

https://c24.page/8ppc2n9ajb8u599x2c83jk28c6
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Chapter 26:

 Brief Exercises (BE26.1), page 26-31

 Brief Exercises (BE26.6), page 26-32

 Brief Exercises (BE26.7), page 26-32

 Exercises (E26.6), page 26-34

 Exercises (E26.12), page 26-35

 Problems: Set A (P26.3A), page 26-40

 Expand Your Critical Thinking (CT26.4), page 26-44 Chapter 27:

 Brief Exercises (BE27.1), page 27-28

 Brief Exercises (BE27.5), page 27-28

 Brief Exercises (BE27.9), page 27-29

 Exercises (E27.2), page 27-30

 Exercises (E27.6), page 27-31

 Problems: Set A (P27.3A), page 27-33 If you have any questions or do not understand a concept, contact your professor for clarification. Completing these practice exercises and problems will give you practice, which will be helpful as you complete the assignment for this unit.