On reading this chapter in the study guide, I have to say I am a little bit sad to see this is our last chapter for review as this may be an unpopular opinion but this is the aspect of this unit I have actually enjoyed the most (can you believe it!) But for me, I am not studying to be an accountant, I like the people side of things and enjoyed being able to relate this back to what managers do to help me to comprehend the concept of accounting (and I am still not amazingly confident yet but understanding this is not my strong suit is something I am ok with.
The key concepts I have identified in this chapter express that managers need to make decisions everyday that affect the accounting and business reality of their firms in the short term and in the long term.
Because resources are limited, care and attention needs to be devoted to these decisions of managers. Widely used techniques to assist with this take into account the time value of money (which is a dollar now means more than a dollar in the future as it’s worth is uncertain in the future).
It is key for managers to focus on aspects significant to a particular decision and in particular what costs matter to that individual decision prior to making it. The managers should ask themselves, what costs and benefits are likely to be effected because of this decision, and then they are the items to take into account when making that particular decision (relevant to every decision a manager makes).
Sunk costs are costs incurred in the past (past decisions) – being unavoidable costs or already paid so these can’t be considered when pondering future decision. When reading the study guide and discovering an example of sunk costs was advertising fees – this is something I can easily link and follow, so this chapter was getting off to a great start.
The next point I noted was in relation to when a manager is deciding between alternative prospects that any benefits in common to each option would not be included in making the decision as either the cost or the benefit will still be there regardless of the option chosen. Only differential or incremental costs apply to the decision making process.
More relevant questions managers need to ask themselves are
- can this cost be avoided?
- what is the opportunity cost of this decision?
- what are the replacement costs?
Opportunity cost is something that is familiar to me from other units so I was excited to be able to have an item I have actual prior knowledge of (for a change) when reading along, the weighing up of if I do this, what do I miss out on instead is something people use in every situation not just business, as well as the idea of scarcity, it makes for interesting decision making.
However replacement costs seem rather self-explanatory as the cost to replace a resource rather than the initial purchase cost. These costs and questions are important as to consider and make plans for the future is a major part of a manager’s role and they can only do that in relation to decisions relating to the future based on decisions of the past and the current resources they have to hand.
Ideally, managers make decisions they believe will add the most value to the fixed costs and profits of their firm.
· Fixed costs are not those that change with the changes in volume or activity levels – whereas variable costs do change in these circumstances.
A major note in the study guide was that the key to management accounting is Contribution Margin
Contribution Margin = Sales Revenue – Variable Costs
*Products needs to contribute to fixed costs and profit for positive contribution margins and products with negative contribution margins should be avoided!
Negative contribution margins are when the firms variable costs are greater than the profits received from a particular product. They reduce profitability.
There will always be other things to consider in making decisions such as limitation of resources, demand for product, fixed costs and there will always be other people other than equity investors to consider such as suppliers, customers, employees and the general public. Martin made a great point in the study guide that not all important factors are included in the accounting numbers but understanding contribution margins in relations to potential new products or directions, knowing there are limitations, can assist managers greatly.
Resource constraint and market demand constraint are identified a being important to this decision making process in relation to Product mix decisions, which are decisions managers need to make on how much of their products their firm should procure/make and try to sell.
- calculate the contribution margin for each product
- remove any products that have a negative contribution margin
- with remaining products – calucluate the contribution margin per unit of the resource constraint (e.g limited steel)
- Rank each product by contribution margin per unit of resource constraint
- Use information to choose which products to sell (that have the highest contribution margin until the resource runs out or demand is no longer there).
Long term consequences occur in decisions being made involving investing large monetary amounts in non-current assets of the firm for a benefit over some years.
Some firms are in capital-intensive industries (needing large capital investment) and some are not therefore these decisions mean different things to different firms.
Some approaches that managers rely when evaluating capital investment opportunities are the Accounting Rate of Return (ARR) – which uses accounting profits and the Payback period – both of which assume that money carries its same value from today into the future.
ARR (%) = Average Net Profit
Initial investment x 100
The Payback Period of an investment is the expected length of time for an investment to return the initial investment amount and for it to be considered no longer possible to lose money on that investment.
This payback period being considered a measure of risk is a good way to remember this concept – the shorter the period the shorter the time of making loss.
Payback period = Initial investment
Cash flow
In the case of where cash flow from an investment each year is to vary – the cumulative cash flow is calculated for each year –the payback period does ignore the cash flow expected after the repayment of the initial investment amount though.
Discounting cash flows where we can take into consideration the time value of money would be the Internal Rate of Return and the Net Present Value.
These methods are used when we are discounting the expected future cash flows from an investment. These methods are widely used and valued by accountants.
Internal Rate of Return of a potential investment – uses expected future cash flow and acknowledges the time value of money. It is where the net present value of projected future cash flow in the investment reaches zero.
It is noted that a weakness of this method is when an investment is to have a series of outflows of cash rather than a single and initial cash outflow – can have multiple internal rate of return.
The Net Present Value approach measures dollar value added for investors by investment opportunities. It will discount all expected future net cash flow by a discounted rate. The actual discounted rate used can be difficult to define but it is based on the capital used in the investment).
A positive Net Present Value equals a good investment where a negative Net Present Value equals a decline in value and negatives Net Present Value should be avoided.
Management accounting is required to assist with both of the above methods to forecast the future cash flows.
IRR and NPV are DCF – discounted cash flow techniques
DCF assumes each year’s cash flow can be reinvested to earn returns for the life of the investment and that discounting cash flow compounds back from 10 years. DCF techniques are used as a measure of the effect decisions have on the equity investors only but there are so many other factors that we simply can’t include everything in our considerations.
IRR method assumes cash flow reinvestment levels are the same as return on the internal rate of return used in calculations.
NPV method assumes cash flow will be reinvested at the discounted rate, which could be the same as the IRR when the NPV is equal to zero – otherwise it would be different.
The final point that I had noted down from the study guide was that with any approach or technique to be used, there will always be limitations to the use of them and for them to be successful we need to understand what we are doing and what limitations are there so that long term decisions by managers can be analysed for future options with the use of past contribution margins, managers have their best chance at making solid decisions for their firms.
The questions that I have now from reading this chapter are more to do with my company and the next steps in our assignment 2. I am fearful that as my company is a parent company and mainly has services rather than products –will this hinder my chances at the next steps as if I had an easier company or picked a company that had more clearly defined products, could I have a better chance at success. Regardless, I will put my best efforts in anyway and we will have to see how we go!
I have found this chapter to be very interesting to read and I have enjoyed learning more about the techniques mangers can employ to assist them in making decisions for their firms for both the short term and the long term. It is nice to know that there are specific techniques and not just guess work that makes companies succeed.
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