AC 4104 - STRATEGIC

COST MANAGEMENT
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 OVERVIEW OF STRATEGIC COST MANAGEMENT
 Strategy – is a set of policies, procedures and approaches to business that produce long-term
success. It is a set of goals and specific action plans that if, achieved, provide the desired
competitive advantage.
 Strategic Management – involves the development of a sustainable competitive position in
which the firm’s competitive advantage spells continued success. It involves identifying and
implementing these goals and action plans
 Strategic Cost Management – involves the development of cost management information to
facilitate the principal management function which is strategic management. It is the process
that aims to strengthen a company’s strategic position by carefully controlling costs according
the company’s broader objectives.
 Cost Management Information – is the information that the manager needs to effectively
manage the firm, profit oriented as well as not-for-profit organization. This includes financial
information about cost and revenues as well as relevant nonfinancial information about
productivity, quality and other key success factors for the firm.
 Cost Management – is the practice of accounting in which the accountant develops and uses cost
management information. For competitive success, it is enough to emphasize only on financial
information. This could lead management to stress cost reduction (a financial measure) while
ignoring or even lowering quality standards (a nonfinancial measure). This decision could be a
critical mistake which could lead to the loss of customers and market share in the long run.
 Uses of Cost Management Information:
 1. Strategic Management. Management must make sound strategic decisions regarding the
choice of products, manufacturing methods, marketing techniques and channels and other long-
term issues.
 2. Planning and Decision Making. Cost management information is needed to support recurring
decision such as managing cash flows, budgeting raw material purchases, scheduling production,
etc. Planning and decision-making involves budgeting and profit planning, cash flow management
and other decision related to the firm’s operation such as deciding whether to lease or buy a
facility, whether to replace or just repair an equipment, when to change a marketing plan or
when to begin new product development.
 3. Management and Operational Control. Cost management information is needed to
provide a fair and effective basis for identifying inefficient operations and to reward
and motivate the most effective managers.
 Operational control – takes place when mid-level managers (e.g., product managers,
regional managers) monitors activities of operating-level managers and employees (e.g.,
production supervisors, department heads).
 Management control – is the evaluation of mid-level managers by upper-level manager
(e.g., Controller or the Chief Financial Officer).
 4. Reportorial and Compliance to Legal Requirements. Require management to
comply with the financial reporting requirements to regulatory agencies such as the
Securities and Exchange Commission (SEC), Bureau of Internal Revenue (BIR), and other
relevant authorities and agencies. The financial statement information also serves the
other three management functions as these information is often as important part of
planning and decision making, control and strategic management.
 Management Accountant’s Role in Strategic Cost Management
 Management Accounting – involves the application of appropriate techniques and concepts
to economic data so as to assist management in establishing plans for reasonable economic
objectives and in the making of rational decision with a view towards achieving these
objectives. It is the process of identification, measurement, accumulation, analysis,
preparation, interpretation and communication of financial information, which is used by
management to plan, evaluate and control activities within an organization.
 Management accountants – are concerned with providing information to managers, that is,
people inside the organization who direct and control the operations. They are accounting
professionals who develop and analyze cost management and other information.
 Administrative functions that must be performed by management accountant to
provide a system which allows management to receive the necessary information:
 a. Planning – which involves setting of goals for the firm, evaluating the various ways to
meet the goals and picking out what appears to be the best way to meet the goals.
 b. Controlling – which involves the evaluation of whether actual performance
conforms with plan goals; and
 c. Decision making – which involves determination of predictive information
(e.g. relevant costs) for making important business decisions.
 Relationship Between Cost Accounting and Cost Management
 Cost accounting – is a systematic set of procedures for recording and reporting
measurements of the cost of manufacturing goods and performing services. It
includes methods for recognizing, classifying, allocating, aggregating and
reporting such costs and comparing them with standard costs.
 Cost Management – needs the output of cost accounting and its purpose is to
provide managers with information which aids decision. The accounting report
should be tailored to the needs of the decision and the decision maker.
 Strategic Decision Making and the Cost Management Accountant
 Basic Cost Management Perspectives:
 a. Strategic Management Perspective – The enterprise generates profits by attracting
customers willing to pay for the goods and services it offers. . The key to company’s
success is creating value for customers while differentiating itself from the competitors.
Customer value fall into three (3) broad categories, namely: customer intimacy,
operational excellence, and product leadership.
 b. Enterprise Risk Management Perspective – is a process use by an entity to identify
those risks and develop responses.
 c. Corporate Social Responsibility (CSR) Perspective – is a concept where business
organizations consider the needs of all stakeholders when making decisions. They are
responsible not only not only for creating strategies that produce financial results that
satisfy shareholders but also to serve other stakeholders such as customers, suppliers,
employees among others whose interest are tied to the company’s performance.
 d. Process Management Perspective – Most companies organized themselves as functional
departments such as Marketing Department, Research and Development Department, and the
Accounting department. Effective managers, however, understand that business processes, more
than functional departments serve the needs of the company’s most important stakeholders – its
customers. A business process is a series of steps that are followed in order to carry out some tasks
in a business. The term value chain is often used to describe how an organization’s functional
departments interact with one another to form a business process. A Value chain consists of the
major business functions that add value to a company’s products and services.
 e. Leadership Perspective – To achieve success, organizational leaders must able to unite the
behaviors of the fellow employee who have diverse needs, beliefs and goals to the workplace.
Leaders need to understand how the following factors influence human behavior:
 1. Internal motivation –refers to motivation that comes from within one’s self. A leader who is
perceived by employees as credible and respectful of their values to the company can increase the
extent to which those employees are intrinsically motivated to pursue strategic goals.
 2. External incentives – such as bonus compensation are given by many organizations to highlight
important goals and to motivate employees to achieve them.
 3. Cognitive Bias – leaders should be aware that all people (including themselves) should possess
cognitive bias or distorted thought processes such as promoting false assertion that can adversely
affect planning, controlling and decision making. To reduce if not totally eliminate cognitive biases,
a leader may routinely appoint independent team of employees to assess the credibility of
recommendation set forth by other individuals and groups.
 F. An Ethics Perspective – without fundamental trust in the integrity of the business, the economy
would operate much less efficiently. Therefore for the benefit of everyone, including profit-making
companies, it is vitally important that the business be conducted within the ethical framework that
builds and sustain trust. Professional management accountants have developed and implemented a
set of Ethical Standards for practitioners
 Advantages of Strategic Cost Management
 Strategic Cost Management provides number of benefits to different organizations. It has provided
the business with an improved understanding of its sources of profits. Some benefits are given below:
 1. It has developed a framework for reviewing the strategic allocation of resources across the
business based on core business processes and activities.
 2. It has improved the business understanding of its cost drivers leading to improved articulation of its
strategic plans in cost terms.
 3. It has enabled the business to assess, at a high level, how activity-based techniques can be deployed at
different levels in the business to improve its cost management process, such as in budgeting and in process
improvement.
 Uses of Cost Management Information
 Cost management information is needed for each of the following management functions, namely:
 1. Strategic Management. Involves the development of a sustainable competitive position in which the
firm’s competitive advantage spells continued success. It involves identifying and implementing these goals
and action plans. Management must make sound strategic decisions regarding the choice of products,
manufacturing methods, marketing techniques and channels and other long-term issues.
 The strategic emphasis requires an integrated approach which combines skills from all business functions,
namely: marketing< production< finance and accounting/controllership, is necessary in a dynamic and
competitive environment
 Due to increasing strategic issues, cost management has moved from a traditional role of product costing
and operational control to a broader strategic focus: strategic cost management.
 2. Planning and Decision-making. Cost management information is needed to support recurring
decision such as replacing and maintaining equipment, managing cash flows, budgeting raw material
purchases, scheduling production, pricing and managing distribution of products to customers, etc.
 Planning and decision-making involves budgeting and profit planning, cash flow management and
other decision related to the firm’s operation such as deciding whether to lease or buy a facility,
whether to replace or just repair an equipment, when to change a marketing plan or when to begin
new product development.
 3. Management and Operational Control. Cost management information is needed to provide a fair
and effective basis for in identifying inefficient operations and to reward and motivate the most
effective in managing.
 Operational control – takes place when mid-level managers (e.g., product managers, regional
managers) monitors the activities of operating-level managers and employees such as product
supervisors, department heads.
 Management control – is the evaluation of mid-level managers by upper-level managers such as
Controller or the Chief Financial officer (CFO).
 4. Reportorial and Compliance to Legal Requirements. Reportorial and compliance responsibilities
require management to comply with the financial reporting requirements to regulatory agencies such
as the SEC, BIR and other relevant government authorities and agencies.
 The financial statement preparation role has recently received a renewed new focus and interest as
accounting scandals have shown how crucial and important accurate financial information is for
investors. Financial statement information also serves the other three management functions as this
information is often an important part of planning and decision making, control and strategic
management.
 Traditional Cost Management
 Traditional cost management is an accounting method used to determine the cost of making products
to make profit, and it is based on allocating overhead (or indirect) manufacturing costs. This system
relies on calculating predetermined overhead rates and applying the rates to a given metric.
 Traditional costing system use estimated overhead rates for specific cost driver. A cost driver is an
element of the manufacturing process that may incur costs, such as: managerial expenses.
Packaging, machine hours, etc.
 The traditional costing system in accounting is the allocation of factory overhead to products which
is based on the volume of consumed production resources. Companies using this method will apply
overhead to either the number of machine hours used or the direct labor hours which were
consumed.
 Under traditional costing, one would add an average overhead rate to the direct costs of
manufacturing goods or providing services. It is applied on the basis of cost driving, reflecting what is
required to produce finished products.
 Limitations of Traditional Cost Management
 The following are the disadvantages of the Traditional Cost System:
 1. It offers limited accuracy, even in the best of situations.
 2. It wants to ignore unexpected circumstances
 3. It is not always a helpful system
 4. Its simplicity may be too simple
 5. It does not account for non-manufacturing cost
 Ethical Standards for Practitioners of Management Accounting and Financial Management
 Practitioners of management accounting and financial management have responsibility to:
 1. Competence. (a) Maintain an appropriate level of professional competence by ongoing
development of their knowledge and skills; (b) Perform their professional duties in accordance
with relevant laws, regulations, and technical standards; (c) Prepare complete and clear reports
and recommendations after appropriate analysis of relevant and reliable information.
 2. Confidentiality. (a) Refrain from disclosing confidential information acquired in the course of
their work except when authorized, unless legally obligated to do so; (b) Inform subordinates as
appropriate regarding the confidentiality of information acquired in the course of their work and
monitor their activities to assure the maintenance of that confidentiality; (c) Refrain from using
or appearing to use confidential information acquired in the course of their work for unethical or
illegal advantage either personally or through third parties.
 3. Integrity. (a) Avoid actual or apparent conflict of interest and advise all appropriate parties
of any potential conflict; (b) Refrain from engaging in any activity that would prejudice their
ability to carry out their duties ethically;
 (c) Refuse any gift, favor, or hospitality that would influence or would appear
to influence their actions; (d) Refrain from either actively or passively
subverting the attainment of the organization’s legitimate and ethical
objectives; (e) Recognize and communicate professional limitations or other
constraints that would preclude responsibility judgment or successful
performance of an activity; (f) Communicate unfavorable as well as favorable
information and professional judgment or opinions; and (g) Refrain from
engaging in or supporting any activity that would discredit the profession.
 4. Objectivity. (a) Communicate information fairly and objectively; and (b)
Disclose fully all relevant information that could reasonably be expected to
influence an intended user’s understanding of the reports, comments, and
recommendations presented.
 Contemporary Business Environment
 The business environment in recent years has been characterized by increasing competition and
relentless drive for continuous improvement. These changes include:
 1. An increase in global competition;
 2. Advances in manufacturing technologies;
 3. Advances in information technologies, the Internet, and e-commerce;
 4. Greater focus on the customer;
 5. New forms of management organizations; and
 6. Changes is social, political, and cultural environment of business.
 A Greater Focus on Customers
 To succeed in this area, customer value is the focus that businesses of all types must concerned with.
Producing value for the customers has changed the orientation of managers from low-cost production of
large quantities to quality service, faster delivery and ability to respond to the customer’s desire for
specific features.
 Generally, firms choose a strategic position corresponding to one of two general strategies:
 a) Cost leadership
 b) Superior product through differentiation
 Successful pursuit of cost leadership and/or differentiation strategies requires an understanding of
a firm’s value chain (internal) and supply chain (external).
 Strategic Focus of Cost Management
 Phases of the development of cost management systems should consider the following:
 Stage 1: Cost management systems are basic transaction reporting systems.
 Stage 2: Cost management systems focus on external financial reporting. The objective is reliable
financial reports, accordingly, the usefulness for cost management is limited.
 Stage 3: Cost management systems track key operating data and develop more accurate and
relevant cost information for decision making; cost management information is developed.
 Stage 4: Strategically relevant cost management information is an integral part of the system.
 Implementing Strategy
 Balanced Scorecard – translates an organization’s mission and strategy into a set of
performance measures that provides the framework for implementing the strategy.
 The balance scorecard the non-financial objectives that an organization must achieve to meet
its financial objectives. It measures an organization’s performance from four (4) perspectives:
 1. Financial perspective. Measures of profitability and market value among others, as
indicators of how well the firm satisfies its owners and stockholders.
 2. Customer Satisfaction. Measures of quality service and low cost, among others, as
indicators of how well the firm satisfies its customers.
 3.Internal Business Processes. Measures of the efficiency and effectiveness with which the
firm produces the product or service.
 4. Innovation and Learning. Measures of the firm’s ability to develop and utilize human
resources to meet the strategic goals now and into the future.
 Strategic Measures of Success
 The strategic cost management system develops strategic information, including both financial and non-
financial information.
 Financial performance measures include among others:
 a. Growth in sales and earnings
 b. Cash flows
 c. stock price
 They show the impact of the firm’s policies and procedures in the firm’s current financial position and
therefore, its current return to the stockholders.
 Non-financial measures of operation include among others
 a. Market share
 b. Product quality
 c. Customer satisfaction
 d. Growth opportunities
 The nonfinancial factors show the firm’s current and potential competitive position as measured
from three additional perspective, namely:
 1. the customer;
 2. internal business process; and
 3. innovation and learning
 Strategic financial and nonfinancial measures of success are also commonly called Critical
Success Factors (CSFs).
 COMPETITIVE STRATEGIES
 For a firm to sustain a competitive position, it must purposefully or as a result of market forces,
arrive at one of the two competitive strategies, namely:
 1. Cost Leadership – this is a competitive strategy in which a firm succeeds in producing products
or services at the lowest cost in the industry. A firm that is a cost leader makes sustainable profits
at lower prices, thereby limiting the growth of competitions in the industry through its success in
undermining the profitability of competitors.
 2. Product Differentiation – this strategy is implemented by creating a perception among
consumers that the product or service is unique in some important way, usually by being of high
quality, features or innovation. This perception allows the firm to charge higher prices and
outperform the competition in profits without reducing costs significantly.
 CONTEMPORARY COST MANAGEMENT TECHNIQUES
 Managers commonly used the following tools to implement the firm’s broad strategy and to
facilitate the achievement of success on critical success factors:
 a) Total Quality Management. To survive in an increasingly competitive environment, firms
realize that they must produce high-quality products. As a result , an increasing number of
companies have instituted total quality management programs to ensure that their products are
of the highest quality and that production processes are efficient. Total quality management
(TQM) – is a technique in which management develops policies and practices to ensure that a
firm’s products and services exceed customer expectations. Most companies with TQM develop a
company that stresses listening, making products right the first time, reducing defective products
that must be reworked and encouraging workers to continuously improve their production process.
 b) Just-In-Time (JIT). Is the philosophy that activities are undertaken only as needed or demanded. JIT is a
product system also known as pull-it-through approach, in which materials are purchased and units are
produced only as needed to meet actual customer demand. In a JIT system, inventories are reduced to the
minimum and in some cases, zero.
 Just-In-Time JIT) production –is a system in which each component on a production line is produced
immediately as needed by the next step in the production line. In a JIT production line, manufacturing
activity at any particular work station is prompted by the need for that station’s output at the following
station.
 c) Process Reengineering
 Reengineering – is a process for creating competitive advantage in which a firm reorganizes its operating
and management functions, often with the result that jobs are modified, combined or eliminated. It is
defined as “fundamental rethinking and radical redesign of business process to achieve dramatic
improvements in critical contemporary measures of performance, such as cost, quality, service and speed.
 Process reengineering – is a radical approach where a business process is diagrammed in detail, questioned
and then completely redesigned in order to eliminate unnecessary steps, to reduce opportunities for errors
and to reduce costs.
 A business process – is any series of steps that are followed in order to carry out some task
in a business.
 The main objective of this approach is the simplification and elimination of wasted effort
and the central idea is that all activities that do not add value to product or service should
be eliminated.
 d) Benchmarking. Is a process by which a firm determines its critical success factors,
studies the best practices of other firms (or other units within a firm) for achieving these
critical success factors, and implements improvements in the firm’s processes to match or
beat the performance of those competitors.
 e) Mass Customization. Many manufacturing and service firms increasingly find that
customers expect product and services to be develop for each customer’s unique needs.
 Mass customization – is a management technique in which marketing and production
processes are designed to handle the increased variety that results from delivering
customized products and services to customers.
 f) Balanced Scorecard. Is an accounting report that includes the firm’s critical success
factors in four areas, namely: a) financial performance, b) customer satisfaction, c)
internal business process, and d) innovation and learning. The concept of balance
captions the intent of broad coverage, financial and non financial of all factors that
contribute to the success of the firm in achieving its strategic goals.
 g) Activity-based Costing and Management
 Activity analysis – is used to develop a detailed description of the specific activities
performed in the operation of the firm. Many firms have found that they can improve
planning , product costing operational control, and management control by using activity
analysis to develop a detailed description of the specific activities performed in the
firm’s operations. It provides the basis for activity-based costing and activity-based
management.
 Activity-based costing (ABC) – is used to improve the accuracy of cost analysis by
improving the tracing of costs to product or to individual customers.
 Activity-based management (ABM) – uses activity analysis to improve operational
control and management control. ABC and ABM are key strategic tools for many
firms specially those with complex operations, or great diversity of products.
 h) Theory of Constraints (TOC). Is a sequential process of identifying and
removing constraints in a system. The theory of constraints emphasizes the
importance of managing the organization’s constraints or barriers that hinder or
impede progress toward an objective.
 The Theory of Constraints approach is a perfect complement to Total Quality
Management and Process Reengineering – it focuses improvement efforts where
they are likely to be more effective.
 i) Life Cycle Costing. Is a management technique to identify and monitor the costs
of a product throughout its lifecycle. It consists of all steps from product design
and purchase of raw materials to delivery of and service of the finished product
 J. Target Costing. Involves the determination of the desired cost for a product or the basis of
a given competitive price so that the product will earn a desired profit. The basic relationship
that is observed in this approach is:
 Target cost = Market determined price – Desired profit
 The entity using target costing must often adopt strict cost-reduction measures to meet the
market price and remain profitable. This is a common strategic approach used by intensely
competitive industries where even small price differences attract customers to the lowest-
priced product.
 k) Computer-Aided Design and Manufacturing. Most companies are using computer-aided
design (CAD) and computer-aided manufacturing (CAM) to respond to changing customer tastes
more quickly.
 Computer-aided design (CAD) – is the use of computers in product development, analysis and
design modification to improve the quality and performance of the product, whereas,
Computer-aided manufacturing (CAM) – is the use of computers to plan, implement, and
control production.
 l) Automation. Involves and requires a relatively large investment in computers,
computer programming, machines, and equipment. Many firms add automation
gradually, one process at a time.
 A flexible manufacturing system (FMS) – is a computerized network of automated
equipment that produces one or more groups of parts or variations of a product in
a flexible manner.
 Computer-integrated manufacturing (CIM) – is a manufacturing system that
totally integrates all office and factory functions within a company via a computer-
based information network to allow hour-by-hour manufacturing management.
 m) E-Commerce. This E-Commerce business model has also attracted many
investors to pursue the use of Internet in conducting business. Established
companies will undoubtedly continue to expand into cyberspace – both business-to-
business transactions and for retailing.
 n) The Value Chain. It refers to the sequence of business functions in which usefulness
is added to the products or services of a company . The term value refers to the increase
in the usefulness of the product or service and a result its value to the customer.
 The value chain is an analysis tool that firms use to identify the specific steps required
to provide a product or service to the customer. The key idea of this concept is that the
firm studies each step in its operation to determine how each contributes to the firm’s
competitiveness and profits.
 Analyzing the firm’s value chain helps management discover which steps of activities are
not competitive, where costs can be reduced, or which activity should be outsourced,
and how to increase value for the customer at one or more of the steps of the value
chain. When properly implemented, these approaches can (a) enhance quality, (b)
reduce costs, (c) increase output, and (d) eliminate delays in responding to customers.
 Internal value chain – is the set of activities required to design, develop, produce,
market and deliver products or services to customers.
 CAPITAL INVESTMENT DECISIONS
 Capital investment decisions – are concerned with the process of panning, setting goals and
priorities, arranging financing, and using certain criteria to select long-term assets. Because capital
investment decisions place large amounts of resources at risk for long periods of time and
simultaneously the future development of the firm, they are among the most important decisions
managers make. Capital budgeting is the process of making capital investment decisions
 Categories of Capital Investments. The 2 general types of capital investment decisions are:
 Independent projects – are projects that, if accepted or rejected, do not affect the cash flows of
other projects. Acceptance or rejection of one product line does not require the acceptance or
rejection of the other product line. Thus, the investment decisions for the product lines are
independent of each other.
 Mutually exclusive projects – are those projects that, if accepted, preclude the acceptance of all
other competing projects. Once a project is chosen, the other is excluded; they are mutually
exclusive. These are projects which require the company to choose from among specific alternatives.
The project to be acceptable must pass the criteria of acceptability set by the company and be better
than other investment alternatives.
 Payback and Accounting Rate of Return: Non-discounting Methods
 Nondiscounting models ignore the time value of money, whereas discounting models
explicitly considers it.
 Payback Period
 Payback period – is the time required for a firm to recover its original investment. When the
cash flows of a project are assumed to be even, the following formula can be used to compute
the project’s payback period:
 Payback period = Original investment / Annual cash flows
 If the cash flows are uneven, the payback period is computed by adding the annual cash flows
until such time as the original investment is recovered.
 Decision Rule: The desirability of the project is determined by comparing the project’s
payback period against the maximum acceptable payback period as predetermined by
management. The project with shorter payback period will be accepted: Thus, if PB period <
Maximum allowable PB then, accept; If PB period is > Maximum allowed PB period, reject.
 Illustration: Suppose that a company is  Answers:
considering two different and mutually exclusive  (1) PB period for Project A:
projects (A and B), where both have a five-year  P2,100,000 / P100,000 = 3.0 years
life and require an investment of P2,100,000.
The cash flow patterns for each project are  (2) PB period for Project B (uneven CFs):
given below:  Annual Time needed
 Project A: Even cash flows of P700,000 per year
 Cash flow for payback
 Project B: P1,200,000, P1,000,000, P900,000,
P500,000, and P300,000  Yr. 1: P2,100,000 1,200,000 1.0 year
 Yr. 2: 900,000 1,000,000 0.9 year
 Required: (1) Calculate the payback period for
project A, (2) Calculate the payback period for  PB period 1.9 years
project B. Which project should be accepted  Project B should be accepted because it has a shorter
based on payback analysis; and (3) What if a payback period.
third mutually exclusive project, Project C  (3) PB period for Project C:
became available with the same investment and
annual cash flows of P1,000,000? Now which
 P2,100,000 / 1,000,000 = 2.1 years
project would be chosen?  Project B still has the better payback of 1.9 yrs.
Accounting Rate of Return
Accounting rate of return (ARR) – is the second commonly used nondiscounting model. The
ARR measures the return on a project in terms of income, as opposed to using project’s cash
flow. It is computed by the following formula:
Accounting rate of return (ARR) = Average income / Original Investment
Average income is computed by summing annual income over the life of the project and then
dividing by the number of years of the project.
Unlike the payback period, the accounting rate of return (ARR) does consider a project’s
profitability; like the payback period, it ignores the time value of money. Ignoring the time
value of money is a critical deficiency and can lead a manager to choose investments that do not
maximize profits.
Discounting models use discounted cash flows, which are future cash flows expressed in terms
of their present value. The use of discounting models requires an understanding of the present
value concepts.
 Decision Rule:
 Under the ARR method, choose the project with the highest rate of return.
Accept the project if the ARR is greater than the cost of capital. Thus:
 If: ARR > Required rate of return; Accept
 If: ARR < Required rate of return; Reject
 Required rate of return – is the minimum acceptable rate of return. It is also
referred to as the discounted rate or the hurdle rate and should correspond to
the cost of capital.
 Cost of capital – is the weighted average of the costs from various sources,
where the weight is defined as the relative amount from each source.
 Illustration: Assume that an investment requires
an initial outlay of P3,000,000 with no salvage
value. The life of the investment is five years
with the following yearly cash flows (in
chronological sequence): P900,000, P900,000,
P1,200,000, P900,000, and P1,500,000
 Required:
 1. Calculate the average income.
 2. Calculate the accounting rate of return.
 3. What if a second competing project had the
same outlay and salvage value but had the
following cash flows (in chronological sequence):
P1,500,000, P1,200,000, P900,000, P900,000, and
P900,000. Using the ARR metric, which project
should be selected, the first or the second? Which
project is really the better of the two?
 Answers:
 1. Average income:
 N/I (5,400,000 – 3,000,000) = P2,400,000
 A/I (P2,400,000 / 5 years = P480,000
 2. ARR = Ave. income / Original investment
 = P480,000 / P3,000,000 = 16%
 3. The second project has an identical ARR
of 16%, thus the metric would say there is
no difference between the two projects.
However, the second project would be
preferred even though it provides the same
total cash because it returns larger amount
of cash sooner than the first project.
 The Net Present Value Method
 Net present value (NPV) – is the difference in the present value of the cash inflows and
outflows associated with a project. It is the excess of the present value of cash inflows
generated by the project over the amount of the initial investment. This is computed as
follows:
 Present value of cash inflows computed based on
 minimum desired discount rate P xx
 Less: Present value of investment xx
 Net present value (NPV) P xx
 Decision Rule: For independent project proposal, accept it if NPV is positive or zero and reject
if NPV is negative. In short:
 If: NPV > 0; Accept
 If: NPV < 0; Reject
 Discounted Rate of Return / Internal Rate of Return
 Discounted rate of return, also known as internal rate of return (IRR) – is
the rate which equates the present value of the future cash inflows with the
cost of the investment which produces them.
 Decision Rule: Accept the proposal investment if DCR or IRR is equal to or
greater than minimum desired rate of return or cost of capital. Reject the
proposal if IRR is lower than the minimum desired rate of return. In short:
 If: IRR = or > Required rate of return; Accept
 If: IRR < Required rate of return; Reject
 Discounted Payback Period
 Discounted payback method – is a method that recognizes the time value of
money in a payback context. This is used to compute the payback in terms of
discounted cash flows received in the future. That is, the periodic cash flows
are discounted using an appropriate cost of capital rate.
 The payback period is computed using the discounted cash flow values rather
than actual cash flows.
 Decision Rule: If the project’s discounted payback (DPB) is shorter than the
maximum allowable discounted payback set by the company, the project
should be accepted. If the project’s DPB is longer than the maximum
allowable DBP set by the company, the project should be rejected.
 Illustration – Payback / Discounted Payback
 A project requiring an investment of P170,000is expected to generate the following cash flows:
 Year 1 60,000
 Year 2 60,000
 Year 3 60,000
 Year 4 60,000
 Year 5 60,000
 Required:
 a) What is the payback period? 2.833 years
 b) If the cost of capital is 15%, what is its discounted payback period? 4 years
 c) Should the project be accepted if the maximum allowable DPB is 3 years? Rejected
 Illustration: Net Present Value (NPV)
 ABC wants to invest in a machine costing P80,000with a useful life of six years and no salvage value. The
machine will be depreciated using the straight-line method and is expected to produce annual cash inflow
from operations, net of income tax, of P22,000. The present value of an ordinary annuity of 1 for 6 periods at
10% is 4.355. The present value of P1 for six periods at 10% is 0.564.
 Required:
 a) Assuming that ABC wants a minimum rate of return of 10%, what is the net present value of this proposed
investment?
 b) Is the proposal acceptable?
 Solution:
 a) PV of annual cash inflows (P22,000 x 4.355) = P95,810
 Less: PV of net investment = 80,000
 Net present value P15,810
 b) Yes, the proposal is acceptable because the proposal could earn more than the minimum return that the
firm desires as indicated by the positive net present value.
 COST-VOLUME-PROFIT (CVP) ANALYSIS
 Basic Concepts for CVP Analysis
 The fundamental concept underlying CVP analysis is that the firm’s costs can be broken
down into variable and fixed costs. A useful tool for organizing the firm’s costs into fixed
and variable categories is the contribution-margin-based income statement.
 Illustration: The company plans to sell 10,000 snowboards at P400 each in the coming
year. Product costs include: direct materials per snow board is P80; direct labor per
snow board is P125; and variable overhead per snow board is P15. Total fixed factory
overhead is P800,000. Variable selling expense is a commission of 5% of price and fixed
selling and administrative expenses total P400,000.
 Required: a) Variable product cost per unit; b) Selling expense per unit; c) Variable cost
per unit; d) Contribution margin per unit; e) Contribution margin ratio; and f) Total fixed
expense.
 Solution:
 a) Variable product cost per unit = DM + DL + VO
 = P80 + 125 + 15 = P220
 b) Selling expense per unit = P400 x 5% = P20
 c) Variable cost per unit = DM + DL + VO + VSE
 = P80 + 125 + 15 + 20 = P240
 d) Contribution margin per unit = Price – Variable cost per unit
 = P400 – 240 = P160
 e) Contribution margin ratio = (Price – Variable cost per unit) / Price
 = (P400 – 240) / P400 = 0.40 = 40%
 f) Total fixed expense = P800,000 + 400,000 = P1,200,000
 *BEP sales volume = Fixed costs and expenses / CM per unit
 *BEP peso sales = Fixed costs and expenses / CM ratio
 *Sales volume with desired profit = (Fixed costs and expenses + Desired profit) / CM per unit
 *Peso sales with desired profit = (Fixed costs and expenses + Desired profit) / CM ratio
 Illustration 1: If competitive selling price per unit is P4 and variable cost per unit is P3 and fixed
costs and expenses of P20,000. What is the BEP sales volume and BEP peso sales?
 Solution: BEP sales volume = P20,000 / P1 = 20,000 units
 BEP peso sales = P20,000 / (P1/P4) or 25% = P80,000
 Illustration 2: Based on the preceding example, if the entity wants a desired profit of P10,000.
What is the sales volume and peso sales?
 Solution: Sales volume = (P20,000 + P10,000) / P1 = 30,000 units
 Sales amount = (P20,000 + P10,000) / (P1/P4) or 25% = P120,000