1.)When, If Ever, Are Fixed Costs Differential?
1.)When, if ever, are fixed costs differential?
Fixed costs are only fixed in the short-run so any long-run decision may have differential fixed costs. For instance, decisions affecting capacity would include differential fixed costs. Differential cost is the difference between the cost of two alternative decisions, or of a change in output levels. The concept is used when there are multiple possible options to pursue, and a choice must be made to select one option and drop the others. The concept can be particularly useful in step costing situations, where producing one additional unit of output may require a substantial additional cost. In essence, you can line up the revenues and expenses from one decision next to similar information for the alternative decision, and the difference between all line items in the two columns is the differential cost. A differential cost can be a variable cost, a fixed cost, or a mix of the two – there is no differentiation between these types of costs, since the emphasis is on the gross difference between the costs of the alternatives or change in output. Since a differential cost is only used for management decision making, there is no accounting entry for it. There is also no accounting standard that mandates how the cost is to be calculated(Stokey, 2009).
2.)How is the evaluation of short-term pricing decisions different from the evaluation of long-term decisions?
Short-term pricing decisions are based on differential costs, any price higher than differential costs will increase profits even if it is lower than full cost. However, in the long-term, prices must cover the full cost of producing the product. One of the most crucial production-related decisions of the firm involves selecting which products to produce, which to postpone, and which to delete from the firm's product line. The product mix decision is determined, in large part, by the economics of their production. However, the costs that are relevant for evaluating a product mix are influenced by the decision's time horizon. In the short run, the costs relevant for evaluating a product are the flexible cost of resources used in its production, as well as the opportunity cost of using a bottleneck activity. In the long run, a company's management can adjust its contractual and managerial policies governing labor and overhead resources to meet its production needs. In effect, over an extended time horizon, a company s committed cost is subject to management control. The ability to change these costs over the long run transforms them from a committed into a flexible cost. Therefore, the incremental cost for evaluating the economics of manufacturing a product in the long run is the cost of all resources used in its production(Kee, 2001).
While production-related decisions are heavily influenced by economic considerations, other attributes of the production process can also play a significant role in determining which products to produce. One of the most important of these factors is the capacity of the firm's production activities. A firm's production and support activities interact to create a system for developing and manufacturing a firm's products. In the short run, the capacity of the firm's support and production activities is fixed. Therefore, the most constrained activity is the system's bottleneck that restricts its operations and determines the production opportunities available to the firm. If the firm attempts to minimize inventory and there are not alternative uses for production-related activities, a bottleneck activity limits the use of resources by non-bottleneck activities, causing the firm to incur unused capacity. The cost of unused resources represents expenditures that increase the cost of the firm's operations and decrease its profitability(Kee, 2001). Consequently, the selection of a product mix and its profitability, in the short run, is heavily influenced by the capacity of the firm's support and production activities.
In the long run, a firm's management can adjust the capacity of its production and support activities. Therefore, the product mix decision can be made independent of capacity considerations. However, to achieve the profitability forecast from analysis of products, the capacity of the firm's support and production activities must be adjusted to the capacity needed to produce the products. If an activity has less capacity than required to manufacture a product mix, a bottleneck will be created that restricts production and changes the set of products that may be optimal to produce. Conversely, if some activities have more capacity than needed in the long run, then unused capacity cost will be incurred. The cost of unused capacity represents a non-value added cost that decreases the profit that may be earned from a product mix(Kee, 2001). Consequently, the profitability of the product mix selected in the long run implicitly assumes that the capacity of the firm's production and support activities will be adjusted to that needed to produce the product mix.
3.)Should facility-sustaining costs be considered in making a short-term pricing decision?
No. Facility-sustaining costs are fixed in the short-term; they will be incurred regardless of production level. Therefore, they are not differential and should not be considered in a short-term pricing decision. Both theory of constraints and activity-based costing provide information that can be useful to decision makers if they interpret and use the information properly. Managers must understand the strengths and weaknesses of both methodologies before they use TOC or ABC information to make decisions. TOC is useful for decisions requiring short-run accounting information. ABC information provides estimates of the long-run cost of organizational activities and cost objects, which can be useful for long-term decisions. The TOC and ABC models, therefore, are complementary rather than conflicting(MacArthur, 1993).
4.)When is the use of full cost information appropriate for pricing decisions?
Full cost information is appropriate for long-term pricing decisions. Surveys show that many firms use full cost to set prices. However, principles of relevant costing imply that product prices should be independent of how a firm allocates fixed manufacturing cost to products. Recent research tries to resolve this conflict between theory and practice by expanding the scope of the problem; pricing is only one part of the larger problem of determining which products to keep and which products to drop, how much capacity to install, and how to allocate available capacity among the products. An emerging view is that we must jointly consider the capacity-planning and product-pricing problems to clarify the role of full costing in these decisions(Balakrishnan, 2002).
5.)Describe the relevant costs for make-or-buy decisions.
The costs that are relevant for make-or-buy decisions are the differential costs.
Business decision that compares the costs and benefits of manufacturing a
product or product component against purchasing it. If the purchase price is higher than what it would cost the manufacturer to make it, or if the manufacturer has excess capacity that could be used for that product, or the manufacturer's suppliers are unreliable, then the manufacturer may choose to make the product. This assumes the manufacturer has the skills and equipment necessary, access to raw materials, and the ability to meet its own product standards. A company who chooses to make rather than buy is at risk of losing alternative sources, design flexibility, and access to technological innovations.
6.)Describe the two distinct decisions of the capital budgeting process.
The first: which projects should be undertaken?
The second: once a project is to be undertaken, how shall the fundsrequired be raised? Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings). It is the process of allocating resources for major capital, or investment, expenditure. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders. Management must allocate the firm's limited resources between competing opportunities (projects), which is one of the main focuses of capital budgeting. Capital budgeting is also concerned with the setting of criteria about which projects should receive investment funding to increase the value of the firm, and whether to finance that investment with equity or debt capital. Investments should be made on the basis of value-added to the future of the corporation. Capital budgeting projects may include a wide variety of different types of investments, including but not limited to, expansion policies, or mergers and acquisitions. When no such value can be added through the capital budgeting process and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program(O’Sullivan, 2005).
7.)Explain the factors that influence the market rate of interest a company must pay for borrowed funds.
The "pure" rate of interest representing the productivity of capital over the term of the loan; a risk factor reflecting the riskiness of the project; the rate of inflation anticipated over the term of the loan. Interest rate levels are in essence determined by the laws of supply and demand. In an economic environment in which demand for loans is high, lending institutions are able to command more lucrative lending arrangements. Conversely, when banks and other institutions find that the market for loans is a tepid one (or worse), interest rates are typically lowered accordingly to encourage businesses and individuals to take out loans.
Interest rates are a key instrument of American fiscal policy. The Federal Reserve determines the interest rate at which the federal government will bestow loans, and banks and other financial institutions, which establish their own interest rates to parallel those of the "Fed," typically follow suit. This ripple effect can have dramatic impact on the U.S. economy. In a recessionary climate, for instance, the Federal Reserve might lower interest rates in order to create an environment that encourages spending. Conversely, the Federal Reserve often implements interest rate hikes when its board members become concerned that the economy is "overheating" and prone to inflation(Heilbroner, 1994).
Another key factor in determining interest rates is the lending agency's confidence that the money—and the interest on that money—will be paid in full and in a timely fashion. Default risk encompasses a wide range of circumstances, from borrowers who completely fail to fulfill their obligations to those that are merely late with a scheduled payment. If lenders are uncertain about the borrower's ability to adhere to the specifications of the loan arrangement, they will often demand a higher rate of return or risk premium. Borrowers with an established credit history, on the other hand, qualify for what is known as the prime interest rate, which is a low interest rate(Heilbroner, 1994).
8.)“If an investment does not fit with an organization’s strategic plan, it is probably not a good idea, even if the net present value is positive.” Under what conditions would this be a true statement? When would it be false?
The statement is generally true. Investments should be made that are consistent with the company’s strategy. Sometimes a deal comes along that is too good to pass up. In such a case, a company might depart from its strategic plan(or revise the plan to accommodate the investment).
9.)How, if at all, should the amount of inflation incorporated in the cost of capital influence projected future cash flows for a project?
If the cost of capital used to discount future cash flows incorporates an inflation premium, then the projected cash flows should be considered in light of that assumed inflation. It need not be true that specific cash flows will increase by the same percentage as the rate of the projected general inflation. Still, it makes sense to consider the effect of general price increases in the economy on the cash flows specific to a given project. Note the mathematical equivalence of reducing the cost of capital or increasing the cash flows, so long as the rate of increase in cash flows is the same each period.
Capital budgeting or investment appraisal is a process which anticipates expenses pertaining to assets as well ascash flows in the future. Investment appraisal takes into account the various factors which impact expenditure in
the long run. Inflation is one such factor, which impacts investments and returns. Inflation and capital budgeting are closely related and at no cost capital budgeting can be completed withouttaking into account inflation. It is a known fact that inflation causes our purchasing power to decline. So, if we
buy an asset for $ 5,000 today, it is probable that the same asset can be bought
for $ 10,000 after a couple ofyears. However, it is assumed that the project cost as well as net revenues increase in a proportionate mannerwith inflation. For this reason, in reality rates of inflation are not taken into account. But this is not true always,inflation does affect capital budgeting. Inflation and capital budgeting are bound to affect cash flows(Taneja, 2012).
10.)In measuring the cost of capital, management often measures the cost of the individual equities. A firm has no contractual obligation to pay anything to common shareholders. How can the capital they provide be said to have a cost other than zero?
Although there is no contractual obligation, shareholders do expect a return or they will invest elsewhere. If a company uses an opportunity cost of capital computed by setting the cost of stockholders' equity to zero, they will undertake some projects that are less profitable than they should. Common stockholders will want to sell their stock which will drive down the market price of the stock. Management's responsibility is to maximize the wealth of shareholders.
PDQ 1.)In chapter 7 of the text (page 249), answer case study question #27.
(Squeaky Clean; customer profitability analysis.)
Note: Amounts are in thousands.
AlternativeStatus QuoDifference
Drop
Super 6
MotelTotal
Revenues (Fees Charged)....$ 350$ 580 $ 230 Lower
Operating Costs:
Cost of Services (Variable) 305 517 212 Lower
Salaries, Rent, and General
Administration (Fixed) 55 55 0
Total OperatingCosts..... 360 572 212 Lower
Operating Profit (Loss)...... $ (10)$ 8$ 18 Lower
Squeaky should not drop the Super 6 Motel account in the short run as
profits would drop by $18,000.
PDQ 2.)In chapter 8 of the text (page 291), answer case study questions #23 a,
b and c.(Nugget Company; Net present value and mutually exclusive projects)
a.
EndDiscountCash Flows Present Value of Cash
ofFactorsFlows
Yearat 12%AMDNECAMDNEC
0 1.00000 $ (1,000,000)$ (1,500,000) $ (1,000,000) $ (1,500,000)
1 0.89286 400,000 800,000 357,144 714,288
2 0.79719 400,000 600,000 318,876 478,314
3 0.71178 300,000 500,000 213,534 355,890
4 0.63552 200,000 0 127,104 0
$ 16,658 $ 48,492
b.Internal rates of return:
AMD = 12.9%NEC = 14.0%
c.Conclusion
Net present value of cash flows discounted at 12 percent is greater for the NEC project than for the AMD project.
Choose the NEC project because it has higher net present value of cash flows and because the net present value is positive. Also, the internal rate of return is higher for NEC.
References
Balakrishnan, R., & Sivaramakrishnan, K. (2002). A critical overview of the use of full-
cost data for planning and pricing. Journal of Management Accounting Research.
Retrieved January 1, 2014, from
Heilbroner, R., &Thurow, L. (1994).Economics Explained: Everything You Need to Know About How the Economy Works and Where It's Going. Touchstone.
Kee, R. (2001). Evaluating The Economics Of Short- And Long-Run Production-Related
Decisions. Journal of Managerial Issues,13(2). Retrieved January 1, 2014, from
Issues/77386449.html
MacArthur, J. B. (1993). Theory of constraints and activity-based costing: Friends or
foes? Journal of Cost Management (Summer): 50-56.
O’Sullivan, Arthur & Sheffrin, S. (2005). Economics: principle in action(pp.375). Upper
Saddle River, New Jersey07458: Pearson Prentice Hall
Stokey, N. (2009). The economics of inaction stochastic control models with fixed costs
(pp. 109-110). Princeton: PrincetonUniversity Press.
Taneja, B., & Maheshwari, R. (2012). Impact of Inflation on Capital Budgeting.
International Journal of Business and Management Research,2(4), 159-166. Retrieved January 1, 2014, from
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