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  1. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 306 306 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS smoothly ahead. Managers will need to manage the project actively through to com- pletion. This, in turn, will require further information-gathering exercises. Management should receive progress reports at regular intervals concerning the pro- ject. These reports should provide information relating to the actual cash flows for each stage of the project, which can then be compared against the forecast figures provided when the proposal was submitted for approval. The reasons for significant variations should be ascertained and corrective action taken where possible. Any changes in the expected completion date of the project or any expected variations from budget in future cash flows should be reported immediately; in extreme cases, managers may even abandon the project if circumstances appear to have changed dramatically for the worse. We saw in Real World 8.12, on p. 289, that Rolls-Royce undertakes this kind of reassessment of existing projects. No doubt most other well-managed businesses do this too. Project management techniques (for example, critical path analysis) should be employed wherever possible and their effectiveness reported to senior management. ‘ An important part of the control process is a post-completion audit of the project. This is, in essence, a review of the project’s performance to see if it lived up to expecta- tions and whether any lessons can be learned from the way that the investment process was carried out. In addition to an evaluation of financial costs and benefits, non-financial measures of performance such as the ability to meet deadlines and levels of quality achieved should also be reported. We should recall that total life-cycle costing, which we discussed in Chapter 5, is based on similar principles. The fact that a post-completion audit is an integral part of the management of the project should also encourage those who submit projects to use realistic estimates. Real World 8.15 provides some evidence of a need for greater realism. REAL WORLD 8.15 Looking on the bright side McKinsey and Co, the management consultants, surveyed 2,500 senior managers world- wide during the spring of 2007. The managers were asked their opinions on investments made by their businesses in the previous three years. The general opinion is that estimates for the investment decision inputs had been too optimistic. For example, sales levels had been overestimated in about 50 per cent of cases, but underestimated in less than 20 per cent of cases. It is not clear whether the estimates were sufficiently inaccurate to call into question the decision that had been made. The survey went on to ask about the extent to which investments made seemed, in the light of the actual outcomes, to have been mistakes. Managers felt that 19 per cent of investments that had been made should not have gone ahead. On the other hand, they felt that 31 per cent of rejected projects should have been taken up. Managers also felt that ‘good money was thrown after bad’ in that existing investments that were not performing well were continuing to be supported in a significant number of cases. Source: ‘How companies spend their money: a McKinsey global survey’, www.theglobalmarketer.com, 2007. Other studies confirm a tendency among managers to use overoptimistic estimates when preparing investment proposals. (See reference 1 at the end of the chapter.) It seems that sometimes this is done deliberately in an attempt to secure project approval.
  2. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 307 307 MANAGING INVESTMENT PROJECTS Where overoptimistic estimates are used, the managers responsible may well find themselves accountable at the post-completion audit stage. Such audits, however, can be difficult and time-consuming to carry out, and so the likely benefits must be weighed against the costs involved. Senior management may feel, therefore, that only projects above a certain size should be subject to a post-completion audit. Real World 8.16 describes how two large retailers, Tesco plc and Kingfisher plc, use post-completion audit approaches to evaluating past investment projects. REAL WORLD 8.16 Looking back In its 2008 corporate governance report, Tesco plc, the supermarket chain, stated: All major initiatives require business cases to be prepared, normally covering a minimum period of five years. Post-investment appraisals, carried out by management, determine the reasons for any significant variance from expected performance. In its 2007/8 financial review, Kingfisher plc, the home improvement retailer, stated: An annual post-investment review process will continue to review the performance of all projects above £0.75 million which were completed in the prior year. The findings of this exercise will be considered by both the new Retail Board and the main Board and directly influence the assump- tions for similar project proposals going forward. Sources: The websites of Tesco plc (www.tescocorporate.com) and Kingfisher plc (www.kingfisher co.uk). As a footnote to our discussion of business investment decision making, Real World 8.17 looks at one of the world’s biggest investment projects, which has proved to be a commercial disaster, despite being a technological success. REAL WORLD 8.17 Wealth lost in the chunnel The tunnel, which runs for 31 miles between Folkestone in the UK and Sangatte in Northern France, was started in 1986 and opened for public use in 1994. From a techno- logical and social perspective it has been a success, but from a financial point of view it has been a disaster. The tunnel was purely a private sector venture for which a new busi- ness, Eurotunnel plc, was created. Relatively little public money was involved. To be a commercial success the tunnel needed to cover all of its costs, including interest charges, and leave sufficient to enhance the shareholders’ wealth. In fact the providers of long-term finance (lenders and shareholders) have lost virtually all of their investment. Though the main losers were banks and institutional investors, many individuals, particularly in France, bought shares in Eurotunnel. Key inputs to the pre-1986 assessment of the project were the cost of construction and creating the infrastructure, the length of time required to complete construction and the level of revenue that the tunnel would generate when it became operational. ‘
  3. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 308 308 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS Real World 8.17 continued In the event Construction cost was £10 billion – it was originally planned to cost £5.6 billion. l Construction time was seven years – it was planned to be six years. l Revenues from passengers and freight have been well below those projected – for l example, 21 million annual passenger journeys on Eurostar trains were projected; the numbers have consistently remained at around 7 million. The failure to generate revenues at the projected levels has probably been the biggest contributor to the problem. When preparing the projection, planners failed to take adequate account of two crucial factors: 1 Fierce competition from the ferry operators. At the time (pre-1986), many thought that the ferries would roll over and die. 2 The rise of no-frills, cheap air travel between the UK and the continent. The commercial failure of the tunnel means that it will be very difficult in future for projects of this nature to be funded by private funds. Sources: Annual reports of Eurotunnel plc; Randall, J., ‘How Eurotunnel went wrong’, BBC news, 13 June 2005, www.newsvote.bbc.co.uk. SUMMARY The main points of this chapter may be summarised as follows: Accounting rate of return (ARR) is the average accounting profit from the project expressed as a percentage of the average investment. l Decision rule – projects with an ARR above a defined minimum are acceptable; the greater the ARR, the more attractive the project becomes. l Conclusion on ARR: – Does not relate directly to shareholders’ wealth – can lead to illogical conclusions. – Takes almost no account of the timing of cash flows. – Ignores some relevant information and may take account of some that is irrelevant. – Relatively simple to use. – Much inferior to NPV. Payback period (PP) is the length of time that it takes for the cash outflow for the initial investment to be repaid out of resulting cash inflows. l Decision rule – projects with a PP up to a defined maximum period are acceptable; the shorter the PP, the more attractive the project. l Conclusion on PP: – Does not relate to shareholders’ wealth. – Ignores inflows after the payback date. – Takes little account of the timing of cash flows. – Ignores much relevant information. – Does not always provide clear signals and can be impractical to use. – Much inferior to NPV, but it is easy to understand and can offer a liquidity insight, which might be the reason for its widespread use.
  4. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 309 309 SUMMARY Net present value (NPV) is the sum of the discounted values of the net cash flows from the investment. l Money has a time value. l Decision rule – all positive NPV investments enhance shareholders’ wealth; the greater the NPV, the greater the enhancement and the greater the attractiveness of the project. l PV of a cash flow = cash flow × 1/(1 + r)n, assuming a constant discount rate. l Discounting brings cash flows at different points in time to a common valuation basis (their present value), which enables them to be directly compared. l Conclusion on NPV: – Relates directly to shareholders’ wealth objective. – Takes account of the timing of cash flows. – Takes all relevant information into account. – Provides clear signals and is practical to use. Internal rate of return (IRR) is the discount rate that, when applied to the cash flows of a project, causes it to have a zero NPV. l Represents the average percentage return on the investment, taking account of the fact that cash may be flowing in and out of the project at various points in its life. l Decision rule – projects that have an IRR greater than the cost of capital are accept- able; the greater the IRR, the more attractive the project. l Cannot normally be calculated directly; a trial and error approach is often necessary. l Conclusion on IRR: – Does not relate directly to shareholders’ wealth. Usually gives the same signals as NPV but can mislead where there are competing projects of different size. – Takes account of the timing of cash flows. – Takes all relevant information into account. – Problems of multiple IRRs when there are unconventional cash flows. – Inferior to NPV. Use of appraisal methods in practice: l All four methods identified are widely used. l The discounting methods (NPV and IRR) show a steady increase in usage over time. l Many businesses use more than one method. l Larger businesses seem to be more sophisticated in their choice and use of appraisal methods than smaller ones. Investment appraisal and strategic planning It is important that businesses invest in a strategic way so as to play to their strengths. Dealing with risk l Sensitivity analysis (SA) is an assessment, taking each input factor in turn, of how much each one can vary from estimate before a project is not viable. – Provides useful insights to projects. – Does not give a clear decision rule, but provides an impression. – It can be rather static, but scenario building solves this problem. l Expected net present value (ENPV) is the weighted average of the possible outcomes for a project, based on probabilities for each of the inputs: – Provides a single value and a clear decision rule. – The single ENPV figure can hide the real risk.
  5. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 310 310 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS – Useful for the ENPV figure to be supported by information on the range and dispersion of possible outcomes. – Probabilities may be subjective (based on opinion) or objective (based on evidence). l Reacting to the level of risk: – Logically, high risk should lead to high returns. – Using a risk-adjusted discount rate, where a risk premium is added to the risk-free rate, is a logical response to risk. Managing investment projects l Determine investment funds available – dealing, if necessary, with capital rationing problems. l Identify profitable project opportunities. l Evaluate the proposed project. l Approve the project. l Monitor and control the project – using a post-completion audit approach. ‘ Key terms Accounting rate of return (ARR) Relevant costs p. 283 p. 261 Sensitivity analysis p. 292 Payback period (PP) p. 265 Scenario building p. 295 Net present value (NPV) p. 269 Expected net present value (ENPV) Risk p. 270 p. 296 Risk premium p. 272 Objective probabilities p. 299 Inflation p. 272 Subjective probabilities p. 301 Discount factor p. 276 Risk-adjusted discount rate p. 302 Cost of capital p. 277 Post-completion audit p. 306 Internal rate of return (IRR) p. 279 References 1 Linder, S., ‘Fifty years of research on accuracy of capital expenditure project estimates: a review of findings and their validity’, Otto Beisham Graduate School of Management, April 2005. Further reading If you would like to explore the topics covered in this chapter in more depth, we recommend the following books: McLaney, E., Business Finance: Theory and Practice, 8th edn, Financial Times Prentice Hall, 2009, chapters 4, 5 and 6. Pike, R. and Neale, B., Corporate Finance and Investment, 5th edn, Prentice Hall, 2006, chapters 5, 6 and 7. Arnold, G., Corporate Financial Management, 3rd edn, Financial Times Prentice Hall, 2005, chap- ters 2, 3 and 4. Drury, C., Management and Cost Accounting, 8th edn, Thomson Learning, 2009, chapters 13 and 14.
  6. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 311 311 E XERCISES REVIEW QUESTIONS Answers to these questions can be found in Appendix C at the back of the book. 8.1 Why is the net present value (NPV) method of investment appraisal considered to be theoretic- ally superior to other methods that are found in practice? 8.2 The payback method has been criticised for not taking the time value of money into account. Could this limitation be overcome? If so, would this method then be preferable to the NPV method? 8.3 Research indicates that the IRR method is extremely popular even though it has shortcomings when compared to the NPV method. Why might managers prefer to use IRR rather than NPV when carrying out discounted cash flow evaluations? 8.4 Why are cash flows rather than profit flows used in the IRR, NPV and PP methods of investment appraisal? EXERCISES Exercises 8.3 to 8.8 are more advanced than 8.1 and 8.2. Those with a coloured number have answers in Appendix D at the back of the book. If you wish to try more exercises, visit the students’ side of the Companion Website at www.pearsoned.co.uk/atrillmclaney. 8.1 The directors of Mylo Ltd are currently considering two mutually exclusive investment projects. Both projects are concerned with the purchase of new plant. The following data are available for each project: Project 1 Project 2 £000 £000 Cost (immediate outlay) 100 60 Expected annual operating profit (loss): Year 1 29 18 2 (1) (2) 3 2 4 Estimated residual value of the plant 7 6 The business has an estimated cost of capital of 10 per cent, and uses the straight-line method of depreciation for all non-current (fixed) assets when calculating operating profit. Neither pro- ject would increase the working capital of the business. The business has sufficient funds to meet all capital expenditure requirements. Required: (a) Calculate for each project: (1) The net present value. (2) The approximate internal rate of return. (3) The payback period.
  7. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 312 312 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS (b) State which, if either, of the two investment projects the directors of Mylo Ltd should accept, and why. 8.2 C. George (Controls) Ltd manufactures a thermostat that can be used in a range of kitchen appliances. The manufacturing process is, at present, semi-automated. The equipment used cost £540,000, and has a written-down (balance sheet) value of £300,000. Demand for the product has been fairly stable, and output has been maintained at 50,000 units a year in recent years. The following data, based on the current level of output, have been prepared in respect of the product: Per unit £ £ Selling price 12.40 Labour (3.30) Materials (3.65) Overheads: Variable (1.58) Fixed (1.60) (10.13) Operating profit 2.27 Although the existing equipment is expected to last for a further four years before it is sold for an estimated £40,000, the business has recently been considering purchasing new equipment that would completely automate much of the production process. The new equipment would cost £670,000 and would have an expected life of four years, at the end of which it would be sold for an estimated £70,000. If the new equipment is purchased, the old equipment could be sold for £150,000 immediately. The assistant to the business’s accountant has prepared a report to help assess the viability of the proposed change, which includes the following data: Per unit £ £ Selling price 12.40 Labour (1.20) Materials (3.20) Overheads: Variable (1.40) Fixed (3.30) (9.10) Operating profit 3.30 Depreciation charges will increase by £85,000 a year as a result of purchasing the new machinery; however, other fixed costs are not expected to change. In the report the assistant wrote: The figures shown above that relate to the proposed change are based on the current level of output and take account of a depreciation charge of £150,000 a year in respect of the new equipment. The effect of purchasing the new equipment will be to increase the operating profit to sales revenue ratio from 18.3% to 26.6%. In addition, the purchase of the new equipment will enable us to reduce our invent- ories level immediately by £130,000. In view of these facts, I recommend purchase of the new equipment. The business has a cost of capital of 12 per cent.
  8. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 313 313 E XERCISES Required: (a) Prepare a statement of the incremental cash flows arising from the purchase of the new equipment. (b) Calculate the net present value of the proposed purchase of new equipment. (c) State, with reasons, whether the business should purchase the new equipment. (d) Explain why cash flow forecasts are used rather than profit forecasts to assess the viability of proposed capital expenditure projects. Ignore taxation. 8.3 The accountant of your business has recently been taken ill through overwork. In his absence his assistant has prepared some calculations of the profitability of a project, which are to be discussed soon at the board meeting of your business. His workings, which are set out below, include some errors of principle. You can assume that the statement below includes no arith- metical errors. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 £000 £000 £000 £000 £000 £000 Sales revenue 450 470 470 470 470 Less Costs Materials 126 132 132 132 132 Labour 90 94 94 94 94 Overheads 45 47 47 47 47 Depreciation 120 120 120 120 120 Working capital 180 Interest on working capital 27 27 27 27 27 Write-off of development costs 30 30 30 Total costs 180 438 450 450 420 420 Operating profit/(loss) (180) 12 20 20 50 50 Total profit (loss) (£28,000) = = Return on investment (4.7%) Cost of equipment £600,000 You ascertain the following additional information: The cost of equipment contains £100,000, being the carrying (balance sheet) value of an old l machine. If it were not used for this project it would be scrapped with a zero net realisable value. New equipment costing £500,000 will be purchased on 31 December Year 0. You should assume that all other cash flows occur at the end of the year to which they relate. The development costs of £90,000 have already been spent. l Overheads have been costed at 50 per cent of direct labour, which is the business’s normal l practice. An independent assessment has suggested that incremental overheads are likely to amount to £30,000 a year. The business’s cost of capital is 12 per cent. l Required: (a) Prepare a corrected statement of the incremental cash flows arising from the project. Where you have altered the assistant’s figures you should attach a brief note explaining your alterations. (b) Calculate: (1) The project’s payback period. (2) The project’s net present value as at 31 December Year 0. (c) Write a memo to the board advising on the acceptance or rejection of the project. Ignore taxation in your answer.
  9. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 314 314 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS 8.4 Arkwright Mills plc is considering expanding its production of a new yarn, code name X15. The plant is expected to cost £1 million and have a life of five years and a nil residual value. It will be bought, paid for and ready for operation on 31 December Year 0. £500,000 has already been spent on development costs of the product, and this has been charged in the income statement in the year it was incurred. The following results are projected for the new yarn: Year 1 Year 2 Year 3 Year 4 Year 5 £m £m £m £m £m Sales revenue 1.2 1.4 1.4 1.4 1.4 Costs, including depreciation 1.0 1.1 1.1 1.1 1.1 Profit before tax 0.2 0.3 0.3 0.3 0.3 Tax is charged at 50 per cent on annual profits (before tax and after depreciation) and paid one year in arrears. Depreciation of the plant has been calculated on a straight-line basis. Additional working capital of £0.6m will be required at the beginning of the project and released at the end of Year 5. You should assume that all cash flows occur at the end of the year in which they arise. Required: (a) Prepare a statement showing the incremental cash flows of the project relevant to a deci- sion concerning whether or not to proceed with the construction of the new plant. (b) Compute the net present value of the project using a 10 per cent discount rate. (c) Compute the payback period to the nearest year. Explain the meaning of this term. 8.5 Newton Electronics Ltd has incurred expenditure of £5 million over the past three years researching and developing a miniature hearing aid. The hearing aid is now fully developed, and the directors are considering which of three mutually exclusive options should be taken to exploit the potential of the new product. The options are as follows: 1 The business could manufacture the hearing aid itself. This would be a new departure, since the business has so far concentrated on research and development projects. However, the business has manufacturing space available that it currently rents to another business for £100,000 a year. The business would have to purchase plant and equipment costing £9 mil- lion and invest £3 million in working capital immediately for production to begin. A market research report, for which the business paid £50,000, indicates that the new product has an expected life of five years. Sales of the product during this period are pre- dicted as follows: Predicted sales for the year ended 30 November Year 1 Year 2 Year 3 Year 4 Year 5 Number of units (000s) 800 1,400 1,800 1,200 500 The selling price per unit will be £30 in the first year but will fall to £22 in the following three years. In the final year of the product’s life, the selling price will fall to £20. Variable produc- tion costs are predicted to be £14 a unit, and fixed production costs (including depreciation) will be £2.4 million a year. Marketing costs will be £2 million a year. The business intends to depreciate the plant and equipment using the straight-line method and based on an estimated residual value at the end of the five years of £1 million. The busi- ness has a cost of capital of 10 per cent a year. 2 Newton Electronics Ltd could agree to another business manufacturing and marketing the product under licence. A multinational business, Faraday Electricals plc, has offered to undertake the manufacture and marketing of the product, and in return will make a royalty payment to Newton Electronics Ltd of £5 per unit. It has been estimated that the annual
  10. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 315 315 EXERCISES number of sales of the hearing aid will be 10 per cent higher if the multinational business, rather than Newton Electronics Ltd, manufactures and markets the product. 3 Newton Electronics Ltd could sell the patent rights to Faraday Electricals plc for £24 million, payable in two equal instalments. The first instalment would be payable immediately and the second at the end of two years. This option would give Faraday Electricals the exclusive right to manufacture and market the new product. Required: (a) Calculate the net present value (as at 1 January Year 1) of each of the options available to Newton Electronics Ltd. (b) Identify and discuss any other factors that Newton Electronics Ltd should consider before arriving at a decision. (c) State what you consider to be the most suitable option, and why. Ignore taxation. 8.6 Chesterfield Wanderers is a professional football club that has enjoyed considerable success in both national and European competitions in recent years. As a result, the club has accumulated £10 million to spend on its further development. The board of directors is currently considering two mutually exclusive options for spending the funds available. The first option is to acquire another player. The team manager has expressed a keen inter- est in acquiring Basil (‘Bazza’) Ramsey, a central defender, who currently plays for a rival club. The rival club has agreed to release the player immediately for £10 million if required. A decision to acquire ‘Bazza’ Ramsey would mean that the existing central defender, Vinnie Smith, could be sold to another club. Chesterfield Wanderers has recently received an offer of £2.2 million for this player. This offer is still open but will only be accepted if ‘Bazza’ Ramsey joins Chesterfield Wanderers. If this does not happen, Vinnie Smith will be expected to stay on with the club until the end of his playing career in five years’ time. During this period, Vinnie will receive an annual salary of £400,000 and a loyalty bonus of £200,000 at the end of his five-year period with the club. Assuming ‘Bazza’ Ramsey is acquired, the team manager estimates that gate receipts will increase by £2.5 million in the first year and £1.3 million in each of the four following years. There will also be an increase in advertising and sponsorship revenues of £1.2 million for each of the next five years if the player is acquired. At the end of five years, the player can be sold to a club in a lower division and Chesterfield Wanderers will expect to receive £1 million as a transfer fee. During his period at the club, ‘Bazza’ will receive an annual salary of £800,000 and a loyalty bonus of £400,000 after five years. The second option is for the club to improve its ground facilities. The west stand could be extended and executive boxes could be built for businesses wishing to offer corporate hospitality to clients. These improvements would also cost £10 million and would take one year to complete. During this period, the west stand would be closed, resulting in a reduction of gate receipts of £1.8 million. However, gate receipts for each of the following four years would be £4.4 million higher than current receipts. In five years’ time, the club has plans to sell the exist- ing grounds and to move to a new stadium nearby. Improving the ground facilities is not expected to affect the ground’s value when it comes to be sold. Payment for the improvements will be made when the work has been completed at the end of the first year. Whichever option is chosen, the board of directors has decided to take on additional ground staff. The additional wages bill is expected to be £350,000 a year over the next five years. The club has a cost of capital of 10 per cent. Ignore taxation. Required: (a) Calculate the incremental cash flows arising from each of the options available to the club. (b) Calculate the net present value of each of the options. (c) On the basis of the calculations made in (b) above, which of the two options would you choose and why?
  11. M08_ATRI3622_06_SE_C08.QXD 5/29/09 3:31 PM Page 316 316 CHAPTER 8 MAKING CAPITAL INVESTMENT DECISIONS (d) Discuss the validity of using the net present value method in making investment decisions for a professional football club. 8.7 Simtex Ltd has invested £120,000 to date in developing a new type of shaving foam. The shaving foam is now ready for production and it has been estimated that the new product will sell 160,000 cans a year over the next four years. At the end of four years, the product will be discontinued and replaced by a new product. The shaving foam is expected to sell at £6 a can and the variable cost is estimated at £4 per can. Fixed cost (excluding depreciation) is expected to be £300,000 a year. (This figure includes £130,000 in fixed cost incurred by the existing business that will be apportioned to this new product.) To manufacture and package the new product, equipment costing £480,000 must be acquired immediately. The estimated value of this equipment in four years’ time is £100,000. The business calculates depreciation using the straight-line method, and has an estimated cost of capital of 12 per cent. Required: (a) Deduce the net present value of the new product. (b) Calculate by how much each of the following must change before the new product is no longer profitable: (i) the discount rate; (ii) the initial outlay on new equipment; (iii) the net operating cash flows; (iv) the residual value of the equipment. (c) Should the business produce the new product? 8.8 Kernow Cleaning Services Ltd provides street-cleaning services for local councils in the far south west of England. The work is currently labour-intensive and few machines are used. However, the business has recently been considering the purchase of a fleet of street-cleaning vehicles at a total cost of £540,000. The vehicles have a life of four years and are likely to result in a considerable saving of labour costs. Estimates of the likely labour savings and their probability of occurrence are set out below. Estimated savings Probability of £ occurrence Year 1 80,000 0.3 160,000 0.5 200,000 0.2 Year 2 140,000 0.4 220,000 0.4 250,000 0.2 Year 3 140,000 0.4 200,000 0.3 230,000 0.3 Year 4 100,000 0.3 170,000 0.6 200,000 0.1 Estimates for each year are independent of other years. The business has a cost of capital of 10 per cent. Required: (a) Calculate the expected net present value (ENPV) of the street-cleaning machines. (b) Calculate the net present value (NPV) of the worst possible outcome and the probability of its occurrence.
  12. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 317 9 Strategic management accounting INTRODUCTION Businesses are increasingly being managed along strategic lines. By this we mean that strategies adopted by a business are increasingly providing the basis for both long-term and short-term decisions. If management accounting is to help guide decision making within a strategic framework, the reports provided and techniques used must align closely with the framework that has been put in place. Conventional management accounting has been criticised, however, for failing to address fully the strategic aspects of managing a business. This criticism does not mean that the management accounting techniques discussed so far are obsolete, but it does mean that the subject must continue to develop if it is to retain a high degree of relevance for decision makers. Strategic management accounting is still a fairly new topic and there is no generally agreed set of concepts and techniques that can help us define precisely what is meant by this term. Nevertheless, some key features of this new topic can be identified, and new accounting techniques which are seen as useful for strategic decision making have emerged. We shall begin the chapter by discussing the nature of strategic management accounting and then go on to look at some of the techniques and methods of analysis that fall within its scope. In this chapter we shall draw on the understanding of topics covered in many of the preceding chapters of the book, particularly Chapters 1, 5 and 8.
  13. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 318 318 CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING LEARNING OUTCOMES When you have completed this chapter, you should be able to: Discuss the nature and role of strategic management accounting. l Explain how management accounting information can help a business gain a l better understanding of its competitors and customers. Describe the techniques available for gaining competitive advantage through l cost leadership. Explain how the balanced scorecard can help monitor and measure progress l towards the achievement of strategic objectives. Discuss the role of shareholder value analysis and economic value added in l strategic decision making. What is strategic management accounting? Strategic management accounting is concerned with providing information that will support the strategic plans and decisions made within a business. We saw in Chapter 1 that strategic planning involves five steps: 1 Establishing the mission and objectives of a business. 2 Undertaking a position analysis, such as a SWOT (strengths, weaknesses, opportun- ities and threats) analysis, to establish how the business is placed in relation to its environment. 3 Identifying and assessing the possible strategic options that will lead the business from its present position (identified in Step 2) to the achievement of its objectives (identified in Step 1). 4 Selecting the most appropriate strategic options (from those identified in Step 3) and formulating long- and short-term plans to pursue them. 5 Reviewing business performance and exercising control by assessing actual perform- ance against planned performance (identified in Step 4). To some extent, conventional management accounting already supports this stra- tegic process. We have seen in Chapter 7, for example, how budgets can be used to compare actual performance with earlier planned performance. We have also seen in Chapter 8 the role of investment appraisal techniques in evaluating long-term plans. Nevertheless, there is scope for further development. It can be argued that if manage- ment accounting is fully to support the strategic planning process, it must develop in three broad areas: l It must become more outward looking. There is general agreement that the conven- tional approach to management accounting does not give enough consideration to external factors affecting the business. These factors, however, are vitally important to strategic planning and decision making. For example, we need to understand the environment within which the business operates when we are undertaking a position analysis or when we are formulating plans for the future. Management
  14. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 319 319 FACING OUTWARDS accounting can play a useful role here by providing information relating to the envir- onment, such as the performance of the business’s competitors and the profitability of its customers. l There must be greater concern for developing and implementing methods through which a business can outperform the competition. In a competitive environment, a business must be able to gain an advantage over its rivals, so that it can survive and prosper over the longer term. Competitive advantage can be gained in various ways and one important way is through cost leadership: that is, the ability to produce products or services at a lower cost than that of other businesses. Although conventional manage- ment accounting provides a number of cost determination and control techniques to help a business operate more efficiently, these techniques are not always enough. Rather than seeking simply to count and manage the costs incurred, costs and cost structures may need to be transformed. Thus, management accounting has a role to play in helping to shape the costs of the business to fit the strategic objectives. l There must be a concern for monitoring the strategies of the business and for bringing these strategies to a successful conclusion. This means that management accounting should place greater emphasis on long-term planning issues and on developing a compre- hensive range of performance measures to try to ensure that the objectives of the business are being met. The objectives of a business are often couched in both finan- cial and non-financial terms and so the measures developed must reflect this fact. Let us now turn our attention to the ways in which management accounting can help in each of the three areas identified. Facing outwards If a business is to thrive, it needs to have a good understanding of the environment within which it operates. In particular, it should have a good understanding of the threat posed by its competitors and the benefits obtained from its customers. There is a strong case for reporting certain information relating to competitors and customers, frequently and routinely to managers. By so doing, managers can respond more quickly to any changes in the environment that may occur. In this section we consider some of the techniques and measures that may help managers gain a better under- standing of these two important groups. Competitor analysis To compete effectively, a business needs to acquire a sound knowledge of its main competitors. As well as helping in strategic planning, this knowledge can also help in pricing and business acquisition decisions. When appraising competitors, a business needs to understand l what strategies and plans they have developed; l how they may react to the plans the business has developed; and l whether they have the capability to pose a serious threat to the business. To gain this understanding, a careful analysis of each main competitor should be carried out. ‘ To illustrate the benefits of competitor analysis, let us say that a business proposes to reduce its sales prices by 10 per cent. What would be the reaction of competitors?
  15. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 320 320 CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING Would this reduction be matched by them and thereby cancel out any advantage to be gained? Would it lead to a price war where sales prices follow a downward spiral? If competitors could not match the price reduction, would they be able to continue to supply, given the likely sales volume reduction that they would suffer? We can see that the proposal to reduce prices cannot be fully evaluated until competitors’ likely reac- tion to the proposal is known. Real World 9.1 provides an example of how one business came to realise that it had to pay more attention to the competition. REAL WORLD 9.1 FT Angling for recovery House of Hardy is a world-famous manufacturer of fishing rods and tackle. It enjoys an unrivalled reputation for its products and has a highly skilled workforce. In recent years, however, it has experienced problems, which have been partly caused by global competi- tion. The business is trying to recover and, in analysing its past mistakes, has recognised that it has been rather too complacent in its approach to competitors. As part of its recov- ery plan it is now paying much more attention to what they are doing. It is now analysing the products offered by competitors and reviewing its own pricing policies in an attempt to compete more effectively. Source: Based on information from ‘How Hardy lost the lure of heritage’, ft.com, 1 December 2003. To find out what drives a competitor and how it might act, four key aspects of its business must be analysed. These are: 1 Objectives. Where is the competitor going? In particular, what are its profit objec- tives, what rate of sales growth is it trying to achieve, what market share does it seek? 2 Strategies. How does the competitor expect to achieve its objectives? What invest- ments are being made in new technology? What alliances and joint ventures are being created? What new products are to be launched? What mergers and acquisi- tions are planned? What cost reduction strategies are being developed? 3 Assumptions. How do the competitor’s managers view the world? What assumptions are held about l future trends within the industry; l the competitive strengths of other businesses; and l the feasibility of launching into new markets? 4 Resources and capabilities. How serious is the potential threat? What is the compet- itor’s scale and size? Does it have superior technology? Is it profitable? Does it have a strong liquidity position? What is the quality of its management? These four features provide the framework for analysing competitors, as shown in Figure 9.1. Gathering information to answer the questions posed above is not always easy. Businesses are understandably reluctant to release information that may damage their competitive position. Nevertheless, there are sources of information that can be used. We shall now consider some of these and, given the management accounting focus of
  16. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 321 321 FACING OUTWARDS Figure 9.1 Framework for competitor analysis There are four key aspects of a competitor that should be examined. this book, will concentrate on those sources providing information about the financial resources and capabilities of competitors. A useful starting point is to examine a competitor’s annual report. In the UK, all lim- ited companies are legally obliged to provide information about their business in an annual report that is available to the public. Similar provisions relate to limited com- panies in most countries in the world. The income statement, cash flow statement and statement of financial position (balance sheet) found in the annual report of a com- petitor can be examined to gain insights about its financial performance and position. Financial ratios may be used to help gain an impression of the profitability, liquidity, efficiency and financing arrangements of the business. Trends may be detected over time and particular strengths and weaknesses identified. Where the competitor is not the whole business, but simply an operating division, the annual reports are likely to be less helpful. This is because the results of the relev- ant division will normally be obscured as a result of its aggregation with the rest of the competitor’s operations. Though large businesses operating as limited companies must publish some information about the sales revenues and profits of their various operating divisions, this is often not enough to enable a full picture of the competitor to be built up. Nonetheless, a competitor’s annual report should still offer some useful information. Furthermore, a business will have detailed knowledge of its own profitability, liquidity, efficiency and so on, which may well help in compiling a pic- ture of the competitor’s position. It may be possible to gain other information from both published and unpublished sources. This could be from l press coverage of the competitor’s business; l statements by managers made at conferences or on the competitor’s website;
  17. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 322 322 CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING l house journals, brochures and catalogues produced by the competitor; l market share data and discussions with financial analysts; l discussions with customers who trade both with the business and with the competitor; l discussions with suppliers to both the business and its competitor; l physical observation, such as insights from ‘mystery shopping’; l detailed inspection of the competitor’s products and prices; l industry reports; and l government statistics on such matters as the total size of the market. By examining such sources, it may be possible to deduce likely capital investments, acquisitions, promotional campaigns, new products and prices, cost structures and so on. It is worth mentioning that specialist agencies can be employed to provide a profile of competitors. These agencies normally rely on the kind of information sources described above. Of particular value to the business is knowledge of its competitors’ cost structures in terms of the extent to which costs are fixed and variable. This would enable the business to make some estimate of the effect on the competitors’ profit of an increase or decrease in sales volume. This might, in turn, enable the business to assess how well placed each competitor might be to react to a change in sales volume and/or sales price. For example, a competitor with a high level of fixed costs (high operating gear- ing) and, consequently, a low margin of safety may not be able to withstand a down- turn in sales volume as comfortably as another business with lower operating gearing. Real World 9.2 concludes this section by revealing that many businesses are not alert to the moves made by competitors and so fail to gain competitive advantage. REAL WORLD 9.2 Too little, too late A global survey of 1,825 business executives by McKinsey, the management consultants, found that businesses were not as active as they should be in responding to competitive threats or monitoring the behaviour of competitors. The survey asked executives how their businesses responded to either a significant change in prices or to a significant change in innovation. The answers of executives were strikingly similar across regions and industries. A majority of executives stated that their businesses found out about the competitive move too late to respond before it hit the market. Thirty-four per cent of those facing an innovation threat and 44 per cent of those facing a pricing change said that they found out about the competitors’ moves either when they were announced or when they actually hit the market. An additional 20 per cent of the respondents facing a price change didn’t find out until it had been in the market place for at least one or two reporting periods. These findings suggest that businesses are not conducting an ongoing, sophisticated analysis of their competitors’ potential actions. That view was supported by the execu- tives’ responses to questions on how they gather information about what competitors might do. Executives most often said that they track information using news reports, industry groups, annual reports, market share data and pricing data. Far fewer respon- dents obtained information from more complex sources such as detailed examination of the products or mystery shopping. Source: Adapted from ‘How companies respond to competitors: a McKinsey global survey’, mckinseyquarterly.com, May 2008.
  18. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 323 323 FACING OUTWARDS Customer profitability analysis Businesses wish to attract and retain customers that produce profitable sales orders. It is, therefore, important to know whether a particular customer, or type of customer, generates profits for the business. Modern businesses are likely to find that much of the cost incurred is not related to the products sold but to the selling and distribution costs associated with those sales. This has led to a shift in emphasis from product profitabil- ity to customer profitability. ‘ Customer profitability analysis (CPA) assesses the profitability of each customer or type of customer. In order for CPA to be undertaken, the total costs associated with sell- ing and distributing goods or services to particular customers must be identified. These include the cost of l Handling orders from the customer. This covers the costs involved with receiving the order and activities relating to it up to the point where the goods are despatched, or the service rendered, including the costs of raising invoices and other accounting work. Visiting the customer by the business’s sales staff. Many businesses have a member of l staff visit customers, perhaps to take orders, but often to keep the customer up to date with the latest developments in the business’s products. Delivering goods to the customer, using either a delivery service provided by another l business, or the business’s own transport. Naturally, the distance involved and the size and fragility of the goods will have an effect on this cost. Inventories holding. Some customers may require a particular level of inventories l to be held by the business: for example, a customer operating a ‘just-in-time’ raw material delivery policy. This can require deliveries to be made frequently and at short notice, in effect putting pressure on the supplier to hold higher inventories levels. (We shall discuss ‘just-in-time’ inventories management in more detail in Chapter 11.) Offering credit. The business will have to finance any credit allowed to its customers. l This could vary from customer to customer, depending on how promptly they pay. After-sales support. Technical assistance or servicing may be offered as part of the l sales agreement. These customer-related costs are probably best determined using an activity-based costing approach to cost allocation. This means that, once customer-related costs are identified, cost drivers must be established and appropriate cost driver rates deduced. Activity 9.1 Imam plc identified the following costs relating to its customers: Order handling l Invoicing and collection l Shipment processing l Sales visits l After-sales service. l Suggest a possible cost driver for each of the items identified. ‘
  19. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 324 324 CHAPTER 9 STRATEGIC MANAGEMENT ACCOUNTING Activity 9.1 continued We thought of the following: Customer-related cost Possible cost driver Order handling Number of orders placed Invoicing and collection Number of invoices sent Shipment processing Number of shipments made Sales visits Number of sales visits made After-sales service Number of technical support visits made These are only suggestions. Other factors may be found that drive each cost. Once customer-related costs are derived, a CPA statement, which is essentially an abbreviated income statement, can be produced for each customer and/or type of customer. The CPA statement will show the relevant sales revenues and, in addition to the customer-related costs identified earlier, will include the basic cost of creating or buying-in the goods or services supplied (that is, cost of goods sold) and any general selling and administration costs of the business. Example 9.1 illustrates a CPA statement. Example 9.1 Imam plc – CPA statement for December Customer A plc B plc C plc D plc £000 £000 £000 £000 Sales revenue 125 75 80 145 Cost of goods sold (87) (52) (56) (101) Gross profit 38 23 24 44 General selling and administrative costs (19) (11) (12) (22) Customer-related costs Order handling (4) (2) (2) (4) Invoicing and collection (4) (2) (2) (4) Shipment processing (6) (4) (4) (8) Sales visits (7) (1) (1) (2) After-sales service (6) – (1) – Profit/(loss) for the month (8) 3 2 4 Where all customers are sold products at the same price, the top part of the CPA statement, which is concerned with deducing the gross profit, may be viewed as relating to product profitability. The bottom part of the CPA statement, which is the part below the gross profit figure, may be viewed as relating to customer profitability. To analyse customer profitability, we can express each of the costs found in this part as a percentage of gross profit. The following table provides the results.
  20. M09_ATRI3622_06_SE_C09.QXD 5/29/09 3:32 PM Page 325 325 F ACING OUTWARDS Customer A plc B plc C plc D plc % % % % Gross profit 100.0 100.0 100.0 100.0 General selling and administrative costs 50.0 47.8 50.0 50.0 Customer-related costs Order handling 10.5 8.7 8.3 9.1 Invoicing and collection 10.5 8.7 8.3 9.1 Shipment processing 15.8 17.4 16.7 18.2 Sales visits 18.4 4.3 4.2 4.5 After-sales service 15.8 – 4.2 – Profit/(loss) for the month (21.0) 13.0 8.3 9.1 100.0 100.0 100.0 100.0 The information generated shows that one customer, A plc, is generating a loss. To find out whether this is a persistent problem, trend analysis can be undertaken which plots the customer-related costs as a percentage of gross profit over time. An example of a trend analysis for A plc is shown in Figure 9.2. Figure 9.2 Trend analysis for A plc The trend in customer-related costs is shown as a percentage of gross profit for A plc, the loss-making customer.
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