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CHAPTER 16
COST ANALYSIS FOR
DECISION MAKING
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Learning Objectives
1. What are the meaning and
application of the following “cost”
terms: differential, allocated, sunk,
and opportunity?
2. How are costs determined to be
relevant for short-run decisions?
3. What is the special pricing decision
when a firm is at full vs. idle
capacity?
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Learning Objectives
4. What are the attributes of capital
budgeting that make it a significantly
different activity from operational
budgeting?
5. Why is present value analysis
appropriate in capital budgeting?
6. What is the concept of the cost of
capital, and why is it used in capital
budgeting?
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Learning Objectives
7. What are the uses of and differences
between various capital budgeting
techniques: net present value, present
value ratio, and internal rate of return?
8. How are issues concerning estimates,
income taxes, and the timing of cash
flows and investments treated in the
capital budgeting process?
9. How is the payback period of a capital
expenditure project calculated?
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Learning Objectives
10. How is the accounting rate of return
of a project calculated, and how can it
be used most appropriately?
11. Why are not all management
decisions make strictly on the basis of
quantitative analysis techniques?
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Learning Objective 1
• What are the meaning and
application of the following “cost”
terms: differential, allocated,
sunk, and opportunity?
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Strategic,
Operational, and
Financial Planning
Implement Plans
Planning and Control Cycle
Performance
Analysis:
Plans vs.
Actual Results
(Controlling)
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Data Collection and
Performance Feedback
Executing
Operational
Activities
(Managing)
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Cost Classifications for Other
Analytical Purposes
• A differential cost is one that will differ
according to the alternative activity
selected
• Allocated costs are those that have
been assigned to a product or activity
using some sort of arithmetic process
– Do not arbitrarily allocate costs because
costs may not behave the way assumed in
the allocation method
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Learning Objective 2
• How are costs determined to be
relevant for short-run decisions?
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Relevant Costs
• Short-run decisions may affect only a
few days or weeks
• Can involve:
– The utilization of resources not otherwise
active
– The opportunity to reduce costs by
adjusting the mix of resources
– The ability to improve profits by further
processing a product
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Decision Analysis
Classifications
• Relevant costs are:
– Differential costs
– Opportunity costs
• Irrelevant costs are:
– Allocated costs
– Sunk costs
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Learning Objective 3
• What is the special pricing
decision when a firm is at full
vs. idle capacity?
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Special Pricing Decision
• Firm is presented with a special offer for their
product below the normal selling price
• Need to know where the firm is operating
relative to capacity
• Need to consider only relevant costs – not
allocated fixed costs
• Also must consider other factor such as affect
on other customers
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Learning Objective 4
• What are the attributes of capital
budgeting that make it a significantly
different activity from operational
budgeting?
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Capital Budgeting
• Capital budgeting is the process of
analyzing proposed capital expenditures
• Capital expenditures are investments in
plant, equipment, new products, etc.
• Want to determine if a large enough
return on the investment can be
generated over time
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Capital Budgeting vs.
Operational Budgeting
• The time frame being considered is different
– longer – in capital budgeting
• Capital budgeting provides an overall
blueprint to help the firm meet its long-term
growth objectives
• Operational budget reflects firm’s strategic
plans to achieve current period profitability
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Learning Objective 5
• Why is present value analysis
appropriate in capital budgeting?
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Investment Decision
Special Considerations
• Investment decisions involve committing financial
resources now in anticipation of a return in the
future
• The time value of money must be considered due
to the length of time involved
• Most firms have more investment opportunities
than resources available
• Capital budgeting procedures help management
identify favorable alternatives
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Qualitative Factors
• Factors other than quantitative factors also
must be considered
• Must consider things such as competitive
risk, managements’ personal goals, effects
of selling additional stock if necessary
• Usually large expenditures require the
approval of the board of directors
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Learning Objective 6
• What is the concept of the cost
of capital, and why is it used in
capital budgeting?
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Cost of Capital
• The cost of capital is the rate of return on
assets that must be earned to permit the
firm to meet its interest obligations and
provide the expected return to owners
• Determining a firm’s cost of capital is a
complex process
• Cost of capital is a composite of borrowing
costs and stockholder dividends and
earnings’ growth potential
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Discount Rate
• The cost of capital is the discount rate
used to determine the present value of
the investment proposal being analyzed
• The discount rate is the interest rate at
which future period cash flows are
discounted
• Ranges from 10 – 20%
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Capital Budgeting Techniques
• Methods that use present value
analysis:
• Net present value (NPV) method
• Internal rate of return (IRR) method
• Methods that do not use present value
analysis:
• Payback method
• Accounting rate of return method
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Variables Used in Capital
Budgeting Methods
• All methods use the amount to be
invested
• The amount of cash generated by the
investment is used in the NPV, IRR,
and payback methods
• The accounting rate of return uses
accrual accounting net income resulting
from the investment
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Learning Objective 7
• What are the uses of and
differences between various
capital budgeting techniques: net
present value, present value ratio,
and internal rate of return?
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Net Present Value
• Net present value method involves
calculating the present value of the
expected cash flows from the project
using the cost of capital as the discount
rate
• Then the net present value result is
compared to the amount of investment
required
• NPV often referred to as the hurdle rate
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Internal Rate of Return
• The IRR method solves for the actual
rate of return that will be earned by the
investment
• The IRR is the discount rate at which the
present value of the cash flows from the
project will equal the investment in the
project
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Learning Objective 8
• How are issues concerning
estimates, income taxes, and
the timing of cash flows and
investments treated in the
capital budgeting process?
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Some Analytical
Considerations
• Estimates – the validity of the present value
calculations will depend on the accuracy of the
cash flow projections
• Cash flows far in the future – due to uncertainty,
usually do not consider cash flows more than ten
years in the future
• Timing of cash flows within the year – present value
factors assume cash flows are received at the end
of the year, but usually received throughout the
year
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Some More Analytical
Considerations
• Investment made over a period of time –
payments on the project may be made
over a period of time, so interest on cash
disbursements needs to be considered
• Income tax effects of cash flows from the
project – must include income tax
expenditures in cash flow projections
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Still More Analytical
Considerations
• Working capital investment – working
capital needs will increase due to
increases in accounts receivables and
inventories and is treated like an additional
investment
• Least cost projects – some expenditures
are required by law, so need to choose the
project with the lowest net cost
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Learning Objective 9
• How is the payback period
of a capital expenditure
project calculated?
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Payback Method
• The payback method is used to evaluate
proposed capital expenditures by determining
the length of time necessary to recover the
amount of the investment
• Add up the cash inflows until the total equals
the investment
• Then determine how many years it has taken
to recover the investment
• Very simple method, but does not consider
the time value of money
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Learning Objective 10
• How is the accounting rate of
return of a project calculated,
and how can it be used most
appropriately?
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Accounting Rate of Return
• Accounting rate of return focuses on the
impact of the investment project on the
financial statements
• Done on a year-by-year basis
• Drawback is time value of money is not
considered
• Often computed so stockholders will know
the effect of the project on the financial
statements
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Learning Objective 11
• Why are not all management
decisions make strictly on the
basis of quantitative analysis
techniques?
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The Investment Decision
• Both quantitative and qualitative factors
are considered
• Qualitative factors may include:
– Commitment to a segment
– Regulations that require an investment
– Technological developments
– Limited resources
– Management’s judgments about the accuracy
of the estimates used
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Integration of Capital Budget
with Operating Budgets
• Several aspects of the capital budget
interact with the development of the
operating budget:
– Contribution margin increases and cost
savings need to be included in the
income statement budgets
– Cash disbursements need to be included
in the cash budget
– Capital expenditures need to be included
in the balance sheet budget
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