II.

Profit Planning: Operational Budgeting

CONCEPT REVIEW: BASIC MANAGEMENT FUNCTION

1. Reviewing ongoing programs

2. Considering proposals for new programs

3. Coordinating programs by means of a formal strategic planning system

Management by Objectives

Tracking managers’ performances against a number of specific objectives expected to be achieved during a given
measurement period.

Budget
 A quantified plan of action relating to a given period of time (CIMA)
 Developed in advance of the period that it covers and is based on forecasts and assumptions (CMA)
 A plan expressed in quantitative, usually monetary, terms covering a specified period of time, usually one
year (Anthony)
 The budget and its administration are entirely management’s responsibility.
 Also called as the “profit plan”.

 For a budget to be useful, it must be quantified.

 Definite target
 Yardstick for control purposes
 The Ultimate Objective of Budgeting - Superior performance, leading to profitability, leading to growth in
shareholder value (“profitable growth”).

The Purposes of Budgeting

 Budgets define goals and objectives, and communicate plans to different parts of the organization (responsibility
 Planning -Developing objectives and preparing various budgets to achieve those objectives. centers)
 Directing and Coordinating -Involves the steps taken by management to increase the likelihood that  Budgets compel managers to plan
the objectives set down while planning are attained and that all parts of the organization are working together  Budgets give authority to budget managers to incur expenditure in their part of the organization
toward that goal.  Budgets are a means of educating managers
 Controlling -Examining the actual results and compare them with plans, identify any deviations, investigate  Budgets are a means of allocating an entity’s resources
reasons for these deviations, and use results for better planning for the next cycle  Budgets act as comparators for current performance (performance evaluation)
 Budgets may be used as targets to motivate managers to improve their performance
Planning Principles  Budgets facilitate awareness of how a department’s or manager’s activities will relate to those of other
departments or managers within the organization (coordination)
1. Strategic Planning -Long-term action plans  Budgets uncover potential bottlenecks
2. Budgetary Planning -Short-term to medium-term plans
3. Operational Planning -Short-term or day-to-day plans Aspects of Budgeting
1. Managerial Aspect
Points to Recall  What managers and others do in the course of preparing or using budgets
o The importance of the VMO of the organization
o The importance of identifying the strategy chosen by the organization 2. Technical Aspect
o The benefits of using the balanced scorecard  How budget numbers are calculated and assembled

Strategic Planning Two Opposing Theories in Attaining Profitable Growth  (CMA)

1. Market Theory
The process of deciding on the programs the organization will undertake to implement its strategies and on the
approximate amount of resources to be allocated to each program.  Management has a passive role
 Making decisions to respond to environmental events as they occur
Strategic Planning: 3 Main Parts
2. Planning and Control Theory
 Management has an active role
 Emphasizes the planning function of management and its ability to control the activities of the business
 More ability to reduce the randomness of events and to deal productively with those that do occur

The External Environment in Planning and Budgeting(CMA)

1. Industry How Budgets Prepared

 Assessing the industry: nature, stage, dynamics, history The Budget Committee
 Competitive position in the industry
 The coordinating body in the preparation and administration of budgets
 Competitive position of rivals
 Authoritative Budgeting
2. National environment  Imposed budgets; Top-down budgeting
 Assessing domestic and international political risk  Superiors simply tell subordinates what their budgets will be
 Impact of globalization
 Risks of government expropriation and war Participative Budgeting
 All parties (top, middle, and lower level managers) agree about setting budget targets
3. Wider macroenvironment  Eliminates the excuse that the budgets are unrealistic or unattainable
 Must be reviewed by higher management to prevent budgetary slack
 Growth rate of the economy
 Interest rates The Right Atmosphere for Imposed Budgets
 Currency exchange rates
 Inflation and deflation  Newly-formed organizations
 Very small businesses
 Periods of economic hardship
 Operational managers lack budgeting skills
Budget Period  Organizational units require precise coordination
 Depends on management
 Annual, quarterly, monthly  The Right Atmosphere for Participative Budgets
 Mature and large organizations
Essentials of Effective Budgeting  Decentralization is applied
 Sound organizational structure  Operational managers have sufficient budgeting skills
 Valid bases: research and analysis  Managers of various operational units coordinate well with each other
 Acceptable or accepted by all levels of management

Behavioral Aspects of Participative Budgeting

 Communication
 Motivation
 Realistic targets
 Goal congruence

 Difficulties in Participative Budgeting

 Pseudo-participation
 Challenges in coordination
 Additional training may be needed
 Budgetary slack

 Budgetary Slack
 Setting revenue or resource targets too low
 Setting expenditure or outflow targets too high

The Budget Manual

 Usually prepared by the management accountant
 A collection of instructions governing the responsibilities of persons and the procedures, forms, and records
relating to the preparation and use of budgetary data (ACCA)
 The Principal Budget Factor The Financial Budgets
 Key budget factor; Limiting factor 1. Capital Expenditures BudgeT
 The factor that limits an organization’s performance for a given period 2. Cash Budget
 Starting point in budget preparation
 It is important to identify this so as to have a more realistic estimate of the budget figures  The Cash Budget
 Shows the cash effect of all the decisions taken in the planning process
The Master Budget  Four possible cash positions that could arise:
 Operating Budget – planned operations for the coming year
 Cash Budget – anticipated sources and uses of cash
o -Short-term deficit
 Capital Expenditure Budget – planned changes in property, plant, and equipment o -Long-term deficit

The master budget represents the overall plan of the organization for a given budget period. It consists of all individual
o -Short-term surplus
budgets for each segment of the organization aggregated or consolidated into one overall budget for the entire firm. o -Long-term surplus

The Operating Budgets   3. Budgeted Balance Sheet – derived directly from the other budgets
1. Sales Budget
2. Production Budget Operating Budgets
3. Materials Purchases Budget
Sales Budget
4. Direct Labor Budget
5. Factory Overhead Budget  The first step is to prepare a sales budget in units and in pesos. The sales volume in units is important in preparing
6. Selling and Administrative Expense Budget production budget, while the peso sales volume is for the budgeted income statement.

The Interrelationship of Budgets

 Sales budget is prepared based on the sales forecasts.

 Expected sales volume; 3,000 units in the first quarter with 500 unit increase in each succeeding quarter.
 Sales price: $60 per unit.
 The above budget is divided into quarters, though weekly, monthly or yearly sales budgets may likewise be
prepared. It is advisable to prepare budgets for shorter time periods to allow management to plan and control
resources in a better manner.

Production Budget
  The desired raw materials inventory levels are determined at the  same time as desired inventory levels for
finished goods and wok-in process are calculated. In this illustrative example, let us assume that Hayes' company
policy is to set  ending inventory levels based on production requirements which is 10% of next quarter's
production requirements, thus P7,200.00 X 10% = 720.00 while the beginning inventory is expected to be at 10%
of the estimated first quarter pounds need for production.
 The company requires 2 pounds of raw materials and the anticipated cost per pound is $4 assumed to remain
constant during the year.
 Assume tat the desired ending direct materials amount is 1,020 pounds for the fourth quarter of 2017.
 Once the quantity of materials required for production and inventories are determined, the materials purchases
budget can now be prepared. The budgeted quantity of raw materials to be purchased can be computed using the
following formula:

Direct Labor Budget

 The direct labor cost budget is computed based on the budgeted production during the period. It is
in fact a mere extension of the production quantity budget.
 To calculate the budgeted direct labor cost, the budgeted quantity production is multiplied by the
required direct labor hours per quantity. This results into the total budgeted direct labor hours
 The expected unit sales were based on the sales budget, expected unit sales. which is then multiplied by the direct labor rate per hour to determine the budgeted direct labor
 The Desired ending finished goods in units is based on the company policy to have enough inventory at the end
cost.
of  each quarter to 20% of the next quarter's budgeted sales. The fourth quarter' ending inventories is assumed
that budgeted sales for the first quarter of 2018 are 5,000.00 units.
 The company must produce not only the sales requirements but also a desired ending inventory level. This is why
the two figures are added in the formula to come up with the total requirements during the period. However, if
there is beginning inventory, this figure reduces the total requirement that must be produced, hence, it is deducted
from the total requirements to arrive at the budgeted production.
 In the illustration above, the beginning inventory for the first quarter is  20% of the estimated first quarter of the
2017 sales units, thus P3,000.00 X 20% = P600.00. The beginning inventory for the other quarters is equal to the
ending inventory of the preceding quarter.

Direct Materials Budget

 This process involves the determination of three items:

1. Quantity of raw materials required for production,.
2. Desired raw materials inventory levels
3. Raw materials purchases budget in quantity and in pesos.

 Assume that Hayes Company  requires 2 hours of direct labor time to produce each unit of finish goods. The
anticipated hourly wage rate is $10.

Factory Overhead Cost Budget

 Unlike direct materials and direct labor which are usually classified as purely variable costs, factory overhead
costs are  composed of both variable and fixed costs elements.
 in preparing factory overhead costs budget, it is advisable to show the two cost elements separately so as to
consider the behavior of each type of costs in relation to budgeted activity levels.

 Quantity of materials required for production or the units to be produced is based on the production budget.
 Budgeted Income Statement
 The total budgeted variable overhead cost for each item is computed by multiplying the cost per unit or the rate per hour
 We can now summarize all the budgets that we have prepared in this operating plan to come up with the
by the corresponding activity level. For instance, the budgeted indirect materials for the first quarter
is 6,200.00determinedbymultiplyingthebudgetedhours6,200bytherateof1.00 per hour. If it is in units, multiply it by the budgeted budgeted income statement.
production or "the units to be produced"
 As regards the budgeted fixed factory overhead costs, let us assume that they are incurred uniformly throughout the
year. Hence, fixed overhead cost figures will remain constant for all the quarters.

Operating Expense Budget

 The operating expense budget budget is composed of selling an administrative expenses which the
company expects to incur during the budget period. The cost include both variable and fixed elements-
the variable cost usually varies with sales volume, while fixed costs remain constant throughout the
period.

Importance of Budgeted Income Statement

 Important end-product of the operating budgets.
 Indicates expected profitability of operations.
 Provides basis for evaluating company performance.

Financial Budget

Cash Budget
 Cash budget is a vital part of financial budget because with this, management can more or less
foresee possible ash shortage or overage which may have a great impact on overall operations
during the budget period.
 The critical parts of the format are the budgeted cash receipts and disbursements for these require
careful analysis and calculations. To compute the budgeted cash receipts, the sources of cash
receipts as well as the time when they would be received must be known. the same thing is true
with budgeted cash disbursements- we must know what we would pay for and when we would
remit such payment.

Illustration:

Hayes Company Assumptions

1. The January 1, 2017, cash balance is expected to be 38,000.Hayeswishestomaintainabalanceofatleast15,000.
2. Sales (Illustration 9-3): 60% are collected in the quarter sold and 40% are collected in the following quarter.
Accounts receivable of $60,000 at December 31, 2016, are expected to be collected in full in the first quarter of
2017.
3. Short-term investments are expected to be sold for $2,000 cash in the first quarter.
4. Direct materials (Illustration 9-7): 50% are paid in the quarter purchased and 50% are paid in the following
quarter. Accounts payable of $10,600 at December 31, 2016, are expected to be paid in full in the first quarter of
2017.
5. Direct labor (Illustration 9-9): 100% is paid in the quarter incurred.
6. Manufacturing overhead (Illustration 9-10) and selling and administrative expenses (Illustration 9-11): All items
except depreciation are paid in the quarter incurred.
7. Management plans to purchase a truck in the second quarter for $10,000 cash.
8. Hayes makes equal quarterly payments of its estimated annual income taxes.
9. Loans are repaid in the earliest quarter in which there is sufficient cash (that is, when the cash on hand exceeds
the $15,000 minimum required balance).

Budgeted Balance Sheet

 Developed from the budgeted balance sheet for the  preceding year and the budgets for the current year

Pertinent data from the budgeted balance sheet at December 31, 2016, are as follows:
Buildings and equipment        $182,000
Common stock                           225,000
Accumulated depreciation         28,800
Retained earnings                        46,480
 Zero-Based Budgeting
 Became popular in the 1970s
 Each cost element must be justified
 Without approval, budget allowance is zero
 Requires far more time than is available during annual budget preparation; time-consuming

 Incremental Budgeting
 Assumes that the starting point for each discretionary expenditure item is the amount spent on it in the previous
budget
1. Cash : Ending cash balance, shown in cash budget
2. Accounts receivable: shown in schedule of expected collections from customers.  Stretch Budgeting
3. Finished goods inventory: Desired ending inventory 1,000 units shown in the production budget times the  The organization attempts to reach much higher goals than those attained previously
total unit cost $44
4. Raw materials inventory: Desired ending inventory 1,020 pounds times cost per pound, shown in the direct  Consultative Budgeting
materials budget.  Inputs are gathered from subordinates, but there is no joint decision-making
5. Building and Equipment: December 31, 2016 balance plus purchase of truck shown in cash budget.
6. Accumulated Depreciation: December 31, 2016 , balance add depreciation shown in OH budget and in  Project Budget
selling and administrative expenses.  Budgets for defined projects
7. Accounts Payable: shown in schedule of expected payments for direct materials.  Contains amounts that are also reported in the budgets for the functional responsibility centers
8. Common Stock: Unchanged from the beginning of the year.  Must be consistent with the budgets of the functional departments that will be supplying resources to the projects
9. Retained Earnings: December 31, 2016 balance plus the income shown in budgeted income statement
 Behavioral Implications of Budgeting
The Success of a Budget Program (Garrison, et.al.)  The managers who set the budgets are often not the ones who are responsible for achieving budgets
1. Top management must be enthusiastic and committed to the budget process  Organizational goals may not coincide with the responsibility center managers’ personal aspirations
2. Top management must not use the budget to pressure employees or blame them when something goes wrong  Control is applied at different stages by different people
3. Highly achievable budget targets are usually preferred when managers are rewarded based on meeting budget targets

OTHER BUDGETING TECHNIQUES Profit-Sharing Schemes

 Periodic or Term Budgeting

 Employees receive a certain proportion of the company’s year-end profits
o Advantages
 A budget is prepared for a specified period of time
 Upon expiration of the period, another budget is prepared  Bonus will be paid out of actual profits

 Rolling or Perpetual or Continuous Budgeting

 Bonus can be paid to non-production personnel

 A budget continuously updated by adding a further accounting period when the earliest accounting period has 
expired o Disadvantages
 Particularly beneficial when costs or activities cannot be forecast accurately
 May not necessarily be applicable to all budgets  Employees have to wait for year-end to receive bonus
 Usually helpful for cash budgets
 Other factors affecting profit may be beyond control of employees
 Activity-Based Budgeting  Involvement of too many employees
 Late 1980s; grew out of the ABC movement
 Uses detailed activity information from ABC

 Examples
-Incentives involving shares
 -Value-added incentive schemes  the study of the effects on future profit of changes in fixed cost, variable cost, sales price, quantity, and mix.
-Incentive schemes
Assumptions in CVP Analysis (adapted from CMA)

Budgeting for Non-Manufacturing Companies

Merchandising Companies

 Basically similar to previously mentioned budgets, except for Manufacturing Budgets (Production, Materials Purchases,
Direct Labor, Overhead Budgets)

Service Enterprises

Critical factor: Coordinating professional staff needs with anticipated services

1. OVERSTAFFING
-Disproportionately high labor costs
-Lower profits due to additional salaries
-Increased staff turnover due to lack of challenging work
Cost Concept and Classifications
2. UNDERSTAFFING
-Lost revenues since client needs cannot be met  Functional Classification
-Loss of professional staff due to excessive workloads o -such as manufacturing (composed of  the three cost elements of production namely: materials, labor and factory
overhead), selling and administrative expenses.
Not-for-Profit Organizations
 Budgeting is just as important for NPOs as it is for profit-oriented companies  Behavioral Classification 
 Budgeting process differs from that of a profit-oriented company o -cost behavior refers to the way cost change with respect to change in the activity level, such as production or sales
 Budget based on cash flows (as opposed to revenue-expenditure budgets)
volume, labor, or machine hours, etc. There are costs which remained constant, some change directly or proportionately
 Starting point: EXPENDITURES
with the change in activity level, and others change in different patterns.
 Management Task: Find sources of funds for planned expenditures
 Budget must be followed; overspending often illegal o -classified as follows
1. Fixed costs
2. Variable costs
3. Mixed costs
4. Semi-variable costs
5. Semi-fixed  costs

I. Fixed Cost
 are costs that do not change with changing levels of activity.
 total fixed cost remains constant regardless of the change in volume.
 fixed cost per unit changes in an indirect or inverse pattern, depending on the direction of the change in the
activity level.
 graphically presented as

II. Variable Cost

III. Profit Planning: Cost-Volume-Profit and Breakeven Analysis o are costs that change directly proportionately with the level of activity.
o the total variable cost increases (decreases) as the activity level increases (decreases).
o the variable cost per activity level remains constant.
COST-VOLUME PROFIT ANALYSIS
 a systematic examination of the relationships among costs, cost driver, and profit. o graphically presented as
 4. type of productive facilities to acquire.

Benefits of CVP Analysis

1. Helps managers understand interrelationships among cost, volume, and profit
2. Useful in many business decisions such as:
 deciding what products to manufacture or sell
 what pricing policy to follow
 what marketing strategy to employ
 what type of productive facilities to acquire

BREAK-EVEN ANALYSIS
III. Mixed Cost
o posses both fixed and variable components.
  BREAK-EVEN POINT – the sales volume level (in pesos or in units) where total revenues equals total costs, that is,
there is neither profit nor loss.
o graphically shown as

Cost Behavioral Assumptions

 Relevant range assumptions - refers to the band of activity within which the identified cost behavior patterns are
valid. Any level of activity outside this range may have different cost behavior patterns.
 Time assumptions - states that the cost behavior pattern identified are true only over a specific period of time.
Beyond this, the cost may show a different behavior.
The Contribution Format Income Statement
Segregation of Fixed and Variable Elements of Mixed Costs
 High-Low Method - a simple and widely used technique of segregating mixed costs components. Per unit Total %
 Procedures:
1. Choose the representative highest and lowest activity level with their corresponding costs. Sales P xx P xxx,xxx 100%
2. Get the difference (or change) between the highest and lowest cost and activity levels.
3. Determine the rate of cost variability with activity level by dividing the difference in cost with the Variable Costs (xx) (xxx,xxx) xx
difference in activity level (computed in step 2)
4. Then apply the rate of variable cost by multiplying it to the activity level. 
5. Determine the total amount of fixed cost by subtracting the total variable cost from the total cost for Contribution Margin P xx P xxx,xxx xx%
any activity levels.
Fixed Costs (xx) (xxx,xxx)
 Note that periods with extraordinarily high and low activity levels and costs should not be included in the selection
process for these points may been caused by abnormal or unusual situations.
P xxx,xxx
 Though the technique is simple, yet it is not precise.  Operating Income P xx

APPLICATIONS OF CVP ANALYSIS

Planning and decision-making, which may involve choosing the: Alternative Contribution I/S
1. type of product to produce and sell;
2. pricing policy to follow;
Sales P xx
3. marketing strategy to use; and
Variable Product Costs (xx)

Manufacturing or Product Margin P xx

Variable Period Costs (xx)

Contribution Margin P xx

Fixed Costs (xx)

Operating income P xx
 IV. Cash Flow Estimation and Capital Budgeting OPPORTUNITY COSTS
Opportunity cost represents the benefits foregone for choosing one alternative over another. In the case of Capital
Budgeting, these benefits might form part of the estimated cash flows because it causes the reduction to the cash flows
Cash Flow Estimation of the entity. Common opportunity costs include revenues forgone from the usage of the long-term asset, among others.

INTRODUCTION Example: Northeast Bank Corp. already owns a piece of land that is suitable for a branch location. The land can be sold
to yield P150,000.00 after taxes. Would this cost be considered? Why? Yes! Because use of the site for this branch
An important factor to make a sound decision for long-term assets is to properly estimate future cash flows used in most would require foregoing this inflow.
capital budgeting techniques. This module is a preparatory topic for capital budgeting and discusses the various methods
and issues surrounding the estimation of cash flows. In the real world, the cash flow is not just handed to the OPERATING CASH FLOWS
accountant, but rather, it must be estimated based on information from various sources. Moreover, uncertainty In estimating cash flows, the cash revenues and costs or cash outlays expected to be generated from the eventual
surrounds the forecasted cash flows, especially that some long-term assets are more uncertain and riskier than others. usage of long-term assets. In practice, this might be tedious to do, however is necessary to establish the merits of
proposed acquisitions. Assumptions for estimating operating cash flows need to have valid and supported bases, to
Estimating Cash Flows provide reasonable assurance in making a sound decision for acquiring long-term fixed assets.
 Estimating cash flows is the most important  but most challenging step of capital budgeting.
 While doing this analysis: FREE CASH FLOW
-Its important to get information from various departments. Free cash flow is the amount of cash that could be withdrawn from a firm without harming its ability to operate and to
-Make sure that realistic economic assumptions are used. produce future cash flows. The equation for free cash flows is as follows:
-Make sure that there are no biases in the forecasts.
 Focus must be on Relevant cash flows not accounting income. FCF = EBIT (1-T) + Dep’n – (Capital Expenditures – Increase in Net Working Capital)
 Only Incremental cash flows are relevant- these are additional cash flows
Where:         FCF                                 -        Free Cash Flow
CONCEPTS IN ESTIMATING CASH FLOWS
The following are the most common concepts and/or techniques in estimating cash flows:                    T                                     -        Tax Rate
1. Timing of Cash Flows
                   Capital Expenditures         -        Amounts set aside for long-term asset acquisition
2. Incremental Cash Flows
3. Sunk Costs
                   Inc. in Net WC                  -        Difference in the change in current assets less change in payables and
4. Opportunity Costs accruals
5. Operating Cash Flows
6. Free Cash Flow The ideal situation is to have a positive free cash flow, which primarily means that the company can distribute returns to
TIMING OF CASH FLOWS its investors in the form of dividends or it can further be used to acquire more fixed assets.
Most business decision analyses would deal with cash flows exactly when they occur, hence, daily cash flows
theoretically would be ideal than annual cash flows. However, it would be more costly to estimate and analyze daily cash A negative free cash flow however does not necessarily mean an unfavorable thing for the entity, as long as the
flows and would not probably be more accurate than annual estimates. Therefore, we generally assume that all cash investment for capital expenditures and net working capital will yield to a returns in the future.  
flows occur at the end of the year.
Determining Project Value
INCREMENTAL CASH FLOWS
Incremental Cash Flows are flows that will occur, if and only if, some specific event occurs. In the case of Capital Estimate Relevant Cash Flows
Budgeting, the acceptance of a project marks the beginning of the projections of incremental cash flows. Cash flows
such as investments in buildings, equipment, working capital needed for the project, sales revenue and operating costs 1. Initial Investment  Outlay = Cost of fixed assets + any initial investment in NOWC.
related with the capital investment. 2. Annual Project Cash Flow

SUNK COSTS  -Depreciation is added back

A sunk cost is an outlay that was incurred in the past and cannot be recovered in the future regardless of whether the  -Interest Expense is not subtracted
project under consideration is accepted. These cash outlays are not relevant in the making of decisions for capital
expenditures, therefore should not be included in the cash flow estimates. Common sunk costs include the cost of old
 -Adjust for changes in NOWC
equipment and irrecoverable operational costs. 3.Terminal Year Cash Flow
Example: In 2020, Northeast Bank Corp. was considering whether to establish a branch office in a newly developed
section in Cebu. In 2021, they hired a consultant to perform a site analysis. This item was expensed in 2021. Is it a  -Extra cash flow usually generated from the salvage value of the fixed assets.
Relevant Cost?  No, It is a sunk cost . It will not affect Northeast's cash flows regardless of whether or not the new
branch will be built.
CASH FLOW VS. ACCOUNTING INCOME – on DECISION MAKING
Important points:
In the decision-making process, accounting income is not the information that is used as a basis or reference, simply
 It often turns out that  a project has a negative NPV if all costs including the SUNK COSTS are considered. because there are items used in the accounting income that may not be a source to reinvest or spend for long-term
 On an incremental basis the project may be a good one because the future incremental cash flows are large assets. Cash is the most common means of purchasing assets, not the accounting income. There are also times that a
enough to produce a positive NPV on the Incremental Investment. capital expenditure would require adjustments to the working capital (current assets and current liabilities) that would
not directly affect accounting income.
  Tax effects make or break a project
 Calculation of depreciation affect taxes
 Cost of Fixed Assets  Faster depreciation results in higher depreciation expense in the earlier years, therefore, lower taxes
in the earlier years
 Assets purchases represents cash outflow
 Accountant's don't treat the purchase of fixed assets as an expense, instead they deduct Depreciation Methods
depreciation each year.
 Full cost of an assets include shipping and installation costs.  Straight line Method
 Depreciable basis = Cost of fixed assets + shipping and installations cost.
o -For stockholder reporting purposes
 Changes in Net Operating Working Capital
 Accelerated Methods
 Excludes cash and marketable securities
 For expansion projects NOWC is  positive, therefore represents cash outflow and when it is o -For tax reporting purposes
negative it represents a cash inflow
 Towards, the end of the project, inventories used will not be replaced and receivables will be
o -One type of depreciation is known as the Modified Accelerated Cost Recovery System (MACRS) U.S. concept
collected, therefore NOWC becomes positive, CASH INFLOW.
-END-
 Interest Expenses are NOT deducted
"Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most"
 We discount a project's cash flow using WACC (Weighted Average Cost of Capital)
 WACC is the rate of return necessary to satisfy all investors - both stockholders and debtholders. -Peter Drucker-
 Subtracting interest interest payments from the project's cash flows would amount to double
counting of interest.
 In contrast, with accountants measure income available to stockholders, not to all investors,
therefore, accountants deduct interest expense.
Part 1: Capital Budgeting - Basic Concepts and Ethics
Replacement Projects
Planning for Capital Expenditures
 Estimate cash flows on an incremental basis
 If the NPV on an incremental basis is positive, the old machine should be replaced Planning for capital expenditures consists of relating plans to objectives, structuring a framework, searching for
proposals, budgeting expenditures, requesting authority for expenditures.

Relating Plans to Objectives

Individual capital projects must be consistent with company objectives and be capable of being incorporated into
company operations. To achieve consistency, all management levels need to be conscious of company objectives and of
the different roles played by each level. Ideally, executive management sets broad goals and objectives; managers of
functional activities formulate specific policies and programs for action that, when approved, are executed by operating-
level management. The lower the level at which a decision is authorized, the greater the need for detailed guidelines;
capital expenditures not conducive to such detail require handling at a higher level.

Structuring the Framework

An organization’s capital expenditure framework is the basis for implementing the capital expenditure program. Several
factors influence the molding and revision of the framework: the company’s organizational structure, philosophy, size,
the nature of its operations and characteristics of individual capital projects. A company manual can be used to detail
policies and procedure and to illustrate forms required for administering the capital expenditure program. Such manuals
should be stripped down to helpful levels to (1) encourage people to work on and submit ideas, (2) focus attention on
useful analytical tasks, and (3) facilitate rapid project development and expeditious review.

Searching for Proposals

A capital expenditure program yields the best results only when the best available proposals are considered and all
reasonable alternatives to each proposal have been evaluated and screened. Ideas should come from all segments of
the enterprise. Everyone in the organization should participate in the search activity within the bounds of their technical
knowledge and ability, their authority and responsibility, their awareness of operating problems, and existing
management guidelines regarding desirable projects. Care must be taken to create and maintain incentive to search out
and bring good projects into the system. This incentive is strong when personnel trust all proposal are reviewed
Tax Effects fairly and objectively.
Budgeting Capital Expenditures of ethical violation. The accountant is obligated to make sure that legitimate policies and procedures are not
The capital expenditures budget is typically prepared for a one-year period. It presents  management’s investment plans circumvented and to make sure that the data used in evaluating capital projects are reliable and  realistic. In most,
at the time the budget is prepared for the coming period. Some projects never materialize; others are added through cases, the accountant should first discuss the perceived ethical problem with the  accounting supervisor (to clarify the
amendments to the budget during the budget year. Thus, the budget must be adaptable to changing needs. The capital significance of the problem and identify possible courses of action) and then with the individuals or individuals involved.
expenditures budget is not an authorization to commit funds; it merely affords an opportunity for decision makers to If the problem cannot be resolved through discussion, the accountant is obligated to provide a full disclosure of all the
consolidate plans by looking at project side by side. The capital expenditures budget passes through details to the executives responsible for evaluating and approving the capital expenditure. If the individual involved  is
several management levels as it moves toward final approval at the executive management level. A clear explanation of the accountant’s immediate supervisor, the accountant should consult the next higher level of management.
the content of the approved budget should be transmitted to the various management levels to avoid
misunderstandings. Evaluating Capital Expenditures

Multiple evaluations of a single proposal may be necessary because (1) circumstances can change during the time span
of the project, from its original idea to its completion, (2) alternatives solutions may be existing for the problem for
which the project is designated, and (3) assumptions may vary as to the amount and timing of cash flows.

The economic evaluation of capital expenditure proposals has received considerable attention in the literature, with good
reason. To survive in the long run, a firm must be profitable. Because capital investment requires commitment of
substantial resources for long periods of time, poor investments can have a material long-term effect on profitability and
survival. Four commonly used techniques for evaluating capital expenditures are discussed in detail in Other Topics.
Although these techniques are useful in selecting projects that will maximize company profits, excessive reliance on
quantitative answers is dangerous. Because the life of a capital project extends well into the future, the data used  in its
quantitative analysis are fraught with uncertainty. It is difficult to predict accurately what will happen next year, and
even more difficult to predict what will happen several years in the future.  Furthermore, because prediction of future
cost and revenue unavoidably contain elements of subjectivity, such data can be easily manipulated by overzealous or
misguided employees.

In evaluation capital expenditures, management must consider many imponderable factors. Strategic considerations and
managerial intuition often drive investment decisions, rather than evaluations of the results of analytic techniques
applied to quantitative data. In some cases, quantitative data are simply no avoidable, or if available, are not reliable. In
Ethical Considerations other cases, investment decisions are determined by the company’s strategic plan or by past choices, in which case
Ethics for management accountants were discussed in Module 1. In capital budgeting, accountant should be especially quantitative analysis may be unwarranted. Other projects are so obviously necessary that economic evaluation is
vigilant, because the capital budgeting process provides both opportunity and temptation for unethical behavior. Some simply not needed. For example, a railway trestle washed out by a flood must be replaced if the line is to continue in
common problems are described in the following paragraphs. use. If the line is profitable, a capital expenditures analysis of the tract replacement would be a waste of time.

Pressure from Superiors or Associates to Circumvent the Approval Process. Some capital expenditures are made for qualitative or legal reasons, rather than for purely economic  reasons. A
manufacturer may be forced to invest in advance manufacturing technologies, improve product quality, improve delivery
In most companies, only projects that require and expenditure in excess of a predesignated level must be evaluated and and service, increase manufacturing flexibility, or produce a less profitable product in response to competitive pressure.
approved. One way of circumventing such a system is to break the capital project up into several small purchases, each A company may be forced into installing dining or recreation facilities for employee use to attract employees. Air and
of which is falls below the designated level that requires approval. If detected by the accountant, the small purchases water pollution regulations may be requiring an expenditure for a waste disposal unit. A sample of actual firms suggest
should be grouped into one project. Sometimes, pressure is put on the accountant to ignore the situation or to that the use of qualitative justification for capital expenditures is common.
cooperated in subverting the system on the grounds that evaluation and approval process saves time, and that project
will be accepted anyway. In other cases, pressure is applied by simple threats. For example, an executive threatens Because investments should be consistent with long term-goals, some potentially profitable projects  may be rejected
to use his or her friendship or authority over the accountant’s immediate supervisor to hinder the accountant’s career because they do not fit into the company’s overall plan. Many firms, particularly  small and medium-sized ones, are not
advancement with the company. diversified and invest only in activities related to their particular line of business. This may be simply a matter of choice,
or it can be a matter of necessity. One firm may lack expertise while another lacks sufficient funds and is unwilling or
Pressure of Write Off or Devalue Assets Below Their True Value to Justify Replacement. unable to secure necessary financing. The mechanics of various evaluation techniques are important, but of still greater
importance is their relationship to the overall capital expenditure planning and control process  and the need for creative
Pressure is sometimes applied by well-meaning associates who believe that a project will benefit the  company in some and thoughtful management.
qualitative survey that will not receive adequate consideration in the evaluation process. At times, pressure is applied by
an executive who want the project approved for personal prestige or comfort (such as new office furniture or new
automobile).

Exaggeration of Economic Benefits of Capital Projects to Increase the Likelihood of Approval.

This is a particularly troublesome problem because predictions about the future  necessarily contain some subjective
judgments and are never perfectly accurate. The problem is compounded when the duration of a proposed capital
project exceeds the period the proposing manager expects to remain in his or her current position. Promotions and job
rotations among lower and middle-level management typically occur at fairly short intervals. There is an incentive
to exaggerate the expected benefits of a capital project to secure acceptance, if a subsequent failure of  the project to
live up to expectations can be blamed on a successor. Although accountants have access to a considerable amount of
data, it is often difficult for them to determine whether predictions are realistic. Even if they believe predictions are
unrealistic, providing convincing evidence is usually difficult. The appropriate course of action in each of these situations
(and any other, for that matter) depends to a great extent on the character of the individuals involved and the nature
 Classification of Capital Expenditures
Capital expenditures projects can be classified into three categories: replacement expenditures, expansion investments,
and improvement expenditures. A proposal can, of course involve more than one classification. An example is a firm
considering a proposal to replace an old printing press for which maintenance cost has become excessive (an equipment
replacement expenditure), with a new press what will offer an expanded productive capacity (an expansion of
investment).
Some projects may not be independent of one another and therefore should be grouped together for  evaluation as a
compound.
Contingent or dependent project can arise, for instance, when acceptance of one proposal is dependent of acceptance of
one or more other proposals. One simple example would be the purchase of an extra-long boom for a crane which
would be of little value unless the crane itself were also purchased; the latter, however, may be justified on its own.
When contingent projects are combined with their independent prerequisites, the combination may be called a
compound project. Thus, a compound project may be characterized by the algebraic sum of the payoffs and costs of
the component projects plus, perhaps, an interaction term.

Replacement Expenditures.
Replacement expenditures include the acquisition of new machinery and/or building to replace worn-out or obsolescent
assets. Historically, the basis for such decision making has been the desire for prospective cost savings; that is,
comparing future cost of the old assets with future costs of the replacement property. In addition to comparisons of
operating costs, the analysis of future costs requires the determination of the prospective purchase price less any
ultimate resale salvage value. One of the most difficult problems is to estimate the probable economic life of
replacement assets. This is the core of any capital expenditure decision. For the present facility, the future decline is
disposal value must be estimated. The original cost of the present facility is a sunk cost, not recoverable and totally
irrelevant to the decision. Accumulated depreciation is also independent of the company’s real future costs. Book value
of existing assets are not relevant to the replacement decision, except for possible income tax consequences. For
example, an increase or decrease in income tax liability can result from the recognition of gain or loss, respectively, from
the sale, exchange or abandonment of an asset. On the other hand, in an exchange of like-kind assets, the income tax
effect results from an adjustment to the tax basis of the  new asset and the amount of depreciation available for tax
purposes, which in turn affects the future income tax liability. An increase of decrease in income tax liability has a direct
effect on cash flow and is, therefore, relevant to the capital expenditure decision.

Expansion Investments.
Expansion investments involve plant enlargement for the purpose of expanding existing markets or invading new
markets. In these cases, the expected results of expanding and not expanding are compared, and the basis for a
decision shifts from cost savings to increased profits and cash inflows. The expected increase in profit is estimated by
preparing a projected in come statement showing additional revenue and expense over the life of the project. The
degree of uncertainty in this type of investment can be great, but it is usually quantifiable.

Improvement Expenditures.
Decisions to improve existing products or facilities, called improvement expenditure, are generally strategic. A firm may
be forced to improve product quality or design to counter the actions of competitors. Failure to improve existing
products can cause deterioration of market share. Improvement may require development of new
processes, modernization of facilities, or both. Because no historical basis for making the capital expenditure  decision
exists and because the return on such an investment is based on maintaining profits in the face of competition, the
benefits are often difficult to quantify. A high degree of sound judgment and business insight is required.
Decisions to add new products can involve the decision to drop existing products or to expand the product line. In either
case, a capital expenditure may be necessary to alter or expand existing facilities. In such cases, the improvement
expenditure is similar to the expansion expenditure in that the emphasis is generally on profit improvement rather than
on reducing maintenance cost. The increase in profits over the life of the capital project must be estimated and
compared with its cost in order for management to determine the value of adding the new product.
Compare and Evaluate Alternative Projects In the current business environment, there is considerable emphasis on modernizing manufacturing facilities by investing
 Financial and nonfinancial criteria in advanced manufacturing technologies. Although it often produces cost savings, the movement toward computer
integrated manufacturing (CIM), robotics, and flexible manufacturing systems (FMSs) is motivated primarily by strategic
 Short and Long-term benefits considerations. Such considerations include the need to improve products quality in the face of increasing competition
 Usually multiple criteria and the desire to be able to adjust production output both in quantity and variety quickly to satisfy rapidly changing
consumer demands. The cost modernization is often very high, and the strategic benefit is generally difficult to quantify.
 Consider all significant stakeholders Nevertheless, in the face of increased competition, particularly from abroad, such investments may be necessary for the
The Capital Budget is part of the Master Budget, and will form part of the Financial Budget, survival of a firm.
and will have a subsequent effect on financial performance.
Steps in the Ranking Procedure
1. Determine the Asset cost or net investment
2. Calculate estimated cash flows
3. Relate the cash flow benefits to their cost
4. Rank the investments
5.
Items Considered in Capital Investment Analysis
 Avoidable costs
 Deferrable costs
 Incremental costs
 Tax effects of certain items
 Weighted average cost of capital (WACC), or Required rate of return
Part 2: Capital Budgeting - Economic Methods of Evaluation
MATHEMATICAL FORMULA FOR CAPITAL BUDGETING TOOLS
Alternative Decisions Rule (Mutually Exclusive Projects)

 ACCEPT projects with the highest NPV

 If Hurdle Rate > Crossover Rate, NPV and IRR lead to the same decision
 If Hurdle Rate < Crossover Rate, NPV and IRR lead to different decisions

METHODS THAT DO NOT CONSIDER THE TIME VALUE OF MONEY

PAYBACK METHOD - the length of time required by the project to return the initial cost of investment.

Payback Period =  Net cost of initial investment 

                                     Annual net cash inflows

ADVANTAGES:

1. Payback is simple to compute and easy to understand. There is no need to compute or  consider any interest rate.
One just has to answer the question: “How soon will the investment cost be recovered?”
2. Payback gives information about the project’s liquidity.
3. It is a good surrogate for risk. A quick payback period indicates a less risky project.

DISADVANTAGES:

1. Payback does not consider the time value of money. All cash received during the payback  period is assumed to be of
equal value in analyzing the project.
2. It gives more emphasis on liquidity rather than on profitability of the project. In other words,  more emphasis is given
on return of investment rather than the return on investment.
3. It does not consider the salvage value of the project.
4. It ignores the cash flows that may occur after the payback period.

BAIL-OUT PERIOD-cash recoveries include not only the operating net cash inflows but also the estimated salvage
value or proceeds from sale at the end of each year of the life of the project.

ACCOUNTING RATE OF RETURN- also called book value rate of return, financial accounting rate of return, average
return on investment and unadjusted rate of return.

Accounting Rate of Return =  Average annual income

                                                  Investment

ADVANTAGES:
 The APR computation closely parallels accounting concepts of income measurement and investment return.
 It facilitates re-evaluation of projects due to the ready availability of data from the accounting records.
 This method considers income over the entire life of the project.
 It indicates the project’s profitability.

DISADVANTAGES:
 Like the payback and bail-out methods, the APR method does not consider the time value of money.
 With the computation of income and book value based on the historical cost accounting data, the effect of
inflation is ignored.

METHODS THAT CONSIDER THE TIME VALUE OF MONEY

PRESENT VALUE (PV) of an amount is the value now of some future cash flow.

PV of P1 or PV Factor (PVF) =      1              

                                             (1+I)N
     where:
              i = discount rate
              N = number of periods

PV of Future Cash Flows = Future cash flows x PVF

FUTURE VALUE (FV of an amount is the amount available at a specified future time based on a single investment (or
deposit) now
 FV of P1 oV Factor = (1+i)n Profitability Index =    Total present value of cash inflows    
                                Total present value of cash outflows
FV of Present Cash Flows = Present cash flows x FVF
                                                            or
ANNUITIES – a series of equal payments at equal intervals of time
If the cost of investment is the only cash outflow:
 ORDINARY ANNUITY (ANNUITY IN ARREARS)- cash flows occur at the end of the periods involved
Profitability Index = Total present value of cash inflows
 ANNUITY DUE (ANNUITY IN ADVANCE) – cash flows occur at the beginning of the periods involved                                       Cost of investment
METHODS THAT CONSIDER THE TIME VALUE OF MONEY Net Present Value Index =  Net Present Value  
                                          Investment
PRESENT VALUE (PV) of an amount is the value now of some future cash flow.
INTERNAL RATE OF RETURN
PV of P1 or PV Factor (PVF) =      1              
                                             (1+I)N the rate of return which equates the present value (PV) of cash inflows to PV of cash outflows. It is the rate of return
     where: where NPV = 0. When the cash flows are uniform, the IRR can be determined as follows:
              i = discount rate
              N = number of periods 1. Determine the present value factor (PVF) for the internal rate of return (IRR) with the use of the following
formula:                                          
PV of Future Cash Flows = Future cash flows x PVF
                              PVF for IRR = Net cost of investment
FUTURE VALUE (FV of an amount is the amount available at a specified future time based on a single investment (or                                                       Net cash inflows
deposit) now
             2.  Using the present value annuity table, find on line n (economic life) the PVF obtained in Step 1. The
FV of P1 or FV Factor = (1+i)n corresponding rate is the IRR.

FV of Present Cash Flows = Present cash flows x FVF                   When cash flows are not uniform, the IRR is determined using trial-and-error method.   

ANNUITIES – a series of equal payments at equal intervals of time ADVANTAGES:

1. Emphasizes cash flows
 ORDINARY ANNUITY (ANNUITY IN ARREARS)- cash flows occur at the end of the periods involved 2. Recognizes the time value of money
 ANNUITY DUE (ANNUITY IN ADVANCE) – cash flows occur at the beginning of the periods involved 3. Computes the true return of the project

DISADVANTAGES:
NET PRESENT VALUE 1. Assumes that the IRR is the re-investment rate.
2. When project includes negative earnings during their economic life, different rates of return
1. Present value of cash inflows -Present value of cash outflows may result.                 
Net Present Value
or PAYBACK RECIPROCAL
2. Present value of cash inflows-Present value of cost of investment
Net Present Value -a reasonable estimate of the internal rate of return, provided that the following conditions are met:
or 1. The economic life of the project is at least twice the payback period.
3. Present value of cash inflows-Cost of investment                2. The net cash inflows are constant (uniform) throughout the life of the project.
Net Present Value  Payback reciprocal = Net cash inflows
ADVANTAGES:                                   Investment
1. Emphasizes cash flows                                        or
2. Recognizes the time value of money
3. Assumes discount rate as the investment rate  Payback reciprocal =        1           
4. Easy to apply.                               Payback period

DISADVANTAGES: DISCOUNTED PAYBACK OR BREAK-EVEN TIME -the period required for the discounted cumulative cash inflows on
1. It requires predetermination of the cost of capital or the discount rate to be used. a project to equal the discounted cumulative cash outflows (usually the initial cost).
2. The net present values of different competing projects may not be comparable because of differences in magnitudes
Crossover Rate
or sizes of the projects.
 The rate at which the NPV of two projects is equal
 NPV Indifference point

PROFITABILITY INDEX Capital Rationing

1. Lack of nonmonetary resources
2. A desire to control estimation bias
3. An unwillingness to issue new equity

The key to decision-making under capital rationing is to select those projects that
maximize the total NPV given the limited capital budget.

Real Options

 Timing option
o Allow the company to delay the investment
 Sizing option

o Allow the company to expand, grow, or abandon a project

 Flexibility option

o Allow the company to alter operations, such as changing prices or substituting inputs

 Fundamental option

o Allow the company to alter its decisions based on future events

Other Important Concepts

 Opportunity costs
 Inflation

Qualitative Considerations in Capital Budgeting

 Employee morale, safety, and responsibility

 Corporate image
 Social responsibility
 Market share
 Growth
 Strategic planning

Post-investment Audits

1. Actual-to-expected cash flow comparisons, unfavorable variances explained

2. Evaluation must be done when all cash flows are already known
3. Assessing the receipt of expected non-quantitative benefits is inherently difficult