Accounting for Management Decision Making
Week 3 Weekly Briefing
Welcome to Week 3! In Week 2, you were introduced to budgets, strategic plans, and forecasts. You learned how important it is to be careful when looking at variances that you are comparing in what has been budgeted with the actual budget, at the same level of activity. This is accomplished by preparing a performance report. You added the terms budgets, strategic plans, forecasts, standards, variances, and performance reports to your accounting vocabulary.
In Week 3, you will continue to build your accounting vocabulary as you study capital budgeting.
In terms of the specific Learning Objectives, you will:
• Evaluate alternatives to discounted cash flows
• Analyze performance measurements methods
• Compute accounting rate of return, payback, net present value, and internal rate of return
• Evaluate the feasibility of potential organizational ventures
In terms of course-level Learning Outcomes, you will:
• Evaluate various accounting measures and their relevance to a wide range of stakeholders
• Analyze various types of budgets, strategic planning, and forecasting
• Employ managerial accounting approaches and information to make effective decisions
• Demonstrate effective communication skills to present accounting information to stakeholders
• Assess managerial accounting tools and their usefulness to organizational leaders
• Apply accounting principles ethically and appropriately to personal and professional contexts
Performance measurement is typically one of the hardest functions managers perform. Common challenges include knowing how and what to measure, and to what do you compare that measurement? Last week, you studied budgets. Budgets are very valuable tools as they help a company determine if certain departments, divisions, or other subparts of an organization met the goals set for them, but they do not take into
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account certain quantitative factors such as how competitors are doing, or qualitative factors that might greatly influence the future of the organization.
It is difficult to gather current information on your competitors, but a way around that difficulty is to survey your customers. If they say you are doing well, and they will return to your organization the next time they need your product or services, you know that you are retaining and possibly gaining market share. If they are unhappy and will not return, you are probably losing market share (Likierman, 2009).
Make sure that the metrics that you use are reliable and are justified for what you want measured. You will learn about a number of financial metrics this week, and they are very useful when analyzing financial information, but they should not be applied to every measurement opportunity. For example, it would not make sense to compute Return on Investment (ROI) for a training program provided through human resources. Qualitative measures would be more useful (Likierman, 2009).
A single metric is not as useful as four or five metrics that are accompanied by qualitative data and compared to industry information. You want to obtain the best information possible that will focus on the future rather than the past. What happened last year or the year before is interesting and informative, but it should not drive decisions for the future.
Tools to Evaluate Opportunities
One decision that managers make that affects the future pertains to evaluating capital investment opportunities. There will be outflows of cash in certain periods and inflows in others. It is not as simple as adding up all of the inflows and subtracting the outflows since they occur at different times. For example, if the company invests $10,000 today and will receive $10,500 in 5 years, there is a positive difference of $500. Does this mean the investment should be made? A decision cannot be made based on this information alone because a dollar today is worth more than a dollar received in the future.
One method that adjusts for this timing difference is discounted cash flow (DCF) analysis which is also called net present value (NPV). This approach has four steps. First, identify the amount and timing of each cash flow. Next, determine the discount rate. Then, calculate the present value of each cash flow. And finally, calculate the NPV of the project (Davis & Davis, 2012).
The discount rate is determined by the organization and is based on the risk of the project and the cost of capital. Different projects may have different discount rates. The present value of the investment does not have to be calculated as it is invested at time zero. The present value of the future cash flows will need to be determined. The easiest method is to use a spreadsheet program such as Microsoft Excel®. The investment is subtracted from the present value of the future cash flows. If the answer is positive, the project should be considered. If it is zero or negative, it probably should not be
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considered. Of course, there is no way to know precisely what the future cash flows will be. NPV is based on an educated estimate of these values.
DCF is not the only method used to evaluate investment projects. Other methods include payback, accounting rate of return (ARR), and internal rate of return (IRR). They all can be useful in decision making, but it is important to also understand their drawbacks.
The payback period is simply the time it takes for the cash inflows to equal the initial investment. If cash inflows are equal, the payback period is the net initial investment divided by the annual cash flow. It is expressed in years. If the cash flows are not equal, the annual cash flows are added together until they equal the net initial investment. The number of years, including partial years, is then computed. Each organization will have determined the number of years to payback that is acceptable. This is a quick screening tool that can be used prior to using more complicated methods. The limitations of this method are that it ignores the time value of money and the cash flows that occur after the payback period (Davis & Davis, 2012).
The accounting rate of return is another method that can be used to evaluate investments. It is also called the return on investment (ROI). The formula is average annual income from the project divided by the average annual investment in the project. It is easy to calculate, but it can lead to an incorrect decision as it ignores the time value of money (Zimmerman, 2014).
The internal rate of return (IRR) is another method that can be used when considering an investment. If the project’s IRR exceeds the organizations cost of capital, the project should be undertaken. The method considers the time value of money; therefore, it is more accurate than those methods that do not consider the time value of money. It is difficult and time consuming unless a spreadsheet program is used. If there are multiple changes in the cash flows from inflow to outflows, etc., the project could yield more than one IRR. (Shim, Siegel, & Shim, 2012).
When analyzing the feasibility of various alternative projects, consider all of the quantitative methods given above, but also look at qualitative factors such as location, cultural differences, employee training needs, regulations, etc.
In summary, capital budgeting decisions should not be made in a vacuum. Gather the metrics, the qualitative research, and talk to your team. Consider your options carefully, and make the best decision you can make after considering all available information.
Davis, C. E., & Davis, E. (2012). Managerial Accounting. Hoboken, NJ: John Wiley & Sons.
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Likierman, A. (2009, October). The five traps of performance measurement. Harvard Business Review, 87(10), 96–101.
Shim, J. K, Siegel, J. G., & Shim, A. I. (2012) Budgeting basics and beyond (4th ed.). Hoboken, NJ: John Wiley & Sons.
Zimmerman, J. L. (2014). Accounting for decision making and control (8th ed.). New York, NY: McGraw-Hill.
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