reading reflection

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CHAPTER 8: WE HAVE GOT TO MAKE SOME DECISIONS

Successful leaders have the courage to take action while others hesitate.

John C. Maxwell

Vacillating people seldom succeed. Successful men and women are very careful in reaching their decisions, and very persistent and determined in action thereafter.

L.G. Elliott

Managers of firms need to make decisions; lots of decisions. In business, opportunities can present themselves continuously. All decisions require managers to predict the future to some extent, either for a short time or for a long time into the future. This is never totally straightforward. How can a firm’s accounts help managers make these decisions? Decisions require managers to predict the future; to look out into the future. Accounting is backward looking. It is a record of what has happened to a firm in the past. How can accounting possibly help managers make decisions; or could it rather hinder them? This is the issue we will consider in this chapter.

We will first look at decisions that only require managers to consider the short-term future, say the next few months or up to a year or so in the future. These short-term decisions may only have implications for a firm for a short while, for example whether Ernst & Young (an accounting firm) decides to accept a contract to provide professional services to a client over the next few months. Alternatively, these decisions might have longer- term implications but can be readily reversed or changed in the short-term, for example the decision by an institutional investor, such as the New Zealand Superannuation Fund, to enter an investment management contract with ING New Zealand, a fund manager, to manage part of its fixed interest portfolio. These sorts of arrangements are usually expected to last for many years but can usually be terminated by the institutional investor with one month’s notice if the fund manager fails to perform satisfactorily.

We will look at how managers need to decide what costs are relevant to their decision, and how accounting can help or hinder them in doing this. We will see that a range of words and ideas can be associated with a firm’s costs, such as sunk, incremental, avoidable, unavoidable, replacement, fixed, variable or opportunity. There are a lot of different types of costs; and a lot of different concepts about costs. How might accounting help or hinder managers to focus on relevant costs (and, indeed, relevant income) in making decisions? We will also see how managers can use accounting to help them focus on the contribution of aspects of a firm’s activities to a firm’s profitability. This is a key concern for managers of a firm.

Some decisions of managers require firms to commit substantial amounts of limited capital to a firm’s operations. As these decisions can significantly affect a firm’s economic and business realities for many years into the future and are often difficult to reverse or change, they require managers to put effort and care into predicting the future. This requires managers to compare money invested today with expected future returns a number of years into the future. We will consider a few techniques managers can use, some involving a consideration of the ‘time value of money’ (that is, money is worth more to us now than in the future) and some that do not. We will consider how accounting, with its focus on past events of a firm, can possibly help managers predict the future. After all, managers are the ones running firms and making the decisions. No-one else is doing this; and they need information about their firm to help them do this.

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8.1 What costs are relevant

Making good decisions is a crucial skill at every level.

Peter Drucker

The first rule in making decisions is to focus on those aspects of a situation relevant to a decision and to ignore those aspects not relevant to the decision. This should help us make better decisions with better outcomes for people with a genuine interest in our firms. In any decision, there are costs and benefits to consider. In most business situations there is a lot of complexity. There is often a lot going on. Which costs and benefits are relevant to a decision? Which are not? And how can accounting possibly help managers focus on what is relevant and safely ignore what is not? This is what we will look at in this section.

Focus on what is relevant

Costs and benefits that are relevant for managers to consider when making decisions are those costs and benefits expected to change because of the decision being made. Sunk costs are costs that have been incurred because of past decisions. They are costs that have already been paid or costs a firm cannot avoid paying in the future. Sunk costs cannot be changed as a result of future decisions. Examples of sunk costs in business can be advertising costs or the costs of researching a new product idea that have already been incurred. Because sunk costs cannot be changed they are irrelevant to future decisions and so should be ignored.

When managers are seeking to decide between alternative opportunities, the costs and benefits common to each alternative are also not relevant to the decision. These costs will be incurred or benefits gained regardless of the opportunity selected. Only costs and benefits that differ between alternative opportunities are relevant to a decision. These costs are called differential or incremental costs. For example, the managers of Ryman Healthcare may be considering a few alternative options for the development of a new retirement village on a 1.955-hectare site it owns in Mount Martha, Mornington Peninsula near Melbourne. The cost of the site would be a common cost to all options it would consider. However, it is not a sunk cost as this cost could be changed because of future decisions; the site could be sold if it was decided not to develop the site. However, the cost of the site would not be a relevant cost when choosing between alternative options for developing the site as it would be a common cost to all options being considered.

Another way of thinking about whether a cost is relevant to a decision is to ask ourselves whether a cost could be avoided because of making a decision. For example, Ryman Healthcare would be paying council rates each year on its 1.955-hectare site in Mount Martha. It would need to continue paying council rates no matter which option to develop the site its managers selected. The cost of paying council rates would be unavoidable and so would be irrelevant to the decision. However, if the managers of Ryman Healthcare were also considering the option of not developing the site and instead selling it, then the council rates on the site would be an avoidable cost and would be relevant to the decision.

Everything is limited

Dost thou love life? Then do not squander time, for that’s the stuff life is made of.

Benjamin Franklin

We saw in Chapter 5 Section 5.4 how planning that is accompanied with consistent and sustained action can help to get time on our side. Otherwise, all that happens is that time will simply pass. My father died just short of his 91st birthday. Throughout his life he kept up with two friends from school; both friends also died a year or two before him. This is a reality for all of us, wherever we are in life. We are all on the ‘conveyor belt of life’ and at the end of life we drop off the conveyor belt. In this life, the conveyor belt does not go on forever. Time in our world is limited.

The implication of this is that for everything we choose to do with our time and energies each day we are choosing not to do a whole heap of other stuff; a whole heap of stuff that we will never be able to do that day

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because we will have used it up doing something else. And the number of days we have to live and do stuff is strictly limited; very limited. It is the same in business. The opportunity cost is the real cost of everything a firm does. This is because all resources, all life, everything that a firm can get its hands on is limited. Everything is limited: everything. The opportunity cost is the maximum or best benefit that could be obtained by any particular resource available to a firm. Also, if a resource of a firm would need to be replaced as the direct result of a future decision of a firm, the cost of replacing that resource is the relevant cost to consider rather than the previous cost of purchasing that resource in the first place. This is called the replacement cost.

What are the implications of this reality of scarcity, of limits, on the way managers make decisions in firms? The key implication is this: managers of firms will face many more opportunities to do things than they will have resources and time to do them. Regardless of the size of a firm, its geographic reach, the amount of resources it can access, all managers of all firms face this basic reality of life and of business: we need to make decisions within constraints. The only costs and benefits relevant to a decision are those that relate to the future, not to the past. Sunk costs are not relevant. They are the result of past decisions already made; future decisions will not affect them one way or the other. Only differential (or incremental) costs and benefits are relevant to a decision. These are the costs and benefits that will differ depending on the decision made.

We saw a much more subtle factor to consider is the opportunity cost of a decision. Usually when we do anything there are many things we cannot do at the same time. Is what we have chosen to do the best choice, or was there a better use of our limited resources? We also saw that replacement cost of an existing resource of a firm can be relevant in some situations. These are some ideas about what costs and benefits are relevant to decisions. Managers must make decisions all the time. It is a constant demand on them. They are, after all, in the driver’s seat of their firms. We will now consider whether accounting, with its focus on past activities of a firm, can help or hinder managers focus on relevant costs and benefits (which typically relate to the future) when making decisions.

8.2 Focusing on contribution

I’ve learned that you shouldn’t go through life with a catcher’s mitt on both hands. You need to be able to throw something back.

Maya Angelou

I have found the paradox that if I love until it hurts, then there is no hurt, but only more love.

Mother Teresa

In life, do we seek to contribute to those around us? Or do we seek to take from others as much as we can and give (or contribute) as little as possible? This whole issue of contribution is a key issue for managers to focus on when making decisions for a firm. Just as we prefer people in our lives that contribute to us, encourage us and affirm us, so managers are looking for alternatives they expect will contribute the most to the fixed costs and profits of their firm. It is this contribution which they expect from various possible alternatives that is a key aspect for managers to focus on when making decisions.

Contribution

We saw in Chapter 6 Section 6.4 the ideas of fixed and variable costs. Fixed costs do not change with changes in volume or activity levels, within the ranges we are considering. Variable costs do change, in direct proportion to changes in volume or activity levels. We also saw that if we change volume or activity sufficiently then all costs will vary; none will be fixed. But in the context of different decisions, some costs will tend to be fixed and others variable. We also saw in Chapter 6 that contribution margin (CM) is the difference between sales revenue (S) and variable costs (VC):

CM = S – VC

If you remember nothing else about management accounting, remember this relationship. Focusing on our

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contribution is also very useful in all aspects of our lives. Where am I contributing? What can I do to contribute the most to others and to myself? Where can I make a difference? In the same way, it is very useful in business. Dulux Group is an Australian listed company that supplies paint and a diverse range of specialist industrial branded products. One of its businesses is Robinhood, which manufactures and distributes kitchen rangehoods, canopyhoods, ducting systems, laundry tubs, ironing centres and food waste disposers in Australia and New Zealand. Prior to 2002, Robinhood was a private company owned jointly by its managers and by private equity investors.

In the 1990s, Robinhood hit some difficulties with its business. The firm had expanded its product range and was distributing a wide range of appliances. Yet it started to find it was making less money, not more. A new chief executive of Robinhood examined carefully the contribution margin of each product and discovered many of the products the firm was distributing were not contributing to the firm’s fixed costs and profit. Indeed, they were generating negative contribution margins. The new chief executive immediately reduced the firm’s product range substantially. Thus, the firm could grow its profits significantly with the remaining products all contributing to the firm’s fixed costs and to profits. In other words, all the remaining products had positive contribution margins. With an emphasis on design and innovation of a more limited and focused product range, Robinhood could expand its business in both New Zealand and Australia and grow the contribution margins of its products and its profits.

It is important to avoid having products with negative contribution margins; that take more from the firm in variable costs than they give in sales. But this does not mean we simply want products with positive contribution margins. If a firm faces no constraints in relation to its access to various resources and to the demand for its products or services, and if its existing fixed costs are unavoidable regardless of which decisions it makes, then all opportunities a firm has should be taken if they make a positive contribution to a firm’s fixed costs and profits. This will be the way to earn the most profits for a firm. But this is never the case. It is never the case in our lives that there are no constraints or limits. And it is never the case in business. Everything is limited. So, we need to make decisions within constraints.

Focusing on the contribution of various alternatives we are considering by concentrating our attention on their contribution margin will help us to make better decisions. But be careful. Seeking to maximise the contribution to fixed costs and profits can help to maximise benefits to equity investors in a firm. However, there are many other parties with genuine interests in firms than equity investors. There are those who provide debt to firms, there are customers, suppliers, employees, unions, other special interest groups and the general community. A successful firm needs to contribute to all people with a genuine interest in a firm. Focusing on contribution margin focuses solely on the interests of equity investors.

Also, there will be many qualitative factors not captured in the accounting numbers we are using to calculate contribution margins. Managers need to take account of much more than what is incorporated into the accounting numbers. However, a focus on quantitative contribution margins can certainly help to support decisions made by managers within constraints and protect managers from striking out into new directions and with new products that may not be providing adequate contribution margins. To help us think about how accounting may help managers make decisions let us look at making decisions with just two constraints: one being the maximum demand for a product; and the other limits on how much of a resource or input we can obtain.

Decisions with just two constraints

To help us see how the accounting concept of contribution margin can help managers make effective decisions, let us think about the situation where managers in a firm have only two constraints on their decisions: one being the maximum demand for a product and the other being a resource constraint. One important decision managers must make is how much of various products should a firm obtain (or produce) and seek to sell? These are called product-mix decisions: what mix or relative weighting of products should a firm have? In this situation, the firm can access as many resources as its needs, except for one resource; and is limited as to how much of each product it can sell. Of course, business decisions can be much more complex

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than this. However, equally in business keeping things simple and focusing on the key essentials to decisions can also be powerful.

This is the approach to use when making product-mix decisions with these two constraints (one a resource constraint, the other a market demand constraint):

 Calculate the contribution margin for each product.

 Eliminate immediately any products that provide a negative contribution margin (remembering the situation with Robinhood).

 Calculate the contribution margin per unit of the resource constraint for all the remaining products that provide a positive contribution margin.

 Rank each product by contribution margin per unit of resource constraint.

 Decide to sell products with the highest positive contribution per unit of resource constraint until demand for the product is exhausted or the scarce resource is completely used up.

Let us look at a simplified example of Robinhood, which as we saw is one of the businesses of Dulux Group. The manager of Robinhood is seeking to decide the best product-mix for the firm and is considering five different products to sell. These products are the Island Curved Glass Canopyhood, the Wall Canopy Rangehood, the Supertub ST7001, the IC1300 Ironing Centre (a fold up ironing centre) and the Emperor Waste Disposal. You might like to visit Robinhood’s website to see the firm’s actual product range which the firm’s current managers have decided to produce and sell. The selling price, variable costs and contribution margins for each product are set out in below.

Figure 8-1: Robinhood simplified product mix decision: contribution margins

Island

Curved Glass

Canopyhood

$

Wall Canopy

Rangehood

$

Supertub

ST7001

$

IC1300

Ironing

Centre

$

Emperor

Waste

Disposal

$

Selling price 600 250 300 300 200

Variable costs 300 150 150 200 250

Contribution margin 300 100 150 100 (50)

Note: These figures are purely fictional and bear no relationship to the real figures for these products of Robinhood in any way.

We can see immediately from that the Emperor Waste Disposal product has a negative contribution margin. We can dismiss this product from further consideration. Including any amount of this product in our product- mix decision will reduce our profitability in much the same way Robinhood did by adding further products to its product range in the 1990s. The manager of Robinhood now has just four products to consider in its product-mix decision: Island Curved Glass Canopyhood, Wall Canopy Rangehood, Supertub ST7001 and IC1300 Ironing Centre. Let us say there is a world-wide shortage of steel caused by China. China is growing its economy strongly and has tied-up more than half of the world’s supply of steel by way of long-term contracts with the major producers of steel throughout the world.

This means Robinhood is only able to access 100 tonnes (or 100,000 kg) of steel next year. This resource constraint threatens to have a major impact on Robinhood’s business. Which product-mix decision by the firm will maximise the firm’s profit and minimise the impact of the current world steel shortage on the firm? The manager now calculates the contribution margin per unit of steel used for each product. This is shown in 8-2 below.

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Figure 8-2: Robinhood simplified product mix decision: constraints in market demand and steel

Island Curved

Glass

Canopyhood

$

Wall Canopy

Rangehood

$

Supertub

ST7001

$

IC1300 Ironing

Centre

$

Market demand (units) 100,000 25,000 250,000 10,000

Steel required per unit 2 kg 1 kg 2 kg 0.5 kg

Contribution margin per kg of steel $150 $100 $75 $200

Note: These figures are purely fictional and bear no relationship to the real figures for these products of Robinhood in any way.

As can be seen in Figure 8-2 above, IC1300 Ironing Centre has the highest contribution margin per kg of steel used. For every kilogram of steel used to make each IC1300 Ironing Centre, Robinhood would make a contribution margin of $200. The manager needs to include as much of this product in Robinhood’s product mix as it can sell. The market demand for this product is expected to be 10,000 units. Robinhood could meet this expected level of market demand for this product without exhausting its supply of steel. The manager decides to include selling 10,000 units of IC1300 Ironing Centre in the firm’s product mix. Including this much of IC1300 Ironing Centre in its product mix will require 5,000 kg of steel (10,000 units × 0.5 kg). If we deduct this 5,000 kg from our constraint of 100,000 kg, this leaves the firm with 95,000 kg of steel it can use to produce other products.

The manager sees that the Island Curved Glass Canopyhood has the next highest contribution margin per kg of steel. The manager needs to include as much of this product in its product mix as it can. The market demand for the Island Curved Glass Canopyhood is 100,000 units. As each canopyhood requires 2 kg of steel, to produce 100,000 units would require 200,000 kg of steel (100,000 × 2). However, after producing 10,000 units of IC1300 Ironing Centre (which used up 5,000 kg of steel), Robinhood only has 95,000kg of steel available. This means it could produce 47,500 units of the Island Curved Glass Canopyhood (95,000/2 = 47,500). As this would use up all the steel available to Robinhood, the firm could not produce any more Island Curved Glass Canopyhood and would not be able to produce any Wall Canopy Rangehoods or Supertub ST7001s.

The product-mix decision that would maximise the contribution margin of Robinhood is set out in Figure 8-3 below.

Figure 8-3: Robinhood simplified product mix decision: contribution margins

Island

Curved Glass

Canopyhood

$

Wall Canopy

Rangehood

$

Supertub

ST7001

$

IC1300

Ironing

Centre

$

Emperor

Waste

Disposal

$

Volume 47,500 0 0 10,000 0

Sales value $28.5m 0 0 $3 m 00

Contribution margin $14.25m 0 0 $1 m 0

The total contribution margin for Robinhood would be $15.25m, with $14.25m coming from sales of Island Curved Glass Canopyhood and $1m from sales of IC1300 Ironing Centre. No other combination of sales of its products would give Robinhood as much total contribution margin. By focusing on the contribution of products to a firm’s fixed costs and profits, managers can make decisions about which products a firm should

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sell. It can also help managers make a range of other decisions, including whether to make a product or service in-house (as Robinson does with its Supertubs) or whether to outsource the production of its products to other parties (as Phil & Ted’s Most Excellent Buggy Company does with its baby buggies, and indeed with most of its products). We have been looking at short-term decisions, such as product mix decisions, which require managers to focus on the next few months or up to a year or so into the future. There are other decisions that can have longer term implications for a firm and which require managers to look out further into the uncharted future of their firm. In the next section, we will look at how accounting can potentially support managers in making long term decisions.

8.3 Long term decisions

No sensible decision can be made any longer without taking into account not only the world as it is, but the world as it will be.

Isaac Asimov

Some decisions managers make have long term consequences for firms. These decisions may involve investing large amounts of money into long-term or non-current assets of a firm, which are expected to provide benefits to the firm over a period of many years in the future. Some firms operate in industries which are by their nature capital-intensive, requiring substantial capital investment into major assets that are expected to provide benefits for many years in the future. The airline industry is such an industry. For example, Singapore Airlines ordered 20 Airbus A380s. It took delivery of the very first Airbus A380 in the world in October 2007. This plane flew its maiden flight between Singapore and Sydney. Singapore Airlines expects to fly its Airbus 380s for many years. At around US$300 million each, Singapore Airlines’ purchase of 20 Airbus 380s involves a total investment of about US$6 billion.

Firms in some industries can operate with business models that require little capital investment, for example Phil & Ted’s Most Excellent Buggy Company. Phil & Ted’s are based in Wellington in New Zealand, and in its earlier years had around 20 staff, an office and a photocopy machine or two. It has in recent years expanded its operations quite a bit and now has about 100 staff in its Wellington head office and a total of about 140 staff around the world; but given the size of the company’s sales and profits its internal operations are still relatively small. Phil & Ted’s are a designer, manufacturer and marketer of a range of premium nursery products with its flagship product being the three-wheeled e3 Explorer buggy. Phil & Ted’s 55 products are exported to 50 countries and sold in 2000 stores worldwide. Phil & Ted’s operate a highly efficient, largely virtual operating business model where it outsources its manufacturing, logistics and distribution to strategic partners. Virtually all its manufacturing is contracted out to firms in China and elsewhere at competitive levels of cost and quality in accordance to Phil & Ted’s proprietary designs and requirements (design and production engineering being core Phil & Ted’s competencies). For low capital-intensive businesses like Phil & Ted’s long- term capital investment decisions are less important than in capital-intensive businesses like Singapore Airlines. However, all businesses still need to make these long-term decisions to some extent. This section looks at how accounting may, or may not, be able to support managers evaluate options to make substantial, long-term capital investments.

Time value of money

When considering decisions with long-term implications for a firm, it is important we understand the idea of time value of money. This means that a dollar now in our hand is generally worth more to us than that same dollar in the future. How could this be? Is not a dollar a dollar at any time? Well, no. As people, we tend to prefer to spend and consume our resources now rather than later. Time is short, and we all need to get on with our lives. Also, we can find ourselves in situations where we have an urgent need for cash. For example, a friend may suggest we go on a trip to North Queensland next month; or our tablet may have died and we need to buy a new one right now; or we may have left our iPhone on a plane and need to replace it. In many situations we need money now, not in the future. So, a dollar (or $1,000) in our pocket today is generally worth more to us than a dollar (or $1,000) in a few years time.

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We may be happy to defer our consumption until sometime in the future. For example, we may be willing to put off visiting North Queensland for a few years and instead to stay home and put our energies into studying accounting or business. Yet in such a case a dollar today is still generally worth more to us than a dollar in the future. In this situation, if we had our dollar (or $1,000) in our hand right now, rather than later, we could put that money in the bank and earn interest on it. For example, with the Commonwealth Bank now you can earn 1.65% per year interest (payable monthly) on a Goal Saver bank account (if you meet certain conditions). If you received $1,000 today, invested it in the bank at 1.65% per year interest and after paying tax on this interest at the rate of 30%, your $1,000 would be worth about $1,012 in one year’s time. That extra $12 could come in handy to buy, perhaps, a (small) lunch at Keppel Bay Sailing Club in Yeppoon.

Another key thing about a dollar today is that it is certain. You have it in your hand right now; no ifs, no buts. That is different to a dollar in the future. A dollar in the future is uncertain; today, a dollar in the future is simply a promise of a dollar in the future. There will always be some uncertainty, or risk, about a dollar in the future. We may, or may not, get that dollar in the future. It is the uncertainty, the risk, of a dollar in the future that is the main reason why we value a ‘certain’ dollar today more highly than an ‘uncertain’ dollar in the future.

For these reasons, we prefer a dollar today rather than a dollar in the future. A dollar today is worth more to us than a dollar in, say, one year’s time. There are some approaches managers can use to help them evaluate capital investment opportunities which do not allow for the time value of money. These approaches simply assume a dollar in the future is worth the same as a dollar today. Two of these approaches are the accounting rate of return (ARR) and the payback period. Both approaches have the advantage they are simple to use and understand.

Accounting rate of return

The accounting rate of return (ARR) can be calculated as follows:

ARR (%) = Average net profit 100

Initial investment 

Let us say Singapore Airlines paid US$300 million for the A380 Airbus. Alternatively, it could have purchased a Boeing 787 Dreamliner for about US$200 million. Let us say the A380 Airbus is expected to initially contribute US$25 million to the net profit of Singapore Airlines in its first year of operation, increasing to US$34 million in the next year and to US$40 million in the third year. By comparison, the Boeing 787 Dreamliner would be expected to contribute US$20 million to the net profit of Singapore Airlines over each of the next three years. Singapore Airlines could have calculated the ARR for each alternative as set out in Figure 8-4 below.

Figure 8-4: Accounting Rate of Return

Year 1

US$m

Year 2

US$m

Year 3

US$m

Average

US$m

A380 Net profit

(after depreciation and tax)

25 34 40 33

Boeing 787 Dreamliner

(after depreciation and tax)

20 20 20 20

Initial investment:

Airbus A380

Boeing 787 Dreamliner

$300 m

$200 m

ARR:

Airbus A380 (33/300)

Boeing 787 Dreamliner (20/200)

11.0%

10.0%

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The Airbus 380 is expected to have an ARR of 11.0% and the Boeing 787 Dreamliner an ARR of 10.0%. Based on this analysis of ARR, the managers of Singapore Airlines would favour the Airbus 380 over the Boeing 787 Dreamliner.

Payback period

The payback period of an investment is how long it is expected to take before an investment returns the cost of the initial investment. The reason this is of interest to managers is that once an investment has returned the cost of the initial investment it is no longer possible to lose money on that investment. All investments by firms in capital items involve risk. This is because, although the initial cost of the investment may be clear and certain at the time the capital item is purchased, the benefits expected to be received from that capital item in the future are uncertain … because no-one knows what will happen in the future with certainty. There is always some doubt and some risk.

However, once an investment has returned its original cost then at least it is no longer possible to make a loss on that investment, regardless of what happens after that point. This is the payback period. It is essentially a measure of risk. The longer the payback period the longer the time in which it is possible the firm may make a loss on its investment; the shorter the payback period, the shorter the time in which a firm could make a loss on its investment. To calculate the payback period for an investment, we simply add the after-tax cash flow expected to be received from the investment each year in the future. At the point where these cash flows equal the amount of the initial investment, this is the payback period.

Where an investment is expected to provide constant cash flow each year, the payback period can be calculated as follows:

Initial investment Payback period =

Cash flow

An investment of $2 million which is expected to provide cash flow of $500,000 per year would have a payback period of 4 years, calculated as:

Initial investment Payback period =

Cash flow

$2,000,000 per year

$500,000

4 years





In the more common case where cash flow from an investment is expected to vary each year, we can simply calculate the cumulative cash flow each year as set out in Figure 8-5 below. We can see the cumulative cash flow from the investment at the end of Year 3 is $1.4 million and at the end of Year 4 is $2.6 million. We can see the cumulative cash flow equals $2 million sometime during Year 4. If we expect the $1.2 million cash flow from the investment in Year 4 to be received evenly throughout the year (that is, $100,000 per month), then the investment would return $2 million exactly half-way through Year 4 and the payback period would be 3½ years. Now payback period is an easy concept to understand and use in business. Accounting numbers from past activities of a firm can be useful to help managers develop forecasts of future cash flow from new investments and help managers use the idea of a payback period in their analysis of capital investment proposals.

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Figure 8-5: Payback period

Investment: $2,000,000

Cash flow

$’000

Cumulative cash flow

$’000

Year 1 200 200

Year 2 400 600

Year 3 800 1,400

Year 4 1,200 2,600

Year 5 1,400 4,000

Year 6 10,000 14,000

The key benefit of the payback method is that it gives some sense of the level of risk of an investment, namely how long it is expected to take before there would be no possibility or risk of making a loss on the investment. However, the big disadvantage of the payback method is that it ignores the expected ‘upside’ from an investment, that is, the cash flow expected after the end of the payback period. After all, the reasons managers would decide to make investments in non-current assets in a firm is because they expect to earn a return greater than the cost of the capital used to make that investment. As you can see in Figure 8-5, the investment is expected to return a large sum ($10 million) in Year 6. The payback method pays no attention to this expected ‘upside’. It also does not consider the time value of money in its evaluation of investment opportunities. In the next section, we will look at two common methods of discounting cash flows to take into account the time value of money: internal rate of return and net present value.

8.4 Discounting cash flow

The best thing about the future is that it comes only one day at a time.

Abraham Lincoln

My interest is in the future because I am going to spend the rest of my life there.

Charles F. Kettering

Prediction is very difficult, especially of the future.

Neils Bohr

We can specifically and mathematically include a consideration of the time value of money by discounting (or reducing) the future cash flow we expect from an investment. If we expect to receive a dollar in five years time from an investment, we could discount or reduce its value so that it would be worth less than a dollar today. We could also reduce the value of a dollar in ten years time by a greater amount and so forth for expected cash flow out into the future. Eventually, as we look out further and further into the future, we could reduce or discount future expected cash flow by so much that after, say, 40 years or so expected future cash flow can become almost worthless in terms of dollars today.

For example, $1.00 in late 2007 could buy a cheap cup of coffee in the morning at the Loaded Hog at Queen’s Wharf in Wellington. I wrote some early versions of a few chapters of this book drinking copious amounts of $1.00 cappuccinos sitting in the sun by Wellington Harbour at the Loaded Hog. However, $1.00 in 40 years

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time discounted by 10% per year would be the same as 2 cents today. In New Zealand, the smallest coin is 10 cents, so 2 cents would get rounded down to zero. In this case, $1.00 in 40 years time would have effectively no value today. Good-bye to those cups of coffee. In any case, the Loaded Hog was quite a few years ago remodelled into Foxglove, which meant goodbye to those cheap cups of coffee in the morning by the waterfront. There are two main methods used to discount expected future cash flow of potential investment opportunities: internal rate of return (IRR); and net present value (NPV). These are the two main discounted cash flow (DCF) techniques used in business. We will look at each of them and consider how accounting can help or perhaps hinder managers to use these techniques to make long-term decisions.

Internal rate of return

The internal rate of return (IRR) method has been widely used in business for many decades. It differs to the accounting rate of return (ARR) method described in Section 8.3 above. The IRR method uses expected future cash flow rather than accounting profits (which is used by the ARR method). We saw in the Purple Chocolates example in Figures 7-1 and 7-2 in Chapter 7 above that for the same six month period Purple Chocolates could have a negative cash flow of $325,000 and yet make an accounting profit of $825,000. As we saw, cash flow and accounting profit are by no means the same thing. Also, the IRR method adjusts expected future cash flow for the time value of money. There is no such adjustment under the ARR method.

The internal rate of return (IRR) of a potential investment opportunity is the rate of return where the net present value of the expected future cash flow of the investment equals zero. For an investment that requires an initial cash outflow as the initial investment and then is expected to provide cash flow to the business over several years, the IRR is the discount rate that will result in the expected future cash flow from the investment equalling the initial investment. The IRR method has the big advantage that it is easy to understand as it expresses an evaluation of investment opportunities as a percentage return on the amount invested. Everyone ‘knows’ that an investment returning an IRR of 20% is better than an investment returning an IRR of 14%. We are all used to the general idea of percentage returns on investment. It also specifically allows for the time value of money.

The IRR method has some drawbacks. Some investments involve a series of cash outflows over time (rather than a single cash outflow at the beginning); in other words, not just a single investment at the beginning but further investments along the way as well. In these situations, the IRR method can produce more than one internal rate of return (IRR). This can be mighty confusing for managers and is a conceptual weakness of the IRR method for investment opportunities requiring a series of cash outflows over a period. Also, the IRR method takes no account of how much a firm might invest in an investment opportunity. An investment of $1 million might offer an IRR of 20% and another investment of $100 million might offer an IRR of 18%, but the latter investment might add a whole lot more value to a firm. The second popular discounted cash flow approach, the net present value (NPV) approach, seeks to measure more directly the ‘value add’ to investors of investment opportunities.

Net present value

The Net Present Value (NPV) approach does not evaluate investment opportunities in terms of percentage returns, but in terms of dollars of ‘added value’. The NPV approach involves discounting all expected future net cash flow by a discount rate (based on how much the capital you use in the investment costs you). A positive NPV indicates an investment would add value to a firm (that is, return more to a firm than the cost of the capital it uses) and a negative NPV indicates it would destroy value (that is, return less to a firm than the cost of the capital it uses). The larger the positive amount of NPV the greater the amount of added value for a firm; the larger the negative amount of NPV, the greater the amount of value it would destroy for a firm. Managers should choose investment opportunities that are expected to provide positive NPV and avoid investment opportunities that are expected to provide negative NPV.

A key difficulty in using the NPV method is determining the discount rate to use. There is always considerable ‘guess-work’ involved in doing this, which adds considerable subjectivity (and thus potential for manipulation) to the results of NPV calculations. Further, the central weakness of both the IRR and NPV methods are

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difficulties in forecasting future cash flow from investments; which is where management accounting can potentially come in to provide some help to managers. Accountants in firms have a key role to help provide reliable and reasonable estimates of expected future cash flow of investment opportunities. Past experience as measured by a firm’s accounting system is often invaluable in helping us do this.

Despite significant difficulties in applying the IRR and NPV methods in practice, both approaches are widely accepted and used by managers in firms to evaluate investment opportunities. There are also a few technical difficulties and weaknesses in using discounted cash flow (DCF) techniques such as IRR and NPV, which are not always fully appreciated by those who use them. For example, DCF techniques assume cash flow received each year can be reinvested for the rest of the life of the investment to earn certain levels of return. This assumption may not be practical. The IRR method assumes reinvestment of cash flow at the same level of return as the internal rate of return (IRR) used in the calculations. The NPV method assumes reinvestment of cash flow at the discount rate used (which would usually be different to the IRR, except when an investment has an NPV equal to zero).

Under DCF techniques, discounting of cash flows compounds. In other words, we discount a cash flow in 10 years time back to 9 years in the future, which we then discount back to 8 years and so on to the present. One thing about compounding is that it becomes very powerful over time. For example, if we were to receive $100 billion in 40 years time, discounted by 10% per year this would be worth about $2 billion today. In other words, $100 billion would pay for about three national broadband networks (NBNs); $2 billion would pay for the bit around North Queensland (maybe); forget about the rest of Australia. And $100 billion in 60 years in the future discounted by 10% per year is worth about $300 million today (the cost of the NBN around Rockhampton, Gladstone and Bundaberg); and $100 billion in 80 years in the future is worth only about $40 million today (well, just a few trenches for the NBN around Yeppoon and the Capricornia Coast).

As we go out further and further into the future everything, even amounts as huge and significant as $100 billion, gradually become worth close to nothing to us today under DCF techniques. Is the future beyond 40 or 60 years really of little or no value today? Clearly, much of what we have of value today has been greatly affected and influenced by decisions and activities and events of people 40 to 60 to 80 years ago (indeed, by people who lived thousands of years ago). Are not these things we value today of real value? Yet these things we might value greatly today, DCF calculations would cause us to value as next to worthless just 40 or 60 years ago.

Clearly, there are limitations to DCF techniques such as IRR and NPV methods, particularly when looking at benefits many years into the future. But they are some of the most useful methods we currently have available to managers to value longer-term investment opportunities. And managers are in the driving seat of their firm and need to make the most effective decisions they can with the tools and techniques they have. Accounting can perhaps help managers by providing numbers that can be used to help make these DCF approaches work as well as they can to support managers make long-term decisions.

Qualitative factors

Ever notice that ‘what the hell’ is always the right decision?

Marilyn Monroe

But there will always be much that is left out of DCF analyses, or any other quantitative analysis, that relies on accounting and other numbers. There are usually many critical qualitative factors that are relevant to long- term decisions of managers that are difficult to incorporate into numbers. There are also impacts of these decisions by managers on many other people besides equity investors. DCF techniques are usually used to simply measure the impact of managers’ decisions on equity investors in a firm. We can never include everything in the numbers in any analysis we may make of a firm’s longer term decisions. This is because these decisions will involve people. And people, and the effects of decisions on people, can never be completely reduced simply to numbers. However, numbers and the thoughtful and careful use of techniques to analyse numbers can be very useful to support decision-making.

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This is the case if we clearly understand what we are doing, and the limitations of any approach we are using. We need to creatively and imaginatively apply techniques to the analysis of options for longer-term decisions by managers. Similarly, all the various quantitative techniques to support managers’ decisions are only as good as the numbers put into the calculations. Although a firm’s management accounts will reflect the past activities of a firm, they will often give useful guidance about what managers could expect from future potential activities of a firm. For example, past contribution margins of a firm’s products can give useful guidance, and be useful starting points, for managers to consider the future contribution margins of a firm’s products. A firm’s management accounts are usually a vital part to support managers in their task of making decisions.

Conclusion

As we have seen in Chapter 5 above, managers are in the driving seat of their firms. They are running a firm, and no-one else. They must constantly make decisions that will impact on the economic and business realities of their firm. We have seen in Chapters 5 to 8 how a firm’s management accounts can potentially help them to engage with and understand the past economic and business realities of their firms. This can then help them to estimate the likely impact on these realities of various potential decisions or choices they as managers could make.

In this chapter, we looked at various short-term and long-term decisions managers need to make and how accounting can help them make these decisions. The decisions managers make in our commercial businesses, public sector entities and not-for-profit entities affect us all. They affect the type, amount and quality of goods and services available to us as consumers; the nature of our working environments and working conditions as employees; the returns we receive as equity investors or debt investors in firms; and how firms’ activities impact on the general community and environment. Indeed, the impact of management accounting on the quality of decisions made by managers in our firms is quite central in our market-based economy.