Management of Discretionary Costs - Essay Example

Running Head: Management Of Discretionary Costs Management of Discretionary Costs of the of the Management f Discretionary Costs (a) Discuss the issues surrounding the management of discretionary costs, in particular the problems relating to the management of a research and development It is impossible for anybody to make projections with 100% accuracy (if reported results are exactly in line with your projections, it will be more likely a case f extreme luck or contacts (a euphemism for insider knowledge). Often people ask us, if such be the case, then why make projections at all Projections serve a very important purpose. They give you a framework to analyze the company's operations in detail and thus understand reasons for deviations from the forecast. Projections, if made with care, at least give a good indication f trend. In other words, projections can at least let you know the broad direction f future financial performance, whether growth will be in the vicinity f 25-30% or 0-10% or -25%. This is f great relevance to the intelligent investor. The other question, is whether one can make projections sitting in air-conditioned comforts without meeting management. Meetings with management serve the purpose f clarifying issues and understanding future strategy, but going to a meeting without understanding the business and drawing a core model is akin to facing Ambrose without cricket gear. Building the core model (in analyst lingo - "earnings model") is critical. To build this you need a good understanding f the company, what it does and in which area. Financial analysts typically follow the following methodology for making projections. Sales forecasting is the first step In case f a multi product company forecasting for each product should be done separately. Key variables - Volumes for each product and category - Unit realization for each product separately For volume growth (or decline as the case may be) estimates, one should look at past trends, industry outlook, company's competitive position and estimated market share. Unit realization forecast would depend on price trends, discounts offered by the trade, prices f competing products, etc. Pricing power f various players and their likely pricing strategies also have a significant influence on the forecast. If one is starting with MRP f the product, care should be taken that prices do not include sales tax, and are typically net f distribution expenses. In case f an FMCG product (Fast Moving Consumer Goods) unit realization f the company, which will appear as gross sales will be typically 65% f MRP price which the consumer pays. Many a times, companies give their volume figures under generic product category name. The volume figures include products f different sizes, types and prices. The analyst has to take care f expected changes in product mix while forecasting. Keep a broad picture f the competitive scenario and its impact on pricing. Also, understand key drivers f pricing, like for petrochemicals, India is a price taker, so global price trends have a bigger influence in determining Indian price trends. Material Costs Estimate material costs, which in most cases is the most significant cost item. Key variables - Raw material prices - Production efficiency, conversion norms and yield improvement have a significant bearing on cost estimation. The analyst has to understand the basic manufacturing process and get a fix on input output norms. Labour Costs For estimating labour costs, one can start with previous year's labour cost and adjust it for the following factors. Key variables - Additions/ adjustments for additional capacity/ new plant, - Reduction for retrenchment/ sale f a unit etc, - Salary increases on settlements with union etc. Many companies plan for settlement hikes and make provisions even if negotiations are delayed, - Bonus, profit linked incentives, - Salary increases. Fuel and power cost Power and fuel cost is a key item in some industries. If for the company under analysis, it is not significant (say less than 2% f sales), an analyst can make a judgmental estimate. Else look at key variables Units f power to make one unit f output, volume f output estimated, Tariff rates f utility companies and fuel prices in different regions where units are located, Availability f power. Given India is a power deficit country, availability f power might restrict production. This also might imply that the company has to invest in back up in form f generators. Freight expenses In cases, particularly when a commodity is moved over long distances, freight is a significant cost component. A good example f this is the cement industry, where it is expensive to transport cement, a bulky product over long distances. Key variables - Average freight rates, - Volumes and distances. Track the dynamics f the industry carefully, as changing demand patterns, new investments, etc tend to have a major bearing on your estimates. For example, if another company sets up a new cement plant nearby, the older company A may have to ship cement over longer distances. Thus, transport costs will increase, reducing margins. Moreover, realization will vary depending on the prices in the faraway markets. Interest Cost Interest cost calculations require - Average long-term debt during the year, - Average working capital borrowings, - Average cost f long-term and - Average cost f working capital debt. It is difficult to calculate interest costs from the long-term debt and working capital figures in a balance sheet. This is due to the fact that balance sheet is prepared at on the last day f the financial year whereas interest costs which feature in profit and loss account would be for the entire year. It could be co-related with the average debt or average working capital loan figures, which are not available in the balance sheet. For instance, if a company has a debt f one million rupees throughout the year and presuming that it repaid it a day before the end f the year (or substituted by some short term liability which is shown as part f working capital, it can show zero debt in the balance sheet. Working capital figures may fluctuate due to seasonal nature f business. Working capital is high in peak season. If the year end falls in peak season, the reported working capital figure can be much higher and vice versa. Interest is capitalized during construction period, therefore interest cost jumps up significantly after any project (funded by debt) is commissioned. The analyst has to keep in mind, sales tax deferral loan which appears as a loan as these loans carry no interest. Also there can be subsidies or concessional loans under certain incentive schemes f the government or government institutions. In effect, interest is a difficult line item to estimate, unless you have access to all capital expenditure estimates, detailed interest and repayment schedules f loans and working capital requirements. So, try to get understand the cash flows f the company for the future, estimate cash surplus deficit and only then try to estimate interest expenses. Also, use both cash/ bank balances available and quality f liquid investments while drawing your cash flow statements. Depreciation Depreciation in a company's account is normally charged as per the Companies Act, Schedule XIV. Companies are free to charge lower or higher rate but there has to be a note to that effect in the annual report. Key variables - Have a fix on routine capital expenditure, - Expansion and the likely date f their commissioning, - Depreciation rates followed by the company for various types f assets. Depreciation is charged pro rata. For instance, if the plant is commissioned in March, depreciation will be charged only for one month if the financial year ends in March. For calculation f income-tax, you can deduct depreciation for six months. Depreciation rates are different depending on the type f assets and vary in case f continuous processes industry, depending on the plant-run for one shift, two shifts or three shifts. Tax liability Taxable profit is calculated after a few adjustments in the accounts. The key variables are - Corporate tax rate, - Depreciation rates and asset build up, - Exports, if any - Backward area benefits, if any Depreciation rates according to the Income Tax Act is different. Also, there can be disallowance f some expenses. In order to calculate taxable profit, the company has to add back book depreciation and deduct depreciation as per Income Tax Act. Rates f income tax are different and the depreciation in Income Tax Act is calculated only on WDV (Written Down Value) method. If the plant is commissioned on 30th September, Income Tax Act allows depreciation for one full year and in case the plant is commissioned in the second half f the financial year, then depreciation is allowed for six months only. One should also note that income tax is calculated on financial year basis only, regardless f the 12 month period the company is following for closing its books. Thus, even in case f companies, which have December year ending, they have to prepare separate accounts to calculate their tax liability for the full year. Also, tax is payable in four instalments as per income tax act by way f advance tax. The effective tax rate, which is tax paid divided by profit before tax is indicative f the tax field/ tax allowances available to the company and has no relation whatsoever to the actual tax rate. Dividend Generally, dividend is paid out f current year profits. In some exceptional cases, it can be paid out f profit from earlier years. This happens if the company has adequate reserves and is confident f a recovery even after making losses or lower profits in one year. Preference dividend is paid only if there are adequate profits to pay out. It has priority over equity dividend. Equity dividend cannot be paid if the company does not have funds or profits enough to pay preference dividend. Equity Capital While making forecasts, you have to take into account possible equity dilution ( in form f rights and public issues). What about bonus issues Bonus is issued out f free reserves, so networth will remain the same. Also, they cannot be predicted with any degree f certainty. One needs to be consistent in terms f funding assumptions. For instance, a company is mooting to set up a project for which it would require equity investment. If you are assuming that the project will be set up, you will have to forecast equity dilution (ie an increase in equity). Factor in additional inflow f debt funds also. The sum total f increase in equity and debt coupled with funds generated from its ongoing business should be greater than the project cost. Whenever the project gets commercialized, increase its sales turnover and factor in its impact on all other aspects. Borrowings Once you prepare the cash flow statement based on the presumptions about profits from operations and working capital, find out funding requirement i.e. repayments falling due and capex, which are the two big line items. So, the sources f funds are from operations (PAT less dividends) and depreciation and other non cash expenses, issuance f debt and equity. The uses are capex, repayment f loans and working capital. This will enable you to get a broad picture f the cash flow position. Use change in loans as the balancing figure, ie if there is a surplus, reduce loans and if there is a deficit increase it. In many cases when loans are taken from financial institutions, even if you have surplus cash, it may not be easy to pre pay the same. In such cases the management might decide to pass surplus funds into investments or other short term current assets. In most cases you will find when companies raise money by way f public issue or GDRs, funds remain parked in loans and advances and investments till they are deployed in the project fixed assets creation. Investments This line item is difficult to estimate as most f times the detailed investment plans are not known to outsiders. One can estimate a part f investments based on cash positions f the company. Or keeping a track f its equity portfolio and checking out dilution in them. For instance, there is big chunk f MRPL shares in Grasim's books, so if MRPL is in need f funds, then you have to factor that in as investments in Grasim's books. Fixed Assets Gross block would increase by the amount f new assets added in the year, net f historical actual purchase price f assets sold or discarded during the year. However, if there is a substantial sale f assets during the year, accumulated depreciation figure should be adjusted. When you look at any balance sheet, you may find that accumulated depreciation figure does not add up to previous balance and current provision. This is due to the fact that every year there may be some assets, which are either sold or discarded and accumulated depreciation amount gets adjusted by that amount. Net Block or net asset is gross block less accumulated depreciation. Investment portfolio is f two types. One which is driven by business needs and the other a parking slot for surplus funds. The investment driven by business needs would include equity investment in subsidiaries, customers, key vendors, joint ventures or deposits with statutory authorities. Whereas the discretionary investment portfolio can comprise debt, fixed income securities or equities purchased through secondary market. Many a time, companies invest in other listed companies belonging to the same group. This investment is discretionary and in most cases detrimental to shareholders interests. This is one reason why companies with a track record f active participation in the stock markets get a low discounting. Working Capital As you know, working capital (or net current assets) is equal to current assets less current liabilities. To forecast this, one must estimate each f the constituents separately. All the items f working capital (except cash, current provisions to some extent) are dependent on sales. So, one need to get a handle on sales and work out each f these components separately (based on norms and past behaviour). - Sales - Norms for each component - Policy - Short term assets/ liabilities Each component f working capital should be estimated separately. Inventory forecast would depend on sales turnover, the company's policies on raw materials, stockings etc. Nowadays, information technology also helps significantly in keeping inventory levels low. If there is a proper flow f information regarding inventories at various levels, particularly for multi-location company, planning at unit levels can improve significantly. This is the basis f Just in Time concepts on inventory management, i.e. keep inventory as low as possible to cut costs. Receivables: This will depend on credit policy f the company. Compare this with past trends. If one expects, competition to pick up, expect better terms in future, i.e. longer receivables turnover. Creditors: Creditors would depend on credit enjoyed mainly from raw materials suppliers. Working capital can also include non-trade current assets and liabilities, which gets camouflaged in loans and advances. In general, it is difficult to estimate loans and advances as they are discretionary in nature. Miscellaneous Expenditure Miscellaneous expenses not written off refers to preliminary and pre operative expenses, which are written off over a period f time (say 5-10 years). The write down policy is highlighted in notes to accounts. Some times there is a loss which is carried forward in the balance sheet. It appears as a debit balance on the asset side. In reality it is a negative reserve and hence networth should be reduced by the amount carried forward in the profit and loss account. Deferred Revenue Expenditure Many a time, expenditure may be f a revenue type but the benefits would accrue to the company over a longer period f time. For instance, an FMCG company can incur significant expenditure towards launching a new product. Typically the expenditure in the first year is far greater than the turnover from the product itself. Obviously the benefit f this advertisement and brand building would accrue over a longer period and it becomes difficult to apply the principle f matching concept. In such cases, accountants follow a rule f thumb and spread expenditure over 3 years, 5 years, 10 years as the case may be. While conservative companies prefer riding off revenue expenditure as soon as possible, the companies where management would like the profit figures to be higher (it may genuinely believe that the higher profit is fair figure and a better reflection f financial status f the company) would defer riding off f certain expenditure. In such cases, the amount not written off is like an asset which appears in the balance sheet. The amount written off every year is like depreciation, which is reduced from the value f the asset in the balance sheet and charged to profit and loss account. (b) based on the problems identified in part (a), prepare a report to the senior management of the research centre proposing a formal process to improve management. As the simulation clearly demonstrates, people demand a higher return on their investment in exchange for taking that greater risk. In Adrian's case for example, who has a high-growth risk profile, it is not feasible to risk a lot for too little. Financial challenges faced by Kramer and Associates, and especially by the director of this investment consulting company deal with attempting to manage clients' portfolios to suit each and everyone's future financial needs. In summary, the simulation involves three clients with different risk profiles. Adrian O'Donnell has a high-risk growth profile, and wants to see returns as quick as one and a half to two years time. Tonya Davidson has a conservative-risk growth profile, and wants to see a steady growth of her investment over the span of 10 years. John Barrett has a moderate-risk growth profile, and wants to see steady returns over a period of five to six years. The challenge arises on how to allocate their investment funds to meet their desired risk and returns level. With treasury bills, the returns are almost exactly what was promised initially, therefore making them an almost risk-free investment. The returns on T-bills are on average about five percent. Stocks on the other hand, have returns of average 10 percent per year. In this case, companies may eventually experience bankruptcy, which means a depletion of one's stocks in that company, or that company may experience enormous growth, meaning that the investor will experience enormous returns. Therefore, the simulation challenges the consultant to find the right mix of investment options to satisfy the goals of each client. In doing the simulation, one has to remember that if one obtains for example of 5-percent return on a low risk stock or no risk T-bill, would it be a financially wise decision to invest in a stock that yielded say a four-percent return It would not; because this would incur a higher chance of negative results (losing your investment) to make less than one would with no risk. One has to justify choosing high-risk investments, and thus expect higher returns on those investments. To manage risk properly, companies must be very familiar with risks they are undertaking. Risks need to become transparent, and therefore companies need to understand exactly what risks they face and how these risks could impact their fortunes. Let's consider Hewlett Packard, which is the world's largest computer and Electronics Company, ranking 11th in the Fortune 500 list, with a powerful team of 142,000 employees, and doing business in more than 170 countries. The company had had headquarters in countries like Canada, Singapore, Japan and Switzerland and it's Research and Development (R & D) investment of nearly $4billion continuously fuels the invention of new products, solutions and technologies. HP's quick ratio has made a great increase in the last three years, which is a sign of increasing liquidity improvement for the creditworthiness of the company. As the competition increases, the firm needs to establish investment strategies that can provide adequate funds for the new projects to compete with other rivals like Dell, Toshiba and others. Stocks can offer greater returns in the short term but they are too risky. On the other hand, bonds have less risk but they are also long-term investments. Thus the best strategy is to invest in its own infrastructure and projects, which have the potential to offer more returns than the first two alternatives. HP has greater leverage than most of its competitors, which means that the company can offer greater returns to shareholders but is also riskier. However, the firm's size allows HP to practice its generic strategies related with low cost, improving technology and quality by using economies of scale. The company seems to use the advantages of having satellites in different countries but additional investments will be needed to protect the strong competitive position in these regions and establish new bases in areas that have economic growth potential. Thus the company can make investments and establish new bases in areas, which may have strong economic potentials in the future, like China, India or Russia. For example, HP can make investments to develop its existing offices in two big cities, Shanghai and Beijing. The Shanghai office can be upgraded into a corporate headquarters like the other corporate headquarters in Singapore and Tokyo. The firm can also spend more funds to increase researches in mobility and build new wireless technology labs in key areas like Silicon Valley, Japan and Germany. These labs will focus on increasing network security, cost saving and developing new products. Since the firm's major earnings are coming from the printing division, this creates a risky situation for the company. HP can avoid or reduce this risk by using the benefit of merger with another computer giant and can increase its production in PC and workstation markets. However, there is a great pricing pressure in the overall PC market. Dell is a strong competitor and has a focus on the standardized computer markets. The company eliminates inventories more efficiently than any of its competitors which is a main threat for HP. Thus an acquisition strategy may not change anything except increasing inventory levels and costs if the firm does not focus on its internal operations and reduce its inventory levels. Besides the new merger or acquisition target should be a profitable company, because the company should take lessons from the past. For example, the Compact Merger is already considered a failure that increased the overall costs of operations. 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