Decision Making As a Critical Part of Good Management - Essay Example

Decision Making As a Critical Part of Good Management Introduction Accounting and Finance have various roles in our day-to-day life, especially in our organizations. Some of these roles involves decision making, which is a critical part of good management in any organization[Bri92]. Most managers have found the use of financial information to be critical and very important in enabling their organizations to succeed in business as well as become competitive in the industries within which they operate[Pur141]. Some of the areas where financial information is required for good decision making includes making investment decisions, production as well as company evaluation decisions. This report is based on certain scenarios of NENE, Benjamin and Peters Limited that are faced with different situations and require financial decision making on choice of project, company evaluation as well as production decisions. The report will use financial calculations of various business analysis tools to help with the decision making. The report will be confined to the information provided in the particular case studies when making decisions. Other outside sources such as books and journals are also used to reinforce certain calculations, principles and analysis tools when making decisions concerning particular case studies. Question 1 a) i) Projected Cash Flows Cash flows of Alpha: 　Year Cash inflow/outflow £ Depreciation £ Disposal proceeds £ Cash Flows £ Cumulative cash flows £ 0 -100,000 0 0 -100,000 -100,000 1 15,000 18,000 0 33,000 -67,000 2 18,000 18,000 0 36,000 -31,000 3 20,000 18,000 0 38,000 7,000 4 32,000 18,000 0 50,000 57,000 5 18,000 18,000 10,000 46,000 103,000 6 2,000 0 0 2,000 105,000 Cash flows of Beta: 　Year Cash inflow/outflow £ Depreciation £ Cash Flows £ Cumulative cash flows £ 0 -90,000 0 -90,000 -90,000 1 20,000 30,000 50,000 -40,000 2 25,000 30,000 55,000 15,000 3 -50,000 30,000 -20,000 -5,000 4 10,000 25,000 35,000 30,000 5 3,000 25,000 28,000 58,000 6 0 25,000 25,000 83,000 ii) Payback Period Alpha Payback period: 2 years (representing the year just before the cumulative cash flow becomes positive) + 31/38 (representing the remaining period for the project to achieve the zero cumulative cash flow amount). Therefore, the Payback period for project Alpha will be 231/38 years or 2.82 years. Beta Payback period: 3 years (representing the last year where the cumulative cash flow is still negative) + 5/35 (representing the proportion of years left for the last negative cash flow amount to become zero). Therefore, the Payback period for Beta project will be 3 5/35 years or 3.14years. iii) Accounting Rate of Return To calculate the accounting rate of return, we use the formula: ARR = (Average Annual Operating profit / Average Investment Amount) x 100%. ARR for Alpha Project: The Average annual Operating profit is calculated by adding up all the operating profits provided for the six years period and dividing by the number of years. This comes to (205,000 / 6) = 34, 167.7 equivalent to 34,200 pounds. But this is the amount before depreciation. With the annual depreciation rate being 18,000 (100,000 – 10,000) / 5 = 18,000 pounds, the average annual operating profit will be the average annual profit minus depreciation. Which is 16,200 (34,200 – 18,000). This is the amount after depreciation. The average investment will, therefore, be calculated as; (100,000 – 10,000)/2 = 55,000 pounds. Therefore, ARR = (16,200/55,000)* 100 = 29.45% ARR for Beta Project: The average annual operating profit before depreciation is calculated by adding up the profits for each year and dividing by the number of years (6). This comes to 28,830 pounds (173,000 / 6). The depreciation for this project is (90,000 – 0 + 75,000 – 0)/ 6 = 27,500. If we minus depreciation from the original average annual operating profit, we get 1,330(28,830 – 27,500) which is the average annual operating profit after depreciation. To calculate the average investment we use (90,000 + 75,000)/ 2 = 82,500 pounds. In this case, ARR = (1,330/82,500)*100 = 1.61% iv) Net Present Value NPV for project Alpha: Time (years) Cash flows £ Discount factor (14%) Present value £ 0 -100,000 1 -100,000 1 33,000 0.877 28,941 2 36,000 0.769 27,684 3 38,000 0.675 2,565 4 50,000 0.592 29,600 5 46,000 0.519 23,874 6 2,000 0.456 912 NPV 36,661 NPV of project Beta: Time (years) Cash flows £ Discount factor (14%) Present value £ 0 -90,000 1 -90,000 1 50,000 0.877 4,385 2 55,000 0.769 42,295 3 -20,000 0.675 -13,500 4 35,000 0.592 2,0720 5 28,000 0.519 14,532 6 25,000 0.456 11,400 NPV 29,297 b) Recommendation To advise NENE Limited on the most appropriate project to undertake, all the four appraisal methods must be evaluated. To begin with, using the cash flows of the two projects, it is vividly clear that that project Alpha seems a good project as it has more cash flow (£105,000) than project Beta (£83,000). The general criteria for using cash flows in making such decisions is that, the project with positive cash flow should be undertaken, and at the same time, the project with the high cash flow should be preferred over the one with low cash flow[Gol95]. Project Alpha has the potential of increasing the shareholders’ income due to high cash flow involved at the end of the evaluation period. Project Beta is also good since it has a positive cash flow, however, its cash flow is low. It will, therefore, only be wise for NENE Limited to undertake project Alpha as far as cash flows are concerned. Secondly, when using the payback period, it is advisable that a project with the shortest payback period to be preferred over the project with longer payback period. As payback period represents the period in years that a project is likely to take before it pays back the cost of its initiation, the shorter this period is, the earlier the project begins giving its profits[HMW86]. According to calculations above, project Alpha will take approximately 2.82 years to breakeven out of its six years. On the other hand, project Beta will take approximately 3.14 years to breakeven. It is therefore very clear that project Alpha takes a shorter period to repay its initial cost than project Beta. It is therefore advisable for the management to take up project Alpha and leave project Beta. Thirdly, using the Average Rate of Return, it is advisable that the project with the ARR greater than the firm’s discount rate should be accepted[Elm93]. The firm’s discount rate is 14% while the ARR for Alpha and Beta projects are 29.4% and 1.6% respectively. This shows that, Alpha project should be taken up and Beta project abandoned. Fourthly, using the Net Present Value, the general criteria is always that, the project with a positive NPV should be taken up, but that which has the highest NPV should be the most preferred[Gri03]. Using the calculations above, the NPV for the Alpha projects is £36,661, while the NPV for Beta project is £29,297. It is there’re very clear that project Alpha should be accepted while Beta is rejected since project Beta has a low NPV. In general, it is recommended that NENE Limited should take up project Alpha and implement it since it is economically more viable than project Beta. Project Alpha has higher cash flow, lower payback period, higher Average Rate of Return and higher Net Present Value than project Beta, therefore, it will increase the shareholders’ income, payback the invested amount faster, and the amount of cash flow at the end of its period will be higher[Del081]. c) Critical Discussion of Appraisal Methods i) Internal Rate of Return Internal rate of return is this capital decision making method that equates the Net Present Value of a project to zero. To use IRR in making a general decision, it is usually preferred that the project with a higher IRR is chosen. With all other factors remaining equal, the project with the highest IRR can easily be chosen as the best to be taken up. This method is very easy to calculate just as it is easy to interpret. The method is also good as it considers the time value for money. It is, however, not preferred as it does not consider the future costs, the reinvestment cost as well as the size of the project. ii) Payback Period Payback period of a project is that time it takes to repay its investment amount. Different projects take different period to repay the investment amount since they are usually faced with different investment situations. However, the decision criteria for the Payback Period is that, the project with the shortest payback period should be accepted with preference over the project with a longer payback period[Loh93]. The reasoning behind this criterion is that, the project with a short payback period will begin giving profits earlier than the project with a longer payback period. The advantages of using this method include the fact that it is simple and easy to calculate as well as understand the results. The method also focuses on cash, as it emphasizes on the speed of return as the main focus. On the other hand, this method does not take into consideration the cash flows that come after the payback period and does not consider the time value for money. The method also encourages thinking in the short-term as it also ignores the qualitative aspects of a project decision. iii) Accounting Rate of Return It is basically the profit amount expected from an investment made. This return divides the average profit by the amount of the initial investment to find the return or ratio that can be expected. As a result, it allows the investor to compare the profits of the projects and decide on which one to take up on the basis of high expected rate of return[Bri92]. In short, the higher the ARR the better the project as it shows that the expected profit from the project will also be high. This method is liked as it gives a percentage return which is possibly compared with the target return and looks at the whole profitability of the project. However, the method does not take care of time value for money and cash flows as it only looks at the profits. iv) Net Present Value Net Present Value represents the difference that exists between the present value of the cash inflows and that of cash outflows. The method assesses the profitability of a project or an investment. The general criterion for NPV is that, a project with a positive NPV should be accepted[Pin97]. However, in a case where all the projects have positive NPV, the one with the largest NPV should be preferred. It, therefore, shows that, the larger the NPV, the more preferable the project is than the ones with smaller NPV. This method is most preferred as it takes care of time value for money, considers all the cash flows involved and has a decision making mechanism of either rejecting or accepting a project. However, the method is very complicated, difficulty in selecting most appropriate discount rates and its calculation is also sensitive to the cost of initial investment. Question 2 a) Ratio Analysis i) Return on Capital Employed (ROCE) = Net Operating Profit/ Capital Employed ROCE for Benjamin = 10,000/42,000 = 23.8% ROCE for Peters = 15,000/44,000 = 34.1% ii) Gross Profit Margin = (Revenue –COGS)/ Revenue GPM for Benjamin = (80,000 – 60,000)/80,000 = 25% GPM for Peters = (120,000 – 96,000)/ 120,000 = 20% iii) Operating Profit Margin = Operating Income/ Net Sales OPM for Benjamin = 10,000/ 80,000 = 12.5% OPM for Peters = 15,000/120,000 = 12.5% iv) Acid Test Ratio = cash and cash equivalents / current liabilities ATR for Benjamin = 45,000-15,000/5,000 = 6 ATR for Peters = 40,000-17,500/10,000 = 2.25 v) Inventory days = Ending Inventory / (Cost of Goods Sold / 365) ID for Benjamin = 15,000/ (80,000/365) = 114.06days ID for Peters = 17,500/ (120,000/365) = 60.83 days vi) Trade Receivable Days = Average Gross Receivables / (Annual Net Sales/365) TRD for Benjamin = 25,000 (60,000/365) = 152.08 TRD for Peters = 20,000 (96,000/365) = 76.04 vii) Trade Payable Days = Ending Accounts Payable/ (Purchases/ 365) TPD for Benjamin = 5,000 / (60,000/ 365) = 30.4 TPD for Peters = 10,000 / (96,000/365) = 38.02 b) Recommendation Profitability To begin with, the Return on Capital Employed ratio measure the profitability of a firm and the efficiency of employing its capital. A higher ROCE usually implies more efficiency with which a firm’s capital is employed[Sar13]. From the calculated results above, ROCE for Benjamin and Peters are 23.8% and 34.1% respectively. It therefore indicates that, Peters will be a good investment to go for by NENE management since it is more efficient in employing capital. The profits from this investment will, therefore, be higher than those from Benjamin Limited. Gross profit margin will help NENE management to assess the financial health of these two firms through showing the cash proportion that remains from the collected revenues after the firm has accounted for the cost of goods sold. Generally, for a company to be more efficient, it should have higher gross profit margins[Cla11]. From the calculations, the GPM for Benjamin and Peters are 25% and 20% respectively. It shows that, for every pound that Benjamin earns from the revenues, it actually remains with only 0.25 of it while Peters remains only with 0.2 of a pound. The ratio shows that when NENE management goes for Benjamin, they will be left with more profit after the COGS than if they go for Peters. Operating Profit Margin usually measures the proportion of revenues of a company’s that remains after all the variable costs of production such as salaries, have been settled. For a firm to be able to meet its fixed costs, there’s a need of the operating cost being healthier[Mas14]. A higher OPM is said to be a healthier one. Benjamin and Peters both have 12.5% OPMs. The management of NENE Limited should therefore realize that both firms will enable them to meet both variable and fixed cost well and leave them with better money. Liquidity To assess the liquidity of the two firms, NENE Limited will have to use the Acid-Test ratio. This is the ratio that is used to indicate a form’s capability to settle its short-term liabilities using the short-term assets it has without getting into its inventories[Kui08]. Generally, when a form has an acid-test ratio of less than 1, it shows its incapability to meet its short-term debts, hence, it should be looked at with a lot of caution. Benjamin and Peters have acid-test ratios of 9 and 4 respectively. It shows that, both forms are able meet their short-term liabilities. However, Benjamin is more efficient in meeting its short-term debts since it has a higher acid-test ratio. It is therefore more liquid than Peters. Working Capital Management In managing working capital, NENE management will look at the Trade Receivable days to assess the two firms. TRD shows proportion of days that the customer’s invoice will take before the money is collected or received in the company[Ayu15]. Generally, the shorter the period, the better for the company’s capital since it enables the company to have adequate capital in time to reinvest. Benjamin and Peters have TRD of approximately 153 and 77 days respectively. This shows that, Peters is better in managing its capital than Benjamin. Trade Payable Days on the other hand, shows the proportion in days that a firm takes before paying its suppliers. The shorter this number, the better for the company as it makes the company to stay out of debt sooner. In this case, Benjamin, which seems to pay its customers only within 30 days is more efficient in managing its capital than Peters that takes close to 38 days. c) Limitations of Ratios Ratios are good when comparing company performance, however, it is hard to use ratios where with large firms that have different divisions operating in different industries[Ama13]. Determining a meaningful set of ratios for an industry’s average is usually not easy. During inflations, profits are distorted, hence, ratios are affected. Comparing these ratios of the same company over a period, will not provide a sound judgment. Ratios are also affected by different accounting practice[Kam04]. It is also hard to generalize and that a ratio is good or bad. Some ratios are very hard to interpret, therefore, untrue interpretation may be used to give untrue judgment. Because some ratios also give values that are very hard to recognize as either good or bad, it is very hard using them to make decisions. Due to different sources from which the ratios originate, sometimes we use various definitions for various ratios. This makes it hard to use ratios to provide uniform analysis when it is required. Question 3 a) Costing i) Traditional Costing Method ii) Overhead absorption rate (OAR) = £4,410,000/(0.5x20000+1000+10000) =£210 iii) Calculating the indirect costs for each model: 　Model A (£) B (£) C (£) Direct Labor Hours 0.5 1 1 Rate of Overhead absorption 210 210 210 Per Unit Overhead absorption 105 210 210 iv) Full cost and per unit selling prices: 　Model A (£) B (£) C (£) Direct material 25 62.5 105 Direct labor 4 8 8 Per unit overhead absorption 105 210 210 Per unit full cost 134 280.5 323 Mark-up 20% 26.8 56.1 64.6 Selling Prices 160.8 336.6 387.6 v) Activity-based costing method: 　Model A (£) B (£) C (£) Machine Hours 40.00% 15.00% 45.00% Total overheads of machining 2,780,000 Overheads absorbed 1,112,000 417,000 1,251,000 Production 20000 1000 10000 Per Unit Overhead absorption 55.6 417.0 125.1 vi) 　Model A (£) B (£) C (£) Material Orders 47.00% 6.00% 47.00% Total overheads of machining 590,000 Overheads absorbed 277,300 35,400 277,300 Production 20000 1000 10000 Per unit absorption overhead 13.9 35.4 27.7 vii) 　Model A (£) B (£) C (£) Space 42.00% 18.00% 40.00% Total overheads of machining 1,040,000 Overheads absorbed 436,800 187,200 416,000 Production 20000 1000 10000 Overhead absorption per unit 21.8 187.2 41.6 viii) 　Model A (£) B (£) C (£) Direct material 25 62.5 105 Direct labor 4 8 8 Machining 55.6 417 125.1 Logistics 13.9 35.4 27.7 Establishment 21.8 187.2 41.6 Per unit full cost 120.3 710.1 307.4 Mark-up 20% 24.06 142.02 61.48 Selling Prices 144.36 852.12 368.88 b) Difference between Activity Based Costing and Traditional Costing Method It is important for the management of NENE Limited to understand that traditional costing method uses the volume of a cost driver to assign manufacturing overhead. Cost driver, in this case, refers to a factor that causes costs to be incurred[Pie06]. On the other hand, Activity-based costing uses the system uses the activities required to produce an item in allocating the manufacturing cost[Kar11]. We require the cost objects and the resources that were used to, when evaluating the cost, in the traditional costing system. On the other side, the cost will depend on the activities used by the cost objects in the Activity based system. The last important point that the management needs to know is that, ABC method is complex but more accurate to use than the traditional costing method. Traditional costing is very easy to use and apply. It makes it easy for managers to provide away of allocating overhead by the use of direct labor hours. It is also easy to trace all the direct costs that are product associated when using the traditional costing method. However, the method is outdated as many advanced manufacturing methods have come up that reduce the labor hours. Machines and computers are more used to do the work than labor. This makes traditional costing method to be obsolete. Activity based costing, on the other hand, has come to improve the performance process. It makes things easy as most of the things are automated. The method uses cost drivers to allocate indirect costs. It also helps in the identification of products and their costs. However, the method is complicated and can result to confusion. It is also very expensive to implement as it requires a lot of trained personnel as well as equipment to run. Conclusion It is possible to use financial information when advising investors on the issues of project selection and even production methods to use. The report has management to help NENE Limited in making its decision, right from choosing project Alpha through Benjamin Limited and to using ABC costing method. Some of the methods used above, such as ratio analysis, have various limitations when making investment decisions. It is therefore, advisable that they should not be used independently when making decisions. Bibliography Bri92: , (Brief & Lawson, 1992), Pur141: , (Purwati, et al., 2014), Gol95: , (Goldwater & Fogarty, 1995), HMW86: , (Martin, 1986), Elm93: , (Elmendorf, 1993), Gri03: , (Grinyer & Green, 2003), Del081: , (Delaney, et al., 2008), Loh93: , (Lohmann & Baksh, 1993), Pin97: , (Pinches & Lander, 1997), Sar13: , (Sarkar & Sarkar, 2013), Cla11: , (Clayton & Ellison, 2011), Mas14: , (Masuku, et al., 2014), Kui08: , (Kuipers & Boertje, 2008), Ayu15: , (Ayub, 2015), Ama13: , (Amaechi & Nnanyereugo, 2013), Kam04: , (Kaminski & Guan, 2004), Pie06: , (Pierce & Brown, 2006), Kar11: , (Kareem, et al., 2011), Read More