Cost-Volume-Profit Analysis Incorporating the Cost of Capital - Term Paper Example

COST -VOLUME -PROFIT Analysis Incorporating the Cost of Capital INTRODUCTION (Objective) Objective Summary: The objective of the paper is persuade managers of the importance of including cost of capital in their decision making activities. The cost of capital is arrived at by by including the interest paid for borrowing money. The inclusion of the interest paid for money borrowed is called present value. Then the total cash inflows from generating money from the asset invested in high value assets will reduced by the present value of the money borrowed. The difference between the two is known as net present value. A positive net present value is good for the company. On the other hand, A negative net present value is a bad management decision. Thus, management must not push through with the planned investment. The Net present value is arrived at by the following: The managers will invest in a capital asset only if the net cash inflows are more than cost of capital. The difference between the two is the net cash inflow. The entire articles gives evidences that this very popular formula is more than just a formula. The entire journal is devoted to giving importance to the factors of sales, variable expenses and costs, as well as fixed expenses an costs. Clearly, the objective of the paper is persuade managers of the importance of cost of capital in decision making activities. Critique: The objectives are correctly stated. The objective truly draws the reader to the reasons of managers in using the various components in the cost volume profit analysis. For, the article clearly explains how the sales, variable expenses and costs as well as fixed expenses contributed to the increase and decrease of net income. The article clearly shows that cost of capital is a very important tool in determining if it would be economically profitable to infuse more money into a high monetary value assets (Schneider,1). Obviously, the objectives are correctly stated. Key issue /theories considered Summary: One of the key issues considered in the article shows that cost of capital is arrived at by by including the interest expense spend for borrowing money. This inclusion of the interest paid for money borrowed is called present value. Then the total cash inflows from generating money from the asset invested in high value assets will reduced by the present value of the money borrowed. the net present value in determining if it is profitable to invest large sums of money in a new equipment or other similar large funded investments. The articles states that Cost Volume Profit Analysis incorporates the cost of capital. Evidently, one of the key issues considered in the article shows that cost of capital is arrived at by by including the interest expense spend for borrowing money. Further, this same article also explains that there is a strong relationship between cost of capital and factors like net revenues, variable expenses and fixed expenses. In addition, the articles tells that managers would make better decisions if the cost of capital is included in the cost volume profit analysis. The article also tells that the manager's process improvement decisions must also include financial data under product mix and pricing. This formula is the mathematical representation of the economics of producing a product. The article shows that the investment is not good if the cost of capital is more than the net cash inflow from operating the investment. On the other hand, an investment in high value items is an excellent management decision if the net cash inflow exceeds the cost of the capital. The article also discusses that increases in variable costs will decrease profits. On the other hand, increases in net revenues increases profits. Further mathematical computations show that net profit is the difference between the net revenues and total expenses and costs. Truly, this same article also explains that there is a strong relationship between cost of capital and factors like net revenues, variable expenses and fixed expenses. Also, the same article emphasises that managers prefer to use other tools in their decision making activities. The other decision making tools include the current ratio, quick ratio, times interest earned, payback period, make or buy a product, retain branch or shut down, budgeting, capital budgeting, transfer to another department pricing, product pricing, cost center responsibility accounting, receivables turnover, inventory turnover, return on equity, return on assets, debt to equity and many other formulas. Truly, the same article emphasises that managers prefer to use other tools in their decision making activities. Further, the above article states that some economists theorise that cost of capital should include economic income. The normal accounting income does not include monetary value fluctuations. The economists complain that the management formula, cost volume profit analysis, do not take into consideration the standard economic theories of supply and demand. Likewise, many of the economists believe that this management formula does not take into consideration the elasticity of supply, demand, and production efficiency. One of the basic differences between the Cost Volume Profit analysis and the price theory models is that the cost volume profit formula flatly ignores the the curvilinear nature of total revenue and total cost schedules . The economists have differentiated accounting income from economic income. Economic income is described as the periodic measure of an item's performance just like accounting income. One of the differences between accounting income and economic income is that economic income in one time period is not additive. Here, the time value of money is inherent in the cost of investment capital . Unquestionably, the above article states that some economists theorise that cost of capital should include economic income. Critique: Based on the above discussion, the cost of capital is a necessary ingredient in making better management decisions. For, cost of capital is a compulsory ingredient in computing or the net present value of the equipment investment (Gomes, and Islam,1). The cost volume profit formula shows that the variable costs will increase in direct proportion to the increase in the number of units sold. Also, a decrease in the number of units sold will produce a directly proportional decrease in the variable costs. This same formula also shows that the fixed costs will not increase if the number of units sold will increase. In terms of decision making, the cost volume profit formula tells us that the company must generate sales at more than the break even units to be profitable. Definitely, the cost of capital is a necessary ingredient in making better management decisions. (Gomes, and Islam,1). Methodology used Summary: The article states that information was gathered through the use of secondary materials. The bibliography clearly indicated that the authors used professional refereed journals to support their is. Secondary resources include textbooks, professionally refereed journals. The advantage of using secondary resources is that they can be bought any time if there is an available copy. Many Internet websites are not good secondary resources because the author of such website articles may not have the expertise needed explain the topics. Clearly, the secondary source method is used for this research. The references include books by Biddle, Chen, Ferguson, Garg. Evidently, the article states that information was gathered through the use of secondary materials. Critique: The authors were right in using secondary resources. For, the authors of such references are experts in their field. The authors are experts in the field of research, economics, profitability, management, investments and the like. Conclusion Summary: The objective of the paper is persuade managers of the importance of including cost of capital in their decision making activities. Obviously, the objectives are correctly stated. Evidently, one of the key issues considered in the article shows that cost of capital is arrived at by by including the interest expense spend for borrowing money. Truly, this same article also explains that there is a strong relationship between cost of capital and factors like net revenues, variable expenses and fixed expenses. Truly, the same article emphasises that managers prefer to use other tools in their decision making activities. Unquestionably, the above article states that some economists theorise that cost of capital should include economic income. Definitely, the cost of capital is a necessary ingredient in making better management decisions. Evidently, the article states that information was gathered through the use of secondary materials. Critique: The article truly explains in detail why cost of capital is a necessary tool in making management decisions especially in capital budgeting activities. Cost of capital gives better information so that managers can make better quality decisions in lesser time. The article correctly explains the the cost of capital is only a part of the net present value. The article correctly states that net profit is influenced by the increases (or decreases) in net revenues. Undoubtedly, the article is correct in stating that the net profit are influenced by increases and decreases in the costs and variable expenses. Convincingly, the article truly explains in detail why cost of capital is a necessary tool in making management decisions especially in capital budgeting activities (Guidry, Horrigan, and Craycraft,1). Inter -relationship between the objective, the literature, the secondary research performed and conclusions drawn Clearly, there is a strong relationship between the objective, the literature, the secondary research performed and conclusions drawn. The objective was used as the starting point. It was the beacon that showed how literature unraveled the importance of cost of capital, secondary resources and conclusions in a harmonious and inter -complementary line. Next, the literature was used as the first resource material. The literature described in detail the cost of capital, economic income, accounting income, cost volume profit analysis. Then, the secondary research materials were used to back up or support the literature and the objective. Finally, the conclusion is the summary of the findings of the secondary resources and the literature (Schneider,1). Conclusively, Cost of capital MUST be incorporated in cost volume profit analysis for managers to improve the quality and speed of their decision making activities. Works Cited Cost Volume Profit Analysis Literature, retrieved March 31, 2008, 213912_CVP.PDF Barber, Joel R. "Cost of Capital with Flotation Costs." Quarterly Journal of Business and Economics 43.3-4 (2004): 3+. Gomes, Lawrence J., and Muhammad M. Islam. "Market Power and Cost of Capital under Uncertainty." Quarterly Journal of Business and Economics 28.4 (1989): 61+. Guidry, Flora, James O. Horrigan, and Cathy Craycraft. "CVP Analysis: A New Look." Journal of Managerial Issues 10.1 (1998): 74+. Mcmahon, Richard G.P., and Scott Holmes. "Small Business Financial Management Practices in North America: A Literature Review." Journal of Small Business Management 29.2 (1991): 19+. Schneider, Arnold. "How to Include Earnings-Based Bonuses in Cost-Volume-Profit Analysis." Journal of Managerial Issues 6.2 (1994): 231+. Read More