Managerial Accounting Impact - Case Study Example

Part Accounting Impacts Option A: “Pull the Plug” Sales Proceeds from UK armed forces (500 x £30,000) £15,000,000 Cost of Sale Variable cost incurred for 500 units (500 x £14000) (7,000,000) Depreciation expense first four months (from July 2010) (3,333,333) Salary expense (four months) (2,666,666) (13,000,000)* Trading Profit 2,000,000 Other Expenses Rental payments (5,000,000) Committed Fixed cost for four months (3,333,333) Security Charges (300,000) Notice payments incurred on account of sacking staff (2,000,000) (13,333,333) Loss from Sale of Equipment (£10,000,000 – £26,666,666) (16,666,666) Loss before tax (28,000,000) * Results round off Option B: Dandynia Deal Sales Proceeds from Dandynia (1000 x £35,000) £35,000,000 Cost of Sale Basic Variable cost incurred (1000 x £14000) (14,000,000) Component cost incurred (1000 x £7000) (7,000,000) Overtime Production cost (2,000,000) Depreciation expense first six months (from July 2010) (5,000,000) Salary expense of six months (from July 2010) (4,000,000) (32,000,000) Trading Profit 3,000,000 Other Expenses Rental payments (5,000,000) Committed Fixed cost for six months (5,000,000) Security Charges (200,000) Notice payments incurred on account of sacking staff (2,000,000) (12,200,000) Loss from Sale of Equipment (£6,000,000 – £25,000,000) (19,000,000) Loss before tax (28,200,000) Assumptions Company takes security charges and notice payments as other expense rather than as production cost since the expenses are to be incurred after discontinuing production. Production capacity wouldn’t exhaust until at least 1000 units are manufactured which imply that fixed cost would remain same for the production of required quantity (Cost-Volume-Profit and Business Scalability n.d.). The depreciation has been charged for four months. Since in this case the equipment is sold in the same year in which it was purchased, this may imply that no depreciation would be accounted for in the year-end adjustments and thus scrap value could be subtracted from the initial purchasing cost to find the book value. But under IAS 16, which requires the depreciable period to begin from when equipment is available for use to the period when it is derecognized (International Accounting Standards Board 2003), the depreciation in the given case has been accounted for four months. Besides, on the basis of the fact that extra use of production line for two more months would reduce its scrap value, one can analogize that the production line would not be as ‘good’ as a new machine even in four months and thus should be depreciated month-wise. The annual salary of production staff is decomposed into monthly salary given that salary will be paid to them up till the month when they are sacked. [That’s why the union might have negotiated notice payments for the staff as they would be loosing the salaries on the remaining months of the year when they will be sacked]. Committed fixed costs are assumed as those expenses, such as electricity charges, which are incurred on monthly basis and so the annual fixed cost in decomposed into monthly fixed cost and is taken up till the period of production in the industrial unit. Incremental / Decision-Relevance Impacts Cash Outflows Already Incurred Variable cost incurred for 500 units (500 x £14000) (7,000,000) Salary expense (four months) (2,666,666) Rental payments (5,000,000) Committed Fixed cost (four months) (3,333,333) (18,000,000)* * Results round off Option A: “Pull the Plug” Sales Proceeds from UK armed forces (500 x £30,000) £15,000,000 Other Expenses Security Charges (300,000) Notice payments incurred on account of sacking staff (2,000,000) (2,300,000) Proceeds from Sale of Equipment 10,000,000 Incremental Profit before tax 22,700,000 Option B: Dandynia Deal Sales Proceeds from Dandynia (1000 x £35,000) £35,000,000 Cost of Sale Basic Variable cost (500 x £14000) (7,000,000) Overtime Production cost (2,000,000) Component to be purchased for other deal (£2000 / unit) (2,000,000) Salary expense of additional two months (1,333,333) (12,333,333) Trading Profit 22,666,666 Other Expenses Committed fixed cost for additional two months (1,666,666) Security Charges (200,000) Notice payments incurred on account of sacking staff (2,000,000) (3,866,666) Proceeds from Sale of Equipment 6,000,000 Incremental Profit before tax 24,800,000 Comparing The Result With Cash Outflows Already Incurred Net Cash flow from Option A (£22,700,000 – £18,000,000) £ 4,700,000 Net Cash flow from Option B (£24,800,000 – £18,000,000) £ 6,800,000 Assumptions There is no use of factory other than the production of catapults so that no other productive activity is expected after discounting the production of catapults. Committed fixed cost, which has been decomposed into monthly basis, doesn’t cover any non-cash expense. Purchase cost of the components needed for modification is sunk cost as this cost has already been incurred. Rent expense, committed fixed cost, and salary expense for initial four months and variable cost of initial 500 units is also considered as sunk cost since these costs have been incurred before taking any step with respect to any of the two options. Replacement component for the other contract will cost £2000 / unit covering any variable purchase and transport expense with no fixed delivery charges assumed for repurchasing this component. All the incremental figures are incremental in comparison with the figures incurred before considering either of the deal. That is, each of the two deals is analyzed in incremental form as compared to the cost incurred before going for any of these two options; its not like that incremental figures of one deal are expressed as incremental in comparison with the base figures of either deal. Instead the initial figures are expressed as base figures for each of the deals. This is meant to smoothly compare each deal from the initial situation separately and then comparing the incremental results of each. Part 2: Report to Smiffy’s Chief Executive, Billy Whizz Facing with the severe cost of writing off the Beanonia Deal, not only a significant portion of the production of Smiffy Ltd came to halt but the company has been posed to the risk of losses. The market price of its shares has been badly affected. Yet, what’s worst can be happened has been so. The only step is to dig into the two options in terms of incremental impacts to recognize just the outcome of given option. The rational behind considering the incremental impact is that it just accounts for the relevant info which is coupled with the given decision i.e. the info being affected just by the decision (Drury 2001, p. 82). While comparing these options incrementally, Dandynia deal has found to be more profitable and cash-generating as compared to the first deal. The deal promises incremental cash flows of worth £24.8 millions as compared to the first option promising £22.7 millions. In absolute terms, the potential net cash flows from Dandynia deal is £6.8 millions as compared to £4.7 millions generated from the option A. On the other hand, as per the results from conventional accounting approach, loss from the Dandynia deal, £28.2 millions, is more than the loss from the ‘UK armed forces’ deal, £28 millions. Thus, the conventional-accounting approach is reversing the above decision. This tendency of accounting approach to flip the preferred decision is based on the fact that a significant level of decision-relevant info is getting bordered by a lot of traditional and irrelevant accounting figures, in the calculation of bottom-line results. Due to this reason, the management should not rely on the accounting approach as far as decision making is concerned, even if the accounting approach seems to yield the same result. It can be found that conventional accounting approach above is not accurately reflecting the just impact of the given decision choice. Besides this conceptual difference, the difference between the two approaches can also be analytically evaluated item-wise under each option. This analytical comparison favors the basis of making the decision towards the decision-relevance approach. Starting the comparison from the main element which patently distinguishes the two approaches, i.e. depreciation of production line, the preference of the incremental approach over the accounting one is evident since depreciation is just a historical non-cash expense and is considered in accounting analysis only for the purpose of taxation. The accounting profit of the company has been reduced by the four-month depreciation amount under the option A and by the six-month depreciation amount under the option B where production line is used for two more months. However, this expense doesn’t impact any cash flows. That’s why this item shouldn’t be undertaken while making the decision for recommended option. This is reflected by the principle that any accounting figure that doesn’t incorporate cash flows must be gone through carefully (Helfert 2001, p. 263f). Moreover, as per the general principle of decision-relevance accounting, depreciation is irrelevant because it is the sunk cost i.e. a historical cost which is irrecoverable in the given situation (Caplan 2006). Accompanying the underlying concept of ignoring depreciation, ignoring the loss on sale of production-line can be prominently analogized. Under the accounting approach, the loss on the sale of equipment has further accumulated the loss in both options. But in the decision-relevance approach, just the proceeds from the sale of production line, being incremental, have been considered and are not compared with book value. In this regard, the two approaches are producing the opposite impacts on profits. One is adding on the loss by taking depreciation as an expense while the other is adding on the cash flow by taking just the sale proceeds. This reflects how the two approaches can eventually divert the result. Of course, this doesn’t mean that the accounting approach is wrong in itself; instead this implies that the approach is wrong if used for the decision-making purpose! The other cashed, fixed sunk costs are rent expenses and other fixed expense accounting for a total amount of £15 millions. Since the industrial unit has been rented and the fixed costs of the initial four months have been paid before considering the two options, these costs are considered as sunk costs which means that they can’t be changed by any current or future decision and are also not expected to be recovered at all (Khan & Jain 2007 p. 22.4). Even though these are cash expenses, they are not considered as the decision-relevant information since they wouldn’t impact the incremental cash flow from any deal. Not all fixed costs are irrelevant; any cost can or can’t be relevant depending on its differential impact (Nurre n.d.). From the given data it can be inferred that the variable cost of initial 500 units of catapults as well as the initial four-month salary of the production staff are also the sunk costs since they have been paid before going for either of the two options. Thus, these expenses will also not impact the cash flows from any of the deals. All of these expenses are adding on the loss in traditional accounting computations but ‘in real’ they are not impacting the cash flows at all. However, the variable cost of the remaining 500 units as well as salary and other fixed expenses that have to be paid for the further two-month production under Dandynia deal are relevant to the decision as these are resulting from this deal. They will obviously impact the cash flows. That’s why these figures are included in their incremental form, i.e. for the additional period, to reflect their impact marginally. Besides this, these costs are also the part of accounting costs but in that case they are not taken incrementally. Other variable cost in Dandynia deal is the cost of components needed for modifying the catapults as per the requirement of the deal. Since these components are used in the production of catapults, the cost of these components is said to be incurred as an accounting cost of sale. In other words, the cost is adding on the accounting loss. However, since these components have already been purchased for some other deal, they should not account for Dandynia deal, in real. It is thus not a relevant figure for the deal in that it is not impacting any cash flow. The purchase cost of these components is the sunk cost – it will remain incurred even if Dandynia deal is not accepted. Consequently, the cost of replacement component, which has now to be purchased, will impact the cash flows from the current Dandynia deal. Although the replacement components wouldn’t be used in the production of catapults implying that their cost wouldn’t be incurred as an accounting cost of sale, the cost would really be incurred because these components are to be purchased due to the deal. Although, it has not affected the accounting loss, it has actually affected the cash flow from the deal. Given this, the significance of decision-relevant info is evident entailing its future-oriented nature rather than past-oriented which also incorporates special-purpose costs that are pertinent only to the situations for which they are incurred (Khan & Jain 2007 p. 22.4), whether it is current or forward-looking situation. Other incremental costs are overtime salary, notice payments, and security charges. As compared to the initial figures, when none of the options are considered, notice payments and security charges impact cash flows in both deals and so are relevant figures in both. They are, yet, also impacting the accounting results. However, given the additional use of industrial unit in the Dandynia deal, the security charges are saved by £1 lac. Similarly, overtime production expense will be incurred as a decision-relevant expense in the Dandynia deal and is also impacting both the accounting and decision-relevant results. Dandynia deal is thus further adding £2 millions of overtime production cost as compared to the first deal. In terms of sales, earnings of both deals are incremental. To sum up, taking the affects of additional costs including cost of replacement components and ignoring the affects of irrelevant costs – including variable cost of initial 500 units, initial four-moth salary and fixed expense, depreciation expense, rent expense, and cost of already purchased components – the decision-relevance approach favors Dandynia deal against the either. Although other than the above-mentioned relevant costs also significantly contribute in this result, these are impacting both the incremental and accounting profits, whereas above mentioned added and ignored costs are more significantly contributing in distinguishing decision-relevant results with the later. In this way, the decision-relevance approach is representing the real impacts of the deal and so its findings should be considered. It is recognizing the opportunity cost Smiffy would have to face if management didn’t consider the recommended Dandynia deal. That’s the opportunity cost of £24.8 millions, too impressive to be ignored! Part 3: Report to the Group Chairman, Alexander Lemming Given the severe impact of rejection of Beanonia deal on the profitability and share value of Smiffy, the need for a promising turnaround plan arises which can yield maximum profitability in the present scenario. From the decision-relevance analysis it has been established that the best recommended option for the Smiffy Ltd is Dandynia deal given its higher incremental and net cash flows. After selecting this option, the one part of the plan is determined. The other important part left is to reflect this profitability in the fundamental as well as market value of the Smiffy’s share. The targeted end result is thus to pull through the investors’ confidence and so to recover the loss in share prices. Since investors really care for the impact of any decision on the potential cash return on the shares (and also the gain in market value which is again based on Smiffy’s financial position), they should be given the explanations of the recommended option in terms of key cash-generating results that are expected from the Dandynia deal. It should be highlighted to them that £24.8 millions of incremental cash flows and thus £6.8 millions of net cash flows substantially contribute in recovering the cash position of the company. In this regard, the extensive amount of cash outflows that are already occurred can be well ignored in front of such a promising opportunity. The City investors should be made realized about the fact that conventional financial statements not always determine the current cash position of the company. What should be valuable for investors is not the historical cost but the present as well as future cash flows. Thus investors should be recognized not to consider the huge sunk costs of rent and production line but to consider the impressive cash flows potentially generated by the deal. They should also be recognized not to discourage from the news and highlights evidencing costly purchase of the components for the required modifications since these costs are not affecting the cash flows generated by this deal and the replacement component that has to be purchased is expected to be very inexpensive. Thus the higher incremental catapults’ sale of £20 millions from Dandynia deal is further stimulated by the lower incremental cost effect. This shows that not only the potential loss has been mitigated but the idle production facility can also be best utilized to capture the upcoming opportunity promising a fresh stream of cash flows. Investors should be explained the fact that in the conventional profit-loss statement of Smiffy under the Dandynia deal, high topline amounts are not transferred as such to the bottom line results due to the involvement of significant amount of irrelevant costs. In the lights of this, investors should be acknowledged by the importance of relevant cash flows over the conventional accounting results. Thus, in order to best present the decision to the City investors, they shouldn’t be burdened with such ‘beside-the-point’ accounting numerals but should be highlighted with the key cash-generating impacts of the recommended deal which would also impact the market value of the Smiffy’s share. Bibliography Caplan, D 2006, Management Accounting Concepts and Techniques, Web version, accessed 30 January 2011 from Ibrary.albany.edu Cost-Volume-Profit and Business Scalability n.d., accessed 29 January 2011, < http://www.principlesofaccounting.com/chapter%2018.htm>. Drury, C 2001, Management Accounting for Business Decisions, 2nd edn, Canale & C, Italy. Helfert, EA 2001, Financial Analysis: Tools and Techniques: A Guide for Managers, e-book, accessed 30 January 2011 from Googlebooks.com International Accounting Standards Board 2003, IAS 16 – Property, Plant and Equipment, Birzeit Consulting, accessed 28 January 2011, . Khan, MY & Jain 2007, Management Accounting, e-book, accessed 29 January 2011 from Googlebooks.com Nurre, R n.d., Relevant Costs for Decision Making, San Mateo County Community College District, accessed 29 January 2011, . Read More