6.2 Conventional Capital Budgeting Analysis of A Manufacturing Company (Being corrected)

 

Capital budgeting is the process of undertaking the evaluation of potential major investments or projects. Some examples of projects that require capital budgeting before approval or rejection can be the big investment in outside ventures or new plant construction (Kenton, 2021). In the case of a manufacturing company being concerned, the company is evaluating two new equipment options to be chosen as a new product suitble for the production enhancement. The company’s manager requested the finance and accounting department to give recommendations on how to choose the best option based on capital budgeting analysis.

The three main capital budgeting calculations to be performed are NPV, IRR and Payback period. In more detail explanation, in relation to the available data of the problem, they can be defined and articulated as,    

1.      NPV (Net present value) is the difference between cash outflow and cash inflow’s present values over a period of time. In my detail calculations, a present value of a time period is the multiplication between present value factor (PV = 1/(1+r)ⁿ, r = rate of return, n = periods) and total cash in or out of that period. And the net present value is sum of all available periods. Positive NPV  means that ,in present dollars, anticipated costs are less than projected earnings. In other words, Positive NPV indicates profitable investments  and Negative NPV indicates unprofitable ones (Fernando, 2021).

2.       IRR (Internal rate of return) is a used metric for financial analysis to do the estimation of potential investment’s profitability. In a discounted analysis of cash flows, it is a rate of discount making the NPV of all cash flows  (Fernando, 2021).

0 = NPV = sum_t=1^t=T (C_t ​/(1+IRR)^t  - C₀ )

​where :

C_t ​ = Net cash inflow during the period t

C₀ = Total initial investment costs

IRR=The internal rate of return

t=The number of time periods​
 

In general, higher IRR means better investment based on the definition to make total NPV quickly goes to zero (Ganti,2021). In this research, general excel formula to calculate the IRR can be written as : =IRR(Total cash at year 0: Total cash at year n, initial guess value)

3.      Payback period is the required amount of time for the investment cost recovery. In other word, it is the time for the investment to reach the Break Even Point (BEP) (Kagan , 2021 ). Our detail calculation purpose in the excel sheet uses the fact that the payback period is the time at exactly zero cumulative cash flow. In the two options, no zero cumulative cash flows are available. Therefore, we use the linear regression technique to find the linear equation to find the Payback period which is the year as the x axis at which cumulative cash flow is exactly zero at the y axis.     

 

Based on the above definition and articulation, further summary of calculation can be done by the following table,

Required rate of return for both options

0.08

For Option 1 :

Therefore, for Option1 :

Present value = total cash * PV (Present Value) factor

NPV = sum(B14:I14) = $ 56470.64163

IRR = IRR(B10:I10,0.1072) = 18% ;  (Note : 0.1072 is a guessing value )

Payback Period = 4 years 10.13114754 months

(the x value =295500/61000 =4.844262295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 61000x -295500)

For Option 2 :

Therefore, for Option 2 :

Present value = total cash * PV (Present Value) factor

NPV =SUM(B29:I29) = $ - 9336.578665

IRR = =IRR(B25:I25,0.1072) = 9% ;  (Note : 0.1072 is a guessing value )

Payback Period = 5 years 9.401055537 months

(the x value =597225/103265 = 5.783421295 years,  for y value = $ 0 (Cumulative cash flows)  at the equation of y = 103265x -597225)               

Based on the calculation results, the meaning of the option 1 NPV value > 0 was previously discussed as indication of profitable investment. While the option 2 NPV value < 0 indicates unprofitable investment. IRR option 1 (18%) which is greater than IRR option 2 (9%) indicates that the IRR of option 1 is better than that of Option 2 since the higher IRR is the better investment. Moreover, the payback period of option 1 with the amount of 4 years 10.13114754 months is faster than the payback period of option 2 with the amount of 5 years 9.401055537 months.   

In conclusion, based on the above NPV, IRR, and payback period comparisons between the two options, the manufacturing company should choose the option 1 as a new equipment product suitable for the production enhancement. The analysis of preferring the option 1 is also proven right by considering the other factors that even though the price of the option 1 with no salvage value is more expansive than option 2 with salvage value of $10,000, materials, labors and maintenance costs of the option 1 is  cheaper than those of the option 2. Therefore, the option 1 is the best choice.

Note : This conventional calculation was performed using required rate of return. In the Islamic perspective, the cash flow data are based on profit and loss sharing. 

References 

Kenton, W. (2021, October 13). What is capital budgeting? Investopedia. Retrieved October 14, 2021, from https://www.investopedia.com/terms/c/capitalbudgeting.asp. 

Fernando, J. (2021, October 13). Net present value (NPV). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/n/npv.asp. 

Fernando, J. (2021, October 13). Internal Rate of Return (IRR). Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/irr.asp. 

Ganti, A. (2021, October 13). Internal Rate of Return (IRR) rule. Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/i/internal-rate-of-return-rule.asp. 

Kagan, J. (2021, October 13). What is the payback period? Investopedia. Retrieved October 13, 2021, from https://www.investopedia.com/terms/p/paybackperiod.asp. 

 

6.1 Capital Budgeting Risks

 

The term risk in this case is the uncetainy degree associated wih an asset’s returne. There exist many kinds of risks in capital budgeting, including project specific, market, international, corporate, industry specific and stand-alone risks (Anonimus, n.d.). In more detail explanation, Project specific risk is the relatively specified risk for a certain project. The risk can happen as a result of discount rate or cash flow estimation error done by deficiency in management leading to unfavorable situation that the actually realeased cash flow become less than the projected one (Sarav and Sarav, 2017). Market specific risk results from macroeconomic factors rates of interest and inflation. This kind of risk significanlty happen in the time of unstable or weak economical condition. Once the economic situation is down, product demand decreases, potentially creating unprofitable project (Rodeck, 2016). International risk exposure happen as a result of involved or shared capital budget projects between companies across countries, which entail exchange rate and political project risks. Political or civil unrest potenially caused entirely lost investment if the ongoing project is being established in a country of unstable political structures (Rodeck, 2016). Corporate risk can be defined as risk of organization suferring from declines in earning and revenues as a result of unfavorable events affecting the organization or corporation (Anonimous, 2020). Industri specific risk means the risk affecting the sector of industry where the companies the runs the business. The last one is he stand alone risk which has association with a single company or unit of operation, asset or division of a company in its opposition to a well diversified and larger portofolio (Chen, 2021).             

Based on the above definition, the most significant risks are project, market and international risks. The specific reasons can be based on the above definition that the market and project risk have a close relation each other. Existing interest based investment will give heavy usury that really makes the project unprofitable. The project cost will increase so much if the established method only takes interest not based on profit and loss sharing, the poor will get poorer and the rich will get richer. Therefore, the investment system should be chosen if not only profit but also loss will be shared between the investors and business contributors.  In relation to the product if the market demand is down, the project will be considerably unprofitable due to the fact that their production rates will go down proportionally with decreasing demands. If the projects of making the massive product are still done as usual. Many products will remain in the inventories for a long period of time. This is unfavorable since the products might reduce the original reliability and quality. The third risk that mostly contribute to the global economic problem is the international risks. This risk actullay happen on the shared exporting and importing projects on very high demand such as the current covid 19 vaccines. The rejection of some citizens to take imported vaccines from specific countries due to the existing hatred or kinds of sensitive issues making them massively reject the national and vaccination program with the result that the country’s investment for the national and world herd immuniy will be difficult to achieve.   

 

References

Anonimous. (n.d.). Boundless finance. Lumen. Retrieved October 11, 2021, from https://courses.lumenlearning.com/boundless-finance/chapter/the-relationship-between-risk-and-capital-budgeting/.   

Sarav, & Sarav Author. (2017, June 4). Risks in Capital Budgeting. Mytypings.com. Retrieved October 11, 2021, from http://mytypings.com/risks-in-capital-budgeting/.  

Rodeck, D. (2016, October 26). What factors increase the riskiness of a capital budgeting project? Small Business - Chron.com. Retrieved October 11, 2021, from https://smallbusiness.chron.com/factors-increase-riskiness-capital-budgeting-project-15829.html. 

  Anonimous. (2020, September 8). Guide to corporate risk in capital budgeting - WELP magazine. Welp Magazine - Business Strategy, Executive Software, Growth Hacking and more... Retrieved October 11, 2021, from https://welpmagazine.com/guide-to-corporate-risk-in-capital-budgeting/.  

AbuJubara, A. A. (2020, March 16). Risks Associated with Capital Budgeting. Amjed online . Retrieved October 11, 2021, from https://amjedonline.com/2020/03/16/risk/.  

Chen, J. (2021, May 19). What is standalone risk? Investopedia. Retrieved October 11, 2021, from https://www.investopedia.com/terms/s/standalone_risk.asp. 

 

 

 

 

 

5.3 My LC (Learning Consultants)’s Master Budget

In accordance to the concerned topics, I choose to take the topics of my ongoing educational works. I have been running an educational service provider - Learning Consultants (LC) for two years. So far, my first purpose on establishing the LC is to happily contribute to the people’s education. I span the digital based platform in collaboration with youtube, blogspot, and wordpress. In the future, I  want to build my own in house built websites or even the use of google domain and premium blogspot or wordpress as well as constructing physical building for the institution. In the two years run of LC, I don’t think about how profitable I will be. I just think to share values to all people. This results in unsustainable activity in the future. Therefore, I choose to create subsidized educational service accessible for all people. For this reason, I need to create the well-established LC’s master budget.

The process to create the LC’s budgets begin with the first quarter of yearly project of university entrance exam preparation of all senior high school students in an event namely Ciamis Learning Camp (CLC). The budget of the next quarter can be taken as other periodic educational activities for long term preparation or other educational programs. As the first quarter project, it was established as a non-profit organizational project. In the future, we consider to generate profit by taking educational fees for high economy students to be given as subsidized scholarships for basic needs of all students and learning facilitators. As the first quarter project, the budgeting process start with the review of last year’s data which is considered to be critical for the expenditures of legal authority sponsors (Heisinger, & Hoyle, (n.d.)). Last year the YBMPLN as a CSR of our national electrical company was the only sponsor for the event. The sponsor gave us the total amount of about Rp. 20000000 (twenty million rupiah) or around $ 1409.34395 for a quarter social educational project. Other unseen assets considered as profitable in the future are the number of social media subscribers. Currently, the LC’s youtube subscriber is 266. Fb page is about 285 and Ig follower is 184. The number of youtube subscriber is targeted to be at least 1000 to generate advertising based revenues. Further aspiration is the available android and web based application for future educational activities.  In detail, some important points of master budget calculations can be given in the following table,

Table 1 : LC (Learning Consultanst)’s Budgeted income statement

Based on the master budget, we recognized the CLC project start in the first quarter from January to April. This is well chosen since we know the university entrance exam is usually nationally held in May. In the first quarter, all sponsor funds with the amount of Rp. 20000000 are fully given to 20 best students @ Rp.1000000 to improve their achievement, to teach other students and to motivate them for getting the admission. For that quarter period, the net income is supposed to be Rp. 40720400 if the total number of targeted registered students reach 15000 persons paying the cost of the cheapest ticket of Rp. 12000. In the second to fourth quarter, available students are the ones doing long time preparation for university entrance, school, or TOEFL exams. In each three quarter, the targeted registration is to reach 5600 persons @Rp. 25000 giving net income of Rp. 720400 for quarter 2 to 4 and Rp. 42881600 that year.     

Based on comparison of the above data to the previous master budgets of the manufacturing companies. The master budget of general service such as educational service provider are different. As we were concerned with the Krakatau Steel Inc as one of the government owned manufacturing companies which produce diverse steel products, My LC (Learning Consultants) as one of the privately owned companies provide educational service instead of seen object as branded products. In generals, principal differences can be seen in the cost calculations of sold products or services which can be seen in the following illustration (Anonimous, n.d.),

Sevice company	Manufacturing company
Provided service cost	Manufactured product cost
Overhead and labor costs in primary	Overhead, labor and materials
Online or digital learning inventories such as android and web based	Real building inventories

 

References

Heisinger, & Hoyle. (n.d.). Budgeting in Nonmanufacturing Organizations. Budgeting in nonmanufacturing organizations. Retrieved October 7, 2021, from https://2012books.lardbucket.org/books/accounting-for-managers/s13-04-budgeting-in-nonmanufacturing-.html. 

Anonimous. (n.d.). Manufacturing, Merchandising and Service Companies. Managerial accounting. Retrieved October 8, 2021, from http://www.csun.edu/~hfact004/Managerial.html.

 

 

5.2 Variance Analysis of A Fruits Company

 

Variance analysis is the process of analyzing the standard and actual cost differences. The analysis is done by management accountants to analyze the direct materials, labor and manufacturing variances (Heisinger & Hoyle, n.d). In this case, the company budgeted to sell $500,000 worth of cartons at a price of $25 each. Actual sales met a budget of $500,000 at $25 per carton.

Based on the available data and the above information, we can do the following calculation and articulation:

Table 1: Variance analysis calculation of the fruit company (wrong calculation of direct material price variance. The correction is explained in no 3.)

1.     Standard cost per unit is the specific cost per unit. While the budgeted costs are the total cost given a certain activity level (Heisinger & Hoyle, (n.d.)).

Standard cost of unit of carton (SP): budgeted unit cost of fruit + budgeted unit cost of package + budgeted unit cost of labor = $10.00 + $0.50 + $4.50 = $15.00

2.     Actual cost per unit of carton (AP) : actual unit cost of fruit + actual unit cost of package + actual unit cost of labor = $12.21 + $0.55 + $7.50 = $20.26

3.     Direct material price variance, AQ^P definition is on the table.      

= (AQ^P)*(AP-SP) = 211000*($20.26 - $15.00) = $1,109,860.00 (This value was                     wrong and need correction)

Direct materials are consumed supplies and materials during the product manufacture (Bragg, 2021).

4.     Direct material usage variance =  (Actually used quantity - Standard usage quantity) x Standard cost per unit (Bragg, 2021) = ((AQ^U) – (SQ))*SP

The problem does not specifically mention the used materials in production. This assume the purchased materials are also totally used. Since we also know that SQ is standard quantity of materials for actual level of activity. Therefore, AQ^U = AQ^P = SQ giving the result that the direct material usage variance is zero

5.     Direct labor rate variance

= ((actual labor cost per carton/actually spent hours per carton)-(budgeted labor cost per carton/budegetedly spent hours per carton))*actually spent hours per carton* (#Units of carton)

= (Actual Rate – Standard Rate) × Actual Hour = (AR-SR) x AH

= (($7.50 /0.75)-($4.50/0.5))*0.75*20000 = $15,000.00

6.     Direct labor efficiency variance   

= (AH − SH) × SR = (actual hour – standard hour) *# Units of cartons* standard rate = (Actual hour – Standard hour)*# Units of cartons* (budgeted labor cost per carton / budgetedly spent hour per carton) (budgeted labor cost per carton / budgetedly spent hour per carton)

= (0.75-0.5) hour *20000*($4.50 / 0.5 hour) = $45,000.00 

To assess whether the actual performance is better than budgeted expectation, we can analysis the above data one by one.  The actual and standard cost variance giving the difference of AP-SP = $20.26 - $15.00 = $5.26 meaning that the actual price is greater than the budgeted one. This is not a good performance due to the fact that customers of the fruit company tend to find lower prize. This variance in budgeted and actual price also impacts the direct material variance. Since (Actual Price – Standard Price) > 0 and the variance of direct material is proportional to the price difference then the actual direct material price is greater than the budgeted one. For the company this is unfavorable due to the need to decrease the cost as much as possible. Direct material usage having the zero variance means that all purchased materials are totally used telling the optimum performance of the company. The value of direct labor rate variance which is greater than zero means the actual rate is greater than budgeted one. This condition is also unfavorable since the company needs to pay more for the labor rate. Lastly, the greater variance of labor efficiency is also unfavorable due to inefficient labor cost of actual case.

In the real work, we are to discuss with some involved individuals in root cause identification of the variances. As the company’s owner, we should contact the production manager who should be responsible for the root cause of the actual and standard price variance, direct material price and usage variances. We also should contact the human resource development manager who should be responsible for the root cause of labor rate and labor efficiency variances. Overall, the involved managerial accounting professionals can be asked for further verification and discussion about the causes of each variances.    

As usual, to propose the well thought causes of each variances. We should start from the first root cause which is the actual and standard price variance. That variance comes as a result of the fail prediction of the fruit price in the market or from the first plant grower. At that time the price increase to the certain predicted amount. Other factors can be the increase of the price of the fertilizer for the fruit plants. In the material price variance, the actually used package weight less than the budgeted one with the greater price in the actual one. The difference is $1000. This variance is a result of the increase in the price of packaging materials. The manager must have failed again in predicting the price. This can happen if the company has less interaction with survey of market price for the materials. Labor rate and efficiency variances with greater value in the actual one can happen as a matter of fact that the actual performance require more time to produce which expects the company to pay more for the labor salaries.           

In conclusion, the greater values of actual performance than the budgeted expectation require the strong attention of the management to the actual and standard price variance, direct material price variance, labor rate and efficiency variances. In this matter, we suggest some courses of action:

1.     The CFO with the budget committee should do well-established digital and direct quantitative and qualitative survey of the market price for the available fruits if they are going to buy it from grower.

2.     If they are going to have their own plants to grow and sell their own fruits. They should make sure to make a good way of farming using state of the art technology such as using the IoT (internet of things) to control the farming process until to market it in such a way that they can have qualified fruits affordable for the customers and profitable for them as the producers and suppliers.

3.     The company should thing on the best brand of the company to be put in the package. As usual the package process should be optimally done by the state of the art IoT technology letting them have the best in class package and reduced cost of packaging.

4.     To reduce spent time or working hours, the company should thing of investing in buying the good technology to help the human employers such us the use of robotic machine which can do more precisely effective jobs with the most time efficient

 

References

Heisinger, K., & Hoyle, J. B. (n.d.). Explain how standard costs are established. Standard costs. Retrieved October 5, 2021, from https://2012books.lardbucket.org/books/accounting-for-managers/s14-02-standard-costs.html  

Bragg, S. (2021, April 16). Direct materials definition. AccountingTools. Retrieved October 6, 2021, from https://www.accountingtools.com/articles/what-are-direct-materials.html. 

Bragg, S. (2021, April 16). Direct material usage variance. AccountingTools. Retrieved October 6, 2021, from https://www.accountingtools.com/articles/what-is-the-direct-material-usage-variance.html.

Official solution : 

solved problem

Chapter 12. Coordinate geometry (B. Positif and negative coordinates part 1)