ACCT7107

ACCT7107
Management Accounting and
Control
Lecture 7
1. Strategy, Balanced Scorecard and Strategic
Profitability Analysis
2. Capital Expenditure Analysis with
Discounted Cash Flows

Text Reading: Horngren

Ch 12 and Ch 21. 1

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Learning Objectives
1. The Balanced Scorecard:
Recognise the two generic strategic positioning strategies

Understand the purpose of developing a Balanced Scorecard

Describe the 4 perspectives of the Balanced Scorecard, how they
relate to each other and the organisation’s strategy
Analysechanges in operating income due to growth, price-recovery
and productivity and use to evaluate strategy
2. Capital Expenditure Analysis :
 Understand the five stages of capital budgeting for a project
Useand evaluate the two main discounted cash flow (DCF)
methods: net present value (NPV) and internal rate-of-return (IRR)
Use and evaluate the payback and discounted payback method
Useand evaluate the accrual accounting rate-of-return (AARR)
method
Identify relevant cash inflows and outflows for capital budgeting
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Lecture – Overview
1. Strategy: Analysis, positioning and implementation
2. The Balanced Scorecard
o The four perspectives
• Financial
• Customer
• Internal Business Process
• Learning & Growth
3. Strategic Analysis of Profitability
o Analyse changes in operating income to evaluate strategy
• assess the impact of market growth
4. Capital Expenditure Analysis
• Capital Budgeting,
• The 5 stages of Capital Budgeting
• Discounted Cash Flows
• NPV and IRR
• Payback, Discounted Payback, Accrual Rate of Return
• Relevant Cash Flows

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1. Strategy
 Strategy describes how an organisation matches its own
capabilities with the opportunities in the market place to
accomplish its overall objectives
• A thorough understanding of the industry is critical to implementing a
successful strategy
• Value proposition ‒ the set of customer values that an organisation
will seek to provide
• Core competencies ‒ the means of creating that value for customers
• Focus on a few things by doing better than its competitors
• Producing long-term growth and survival

 Part of Strategic Cost Management/Strategic Performance Measurement

System (integrated performance measurement system)
• Uses financial and non-financial information/measures
• Used to develop and identify strategies to produce sustainable
competitive advantage

An organisation must create value for its customers but must

differentiate itself from its competitors
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Strategic Analysis
 Internal analysis
 product lines; management; R&D; production; marketing; strategy

 External/Industry analysis – focuses on 5 aspects

1. Competitors/competitive intensity (price/cost, quality and time)
2. potential market entrants
3. Substitute/equivalent products
4. customer bargaining power
5. (input) supplier bargaining power

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Strategic Positioning
 Cost leadership
• producing products or services at lowest cost in the industry - through
productivity and efficiency improvements, elimination of waste, redesign,
reengineer processes, tight cost control…
• Competitive advantage: lower selling prices

 Product differentiation
• developing and maintaining a unique and superior value for the product, as
perceived by customer
• Competitive advantage: brand loyalty and the willingness of
customers to pay high prices

 Focus (niche)
• targeting its attention to a specific segment of a market

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Why are strategies hard to implement?

The Source of Value Has Shifted From Tangible to Intangible Assets

Percentage of market value related to…

Intangible
38% 62% 85%
Assets

Tangible
Assets 62% 38%

15%

1982 19921 20002

1. Brookings Institute
2. Baruch Lev analysis of S&P 500 companies

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Creating Value From Intangible Assets Involves

Complex Interactions

“Intangible Assets Do Not Have A Direct Impact on

Financial Results - They Have Second- or Third-Order Impacts”

Training

Service Customer Customer

Revenue
Quality Confidence Retention
Information
Technology

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Traditional vs BSC VIEW
When companies spend money to enhance their intangible assets by:
• training employees
• improving processes
• developing new products
• creating customer loyalty

Prof. Robert Kaplan:

Traditional view: “That cost you money this period, that’s an expense.You’re
now worth less.”
BSC view: “…now worth more, because you are improving the capabilities that
are driving future value.”

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Strategy Implementation
 The challenge to any organisation is how to
effectively implement chosen strategy.
 Balanced Scorecard - translates an organisation’s mission
and strategy into a comprehensive set of performance measures
 A formally derived combination of measures,
structured to express a cause and effect relationship
between specific measures and overall organisational
objectives and the achievement of strategy
 A strategic management system (framework for implementing
strategy)
 Measures and manages all aspects of a company’s performance
 Balances traditional financial measures of success (results of actions
already taken) with non-financial (operational) measures (the drivers
of future financial performance)

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2.The Balanced Scorecard

Four Basic Perspectives:
Financial perspective
How should we appear to
our shareholders?

Business and production

Customer perspective Mission process perspective
and
How should we appear to strategy At what business
our customers? practices must we excel?

Learning and growth

perspective
How should we sustain
our ability to grow,
change and improve?

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Where does a BSC begin?

A strategy map visually represents the cause-and-

effect relationships between an organisation’s
strategic objectives.
 It describes the process for transforming intangible assets to tangible
customer and financial outcomes
 Steps involved in building a strategy map and BSC
1. Conduct an external/internal analysis to formulate strategy
2. Decide on strategic themes
3. Build a strategy map that links the objectives from all 4 perspectives
4. Choose appropriate performance measures and targets under each
perspective
5. Choose strategic initiatives to carry-out your strategy.

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Makes explicit
Strategy Map the strategy’s
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Exhibit 12‐2 hypothesis

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The Balanced Scorecard Defines a Strategy’s

Cause and Effect Relationships in 4 perspectives
Vision and Strategy

Financial Perspective
If we succeed,
how will we
look to our
shareholders?

Customer Perspective

To achieve my
vision, how
must I look to
my customers?

Internal Perspective

To satisfy
my customer, at
which processes
must I excel?

Learning & Growth

To achieve my
vision, how must
my organization
learn and
improve?
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THE BALANCED SCORECARD: A STRATEGIC MANAGEMENT 
SYSTEM
• The strategy is the reference point for
the entire management process
• The shared vision is the foundation for
strategic learning

Translating the
vision
• BSC alignment
exists from
top to bottom Balanced
Communicating Feedback and
• Compensation
and linking Scorecard learning
is linked to
strategy

Business Planning

• Stretch targets are rationalised and accepted

• Strategic initiatives are clearly identified
• Investments are rationalised by the strategy
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• Annual budgets are linked to long-range plans
Source: R.S Kaplan (1998) The Balanced Scorecard: The power of alignment and Strategic Learning, HBS Lecture.

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1) Financial Perspective
Evaluates the profitability of the strategy
Financial performance measures
Revenue
growth ROI
Operating
income

Provide a common language for analysing and

comparing companies (objective measures; lag)

But financial measures And Non-financial measures

not sufficient to guide not sufficient for providing the
performance in creating value bottom line score
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Financial Perspective Objectives

Increase
shareholder value

Achieve productivity Generate revenue

improvements growth

Enhance
Improve Increase existing Expand
cost asset customer revenue
structure utilisation value opportunities

• Grow sales to • Generate sales

• Lower unit • Achieve higher existing from new
costs capacity utilisation customers products, new
• Reduce S, G &A • Reduce working • Improve customer customers, and
expense capital requirements profitability new markets

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2) Customer Perspective
Identifies the targeted customer and market segments and measures the
company’s success in these.
Focuses on how the organisation should look to its
customers if it is to succeed – how do we create value for our
customers? (outcome measures; lead and lag)
Customer
satisfaction and loyalty

Customer
Key acquisition
performance
Measures in Market
share

Customer
profitability
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Examples of Customer value propositions –

under different strategic objectives
Low total cost Measures

Be a low cost supplier Price relative to competitors..

Deliver consistent high quality # and % customer complaints

# incidents of warranty and field service
repairs
Provide a quick, easy purchase % on time delivery, Customer lead-time, %
perfect orders completed

Product leadership Measures

Offer high performance products Customer innovation rating, competitive

product performance, gross margin on new
products
Be first to market with new products # products first to market

Customer Solutions Measures

Provide customised solutions # customers with profiled preferences

Sell multiple products and services to # products and services per customer
customers # high sales value customers

Deliver excellent after sales service Revenues from maintenance, repair, logistics

Develop personalised relationships Client retention

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3) Business Process Perspective

Focuses on internal operations that create value for customers.
Which are the key processes that create and deliver the value
proposition for customers and achieve productivity improvements for
the financial objectives. Employees who do the work are the best source of new ideas for
better business processes (lead and lag measures)

Develop innovative products

Innovation and services,
processes Achieve excellence in R&D
Achieve superior supplier reliability
Improve cost, quality
Operations and cycle times
Key Management Improve asset utilisation
Deliver responsively
measures
in Acquire new customers
Customer Satisfy and retain existing customers
management Generate growth with customers

Environment
Regulatory and Health and safety
Social Processes Employment practices
Community investment

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Examples of Business Process Objectives and Measures

Process Objectives Measures

Operations management • Supplier ratings: quality, delivery and cost
•Improve the cost, quality, and cycle times of • Cost per unit of output
operating processes • Product and process defect rates
• Product cycle times
• Lead times from order to delivery
•Improve asset utilisation • Capacity utilisation %
• Equipment reliability, percent availability

Customer management • %leads converted

•Acquire new customers • Cost per new customer acquired
•Satisfy and retain existing customers • Time to resolve customer concern/complaint
• # customers willing to recommend
•Generate growth with customers • # products and services per customer
• Revenue or margin from post-sales services
Innovation • # new ideas entering product/service development
•Develop innovative products and services • # patent applications filed/earned
•Achieve excellence in R&D processes • Total product/service development time
• Product development cost vs budget
Regulatory and Social • # environmental and safety incidents
•Improve environmental, health and safety • Days absent from work
performance
• Employee diversity index
•Enhance reputation as a good neighbour • #employees from disadvantaged communities

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4) Learning and Growth Perspective

Identifies the people and information capabilities the
company must excel at to achieve superior internal
processes that create value.
Focuses on the capabilities of people and systems –
provides the foundation for strategy (lead measures)

Managers are responsible for developing employee

capabilities
Key measures in

Human Organisation
resources
Information
technology

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Examples of Learning and Growth Objectives and Measures

Objectives Measures
Human resources
•Develop strategic capabilities/competencies • % employees with required capabilities and skills
• Hours of training provided
•Attract and retain top talent • Employee satisfaction
• Turnover of key personnel
Information technology
•Provide applications that support the strategy • Strategic information coverage: % of critical
•Develop customer data and information processes supported with adequate system
applications
systems • Availability of customer information (e.g. CRM
systems, customer databases)
Organisation culture and Alignment
•Create a customer-centric culture • Employee culture survey
•Align employees goals to success • % of employees with personal goals linked to
organisational performance
•Share knowledge about best practices and • # of new practices shared and adopted
customers

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Environmental and Social

Performance and the BSC
Many company’s are promoting sustainability to achieve:
 Long-term financial performance
 Social performance (eliminating employee injuries, improving product
safety)
 Environmental performance (reducing greenhouse gas emissions)

Managers interested in measuring environmental and social performance are

incorporating these factors into their balanced scorecards to set priorities
for initiatives, guide decisions and actions and fuel discussions around
strategies and business models to improve performance.

Companies use a variety of measures including:

Cost of preventing and remediating environmental damage (financial)
brand image (customer)
energy consumption (internal-business)
implementation of ISO 14000 environmental standards (learning &
growth).
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Balanced Performance Measures?

Balanced between
 Lag measures and lead measures
 Outcomes of decisions and operations (effort; progress towards
objectives)
 Information – actionable and manageable (drivers of outcomes)
 Objective measures and subjective measures
 quantified and verifiable
 judgmental
 External measures and internal measures
 customers and shareholders
 process and capabilities
 Financial measure and non-financial measures
 Monetary terms
 Non-monetary units
 Short term and long-term

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Non-financial Performance Measures

 Play key role in contemporary responsibility accounting

systems
 Operational control (& continuous improvement)
◦ before vs after the fact
 Operational measures - increase employee involvement
◦ physical vs financial measure of activity
• efficiency, quality and time

Advantages Disadvantages
•drivers of future financial •wide choice of measures
performance •development can be ad hoc and
•more actionable undirected
•more understandable / easier to •trade-offs made
relate to •lack integrity
•may not easily translate into financial
outcomes
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Summary: Steps in implementing the

Balanced Scorecard
1. Clarify vision, core competencies and strategies
2. Analyse perspectives to develop performance objectives and
measures
3. Construct a strategy map to reinforce the links between
measures
4. Communicate, link throughout organisation and refine
5. Establish performance targets and action plans
6. Collect and analyse scorecard data to monitor performance
7. Investigate variances and reward employees
8. Provide feedback and refine the balanced scorecard

Note – these steps focus on the technical aspects of implementation – a range of

behavioural aspects will also influence success of implementation eg., top
mgmt support, use of multiple champions, adequate communication
throughout process, org-wide participation 27

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Lecture Example – for discussion

Horngren P12-30
Scott Co (MM) manufactures a DVD player called the Maxus. The company sells the
player to discount stores throughout the country. This player is significantly less
expensive than similar products sold by Scott’s competitors, but the Maxus offers just
DVD playback, compared with DVD and Bluray playback offered by competitor
Nomad Manufacturing. Furthermore, the Maxus has experienced production
problems that have resulted in significant rework costs. Nomad’s model has an
excellent reputation for high quality but it is more expensive.
Required:
1.Draw a simple customer preference map for Scott and Nomad using the attributes
of price, quality and playback features.
2.Is Scott’s current strategy one of product differentiation or cost leadership?
3.Scott would like to improve quality and decrease costs by improving processes and
training workers to reduce rework. Scott’s managers believe that increased quality
will increase sales. Draw a strategy map describing the cause-and-effect relationships
among the strategic objectives you would expect to see in Scott’s balanced
scorecard.
4.For each strategic objective suggest a measure you would recommend in
Scott’s balanced scorecard.
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Lecture Example: 12-30

1. The customer preference map for DVD players for Scott Company and
Nomad Manufacturing on price, playback features, and quality.

2. Strategy?

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3. Strategy Map

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4. In IBP, Scott needs to set targets for decreasing % reworked units (and
defective products sold) and identify measures that would be leading
indicators of achieving this goal – then need to measure how the
market is reacting and how this is affecting financial performance.

Financial Perspective Operating income from productivity and quality improvement

Operating income from growth
Revenue growth

Customer Perspective Market share

Number of additional customers
Customer-satisfaction ratings

Internal-Business- Percentage of products reworked

Process Perspective Percentage of defective products sold
Number of major improvements in manufacturing process

Learning-and-Growth Employee-satisfaction ratings

Perspective Percentage of employees trained in quality management
Percentage of line workers empowered to manage processes
Percentage of manufacturing processes with real-time feedback

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Good Balanced Scorecard Features

1 It tells the story of a company’s strategy by articulating a
sequence of cause-and-effect relationships.
2 It assists in communicating the strategy to all members
of the organization by translating the strategy into a
coherent and linked set of understandable and measurable
operational targets.
2 Must motivate managers to take actions that will eventually
result in improvements in financial performance.
4 Limits the number of measures used by identifying only the
most critical ones.
5 Highlights sub-optimal trade-offs that managers may make
when they fail to consider the operational and financial
measures together.
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The Balanced Scorecard

Translates the Strategy to Operational Terms
MISSION
Why we exist
VALUES
What’s important to us

VISION
What we want to be

STRATEGY
Our game plan

BALANCED SCORECARD
Translate, Focus and Align
STRATEGIC INITIATIVES
What are the essential activities?
TOTAL QUALITY MANAGEMENT
What we must improve
EMPOWERMENT / PERSONAL OBJECTIVES
What I need to do

STRATEGIC OUTCOMES

Satisfied Delighted Efficient and Effective Motivated & Prepared

SHAREHOLDERS CUSTOMERS PROCESSES WORKFORCE
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3. Strategic Analysis:
Evaluating success of strategy

Change in operating income

Growth Price Recovery Productivity

Revenue and Revenue and cost Comparison of
cost effect effect cost decreases
• increase in • change in price • fewer inputs
quantity of
• changes in input • better input mix
output sold
prices
• less capacity
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Evaluating success of strategy –

a basic example
Assume the following operating incomes for 2 years:
Year 1 Year 2
Revenues:
(1,000,000units x $26) $26,000,000
(1,100,000units x $24) $26,400,000
Expenses:
Variable Costs: Materials
(3,000,000m² x $1.35) 4,050,000
(2,772,000m² x $1.31) 3,631,320
Fixed Costs
(640,000 machine hours x $25) 16,000,000
(640,000 machine hours x $26) 16,640,000
Operating Income $ 5,950,000 $ 6,128,680

Required: Provide an analysis of the growth, price-recovery and productivity

components of the change in operating income. Assume production equals
sales; that the fixed cost capacity is machine hours of available35capacity, and
one unit requires .5 machine hours.

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GROWTH COMPONENT

The growth component measures the change in

operating income attributable solely to a change in
the quantity of output sold between the current
and the prior period.

Example:
 Growth component calculations use Yr 1 output prices, input
prices, efficiencies and capacity relationships.
 From the information, in Yr 1, the Company produced and
sold 1,000,000 devices at $26 per unit. In Yr 2, the Company
produced and sold 1,100,000 devices at $24 per unit.

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What is the revenue effect of growth?

Revenue effect of growth component = (Actual
units sold Yr 2 – Actual units Yr 1) × Output price
Yr 1
Formula approach:
(1,100,000 – 1,000,000) × $26 = $2,600,000 F
Favourable because increased sales increases operating
income.
Worksheet approach:
Year 1 GROWTH Year 2
Revenue:
Units x SP Units x SP Units x SP
1,000,000 x $26 1,100,000 x $26 1,100,000 x $24
$26,000,000 $28,600,000 $26,400,000

$2,600,000F
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What is the cost effect of growth?

Measures how much costs would have changed in Yr 1 if
the company had produced 1,100,000 (Yr 2) units.

MUST distinguish variable costs from fixed costs – WHY?

Variable Costs:

To produce the higher output sold in Yr 2, more inputs

would be needed.
The cost increase from growth measures the amount by which costs
in Yr 2 would have increased if the relationship between inputs and
outputs (and their prices) that existed in Yr 1 continued in Yr 2
(ie., NO Change in productivity is allowed).

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Cost effect of Growth Component

= (Actual units of input or capacity that would have been
used in Yr 1 to produce Yr 2 output - Actual units or
capacity to produce Yr 1 output ) x Input prices Yr 1

For the example:
3,000,000 square metres of materials were used to produce the 
1,000,000 units in Yr 1 at a cost of $1.35 per square metre. 
Input used to make a unit of output? 
3 m² per unit was the Yr 1 input/output relationship.
To make 1,100,000 units?
3,000,000/1,000,000 × 1,100,000 = 3,300,000 m

What is the cost effect of the materials growth

component?
(3,300,000 – 3,000,000) × $1.35 = $405,000 U 39

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Fixed Costs:
Cost effect of Growth Component = (Actual units of
input or capacity that would have been used in Yr 1 to
produce Yr 2 output - Actual units or capacity to
produce Yr 1 output ) x Input prices Yr 1
As units produced and sold increase, fixed costs generally
do not change (within the relevant range).
640,000 machine hours of capacity were available to produce the
1,000,000 units in Yr 1 at a cost of $25 per machine hour.
The required capacity did not change for the production of the
1,100,000 units in Yr 2, ie., there was sufficient existing capacity to
manufacture the additional units

What is the cost effect of the Fixed cost growth

component?
(640,000 – 640,000) × $25 = $0
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Operating Income and the Growth Component

What is the net increase in operating income as

a result of growth?
Revenue effect of growth component $ 2,600,000 F
Cost effect of growth component – Materials 405,000 U
Cost effect of growth component – Fixed costs 0
Increase in OI due to growth component $ 2,195,000 F

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Price-Recovery Component
Price-Recovery Component – measures the change
in operating income attributable solely to
changes in prices of inputs and outputs between
the current and prior periods

For the example: Measures the change in revenues and the

changes in costs to produce the 1,100,000 devices
manufactured in Yr 2 as a result of two factors:
– Change in output price of the device
– Change in prices of the inputs required to make the device

A company that has successfully pursued a product

differentiation strategy will be able to increase its output
prices faster than the increase in its input prices i.e., it will show
a positive price-recovery component.
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Revenue effect of the price recovery

component
Revenue effect of price-recovery component = (Output
price in Yr 2 – Output price Yr 1) × Actual units of output
sold Yr 2

We have already considered the growth effect (volume) now consider

the price.

What is the revenue effect of the price-recovery

component?
($24 – $26) × 1,100,000 = $2,200,000 U

It is unfavourable because there was a decrease in output price

between Yr 1 and Yr 2.
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Variable costs (Materials):

Cost effect of price-recovery component = (Input prices

in Yr 2 – Input prices in Yr 1) × Actual units of inputs
that would have been used to produce Yr 2 output in Yr 1
For the example:
Yr 1 direct materials cost = $1.35/m
Yr 2 direct materials costs were $1.31/m.

What is the cost effect of the price-recovery component for

materials?
($1.31 – $1.35) × 3,300,000 = $132,000 F

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Fixed Costs:
Cost effect of price-recovery component = (Price per unit
of capacity in Yr 2 – Price per unit of capacity in Yr 1) ×
Actual units of capacity in Yr 1 (if adequate to produce
Yr 2 output in Yr 1)
Or x (If Yr 1 capacity is inadequate to produce Yr 2 output
in Yr 1) the units of capacity required to produce Yr 2
output in Yr 1
For the example:
Price per unit of capacity in Yr 2 is $26 per hour but in Yr 1, was
$25 per hour.
Yr 1 capacity was adequate to produce Yr 2 output.

What is the cost effect of the price-recovery component for

fixed costs?
($26 – $25) × 640,000 = $640,000 U

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Operating Income and the Price-recovery

Component

What is the net increase in operating income as a result

of price recovery?
Revenue effect of P-R component $ 2,200,000 U
Cost effect of P-R component – Materials 132,000 F
Cost effect of P-R component – Fixed costs 640,000 U
Increase in OI due to P-R component $ 2,708,000 U

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Productivity Component
The productivity component measures the change in costs
(using Yr 2 input prices) attributable to a change in the
quantity of the inputs used in the current year relative to
the quantity that would have been used in the previous
year to produce the current years output.
If favourable, it measures how costs have decreased as a result of
using fewer inputs, a better mix of inputs, and less capacity to produce
Yr 2 output, assuming Yr 2 input prices ie., using inputs efficiently to
lower costs
Use Yr 2 prices and output.
There is no revenue component for productivity!

A company that has successfully pursued a cost leadership strategy will be

able to produce a given quantity of output with a lower cost of inputs i.e., it
will show a large positive productivity component.

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Productivity Component
Variable costs (Materials):

Productivity component
=Actual units of inputs to produce Yr 2 output
– Units of inputs required to produce Yr 2 output in Yr 1
X Input prices in Yr 2

For the example:

2,772,000 m² of DM were actually used in the Yr 2.
Actual price was $1.31/m ²

What is the productivity component of cost changes for

materials?
(2,772,000 – 3,300,000) × $1.31 = $691,680 F
There is a $691,680 increase in operating income due to the
productivity component.
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Productivity Component
Fixed costs:
Productivity component
= Actual units of capacity in Yr 2
– Actual units of Yr 1 capacity (if adequate to produce Yr
2 output in Yr 1)
x Price per unit of capacity in Yr 2
If Yr 1 capacity is inadequate to produce Yr 2 output in Yr 1,
then - units of capacity required to produce Yr 2 output in Yr 1
For the example:
Yr 1 capacity of 640,000 hours was adequate to produce the Yr
2 output.
Actual price per unit of capacity in Yr 2 was $26.
What is the productivity component of cost changes for
fixed costs?
(640,000 – 640,000) × $26 = $ 0
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Operating Income and the Productivity Component

What is the net increase in operating income as a

result of price recovery?
Revenue effect of Productivity None
Cost effect of Productivity – Materials $ 691,680 F
Cost effect of Productivity – Fixed costs 0
Increase in OI due to Productivity $ 691,680F

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Worksheet?
Year 1 Year 2
Revenue:
GROWTH PRICE
Units x SP Units x SP
1,000,000 x $26 1,100,000 x $26 1,100,000 x $24
$26,000,000 $28,600,000 $26,400,000
$2,600,000F $2,200,000U

Material Costs: (note qty is in ‘000s)

GROWTH PRICE PRODUCTIVITY
AInputs x CP AInputs x CP
3 x 1,000 x $1.35 3 x 1,100 x $1.35 3 x 1,100 x $1.31 2,772 x $1.31
$4,050,000 $4,455,000 $4,323,000 $3,631,320
$405,000U $132,000F 691,680F

Fixed Costs:
AInputs x CP AInputs x CP
640,000 x $25 640,000 x $25 640,000 x $26 640,000 x $26
$16,000,000 $16,000,000 $16,640,000 $16,640,000
$0 $640,000U $0
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Evaluating success of strategy

Change in operating income

$178,680

Growth Price Recovery Productivity

Revenue effect Revenue effect Cost effect
$2,600,000F $2,200,000U $691,680F
Cost effect Cost effect
$405,000U $508,000U
$2,195,000F $2,708,000U

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Evaluating success of strategy

 A company that has successfully pursued a product
differentiation strategy will be able to increase its
output prices faster than the increase in its input prices
ie., it will show a positive price-recovery component.
 A company that has successfully pursued a cost
leadership strategy will be able to produce a given
quantity of output with a lower cost of inputs ie., it will
show a large positive productivity component.
 A company that successfully pursued a product
differentiation strategy or a cost leadership strategy
will show a positive growth component.

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Other impacts…

 The company’s change in operating income may be

the result of a change in market size or other
favourable economic conditions.
 If the growth came as a result of a cost (price)
leadership strategy, the change in operating income from
cost leadership should include the productivity gain,
change in operating income from productivity-related
growth, and any decrease in operating income from
lowering prices.

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Example
Problem for self study Chapter 12
 Following a strategy of product differentiation, Westwood
Corporation (W) makes a high-end kitchen range hood, KE8.
W’s data for 2012 and 2013 follow on the next slide.
 In 2013, W produced no defective units and reduced direct
materials usage per unit of KE8.
 Conversion costs in each year are tied to manufacturing
capacity.
 Selling and customer service costs are related to the number
of customers that the functions are designed to support. W
has 23 customers (wholesalers) in 2012 and 25 customers in
2013.

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2012 2013
Units of KE8 produced and sold 40,000 42,000
Selling Price $100 $110
Direct Materials (sq ft) 120,000 123,000
DM cost per sq ft $10 $11
Manufacturing capacity for KE8 50,000units 50,000units
Conversion Costs $1,000,000 $1,100,000
CC per unit $20 $22
Selling & Customer Service capacity 30customers 29customers
Selling & Customer Service Costs $720,000 $725,000
Cost per customer $24,000 $25,000
Required: (1) Describe elements you would expect to see in W’s BSC.
(2)Calculate the growth, price recovery and productivity components that explain
the change in the 2012 to 2013 income. Can you use the worksheet to get the
variances?
(3) Suppose during 2013, the market size for high-end rangehoods grew 3% and
all increases in market share are due to W’s product differentiation strategy. How
much of the change in OI is due to the industry market size factor, cost
leadership and product differentiation? (4) How successful was the56strategy
implementation?

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(2) Solution using worksheet approach

2012 Growth P-R Prod 2013

Revenue
40000* 42000* 42000* ---- 42000*
$100 $200000 $100 $420000F $110 $110
$4000000 F $4200000 $4620000 $4620000
DM (V)
120000* 126000* 126000* 123000*
$10 $60000 $10 $126000U $11 $33000 $11
$1200000 U $1260000 $1386000 F $1353000

CC (F)
50000* 50000* 50000* 50000*
$20 0 $20 $100000 $22 0 $22
$1000000 $1000000 U $1100000 $1100000
S&CS (F)
30*$24000 0 30*$24000 $30000 30*$25000 $25000 29*$25000
$720000 $720000 U $750000 F $725000

OI $140000 $164000 $58000

$1080000 F F F 57 $1442000
$362,000

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(3) Analysis
Effect of Industry market size factor:
Of the 2000 unit increase, 3%*40000 = 1200units is due to growth in market
size
$140,000F * (1200/2000) = $ 84,000F
Effect of Product Differentiation on OI:
Increase in SP $420,000F
Increase in input prices (costs) 256,000U
Growth in Mkt Share due to PD (140000*800/2000) 56,000F
Change in OI due to PD $220,000F
Effect of cost leadership on OI:
Productivity component $ 58,000F
Change in OI $ 362,000F

Did the strategy succeed?

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Quick Check 1 
The growth in market share is used in calculating the net
income effect

1. of industry growth.
2. of product differentiation.
3. of cost leadership
4. of either cost leadership or product differentiation, depending
upon the strategy chosen.

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Quick Check 2 
The following strategic analysis of profitability was prepared for the Corum Company:
Revenue and Revenue and
Income Cost Effects Cost Effects of Cost Effect of Income
Statement of Growth Price-Recovery Productivity Statement
Amounts Component Component Component Amounts
in 2010 in 2011 in 2011 in 2011 in 2011
(1) (2) (3) (4) (5)
Revenues $300,000 $40,000 F $85,000 F $ 425,000
Costs 240,000 24,000 U 34,000 U 8,000 U 306,000
Op Inc $60,000 $ 16,000 F $51,000 F $8,000 U $ 119,000
$59,000 F
change in operating income
The market growth rate in the industry was 9% in 2011. Sales in 2011 were 17,000 units at
$25 each. Corum sold 15,000 units at a unit-selling price of $20 in 2010.
The effect of the industry market size factor for Corum Company in 2011 was:

1. $5,200
2. $10,800
3. $12,240
4. $13,500

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Quick check 3
An operating income analysis of JK Ltd revealed the following:
Operating income for 2012 $1,500,000
Add growth component 75,000
Deduct price-recovery component (45,000)
Add productivity component 60,000
Operating income for 2013 $1,590,000
JK’s operating income gain is consistent with the:

1. Reengineering strategy.
2. Product differentiation strategy.
3. Cost leadership strategy.
4. Downsizing strategy.

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4. Capital Expenditure Analysis

Introduction :
 Working closely with accountants, top executives have to
figure out how and when to best allocate the firm’s financial
resources among alternative opportunities to create future
value for the company. Because it is hard to know what the
future holds and how much projects will ultimately cost, this
can be a challenging task, but it is one that managers must
constantly confront.
 This chapter explains the different methods organizations use
to get the “biggest bang for their buck” in terms of the
projects they invest in or undertake.

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Capital Expenditure
Terminology:
 Capital budgeting is the process of making long-run planning
decisions for investments in projects.
 In much of accounting, income is calculated on a period-by-
period basis.
 In choosing investments, managers make a selection from
among multiple projects, each of which may span several
periods.

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Two Different, Intersecting Dimensions of

Capital Budget Cost Analysis
 Horizontally across as the project dimension, and
 Vertically upward as the accounting-period dimension.
 To make capital budgeting decisions, managers analyze each
project by considering all the life-span cash flows from its
initial investment through its termination.

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Project and Time Dimensions of Capital

Budgeting, Illustrated

Exhibit 21.1 The Project and Time Dimensions of Capital Budgeting

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Five Stages in Capital Budgeting

1. Identify projects - identify potential capital investments that
agree with the organization’s strategy.
2. Obtain information - gather information from all parts of
the value chain to evaluate alternative projects.
3. Make predictions - forecast all potential cash flows
attributable to the alternative projects.
4. Make Decisions by Choosing Among Alternatives -
Determine which investment yields the greatest benefit and
the least cost to the organization.
5. Implement the decision, evaluate performance, and learn
(generally separated into two phases):
a. Obtain funding and make the investment selected in stage 4.
b. Track realized cash flows, compare against estimated numbers, and
revise plans if necessary.
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Capital Budgeting and Working Capital

 New projects often require additional investments in current

assets, such as inventories and receivables. Working capital in
this chapter refers to the difference between current assets
and current liabilities. Any additional investment required for
a project will be included in that project’s cash flows.

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Four Capital Budgeting Analysis Methods

1. Net present value (NPV)

2. Internal rate of return (IRR)
3. Payback period
4. Accrual accounting rate of return (AARR)
Methods 1 and 2 (NPV and IRR) are discounted cash flow
(DCF) methods.
 We will look at each method in more detail but first, we’ll
distinguish discounted cash flow methods from the other
methods.

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Discounted Cash Flows (1 of 2)

 Discounted cash flow (DCF) methods measure all expected

future cash inflows and outflows of a project discounted back
to the present point in time.
 The key feature of DCF methods is the time value of
money which means that a dollar received today is worth
more than a dollar received at any future time.
 The reason is that $1 received today could be invested at, say,
10% per year so that it grows to $1.10 at the end of one year.

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Discounted Cash Flows (2 of 2)

 The time value of money is the opportunity cost from not

having the money today.
 DCF methods use the required rate of return (RRR), which is
the minimum acceptable annual rate of return on an
investment.
 RRR is internally set, usually by upper management, and
typically represents the return that an organization could
expect to receive elsewhere for an investment of comparable
risk.
 RRR is also called the discount rate, hurdle rate, cost of
capital, or opportunity cost of capital..

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Net Present Value (NPV) method

 The NPV method calculates the expected monetary gain or

loss from a project by discounting all expected future cash
inflows and outflows back to the present point in time, using
the Required Rate of Return (RRR).
 Based on financial factors alone, only projects with a zero or
positive NPV are acceptable.
 We’ll use three steps for the NPV method.

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Three-Step NPV Method

 Draw a sketch of the relevant cash inflows and outflows (see

right side of next slide).
 Discount the cash flows using the correct compound interest
table from Appendix A and sum them.
 Make the project decision on the basis of the calculated NPV
(zero or positive should be accepted because the expected
rate of return equals (zero) or exceeds the required rate of
return).

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NPV Method - Example

Exhibit 21.2 Net Present Value Method:Vector’s Hybrid Bus

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Internal Rate of Return (IRR) Method (1of 2)

 The IRR Method calculates the discount rate at which an

investment’s present value of all expected cash inflows equals
the present value of its expected cash outflows.
 The IRR is the discount rate that makes NPV = 0.
 A project is accepted only if the IRR equals or exceeds the
firm’s RRR (required rate of return).

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Internal Rate of Return (IRR) Method (2 of 2)

 Managers or analysts solving capital budgeting problems

typically use a calculator or computer program to provide the
internal rate of return, but a more manual trial and error
approach can also provide the answer.
 Trial and error approach:
 Use a discount rate and calculate the project’s NPV. Goal:
find the discount rate for which NPV = 0
 If the calculated NPV is greater than zero, use a higher
discount rate.
 If the calculated NPV is less than zero, use a lower discount
rate.
 Continue until NPV = 0.

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IRR Method - Example

Exhibit 21.3 Internal Rate-of-Return Method:Vector’s Hybrid

Busa

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Comparing The NPV & IRR Methods (1of 3)

 NPV is generally preferred because its use leads to

shareholder value maximization.
 NPV measures capture the value, in today’s dollars, of the
surplus the project generates for the firm’s shareholders over
and above the required rate of return.
 The NPV value can always be computed for a project, and
because it is expressed in dollars, it can be summed to
calculate an NPV of a combination or portfolio of projects.
 NPV method can be used when the RRR varies over the life
of the project.

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Comparing The NPV & IRR Methods (2 of 3)

 If the IRR is less than the RRR, the NPV is negative (favoring
rejection). Obviously, managers prefer projects with higher
IRRs to projects with lower IRRs, if all other things are equal
 For example, if a company has an RRR of 12% and the IRR of
a project is 12%, it means the cash inflows from the project
are adequate to (1) recover the net initial investment in the
project and (2) earn a return of exactly 12% on the
investment tied up in the project over its useful life.

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Comparing The NPV & IRR Methods (3 of 3)

 IRR is more prone (than NPV) to indicate erroneous

decisions.
 IRR implicitly assumes that project cash flows can be reinvested at the
project’s rate of return.
 NPV accurately assumes that project cash flows can only be reinvested
at the company’s required rate of return.
 Still, the IRR method is widely used. Why? Managers find the
percentage return computed under the IRR method easy to
understand and compare.

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Sensitivity Analysis

 To present the basics of the NPV and IRR methods, we have

assumed that the expected values of cash flows will occur for
certain.
 To manage the uncertainties that are likely to exist, managers
use sensitivity analysis or the “what-if” technique introduced
in Chapter 3.
 A common way to apply sensitivity analysis for capital
budgeting decisions is to vary each of the inputs to the NPV
calculation by a certain percentage and assess the effect on
the project’s NPV.

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Payback Method, Overview (1 of 2)

 The Payback method measures the time it will take to recoup,

in the form of expected future cash flows, the net initial
investment in a project.
 Like the NPV and IRR methods, the payback method does
not distinguish among the sources of cash flows.
 The payback method highlights liquidity, a factor that often
plays a role in capital budgeting decisions, particularly when
the investments are large. Managers prefer projects with
shorter payback periods (projects that are more liquid) to
projects with longer payback periods, if all other things are
equal.

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Payback Method, Overview (2 of 2)

 Organizations choose an acceptable project payback period.

Generally, the greater the risk, the shorter the payback period
should be.
 Shorter payback periods are preferred because managers are
less confident about cash flow predictions that stretch far
into the future.
 The payback method is easy to understand.
 The two weaknesses of the payback method are:
 Fails to recognize the time value of money.
 Doesn’t consider the cash flow beyond the payback point
which can cause it to deliver an opposite result from the NPV
method and can lead to project with high short-run cash
flows being selected.
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Payback Method, Calculation

 With uniform cash flows:

Payback Period = Net initial investment /
Uniform increase in annual future cash flows

 With non-uniform cash flows:

 add cash flows period-by-period until the initial investment is
recovered; count the number of periods included for payback period.
 It is relatively simple to adjust the payback method to
incorporate the time value of money by discounting the
expected future cash flows before performing the
calculations.

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Accrual Accounting Rate Of Return Method

(AARR)
 The AARR method divides the average annual [accrual accounting]
income of a project by a measure of the investment in it.
 That “measure of the investment” in the project can vary company
by company.
 Also called the accounting rate of return.
 The AARR method is similar to the IRR method in that both
calculate a rate-of-return percentage; however, the IRR method is
generally regarded as better than the AARR.

Increase in Expected Average

Accrual Accounting Annual After-Tax Operating Income
Rate of Return = Net Initial Investment

 Remember that the value used for the denominator can vary so be
sure you understand how the AARR is defined in each individual
situation.
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AARR Method, Advantages and

Disadvantages
 Firms vary in how they calculate AARR.
 Easy to understand, and uses numbers reported in financial
statements.
 Does not track cash flows.
 Ignores time value of money.
 When different methods lead to different rankings of
projects, more weight should be given to the NPV method
because the assumptions made by the NPV method are most
consistent with making decisions that maximize a company’s
value.

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Relevant Cash Flows in DCF Analysis

 One of the biggest challenges in capital budgeting, particularly

DCF analysis, is determining which cash flows are relevant in
making an investment selection.
 Relevant cash flows are the differences in expected future
cash flows as a result of making the investment.
 A capital investment project typically has three categories of
cash flows:
 Net initial investment.
 After-tax cash flow from operations.
 After-tax cash flow from terminal disposal of an asset and
recovery of working capital.

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Relevant After-Tax Cash Flows

 We’ll look at each category of relevant cash flows, but first let’s be sure
we understand the effect that taxes can have on the cash flows.
Exhibit 21.5 Effect on Cash Flow from Operations, Net of Income Taxes, in
Year 1 for Vector’s Investment in the New Hybrid Bus

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Relevant Cash Flows: Net Initial Investment

 Three components of net-initial investment cash flows:

1. Initial machine investment.
2. Initial working capital investment.
3. After-tax cash flow from current disposal of old machine.

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Relevant Cash Flows: Cash Flow from

Operations
 Two components of cash flow from operations:
1. Annual after-tax cash flow from operations (excluding the depreciation
effect).
2. Income tax cash savings from annual depreciation deductions.
 For economic-policy reasons, tax laws specify which depreciation methods and which
depreciable lives are permitted. When there is a legal choice, take the depreciation
sooner rather than later because this will increase a project’s NPV.

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Relevant Cash Flows: Terminal Disposal Of

Investment
 Two components of Terminal Disposal of Investment:
1. After-tax cash flow from terminal disposal of asset (investment).
2. After-tax cash flow from recovery of working capital (liquidating
receivables and inventory that was needed to support the project).

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Lecture Example – Capex

ABC manufacturing is considering expanding their product range to include a new
product. It would generate annual EBITDA of $250,000 for five years.

A new machine would have to be acquired, costing $500,000. It would be sold for
$50,000 at the end of the five years. Depreciation for accounting purposes is 20%
straight line, and 40% diminishing value for tax purposes.

An investment in working capital would be required, being inventory of $200,000,

which would be recovered at the end of the product life in year 5.

ABC has a hurdle rate of 15%. The tax rate is 30%.

Required:
Calculate the yearly cash flows and calculate the NPV and IRR.
Use the Capex Lecture Problem - Excel Template (available on BlackBoard).

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Lecture Example – Capex

Use the Capex Lecture Problem - Excel Template (available on BlackBoard).
CASH FLOWS Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

EBITDA (net of tax) 175,000 175,000 175,000 175,000 175,000

Inventory (200,000) 200,000
Investment (500,000)
Depreciation (tax effect) 60,000 36,000 21,600 12,960 7,776
Sale proceeds 50,000
Tax effect of gain on sale (3,336)

After-tax cash flows (700,000) 235,000 211,000 196,600 187,960 429,440

NPV 114,136
IRR 21.2% Diminishing value depreciation schedule:

Investment 500,000 Depn. Book value Tax effect

Annual EBITDA 250,000 Year 1 200,000 300,000 60,000
Additional working captial 200,000 Year 2 120,000 180,000 36,000
Salvage value year 5 50,000 Year 3 72,000 108,000 21,600
Tax rate 30% Year 4 43,200 64,800 12,960
Required return 15% Year 5 25,920 38,880 7,776
Tax depn (dimin. value) 40% Sales proceeds 50,000
Accounting depreciation 20% Gain on sale: 11,120 3,336 92

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