It is a fact that virtually all organizations are faced with myriad of challenges in facing the future with its many uncertainties (Malcolm et al, 2005). However, in majority of these firms, strategic decisions pertaining to investments are mostly based on projections of future occurrences or events. In spite of the fact that managers clearly understand the implications of not factoring in future uncertainties, the difficult process of planning makes many manager ignore likely costs and assume that no serious problems will affect the operations of the company. Assuming that a given company is faced with a strategic decision of building a manufacturing plant, it is clear that such an investment will require a large capital outlay as well as managerial attention (Pogue, 2010).
The returns on investment in such a plant do not only depend of technical success but also on external factors like market capabilities, structure a, and the industry at the time of completion. Therefore, future uncertainties and the actions of the firm on such developments will be critical in determining the success or failure of investing in the manufacturing plant. It is because of this that managers are confronted with the question of to factor in future occurrences as well as future responses in the analysis stage of a capital investment plan. According to Pogue (2010), engaging in investment activities is important in securing growth for any organization. This paper will evaluate how methods of investment appraisal are important in undertaking investment decisions. In addition, it will also evaluate the different methods of costing products and services.
Investment Appraisal Techniques
Based on the aims and objectives of an organization, the purpose of the investment appraisal process is to identify how an investment will affect the value of the organization. The major focus is on increasing the firm’s wealth by undertaking investments that provide returns that are higher that the associated costs. The appraisal process requires an analysis of the firm’s expected future cash flows which will be received over a given period s of time. In order to undertake a proper comparison of cash flows expected over different time periods, it is important to “convert them to a common base or time period” (Meyer 2002, p. 15). This is achieved by converting expected future streams of income into present day values or vice versa.
The process of investment appraisal enables managers to select those projects that will advance the goals and objectives of a firm as well as maximize shareholders wealth. There are several methods that are used to evaluate investment appraisal projects. These include; the payback method, Return on investment (ROI), Accounting Rate of Return and Discounted Cash Flow (Pogue, 2010). When applying the discounted cash flow, several techniques are usually applied. These include the net present value (NPV), profitability index (PI), and internal rate of return (IRR). Payback method is the most common method used and it is also the easiest one to understand. It provides basically the time period that a particular project will take to recover the initial cash outlay. The ARR is simple technique also that is calculated by dividing a project’s profits with average investment.
Average profits are determined by summing up profits of consecutive years and dividing the sum by the number of years. On the other hand, the average investment is the sum of the initial investment plus the expected residue value of the asset divided by two. Discounted Cash Flow is the incremental after-tax which is used to determine the benefits expected from an investment. The net present value (NPV) is the difference between the present values of all expected future stream of income and the present value of the initial capital outlay, discounted using the firms cost of capital. On the other hand, the profitability index (PI) is the ratio of the present value of all future net cash flows to the initial costs.
The internal rate of return (IRR) is defined as the rate of discount which makes the present value of an investment to equal the present value of all expected future cash inflows. The purpose of investment appraisal techniques is not to do away with the brilliant businessman or even do away with good luck. However their purpose is to quantify all the elements that can be measured so that management can be in a position to determine whether a project is viable and can add value to the firm, and maximize shareholder’s value. Therefore, investment appraisal techniques are vital in determining whether investments will create benefits or problems to a given organization.
Investment Decisions and Investment Appraisal
According to Lucey (2003) development in technology might have a big effect on market structures even in developed economies. In modern competitive environments, there exist complex interrelationships of ownerships as well as control “which are abstracted from in much more formal analysis; their justification derives, in part., from the need to co-ordinate complementarity activities” (Pogue, 2010, p. 14). The size of a firm can be explained by the numerous activities that need planned coordination but not by economies of scale associated with any single operation. However, all activities do not work towards integration. According to Cooms et al (2005) the lack of knowledge by an investor, both technical and the prospects of other players in the industry, checks his desire or willingness to make long-term obligations and to move with others. Both the micro and macro environment of a company identifies the opportunities that a company faces in any given time. However, the growth path and growth rate of the company cannot be determined by such factors alone (Canals 2000).
According to Canals (2000), it the investment decisions that a firm chooses to pursue which determines or triggers tits growth. In essence, these decisions must are closed linked to the prior development of a business idea and depend largely on the firm’s internal and external environment. Strategic investment decisions are usually related to the expansion of a firm’s potential. Low cost structure or differentiation strategies cannot alone help a firm achieve a certain position in the competitive arena. Behind these strategies lies other qualities as there are other capabilities, if well utilized, can enable a firm to gain a competitive edge in the market. As a result, the development of a business idea requires a definition of the capabilities that will be important for the company in the near future as well as an approach of coming up or acquiring such capabilities. In addition, this approach requires a strategic decision which does not include any other alternative direction (Gowthorpe, 2005).
One of the characteristics of investment decisions is that they tie the firm’s future and identify its growth path (Pogue, 2010). Strategic investment decisions provide new opportunities for a firm and also give new lease of life to the existing ones. Since these investments cannot be reversed, poor investment decisions will make a firm lose its value overtime. Investment decisions have a very important part to play in accounting for growth process as well as in the continued pursuit of growth strategy in a firm. Investment decisions also assist in explaining some of the challenges that are faced by a company while trying to implement change (Hansen & Mowen, 2010)
Organizational change comes into effect as a result of innovation in the production systems that result from investment decisions. The economic effects of innovation depend on how it is incorporated throughout the productive fabric and also on the technological strategy pursed by a firm. Investment decisions are geared towards achieving growth for the firm that pursues them. Therefore, the use of appraisal techniques in making investment decisions increases the chances of good decisions that will help the firm achieve its goals (Schuster et al, 2007).
Investing in viable projects is vital in achieving growth of any firm. The above investment techniques assist managers and planners in evaluating how investments will perform in the near future. In addition, the techniques ensure that the value of an investment will impact the value of the firm. Investment appraisals give clear information on what will happen if a firm undertakes a particular investment decision. Therefore, these techniques provide an outlook of what the most important focus of a firm should be in terms of investment.
Different Approaches to Costing
The importance of traditional managerial costing systems has been an issue of debate by academicians and practitioners basing their argument on the irrelevance of the traditional costing technique in the manufacturing environment. The debate also included the irrelevance of traditional managerial costing systems due to its exclusion of meaningful cost data for marketing, distribution, and its role in customer service functions (Lucey, 2003).
Currently, the uses of corporate management accounting systems have been very inadequate. Lucey, (2003) argued that due to technological advancements that has led into global and domestic competition, and improvements in information processing, management accounting systems have been very inadequate in providing timely information for process control, product costing, as well as, performance evaluation activities of managers.
Companies can develop competitive advantage and sustain it after identifying value chain and other cost drivers that provides a meaningful value of the activities of the value chain. In order to achieve this, companies should be able to control and manipulate the cost drivers better than their rivals by employing the use of strategic cost analysis. Strategic cost analysis employs the use of cost data in strategic planning. This is a powerful tool to be used by companies to enhance their competitive advantage.
Lucey, (2003) emphasized on the usefulness of strategic cost analysis stating that, when combined with other costing methods , this tool can direct managers to take strategic initiatives in product designing, product cost, customer service, pricing, and automation as well. Hence, strategic cost analysis provides a company with an opportunity to analyze the value of their product or service in order to be able to make necessary adjustments.
Marginal or Variable Costing
In most circumstances, the computation of direct costs may be inconsistent in providing regulations’ definition of cost of production. Based in management accounting practices, direct costs refer to costs that can easily be identified for a particular product or processes for specific purposes. In some cases, may refer to variable costing. Direct costing is a method of product costing that charges only the variable costs of manufacturing to the product. The variable costs encompass only variable manufacturing costs to mean the cost of a product. Product costs includes, direct materials, direct labour, as well as, variable manufacturing costs.
According to Abdallah (2004) all fixed manufacturing costs are not among the inventoriable costs hence, they are not expensed during the fiscal year in which they are incurred together with all selling and administrative expenses. Thus, the variable or marginal approach is very vital in decision making. The variable or marginal approach should be used with more caution in situations that require a lot of commitments in decision making to ensure that costs and expenses and the markup or profit are accounted for to enhance continuity in business. Lucey, (2003) stated that the variable or marginal costing approach can not be used indiscriminately in such circumstances. Marginal costing approach is based on short term decision making because it is simple and easy to administer. It focuses on the same ideas with break even analysis. Hence, the approach maintains the behaviour of both costs and revenues constant throughout the decision making process. In employing the marginal costing approach a critical scenario to be achieved is the point where total revenues and total costs are equal.
Full or Absorption Costing
The channel structure directly depends on the cost of a product. Thus, this implies that the unit cost of a forklift truck to be considered an investment and is high in most cases. Such investments are used repeatedly by a business enterprise hence, funding them may be a deciding factor in making decisions on when to purchase them and the appropriate brand. Most of such equipment investments like the forklifts are traded in by exclusive retailers which deal in specific brands or through transactions made through company branch retailers. Such investments are associated with high purchase price.
As observed by Palmer & Randall (2002) there are several advantages provided by a manufacturer to the users. These advantages may include special options offered by the manufacture before the delivery f the product to the user. In order to achieve this, there are certain market characteristics that may involve a short line of communications, no provision of warehousing for such products for wholesale distribution. Furthermore, there is a frequent involvement by the manufacturer with its retailers. It is necessary to have different ways to gather data for specific uses especially, in involving a full or absorption costing system (Hansen & Mowen (2010). Meyer (2002) argued that the use of absorption costing requires some product cost information instead of the full product cost, this may included different costs that may be different to the plant, process, or both but may be fixed or non incremental at the product level.
It is necessary to be able to gather costs that are relevant to certain decision whether it is a decision to accept a special order, terminate a product line, or outsource a component when using costs for decision making. There is need for the management to distinguish the portions of total costs, which are considered as sunk costs which may not be relevant in decision making and that may be processed by a new proposal. According to Hansen & Mowen, (2010) the newly created costs are relevant when applied in most cases. However, certain costs are incurred by the organization as a whole, and apportioned to various cost centres. Furthermore, there is no single method of dividing these costs, but the simplest and most common is the absorption costing. The absorption costing refers to spreading all the cost into the centre. Absorption costing is used to ensure that organizations full costs are absorbed at the service level, this is done to ensure that overhead costs doest not impact upon other incomes or reserves (Palmer & Randall 2002). This is done to ensure that an organization can be able to achieve higher revenues to cover the costs.
Employing this approach is vital since it lead to greater accountability of the major important central services of an organization to the services that provides financial support. There are demerits that are associated with absorption costing. First, absorption costing is very inefficient in solving an organizations central services, this is mainly attributed to lack of incentives that are necessary to minimize or control these costs. Furthermore, organizations competiveness can be reduced if another company bidding for a contract may have leaner costs or is not operating through the absorption model. As stated by Palmer & Randall (2002) the use absorption approach can lead to resentment within service delivery since service managers may feel that they are not providing appropriate support to the central services to the to the failure of their own services . This approach of absorption costing encompasses various kinds of manufacturing costs. Through use of absorption or full costing there is the inclusion of the variable and fixed manufacturing overhead in decision making by ensuring that the maximum amount of revenue to offset the expenses are received by the company.
Activity Based Costing
This method of costing drives costs in an organization deeply because it identifies the actual costs of premises, labor and equipments, that are linked with the activities pursued by the firm instead of applying overhead costs arbitrary (Leitner, 2007). Activity-based profitability analysis has been identified as granular form of costing. This is so because it is used to identify the actual cots of labor, equipment and materials needed to provide a product, serve the client and maintain business operations. Practitioners of this form of costing believe that making costs known helps create opportunities for cost cutting and savings. However, the method doesn’t identify savings targets.
There are two advantages associated with ABC compared to other costing methods. First, ABC makes all costs incurred in production known. This minimizes distortions causes by arbitrary allocation of overhead costs to products and customers (Meyer 2002). Secondly, ABC is able to trace costs back to the economic activities that cause them. This makes it possible to determine the appropriateness of the costs in light of those activities. However, the method is les useful when decisions of costing are made without any reliable information about their effects (Meyer 2002).
Activity based costing is a tool used by companies to allocate its cost through activities to the products and services that are provided to the customers. It is a useful approach in learning about customer cost and profitability and it is used by a firm to help in pricing decisions, outsourcing and in measuring of initiatives that improve business processes. Activity based costing helps a company to determine what comprises cost and if the cost is acceptable to the firm or not.
As such, it is an important method because it can greatly assist in ascertaining whether the expenses and costs incurred by the firm are worth it. This costing method also provides a clear statement of what comprises cost. It provides a better chance for to realign it financial focus and goal. The use of ABC system can minimize the financial worries of the company, thus giving the company an opportunity to analyze its goals and attain newer perceived targets. Another implication for a company is that it can be in a position to utilize such information to create a good image for itself. This is beneficial as a company’s desire to stand tall in the competitive environment is boosted.
In summary, the marginal costing method is focused on short-term decisions since it has features that are simplified. It has the same features as the break even analysis. In absorption costing, both the variable and fixed manufacturing overhead is included. This makes sure that that the optimum income to take care of all costs will be achieved by a firm. ABC helps companies determine what constitutes its costs and whether those costs are acceptable to the company or not. It is a good tool as it helps the firm determine if the costs incurred by a firm are acceptable.