STEP 6: chapter 8 reflections
assignment twoSTEP 6: chapter 8 reflectionsChapter 8 is concerned with the decision making of managers. As I read this chapter, I was reminded that managers are drivers of a firm as we learnt in Chapter 5. They are tasked with having a deep connection to the business realities of their firm and using this knowledge to propel the firm towards a greater vision or goal. A successful manager is someone who can make good decisions. In my experience managers tend to be type A personalities with a clear vision and bucket loads of self-confidence. This is certainly helpful, but it is the knowledge of costs and accounting that provides the basis of any decisions that they make. Like all of us, firms face a scarcity of resources with which to achieve their unlimited wants. Costs are an inevitable part of any activity. Managers must understand these costs and the relevance of these costs to successfully plan for the short and long-term future. What costs are relevant?I was surprised to see that there are so many types of costs (sunk, incremental, avoidable, unavoidable, replacement, fixed, variable or opportunity). Most of these were familiar to me but I hadn’t really considered the importance of understanding the nature of each cost. We have looked in depth at opportunity costs, fixed and variable costs in this unit and the importance of these is indisputable in planning, budgeting and decision making but what in the world are sunk costs? The term itself certainly creates an image of lost money. Perhaps money thrown from a ship into the deep blue sea…there I go again with the shipping metaphors. Concentrate Amy!2903220126174500It turns out, sunk costs are costs that have already been paid and cannot be recovered. In one of my hastier decisions I once bought a Volvo on eBay. I was swept up in the thrill of bidding and the lure of those sleek Swedish curves and leather seats. I tore down to Greater Western Sydney to collect my prize. I threw the $5,000 at the seller before he could change his mind and drove away with smug satisfaction. Those 15 minutes were among of the happiest in my life. I almost made it to Parramatta before smoke started billowing from the hood and the car stopped with a jarring ker-thunk. It turns out that I had bought a lemon. The Volvo was towed to Newcastle and spent the next few years as a lovely outdoor sitting area (with reclining leather seats). The cost of towing the Volvo plus the $5,000 purchase price were both sunk costs as I could not recoup any of the money. A scrap yard ended up salvaging the car (for free) and I learnt an extremely valuable lesson. It is still the subject of much mirth amongst my family and friends a decade later. My experience with the Volvo makes it clearly apparent to me that it is very easy to become overly attached to sunk costs. Because I had already spent so much money, I was very tempted to spend even more to get it up and running again. Similarly, if a firm was to spend a significant sum on a new software system, they would be keen to make it work, even if it hadn’t proved entirely beneficial. It is very difficult to cut your losses. Just as I was saved by the advice of a lovely mechanic, a firm can be saved from incurring additional unnecessary costs by the wisdom of a good manager. As sunk costs are incurred from decisions in the past, they are not relevant to future decisions. So, what are the relevant costs and why are they relevant?Different decisions incur different costs. Differential costs are the relevant costs for decisions involving two alternatives. Identifying the differential cost is important as it helps decide whether a course of action is in the firm’s best interest. I was originally a bit confused about this as I saw it as quite like opportunity cost, where the cost of an activity is equal to the highest valued alternative that must be given up to engage in that activity. Understanding the opportunity cost of any action is crucial to decision making. For example, I have chosen to close my business to study full time. The opportunity cost of this decision is the income I was earning from my business. The opportunity cost of part-time study whilst working in my business would be an extended period studying and delays in finding a job in the field I am interested in. I made the decision to close my business because this option was the most valuable to me personally. In contrast, differential cost is the difference in total costs incurred between two options. If farming sheep costs $12,000 a year and farming cattle costs $14,000 a year then the decision to run a cattle farm has a differential cost of $2,000. I am still not entirely confident that I have untangled these. This subject has constantly shown me how much I don’t know!Incremental (marginal) costs are the costs incurred from creating an additional unit of product. If I was to produce 7 glasses of lemonade at a cost of $3 and 8 glasses of lemonade at a cost of $3.2o then the incremental cost of the 8th glass of lemonade is $0.20.Replacement costs are incurred when essential assets need replacing. Our fridge recently gave up the ghost, so we needed to purchase a new one. The cost of the new fridge was a replacement cost and one that we sorely didn’t need at Christmas time!!Other costs mentioned are avoidable and unavoidable costs. An unavoidable cost is the cost of electricity or something else that cannot be circumvented. These are often fixed costs. An avoidable cost is a cost that might not exist if different courses of action are taken. If a restaurant decides to take lobster off their menu then the cost of buying the lobsters from the fishmongers will be avoided. The restaurant will still have the unavoidable costs of rent, staff and essential services but will no longer have the avoidable cost of selling the lobsters.Moving on from the heady world of costs (and my use of way too many analogies) I focus on the contribution margin. I am aware that this has been covered in my economics class, but I am a bit behind on my economics so will rely on Martin to explain this one for me. Focusing on ContributionMartin explains that:Contribution Margin = Sales Revenue – Variable CostsThe importance of the contribution margin is that it illustrates how much a product contributes to the overall profit of the company. The contribution margin would assist managers in performing break even analysis (the point at where all expenses are covered, and a business can start earning a profit) and in making decisions about the selling price of a product or unit. One of the benefits of calculating the contribution margin is in deciding which products to give preference to (product-mix decisions). If a company which produces both roll-on and aerosol deodorant was to find that aerosol deodorant had a higher contribution margin, then it is likely to be produced in larger quantities than the roll-on deodorant.As in the example of Robinhood, very low or negative contribution margin values indicate economically unviable products. Understanding these values can lead to decisions to cease the production of certain products.I can see that investors and management would be very interested in contribution margins, but I envision that there are some disadvantages to relying too heavily on them. Contribution margin analysis assumes that levels of production, fixed costs and sales levels remain constant. Any change to these factors could render contribution margin analysis inaccurate. Long term decisionsI imagine that making long term decisions for a firm would be quite difficult. None of us has a crystal ball to see what the future holds and we are all aware that catastrophe (like the GFC) could loom around any corner.The value of a dollar now is more than a dollar in the future because the value of the dollar is certain now. However, managers must be brave enough to invest today’s dollars to ensure company growth. Technological advancements, expansion and innovation are all necessary for the continued survival of firms in what is a very competitive market. Imagine if Apple computers had decided to hold onto their money rather than invest in the research and development necessary for the development of the iPhone. They would certainly be in a completely different position today (or completely extinct). It takes great vision, a solid understanding of the business realities of a firm and that type A constitution to weather the risk that is inherent in any decision but in articular in long-term decisions.I was interested to learn about the specific tools used in long-term decision making, specifically the accounting rate of return (ARR), payback period, discounting cash flow (DCF), internal rate of return (IRR) and net present value (NPV).I had never heard of the accounting rate of return (ARR) before, so it took some time for me to make sense of it. Martin tells us that ARR can be calculated as:ARR% = Average net profit / Initial investment x 100I read the Boeing example and completed the formula but still felt like the info wasn’t clicking so I decided to try another example.A Service Station needs to decide whether to install a car wash. The car wash costs $115,000 and is expected to increase revenue by $45,000 per year and have an annual expense of $10,000 per year. The average annual profit will be: $35,000-$10,000 = $25,000The Accounting Rate of Return = ($25,000 / $115,000 ) x 100 = 21.74% This means that for every dollar invested, the car wash will return around $0.22. I would think that this makes the decision to install the car wash economically viable. Now, I have no idea how much car washes earn or cost, so my example is probably a long way from accurate!I can see that the Accounting Rate of Return would be incredibly useful in making capital investment decisions and I am thrilled to add it to my growing accounting toolkit. Thanks Martin!Similarly, I can see that the payback period of any investment is worth understanding. In Jan 2015 my husband and I purchased a 10kW solar system for our home at a cost of $13,000. The system has saved us an average of $3,000 a year on our electricity bills. To calculate the payback period for the system I can use the formula:Payback period = Initial investment / Cash flow = $13,000 / $3,000 per year= 4.33 yearsThis means that the solar system has paid for itself and is now saving us money each year at zero cost. We are beyond the point of the system having the potential to lose us money. Unknowingly my husband and I had already calculated the payback period when making the decision to install the system. We underestimated the saving and calculated a payback period of around 5 years so are happy with the reality.Discounted cash flow estimates the value of an investment based on its future cash flows. To determine the DCF an investor needs to make estimates about cash flows and the end value of the investment. This considers the time value of money that Martin mentions earlier in the chapter. To calculate the DCF investors can consider either the internal rate of return (IRR) or net present value (NPV). I must admit that I found this area of the chapter a bit confusing and sought some help from Google. I was stopped in my tracks when I found the formula for calculating IRR:Eeek!! I can see why this formula was not included in the study guide. Martin was very kind in keeping a lot of the scarier equations out of arm’s reach of us accounting novices!Ploughing on, I learnt that IRR is used to calculate the rate of growth an investment is projected to make. It is helpful in deciding which projects to pursue and which to abandon. I would like to be able to calculate an example here but I am sorry to say that I can’t! I can see that IRR might not be a great method to use for more complex projects as there may be many different internal rates of return when a project has different cash outflows. In this instance the net present value (NPV) method would be better.The net present value (NPV) method is concerned with added value rather than percentage returns. The present value of all cash outflows is subtracted from the present value of all cash outflows. This seemed simple enough until I realised that the timing of these cash inflows and outflows also needs to be considered. Yikes! How can a manager work this out? Then, a discount rate is applied to calculate whether an investment will add or destroy value. What is the discount rate? It makes sense to me that it would be the cost of capital but I am still unsure if this is correct. In simple terms decisions are made with this simple rule:A huge drawback of DCF techniques is that the long-term future they are planning for is not really that long term at all. They rely on the assumption that any investment will be basically worthless in less than a lifetime. I find this really interesting as we know that many investments can provide value for generations.As is always the case, I leave this chapter in awe of the enormity of the world of accounting. I feel like I understand something only to be completely flummoxed by the next concept. Martin has mentioned many times that accounting involves many grey areas and I completely agree with him. The skill of accountants lies in their ability to speak the language of business and translate it into a plan, or a map that can be followed by managers and anyone with an interest in a firm. Far from being black and white, this translation is bound to be a reflection of the accountant themselves. I am both relieved and sad to have finished the study guide. I have really enjoyed the challenge of grappling many of the concepts that Martin has thrown at me but have also been exasperated and sometimes just plain exhausted by them. Writing this reflection has taken two full days instead of the recommended 4 – 4 ? hours. I often find myself wondering about the demigod who can write on of these reflections within the recommended time. Praise be, super accountant!10502906731000 ................
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