Chapter 8: We have got to make some decisions

Successful leaders have the courage to take action while others hesitate.
John C. Maxwell
Vacillating people seldom succeed. Successful men and women are very careful in reaching their decisions, and
very persistent and determined in action thereafter.
L.G. Elliott
Managers of firms need to make decisions; lots of decisions. In business, opportunities can present themselves
continuously. All decisions require managers to predict the future to some extent, either for a short time or for a
long time into the future. This is never totally straightforward. How can a firms accounts help managers make
these decisions? Decisions require managers to predict the future; to look out into the future. Accounting is
backward looking. It is a record of what has happened to a firm in the past. How can accounting possibly help
managers make decisions; or could it rather hinder them? This is the issue we will consider in this chapter.
We will first look at decisions that only require managers to consider the short-term future, say the next few
months or up to a year or so in the future. These short-term decisions may only have implications for a firm for
a short while, for example whether or not Ernst & Young (an accounting firm) decides to accept a contract to
provide professional services to a client over the next few months. Alternatively, these decisions might have
longer-term implications but can be readily reversed or changed in the short-term, for example the decision by
an institutional investor, such as the New Zealand Superannuation Fund, to enter into an investment
management contract with ING New Zealand, a fund manager, to manage part of its fixed interest portfolio.
These sorts of arrangements are usually expected to last for many years but can usually be terminated by the
institutional investor with one months notice if the fund manager fails to perform satisfactorily.
We will look at how managers need to decide what costs are relevant to their decision, and how accounting can
help or hinder them in doing this. We will see that a range of words and ideas can be associated with a firms
costs, such as sunk, incremental, avoidable, unavoidable, replacement, fixed, variable or opportunity. There are
a lot of different types of costs; and a lot of different concepts about costs. How might accounting help or hinder
managers to focus on relevant costs (and, indeed, relevant income) in making decisions? We will also see how
managers can use accounting to help them focus on the contribution of aspects of a firms activities to a firms
profitability. This is a key concern for managers of a firm.
Some decisions of managers require firms to commit substantial amounts of limited capital to a firms
operations. As these decisions can significantly affect a firms economic and business realities for many years
into the future and are often difficult to reverse or change, they require managers to put effort and care into
predicting the future. This requires managers to compare money invested today with expected future returns a
number of years into the future. We will consider a number of techniques managers can use, some involving a
consideration of the time value of money (that is, money is worth more to us now than in the future) and some
that do not. We will consider how accounting, with its focus on past events of a firm, can possibly help
managers predict the future. After all, managers are the ones running firms and making the decisions. No-one
else is doing this; and they need information about their firm to help them do this.
8.1 What costs are relevant
Making good decisions is a crucial skill at every level.
Peter Drucker
The first rule in making decisions is to focus on those aspects of a situation relevant to a decision and to ignore
those aspects not relevant to making a decision. This should help us make better decisions with better outcomes
for people with a genuine interest in our firms. In any decision there are costs and benefits to consider. In most
business situations there is a lot of complexity. There is often a lot going on. Which costs and benefits are
relevant to a decision? Which are not? And how can accounting possibly help managers focus on what is
relevant and safely ignore what is not? This is what we will look at in this section.
Focus on what is relevant
Costs and benefits that are relevant for managers to consider when making decisions are those costs and benefits
expected to change as a result of the decision being made. Sunk costs are costs that have been incurred as a
result of past decisions. They are costs that have already been paid or costs a firm cannot avoid paying in the
future. Sunk costs cannot be changed as a result of future decisions. Examples of sunk costs in business can be
advertising costs or the costs of researching a new product idea that have already been incurred. Because sunk
costs cannot be changed they are irrelevant to future decisions and so should be ignored.
When managers are seeking to decide between alternative opportunities, the costs and benefits common to each
alternative are also not relevant to the decision. These costs will be incurred or benefits gained regardless of the
opportunity selected. Only costs and benefits that differ between alternative opportunities are relevant to a
decision. These costs are called differential or incremental costs. For example, the managers of Ryman
Healthcare may be considering a number of alternative options for the development of a new retirement village
on a 3.5 hectare site it owns in Howick, Auckland. The cost of the site would be a common cost to all options it
would consider. However, it is not a sunk cost as this cost could be changed as a result of future decisions; the
site could be sold if it was decided not to develop the site. However, the cost of the site would not be a relevant
cost when choosing between alternative options for developing the site as it would be a common cost to all
options being considered.
Another way of thinking about whether a cost is relevant to a decision is to ask ourselves whether a cost could
be avoided as a result of making a decision. For example, Ryman Healthcare would be paying council rates each
year on its 3.5 hectare site in Howick, Auckland. It would need to continue paying council rates no matter which
option to develop the site its managers selected. The cost of paying council rates would be unavoidable and so
would be irrelevant to the decision. However, if the managers of Ryman Healthcare were also considering the
option of not developing the site and instead selling it, then the council rates on the site would be an avoidable
cost and would be relevant to the decision.
Everything is limited
Dost thou love life? Then do not squander time, for thats the stuff life is made of.
Benjamin Franklin
We saw in Section 5.4 of Chapter 5 how planning that is accompanied with consistent and sustained action can
help to get time on our side. Otherwise, all that happens is that time will simply pass. My father is now 88.
Throughout his life he kept up with two friends from school. One of these friends recently died and the other is
not in very good health. My father is also not in very good health. These three friends are no longer able to
email, phone or visit each other. This is a reality for all of us, wherever we are in life. We are all on the
conveyor belt of life and at the end of life we drop off the conveyor belt. In this life, the conveyor belt does
not go on forever. Time in our world is limited.
The implication of this is that for everything we choose to do with our time and energies each day we are
choosing not to do a whole heap of other stuff a whole heap of stuff that we will never be able to do that day
because we will have used it up doing something else. And the number of days we have to live and do stuff is
strictly limited; very limited. It is the same in business. The opportunity cost is the real cost of everything a firm
does. This is because all resources, all life, everything that a firm can get its hands on is limited. Everything is
limited: everything. The opportunity cost is the maximum or best benefit that could be obtained by any
particular resource available to a firm. Also, if a resource of a firm would need to be replaced as the direct result
of a future decision of a firm, the cost of replacing that resource is the relevant cost to consider rather than the
previous cost of purchasing that resource in the first place. This is called the replacement cost.
What are the implications of this reality of scarcity, of limits, on the way managers make decisions in firms?
The key implication is this: managers of firms will face many more opportunities to do things than they will
have resources and time to do them. Regardless of the size of a firm, its geographic reach, the amount of
resources it can access, all managers of all firms face this basic reality of life and of business: we need to make
decisions within constraints. The only costs and benefits relevant to a decision are those that relate to the future,
not to the past. Sunk costs are not relevant. They are the result of past decisions already made; future decisions
will not affect them one way or the other. Only differential (or incremental) costs and benefits are relevant to a
decision. These are the costs and benefits that will differ depending on the decision made.
We saw a much more subtle factor to consider is the opportunity cost of a decision. Usually when we do
anything there are many things we cannot do at the same time. Is what we have chosen to do the best choice, or
was there a better use of our limited resources? We also saw that replacement cost of an existing resource of a
firm can be relevant in some situations. These are some ideas about what costs and benefits are relevant to
decisions. Managers have to make decisions all the time. It is a constant demand on them. They are, after all, in
the drivers seat of their firms. We will now consider whether accounting, with its focus on past activities of a
firm, can help or hinder managers focus on relevant costs and benefits (which typically relate to the future)
when making decisions.
8.2 Focusing on contribution
Ive learned that you shouldnt go through life with a catchers mitt on both hands. You need to be able to throw
something back.
Maya Angelou
I have found the paradox that if I love until it hurts, then there is no hurt, but only more love.
Mother Teresa
In life, do we seek to make a contribution to those around us? Or do we seek to take from others as much as we
can and give (or contribute) as little as possible? This whole issue of contribution is a key issue for managers to
focus on when making decisions for a firm. Just as we prefer people in our lives that contribute to us, encourage
us and affirm us, so managers are looking for alternatives they expect will contribute the most to the fixed costs
and profits of their firm. It is this contribution which they expect from various possible alternatives that is a key
aspect for managers to focus on when making decisions.
Contribution
We saw in Section 6.4 in Chapter 6 the ideas of fixed and variable costs. Fixed costs do not change with
changes in volume or activity levels, within the ranges we are considering. Variable costs do change, in direct
proportion to changes in volume or activity levels. We also saw that if we change volume or activity sufficiently
then all costs will vary; none will be fixed. But in the context of different decisions, some costs will tend to be
fixed and others variable. We also saw in Chapter 6 that contribution margin (CM) is the difference between
sales revenue (S) and variable costs (VC):
CM = S VC
If you remember nothing else about management accounting, remember this relationship. Focusing on our
contribution is also very useful in all aspects of our lives. Where am I contributing? What can I do to contribute
the most to others and to myself? Where can I make a difference? In the same way, it is very useful in business.
Dulux Group is an Australian listed company that supplies paint and a diverse range of specialist industrial
branded products. One of its businesses is Robinhood, which manufactures and distributes kitchen rangehoods,
canopyhoods, ducting systems, laundry tubs, ironing centres and food waste disposers in Australia and New
Zealand. Prior to 2002, Robinhood was a private company owned jointly by its managers and by private equity
investors.
In the 1990s, Robinhood hit some difficulties with its business. The firm had expanded its product range and
was distributing a wide range of appliances. Yet it started to find it was making less money, not more. A new
chief executive of Robinhood examined carefully the contribution margin of each product and discovered many
of the products the firm was distributing were not contributing to the firms fixed costs and profit. Indeed, they
were generating negative contribution margins. The new chief executive immediately reduced the firms
product range substantially. As a result, the firm was able to grow its profits significantly with the remaining
products all contributing to the firms fixed costs and to profits. In other words, all the remaining products had
positive contribution margins. With an emphasis on design and innovation of a more limited and focused
product range, Robinhood was able to expand its business in both New Zealand and Australia and grow the
contribution margins of its products and its profits.
It is important to avoid having products with negative contribution margins; that take more from the firm in
variable costs than they give in sales. But this does not mean we simply want products with positive
contribution margins. If a firm faces no constraints in relation to its access to various resources and to the
demand for its products or services, and if its existing fixed costs are unavoidable regardless of which decisions
it makes, then all opportunities a firm has should be taken if they make a positive contribution to a firms fixed
costs and profits. This will be the way to earn the most profits for a firm. But this is never the case in reality. It
is never the case in our lives that there are no constraints or limits. And it is never the case in business.
Everything is limited. So we need to make decisions within constraints.
Focusing on the contribution of various alternatives we are considering by concentrating our attention on their
contribution margin will help us to make better decisions. But be careful. Seeking to maximise the contribution
to fixed costs and profits can help to maximise benefits to equity investors in a firm. However, there are many
other parties with genuine interests in firms than equity investors. There are those who provide debt to firms,
there are customers, suppliers, employees, unions, other special interest groups and the general community. A
successful firm needs to contribute to all people with a genuine interest in a firm. Focusing on contribution
margin focuses solely on the interests of equity investors.
Also, there will be many qualitative factors not captured in the accounting numbers we are using to calculate
contribution margins. Managers need to take account of much more than what is incorporated into the
accounting numbers. However, a focus on quantitative contribution margins can certainly help to support
decisions made by managers within constraints and protect managers from striking out into new directions and
with new products that may not be providing adequate contribution margins. To help us think about how
accounting may help managers make decisions let us look at making decisions with just two constraints: one
being the maximum demand for a product; and the other limits on how much of a particular resource or input
we can obtain.
Decisions with just two constraints
To help us see how the accounting concept of contribution margin can help managers make effective decisions,
let us think about the situation where managers in a firm have only two constraints on their decisions: one being
the maximum demand for a product and the other being a resource constraint. One important decision managers
have to make is how much of various products should a firm obtain (or produce) and seek to sell? These are
called product-mix decisions: what mix or relative weighting of products should a firm have? The firm is able to
access as many resources as its needs, except for one resource; and is limited as to how much of each product it
is able to sell. Of course, in reality business decisions can be much more complex than this. However, equally in
business keeping things simple and focusing on the key essentials to decisions can also be powerful.
This is the approach to use when making product-mix decisions with these two constraints (one a resource
constraint, the other a market demand constraint):
Calculate the contribution margin for each product.
Eliminate immediately any products that provide a negative contribution margin (remembering the situation
with Robinhood).
Calculate the contribution margin per unit of the resource constraint for all the remaining products that
provide a positive contribution margin.
Rank each product by contribution margin per unit of resource constraint.
Decide to sell products with the highest positive contribution per unit of resource constraint until demand
for the product is exhausted or the scarce resource is completely used up.
Let us look at a simplified example of Robinhood, which as we saw is one of the businesses of Dulux Group.
The manager of Robinhood is seeking to decide the best product-mix for the firm and is considering five
different products to sell. These products are the Vetro Island Canopyhood, the Grange Twin Rangehood, the
Supertub ST7000, the Easyiron IC100 (a fold up ironing centre) and the RWD10 Waste Disposal. You might
like to visit Robinhoods website (www.robinhood.co.nz) to see the firms actual product range which the firms
current managers have decided to produce and sell. The selling price, variable costs and contribution margins
for each product are set out in Figure 8-1.
Vetro Island
Canopyhood
$
Grange
Rangehood
$
Supertub
ST7000
$
Easyiron
IC100
$
Waste
Disposal
$
Selling price 600 250 300 300 200
Variable costs 300 150 150 200 250
Contribution margin 300 100 150 100 (50)
Figure 8-1: Robinhood simplified product mix decision: contribution margins
Note: These figures are purely fictional and bear no relationship to the real figures for these products of Robinhood in any way.
We can see immediately from Figure 8-1 that the Waste Disposal product has a negative contribution margin.
We can dismiss this product from further consideration. Including any amount of this product in our product-
mix decision will reduce our profitability in much the same way Robinhood did by adding further products to its
product range in the 1990s. The manager of Robinhood now has just four products to consider in its product-
mix decision: Vetro Island Canopyhood, Grange Twin Rangehood, Supertub ST7000 and Easyiron IC100. Let
us say there is a world-wide shortage of steel caused by China. China is growing its economy strongly and has
tied-up more than half of the worlds supply of steel by way of long-term contracts with the major producers of
steel throughout the world.
This means Robinhood is only able to access 100 tonnes (or 100,000 kg) of steel next year. This resource
constraint threatens to have a major impact on Robinhoods business. Which product-mix decision by the firm
will maximise the firms profit and minimise the impact of the current world steel shortage on the firm? The
manager now calculates the contribution margin per unit of steel used for each product. This is shown in Figure
01.
Vetro Island
Canopyhood
$
Grange
Rangehood
$
Supertub
ST7000
$
Easyiron
IC100
$
Market demand (units) 100,000 25,000 250,000 10,000
Steel required per unit 2 kg 1 kg 2 kg 0.5 kg
Contribution margin per kg of steel $150 $100 $75 $200
Figure 01: Robinhood simplified product mix decision: constraints in market demand and steel
Note: These figures are purely fictional and bear no relationship to the real figures for these products of Robinhood in any way.
As can be seen in Figure 01, Easyiron IC100 has the highest contribution margin per kg of steel used. For
every kilogram of steel used to make each Easyiron IC100, Robinhood would make contribution margin of
$100. The manager needs to include as much of this product in Robinhoods product mix as it can sell. The
market demand for this product is expected to be 10,000 units. Robinhood could meet this expected level of
market demand for this product without exhausting its supply of steel. The manager decides to include selling
10,000 units of Easyiron IC100 in the firms product mix. Including this much of Easyiron IC100 in its product
mix will require 5,000 kg of steel (10,000 units $0.5 kg). If we deduct this 5,000 kg from our constraint of
100,000 kg, this leaves the firm with 95,000 kg of steel it can use to produce other products.
The manager sees that the Vetro Island Canopyhood has the next highest contribution margin per kg of steel.
The manager needs to include as much of this product in its product mix as it can. The market demand for the
Vetro Island Canopyhood is 100,000 units. As each canopyhood requires 2 kg of steel, to produce 100,000 units
would require 200,000 kg of steel (100,000 2). However, after producing 10,000 units of Easyiron IC100
(which used up 5,000 kg of steel), Robinhood only has 95,000kg of steel available. This means it could produce
47,500 units of the Vetro Island Canopyhood (95,000/2 = 47,500). As this would use up all the steel available to
Robinhood, the firm could not produce any more Vetro Island Canopyhoods and would not be able to produce
any Grange Rangehoods or Supertub ST7000s.
Thus the product-mix decision that would maximise the contribution margin of Robinhood would be:
Vetro Island
Canopyhood
$
Grange
Rangehood
$
Supertub
ST7000
$
Easyiron
IC100
$
Waste
Disposal
$
Volume 47,500 0 0 10,000 0
Sales value $28.5m 0 0 $3 m 00
Contribution margin $14.25m 0 0 $1 m 0
The total contribution margin for Robinhood would be $15.25m, with $14.25m coming from sales of Vetro
Island Canopyhood and $1m from sales of Easyiron IC100. No other combination of sales of its products would
give Robinhood as much total contribution margin. By focusing on the contribution of products to a firms fixed
costs and profits, managers can make decisions about which products a firm should sell. It can also help
managers make a range of other decisions, including whether to make a product or service in-house (as
Robinson does with its Supertubs) or whether to outsource the production of its products to other parties (as Phil
& Teds Most Excellent Buggy Company does with its baby buggies, and indeed with most of its products).
These are short-term decisions, which require managers to focus on the next few months or up to a year or so
into the future. There are other decisions that can have longer term implications for a firm and which require
managers to look out further into the uncharted future of their firm. In the next section we will look at how
accounting can potentially support managers in making long term decisions.
8.3 Long term decisions
No sensible decision can be made any longer without taking into account not only the world as it is, but the world
as it will be.
Isaac Asimov
Some decisions managers make have long term consequences for firms. These decisions may involve investing
large amounts of money into long-term or non-current assets of a firm, which are expected to provide benefits to
the firm over a period of many years in the future. Some firms operate in industries which are by their nature
capital-intensive, requiring substantial capital investment into major assets that are expected to provide benefits
for many years in the future. The airline industry is such an industry. For example, Singapore Airlines ordered
20 Airbus A380s. It took delivery of the very first Airbus A380 in the world in October 2007. This plane flew
its maiden flight between Singapore and Sydney. Singapore Airlines expects to fly its Airbus 380s for many
years. At around US$300 million each, Singapore Airlines purchase of 20 Airbus 380s involves a total
investment of about US$6 billion.
Firms in some industries can operate with business models that require little capital investment, for example
Phil & Teds Most Excellent Buggy Company. Phil & Teds are based in Wellington in New Zealand, and in its
earlier years had around 20 staff, an office and a photocopy machine or two. It has in recent years expanded its
own operations quite a bit, but given the size of the companys sales and profits its internal operations are still
relatively small. Phil & Teds are a designer, manufacturer and marketer of a range of premium nursery
products with its flagship product being the three-wheeled e3 Explorer buggy. Phil & Teds products are
exported to 20 countries and exports represent over 90% of its sales. Phil & Teds operate a highly efficient,
largely virtual operating business model where it largely outsources its manufacturing, logistics and distribution
to strategic partners. Virtually all its manufacturing is contracted out to firms in China and elsewhere at
competitive levels of cost and quality in accordance to Phil & Teds proprietary designs and requirements
(design and production engineering being core Phil & Teds competencies). This section looks at how
accounting may, or may not, be able to support managers evaluate options to make substantial, long-term capital
investments.
Time value of money
When considering decisions with long-term implications for a firm, it is important we understand the idea of
time value of money. This means that a dollar now in our hand is generally worth more to us than that same
dollar in the future. How could this be? Is not a dollar a dollar at any time? Well, no. As people, we tend to
prefer to spend and consume our resources now rather than later. Time is short, and we all need to get on with
our lives. Also, we can find ourselves in situations where we have an urgent need for cash. For example, a
friend may suggest we go on a trip to North Queensland next month; or our tablet may have died and we need to
buy a new one right now; or we may have left our iPhone on a plane and need to replace it. In many situations
we need money now, not in the future. So a dollar (or $1,000) in our pocket today is generally worth more to us
than a dollar (or $1,000) in a few years time.
We may be happy to defer our consumption until sometime in the future. For example, we may be willing to put
off visiting North Queensland for a few years and instead to stay home and put our energies into studying
accounting or business. In this situation, if we had our dollar (or $1,000) in our hand right now, rather than later,
we could put that money in the bank and earn interest on it. For example, with the Commonwealth Bank at the
moment you can earn 4% per year interest (payable monthly) on a Goal Saver bank account (if you meet certain
conditions). If you received $1,000 today, invested it in the bank at 4% per year interest and after paying tax on
this interest at the rate of 30%, your $1,000 would be worth about $1,028 in one years time. That extra $28
could come in handy to buy, perhaps, a lunch at the Strand Hotel in Yeppoon.
For these reasons, we prefer a dollar today rather than a dollar in the future. A dollar today is worth more to us
than a dollar in, say, one years time. There are some approaches managers can use to help them evaluate capital
investment opportunities which do not allow for the time value of money. These approaches simply assume a
dollar in the future is worth the same as a dollar today. Two of these approaches are the accounting rate of
return (ARR) and the payback period. Both approaches have the advantage they are simple to use and
understand.
Accounting rate of return
The accounting rate of return (ARR) can be calculated as follows:
ARR (%) = Average net profit
100
Initial investment

Let us say Singapore Airlines paid US$300 million for the A380 Airbus. Alternatively, it could have purchased
a Boeing 787 Dreamliner for about US$200 million. Let us say the A380 Airbus is expected to initially
contribute US$25 million to the net profit of Singapore Airlines in its first year of operation, increasing to
US$34 million in the next year and to US$40 million in the third year. By comparison, the Boeing 787
Dreamliner would be expected to contribute US$20 million to the net profit of Singapore Airlines over each of
the next three years. Singapore Airlines could have calculated the ARR for each alternative as set out in Figure
8-3 below.

Year 1
US$m
Year 2
US$m
Year 3
US$m
Average
US$m
A380 Net profit
(after depreciation and tax)
25 34 40 33
Boeing 787 Dreamliner
(after depreciation and tax)
20 20 20 20
Initial investment:
Airbus A380
Boeing 787 Dreamliner

$300 m
$200 m
ARR:
Airbus A380 (33/300)
Boeing 787 Dreamliner (20/200)

11.0%
10.0%
Figure 8-3: Accounting Rate of Return
The Airbus 380 is expected to have an ARR of 11.0% and the Boeing 787 Dreamliner an ARR of 10.0%. Based
on this analysis of ARR, the managers of Singapore Airlines would favour the Airbus 380 over the Boeing 787
Dreamliner.
Payback period
The payback period of an investment is how long it is expected to take before an investment returns the cost of
the initial investment. The reason this is of interest to managers is that once an investment has returned the cost
of the initial investment it is no longer possible to lose money on that investment. All investments by firms in
capital items involve risk. This is because, although the initial cost of the investment may be clear and certain at
the time the capital item is purchased, the benefits expected to be received from that capital item in the future
are uncertain because no-one knows what will happen in the future with certainty. There is always some doubt
and some risk.
However, once an investment has returned its original cost then at least it is no longer possible to make a loss on
that investment, regardless of what happens after that point. This is the payback period. It is essentially a
measure of risk. The longer the payback period the longer the time in which it is possible the firm may make a
loss on its investment; the shorter the payback period, the shorter the time in which a firm could make a loss on
its investment. To calculate the payback period for a particular investment, we simply add the after-tax cash
flow expected to be received from the investment each year in the future. At the point where these cash flows
equals the amount of the initial investment, this is the payback period.
Where an investment is expected to provide constant cash flow each year, the payback period can be calculated
as follows:
Initial investment
Payback period =
Cash flow

An investment of $2 million which is expected to provide cash flow of $500,000 per year would have a payback
period of 4 years, calculated as:
Initial investment
Payback period =
Cash flow
$2,000,000
per year
$500,000
4 years

In the more common case where cash flow from an investment is expected to vary each year, we can simply
calculate the cumulative cash flow each year as set out in Figure 8-4 below.
Investment: $2,000,000
Cash flow
$000
Cumulative cash flow
$000
Year 1 200 200
Year 2 400 600
Year 3 800 1,400
Year 4 1,200 2,600
Year 5 1,400 4,000
Year 6 10,000 14,000
Figure 8-4: Payback period
We can see the cumulative cash flow from the investment at the end of Year 3 is $1.4 million and at the end of
Year 4 is $2.6 million. We can see the cumulative cash flow equals $2 million sometime during Year 4. If we
expect the $1.2 million cash flow from the investment in Year 4 to be received evenly throughout the year (that
is, $100,000 per month), then the investment would return $2 million exactly half-way through Year 4 and the
payback period would be 3 years. Now payback period is an easy concept to understand and use in business.
Accounting numbers from past activities of a firm can be useful to help managers develop forecasts of future
cash flow from new investments and help managers use the idea of a payback period in their analysis of capital
investment proposals.
The key benefit of the payback method is that it gives some sense of the level of risk of an investment, namely
how long it is expected to take before there would be no possibility or risk of making a loss on the investment.
However, the big disadvantage of the payback method is that it ignores the expected upside from an
investment, that is, the cash flow expected after the end of the payback period. After all, the reasons managers
would decide to make investments in non-current assets in a firm is because they expect to earn a return greater
than the cost of the capital used to make that investment. As you can see in Figure 8-4, the investment is
expected to return a large sum ($10 million) in Year 6. The payback method pays no attention to this expected
upside. It also does not take into account the time value of money in its evaluation of investment opportunities.
In the next section we will look at two common methods of discounting cash flows to take into account the time
value of money: internal rate of return and net present value.
8.4 Discounting cash flow
The best thing about the future is that it comes only one day at a time.
Abraham Lincoln
My interest is in the future because I am going to spend the rest of my life there.
Charles F. Kettering
Prediction is very difficult, especially of the future.
Neils Bohr
We can specifically and mathematically include a consideration of the time value of money by discounting (or
reducing) the future cash flow we expect from an investment. If we expect to receive a dollar in five years time
from an investment we could discount or reduce its value so that it would be worth less than a dollar today. We
could also reduce the value of a dollar in ten years time by a greater amount and so forth for expected cash flow
out into the future. Eventually, as we look out further and further into the future, we could reduce or discount
future expected cash flow by so much that after, say, 40 years or so expected future cash flow can become
almost worthless in terms of dollars today.
For example, $1.00 in late 2007 could buy a cheap cup of coffee in the morning at the Loaded Hog at Queens
Wharf in Wellington. I wrote some early versions of a few chapters of this book drinking copious amounts of
$1.00 cappuccinos sitting in the sun by Wellington Harbour at the Loaded Hog. However, $1.00 in 40 years
time discounted by 10% per year would be the same as 2 cents today. In New Zealand, the smallest coin is 10
cents, so 2 cents would get rounded down to zero. In this case, $1.00 in 40 years time would have effectively no
value today. Good-bye to those cups of coffee. In any case, the Loaded Hog was a few years ago remodelled
into Foxglove, which meant goodbye to those cheap cups of coffee in the morning by the waterfront. There are
two main methods used to discount expected future cash flow of potential investment opportunities: internal rate
of return (IRR); and net present value (NPV). These are the two main discounted cash flow (DCF) techniques
used in business. We will look at each of them and consider how accounting can help or perhaps hinder
managers to use these techniques to make long-term decisions.
Internal rate of return
The internal rate of return (IRR) method has been widely used in business for many decades. It differs to the
accounting rate of return (ARR) method described in Section 8.3 above. The IRR method uses expected future
cash flow rather than accounting profits. We saw in the Purple Chocolates example in Figures 7-1 and 7-2 in
Chapter 7 above that for the same six month period Purple Chocolates could have a negative cash flow of
$325,000 and yet make an accounting profit of $825,000. As we saw, cash flow and accounting profit are by no
means the same thing. Also, the IRR method adjusts expected future cash flow for the time value of money.
There is no such adjustment under the ARR method.
The internal rate of return (IRR) of a potential investment opportunity is the rate of return where the net present
value of the expected future cash flow of the investment equals zero. For an investment that requires an initial
cash outflow as the initial investment and then is expected to provide cash flow to the business over a number of
years, the IRR is the discount rate that will result in the expected future cash flow from the investment equalling
the initial investment. The IRR method has the big advantage that it is easy to understand as it expresses an
evaluation of investment opportunities as a percentage return on the amount invested. Everyone knows that an
investment returning an IRR of 20% is better than an investment returning an IRR of 14%. We are all used to
the general idea of percentage returns on investment. It also specifically allows for the time value of money.
The IRR method has some drawbacks. Some investments involve a series of cash outflows over time (rather
than a single cash outflow at the beginning); in other words, not just a single investment at the beginning but
further investments along the way as well. In these situations, the IRR method can produce more than one
internal rate of return (IRR). This can be mighty confusing for managers and is a conceptual weakness of the
IRR method for investment opportunities requiring a series of cash outflows over a period. Also, the IRR
method takes no account of how much a firm might invest in a particular investment opportunity. An investment
of $1 million might offer an IRR of 20% and another investment of $100 million might offer an IRR of 18%,
but the latter investment might add a whole lot more value to a firm. The second popular discounted cash flow
approach, the net present value (NPV) approach, seeks to measure more directly the value add to investors of
investment opportunities.
Net present value
The Net Present Value (NPV) approach does not evaluate investment opportunities in terms of percentage
returns, but in terms of dollars of added value. The NPV approach involves discounting all expected future net
cash flow by a particular discount rate (based on how much the capital you use in the investment costs you). A
positive NPV indicates an investment would add value to a firm (that is, return more to a firm than the cost of
the capital it uses) and a negative NPV indicates it would destroy value (that is, return less to a firm than the
cost of the capital it uses). The larger the positive amount of NPV the greater the amount of added value for a
firm; the larger the negative amount of NPV, the greater the amount of value it would destroy for a firm.
Managers should choose investment opportunities that are expected to provide positive NPV and avoid
investment opportunities that are expected to provide negative NPV.
A key difficulty in using the NPV method is determining the discount rate to use. There is always considerable
guess-work involved in doing this, which adds considerable subjectivity (and thus potential for manipulation)
to the results of NPV calculations. Further, the central weakness of both the IRR and NPV methods are
difficulties in forecasting future cash flow from investments; which is where management accounting can
potentially come in to provide some help to managers. Accountants in firms have a key role to help provide
reliable and reasonable estimates of expected future cash flow of investment opportunities. Past experience as
measured by a firms accounting system is often invaluable in helping us do this.
Despite significant difficulties in applying the IRR and NPV methods in practice, both approaches are widely
accepted and used by managers in firms to evaluate investment opportunities. There are also a number of
technical difficulties and weaknesses in using discounted cash flow (DCF) techniques such as IRR and NPV,
which are not always fully appreciated by those who use them. For example, DCF techniques assume cash flow
received each year can be reinvested for the rest of the life of the investment to earn certain levels of return.
This assumption may not be practical in reality. The IRR method assumes reinvestment of cash flow at the same
level of return as the internal rate of return (IRR) used in the calculations. The NPV method assumes
reinvestment of cash flow at the discount rate used (which would usually be different to the IRR, except when
an investment has an NPV equal to zero).
Under DCF techniques, discounting of cash flows compounds. In other words, we discount a cash flow in 10
years time back to 9 years in the future, which we then discount back to 8 years and so on to the present. One
thing about compounding is that it becomes very powerful over time. For example, if we were to receive $100
billion in 40 years time, discounted by 10% per year this would be worth about $2 billion today. In other words,
$100 billion would pay for about three national broadband networks (NBNs); $2 billion would pay for the bit
around North Queensland (maybe); forget about the rest of Australia. And $100 billion in 60 years in the future
discounted by 10% per year is worth about $300 million today (the cost of the NBN around Rockhampton,
Gladstone and Bundaberg); and $100 billion in 80 years in the future is worth only about $40 million today
(well, just a few trenches for the NBN around Yeppoon and the Capricornia Coast).
As we go out further and further into the future everything, even amounts as huge and significant as $100
billion, gradually become worth nothing to us today under DCF techniques. Is the future beyond 40 or 60 years
really of little or no value today? Clearly, much of what we have of value today has been greatly affected and
influenced by decisions and activities and events of people 40 to 60 to 80 years ago (indeed, by people who
lived thousands of years ago). Are not these things we value today of real value? Yet these things we might
value greatly today, DCF calculations would cause us to value as next to worthless just 40 or 60 years ago.
Clearly, there are limitations to DCF techniques such as IRR and NPV methods, particularly when looking at
benefits many years into the future. But they are some of the most useful methods we currently have available to
managers to value longer-term investment opportunities. And managers are in the driving seat of their firm and
need to make the most effective decisions they can with the tools and techniques they have. Accounting can
perhaps help managers by providing numbers that can be used to help make these DCF approaches work as well
as they can to support managers make long-term decisions.
Qualitative factors
Ever notice that what the hell is always the right decision?
Marilyn Monroe
But there will always be much that is left out of DCF analyses, or any other quantitative analysis, that relies on
accounting and other numbers. There are usually many critical qualitative factors that are relevant to long-term
decisions of managers that are difficult to incorporate into numbers. There are also impacts of these decisions by
managers on many other people besides equity investors. DCF techniques are usually used to simply measure
the impact of managers decisions on equity investors in a firm. We can never include everything in the
numbers in any analysis we may make of a firms longer term decisions. This is because these decisions will
involve people. And people, and the effects of decisions on people, can never be completely reduced simply to
numbers. However, numbers and the thoughtful and careful use of techniques to analyse numbers can be very
useful to support decision-making.
This is the case as long as we clearly understand what we are doing, and in particular the limitations of any
particular approach we are using. We need to creatively and imaginatively apply techniques to the analysis of
options for longer-term decisions by managers. Similarly, all the various quantitative techniques to support
managers decisions are only as good as the numbers put into the calculations. Although a firms management
accounts will reflect the past activities of a firm, they will often give useful guidance about what managers
could expect from future potential activities of a firm. For example, past contribution margins of a firms
products can give useful guidance, and be useful starting points, for managers to consider the future contribution
margins of a firms products. A firms management accounts are usually a vital part to support managers in their
task of making decisions.
Conclusion
As we have seen in Chapter 5 above, managers are in the driving seat of their firms. They are running a firm,
and no-one else. They have to constantly make decisions that will impact on the economic and business realities
of their firm. We have seen in Chapters 5 to 8 how a firms management accounts can potentially help them to
engage with and understand the past economic and business realities of their firms. This can then help them to
estimate the likely impact on these realities of various potential decisions or choices they as managers could
make.
In this chapter we looked at various short-term and long-term decisions managers need to make and how
accounting can help them make these decisions. The decisions managers make in our commercial businesses,
public sector entities and not-for-profit entities affect us all. They affect the type, amount and quality of goods
and services available to us as consumers; the nature of our working environments and working conditions as
employees; the returns we receive as equity investors or debt investors in firms; and how firms activities
impact on the general community and environment. Indeed, the impact of management accounting on the
quality of decisions made by managers in our firms is quite central in our market-based economy.