ACT4131 Management Accounting III MANAGEMENT ACCOUNTING III

1. APPRAISAL OF STRATEGIC INVESTMENTS ACT4131 Management Accounting IIIMANAGEMENT ACCOUNTING III

2. Investments in Advanced Technology • Innovation and adoption of Advanced technology (AT) is critical for business survival. Why? • Response to environmental changes: • Growing competition • Increasing customer requirements and needs

3. Investments in Advanced Technology • Innovation and adoption of Advanced technology (AT) is critical for business survival. Why? • AT adds value: - productivity and economic growth - increased efficiency and reduced cost • innovation and interaction with customers

4. Advanced Technology (AT) • AT has significant impact on product, process and informational aspects of system • Examples: – stand-alone system such as computer-aided design (CAD) • Intermediate system such as automatic storage and retrieval system (AS/RS) • Integrated system such as flexible manufacturing system (FMS)

5. Characteristics of AT • Long life • Investment requirements that expand several years • Increasing returns over time • Various intangible or system-wide benefits

6. Strategic Investments • Does the investment policy: • support your competitive strategy? • enhance organisational capabilities? • Need to differentiate between Strategic and Tactical investments

7. Tactical Investment • Cost-reduction/saving orientation • Benefits are easily quantifiable and are based on the cost accounting system • E.g. invest in new equipment to reduce labour cost • Technology investments require more than pure labour savings investment

8. Strategic Investments in AT • Strategic due to the technology, quality enhancement • Cash inflow includes benefits from productivity gains due to better design methods, quality improvements and reductions in cycle time, inventory and space • Strategic investment enhances organisational capabilities

9. Enhancing Organisational Capabilities • External integration - link with customers and suppliers to create high-quality product • Internal integration – communication between intra-organisational functions, fast response and quick decision-making

10. Enhancing Organisational Capabilities • Responsive and flexibility – change at low cost and rapidly • Continuous improvement – communication, knowledge, skills

11. Justifying AT Expenditure • Justifying expenditure is a challenge • WHY? - Are there limitations in the traditional accounting techniques? - Do these techniques hinder investments? - Investment analysis ignores strategic considerations?

12. Financial Evaluation • Difficult to justify financially due to: • High initial capital costs that are not easily justified through traditional methods • High hurdle rates imposed (30% return or payback less than 2-3 yrs) • High levels of risk (cannot show big profit early) • Compare with status quo – do nothing – refuse to realistically view risks and opportunity costs

13. Improper Evaluation • Inability to properly justify investments • Benefits of AT are often non-quantifiable and difficult to estimate

14. Linking to Strategy • AT proposals failed if financial justification is not linked to manufacturing and business strategy • Thus, decision-making process should link financial justifications and strategic considerations • Accounting techniques alone are not adequate

15. Traditional Accounting Techniques 1. Payback 2. Accounting rate of return 3. Net present value 4. Internal rate of return 5. Profitability index 6. Economic value added (EVA)

16. Payback Method • Number of years required to recover a project’s initial investment from the cash flow generated from the project. • Ignores time value of money & cash flows after the payback period • Number of years =Cost of investment/annual cash flow

17. Accounting Rate of Return (ARR) • is an accounting-based technique • is obtained by dividing the average accounting income (profit) by the average level of investment • ignores time value of money and deficiencies in GAAPs.

18. Net Present Value (NPV) • The sum of the present values of all cash inflows and outflows associated with the project. • Profitability index is computed by dividing the present value of cash inflows by the present value of cash outflow (The index has to be >1 for any project to be acceptable and is used for comparisons of mutually exclusive projects).

19. Internal Rate of Return (IRR) • The discount rate that makes the project’s NPV equal to zero • If the internal rate of return is less than cost of capital, do not invest in the project.

20. Limitations of Accounting Techniques • All benefits and costs must be quantifiable in monetary terms. • But difficult to quantify some benefits from AT investment such as, e.g. improved quality, flexibility & speed.

21. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (1) inventory reductions Better flexibility and scheduling from new technology Thus, reduced levels of WIP and FG Holding less inventory leads to cash savings

22. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (2) reduced floor space requirements - floor space is reduced through less inventory & better grouping of machines • Space savings reduce costs of space

23. Limitations of Accounting Techniques Unable to measure benefits from investment in AT: (3) improved quality • Decline in scrap, rework and waste • Reduce in cost of quality Difficult to quantify benefits but projected savings inventory, space and quality costs has to be estimated

24. Limitations of Accounting Techniques • Favours investments with short arbitrary payoffs (e.g., payback period). • Simplistic approach such as  hurdle (discount) rate or/and shortening evaluation horizon to adjust for risk. • Ignore the cost of not investing (i.e., static base line)

25. Limitations of Accounting Techniques • Short-term and piece-meal approach – lacks strategic instead focuses on tactical issues • Deficiencies of GAAPs; e.g., asset capitalisation principle leads to bias toward higher associated investment-related costs, and volume-based cost allocation leads to inaccurate cost-savings or benefits.

26. Implications • Consider system wide benefits in analysis – product, process, customer, competitor, employee, strategy • Incorporate intangible benefits although difficult to quantify • Link financial justification to strategy • Supplement financial with other techniques

27. Other Techniques • Analytic Techniques - systems value analysis • Risk analysis • Portfolio models • Strategic Techniques • Strategic needs analysis • Competitive analysis • Phased Techniques - Combination of two or more of other methods

28. References • Ordoobadi, SM & Mulvaney, NJ (2001), Development of a justification tool for advanced manufacturing technologies: system-wide benefits value analysis, Journal of Engineering and Technology Management, 18(2), 157-184 • Jones, TC & Lee, B (1998), Accounting, Strategy and AMT Investment, Journal of Management Science, 26(6), 769-783 • Kaplan, RS & Atkinson, AA (1998), Advanced Management Accounting, (3rd Edition). Prentice Hall. • Dugdale D & Jones C (1991) Financial Justification of Advanced Manufacturing Technology. In Ashton D et al (Eds.) Issues in Management Accounting, Prentice Hall: London, pp.191-213.

29. Exercise • Please prepare answers to Problem 12-2 Acme Telephone Co pp 612-613 from Advanced Management Accounting book by Kaplan and Atkinson (1998)