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Management Accounting: Budgeting and Capital Investment Decisions

Updated on April 14, 2015
One of the more important aspect of Accounting is Budgeting and Capital Investment Decisions in business.
One of the more important aspect of Accounting is Budgeting and Capital Investment Decisions in business. | Source

Management Accounting – On Budgeting and Capital Investments

Management Accounting is the study of the quantitative and qualitative tools in decision making. The exercise involves capital investment decision making on whether to pursue a project or not.

The first phase of making decisions is budgeting. This entails commitment of scarce resources into investment alternatives that would benefit the company over a long period of time. This includes:

  • Budget preparation by all department levels and top management for one year;
  • Identifying sources of funding in the event that shortfalls in cash occurs within the year;
  • Allocation of funds to projects in accordance with the company’s priority of needs.

Capital Budgeting is oftentimes referred to as the act of management to plan and find sources of funding for its capital investments on: plant expansion, modernization, purchase of equipment, and diversification to other product lines. The decision to invest would need a thorough study since it would involve big sums of money over a long term.

Luca Pacioli, a portrait by an unknown Renaissance artist, wrote the accounting ethics in 1494 which served as a guide for the practice of Manement Accounting, among others.
Luca Pacioli, a portrait by an unknown Renaissance artist, wrote the accounting ethics in 1494 which served as a guide for the practice of Manement Accounting, among others. | Source

Two General Types of Capital Investment Decisions

  • Independent capital Investment projects - are evaluated individually and reviewed against set corporate standards resulting to either an accept or reject decision. Example: investment in property, plant, and equipment; product diversification; corporate acquisition; computerization, and: an all out marketing campaign.
  • Mutually exclusive capital investment projects - are projects that are scrutinized by management to be accepted. The projected selected must be better than all other alternatives. Example: rent or lease decisions, manual or computerized accounting operations, preventive maintenance or general overhaul of equipment.


Budgeting and Capital Investment Decisions

Since capital investments entail cash outlays for a long period, Management accounting is generally used to do a thorough study of all parameters before a company embarks on a proposed projects or business. The reasons are:

  • It involves huge capital outlays;
  • The project takes several years to complete, and may involve risk;
  • Errors in decision making may be hard to undo in the future;
  • The success and failure of the company may depend on these critical decisions.

In determining the viability of projects, sunk cost or past costs will no longer be part of budgeting or decision making. Factors to be considered are: earning potentials, market strength, goodwill, and competitive advantage of each proposed project versus disadvantages.

Roman Accounting writing tablet from  Northumberland (1st-2nd century AD) with a Letter from Octavius to Candidus concerning supplies of wheat, hides and sinews. British Museum (London)
Roman Accounting writing tablet from Northumberland (1st-2nd century AD) with a Letter from Octavius to Candidus concerning supplies of wheat, hides and sinews. British Museum (London) | Source

Polls on Budgeting

Is Management Accounting necessary in decision making?

See results

The Important Elements in Capital Budgeting

Evaluating capital investment is a hard thing to do if you do not know which areas to target on. The factors that you need to look for are:

  • Amount of Investment, an example would be,

Amount of Initial Investment

Add:

  • Additional funding needed by the project
  • Additional funding needed for working capital

Total

Less:

  • Funds generated from sale of old assets
  • Avoidable cost

Net Investment

The net Investment is the amount sacrificed by the company in pursuing its decision. The amount would vary depending on several factors. If the old equipment can be used in the project instead of being sold, then it would reduce investment cost proportionately. However, if the cost of repairs are factored in to include all possible expenses, what may result could affect the outcome of the decision.

Without the Right Management Accounting Tools: The Future is Bleak

Source
  • · Net Cash Return from the Project

The net cash return corresponds to the inflows of cash from the project as compared to the outflows that are needed to fund the project. An example would be:

Cash inflow from the project for one year

Less: Cash outflow for operations costs

Net cash inflow before payment of taxes

Less: Taxes [Tax rate (Net cash inflow – Depreciation)]

Net cash inflow after taxes for the year

The net cash return analysis takes into account the effect of taxes in decision making. Non-cash expenses like depreciation are added back to reflect the real cash outflow. Depreciation is a non-cash expense since it is a mere estimate of a fixed assets’ life expectancy, apportioned over its estimated life. Hence, it must not be included in the computation of cash flows.

Management Accounting: Capital Investing and Time Value of Money

  • · Cost of Money or Minimum /Acceptable Rate of Return

The decision whether to proceed with a project or not would also depend on the acceptable rate of return by the company as compared with alternative forms of investment. It is defined as the cost of capital that the firm must pay in order to attract investors.

The Cost of Money may be computed as follows:

a. Cost of Borrowing = Interest Rate(1 - Income Tax Rate)

b. Cost of Preferred Shares = Dividend per share of stock/Market value of Preferred share

c. Cost of Common Shares = Dividend per share of stock/Market value of Common share +Dividend growth rate

d. Cost of Retained Earnings= The same computation as the cost of Common Share.

What you need to know about Flexible Budgets

A systematic analysis of overhead cost would cover the difference between variable and fixed overhead costs. Variable overhead moves in direct proportion to changes in activity, while fixed overhead costs do not change within a relevant range. This distinction is important when constructing a flexible budget and analyzing overhead variances.

The flexible budget would tend to show the different level of cost for each level of activity. The movements in costs would depend if it is variable or not. If variable, the flexible budget is computed based on the cost per unit of activity times the level of activity. If it is a fixed, the total budgeted fixed cost is used as the flexible budget.

The two variances for variable overhead are for variable overhead spending or for variable overhead efficiency. For fixed overhead, the variances would include both budget and volume disparities. The former is the difference between the actual and the budgeted fixed overhead cost. The latter, is the difference between the fixed amount of overhead cost that was applied to inventory and the total amount budgeted.

The sum of all the variances is the over or under applied overhead for the period. Unfavorable variances are the under applied overhead costs; the favorable variances, are the opposite.

Process of Capital Budgeting and Decision Making

Finding Investment Opportunities
Financial Analysis
Decision Making and Project Implementation
Identified during long-term planning process
Estimates of cash flows
Must take into account quantitative and qualitative factors
Once identified, it should be properly analyze
Determining Internal Rate of Return
Timing of cash flows and availability of funding
Further investigation as to doability of the project
Use of quantitative techniques in decision making
Impact on socio, economic and legal aspects
Management Accounting Tool: Decision Tree Analysis
Management Accounting Tool: Decision Tree Analysis | Source

In equipment replacement decisions, which of the following does not affect the decision-making process?

  • Current disposal price of the present or old equipment
  • Operating Cost of old equipment
  • Original fair market value of old equipment
  • Cost of the new equipment


Reference: Management Accounting by Elenita Cabrera, CPA


Choosing from among Investment Proposals

There are many ways of evaluating project proposals. The Finance department uses quantitative as well qualitative techniques in evaluating proposed projects. Among the tools used are:

  • Unadjusted for time or Non-discounted cash flow method

a. Payback period – it measures the length of time that is needed to recover the initial investment. Example, if the company purchase an equipment worth $10,000 with an expected earnings of $2,000 per year, the payback period is five years. The acceptability of the five year period is dependent on management standards.

b. Simple Rate of Return – is computed based on Average Net Income per year/Investment. If the amount is higher than the Required Rate of Return, the project is accepted. If it is lower, it is rejected.

  • ·Adjusted for time or Discounted cash flow method

a. Net Present Value – takes into consideration the cash inflow vis-à-vis outflow with the use of the present value of money. The project is accepted if the Net Present Value is equal to or greater than zero and rejected if it less than zero.

b. Discounted Rate of Return – otherwise known as the Internal Rate of Return or the Time Adjusted Rate of Return. It is the rate that is computed based on the present value of all income streams as against the cost of investing. It is also the amount of money that would be paid each year as interest, for the amount of funds used by the project over its expected life --without incurring a loss.

Does inflation have an effect on Capital Budgeting?

Yes, it does. But it does not affect the result of the analysis if certain conditions are met. When the inflation rate is accounted for in the computation, the outcome would remain the same since both cash flow and the rate of return are adjusted at the same time. Hence, would lead to the cancelling out of both adjustments and will have no effect on the decision.

The Bottom Line

Most companies, whether they are for profit or for charity, should make a thorough analysis of capital investment before embarking on a project. One cannot leave the final outcome to chances alone as management accounting tools can be used to pursue opportunities with more accuracy. Since investible funds are always limited, it is important for management to adopt management investment techniques in choosing projects that gets preference when funding becomes available.

The most popular methods of capital budgeting techniques were discussed in this article that covered Net Present Values (NPV), Internal Rate of Return, and Payback Period from among the many Management Accounting techniques most commonly used by decision makers in budgeting and in capital investment decision-making.

References

  • Managerial Accounting by Ray Garrison
  • Managerial Accounting by Elenita Cabrera
  • Introduction to Managerial Accounting by Larry Walther and Christopher Skousen

Other Work from this author:


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    • csmiravite-blogs profile imageAUTHOR

      Consolacion Miravite 

      4 years ago from Philippines

      Thank you too, Ken. I try to write about other topics in other sites. But they are not my comfort zone. Nonetheless, I sometimes get commendations when I write about other subject areas. It can go to as far as masonry, carpentry, gardening, baking, religion, and relationships. What results is that, I get a headache whenever I write about so many things. Kaya, kaunti lang sulat ko! :)

      writer_csm

    • KenDeanAgudo profile image

      Kenneth C Agudo 

      4 years ago from Tiwi, Philippines

      Hello Csmiravite:

      I have observed that you are fond of writing accounting and government thingy. On my side it was difficult to write such things but you know what you are very lucky since "Finance" has the highest bids on advertisers online so you would probably earn a lot.

      Thank you for the nice words from one of my hub. I really appreciate it.

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