Understanding the Impact of Investment Costs on Productivity and Profitability

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Understanding the Impact of Investment Costs on Productivity and Profitability
by Douglas T. Hicks CPA
Annual Management Accounting Conference
IMA Metro Detroit & Toledo Chapters

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Understanding the Impact of Investment Costs on Productivity and Profitability

  1. 1. Understanding the Impact of Investment Costs on Productivity and Profitability 6th Annual Management Accounting Conference IMA Metro Detroit & Toledo Chapters March 22, 2012Douglas T. Hicks, CPAD. T. Hicks & Co.6905 Telegraph Road – Suite 325Bloomfield Hills, MI 48301248.761.3706www.dthicksco.com © 2012 D. T. Hicks & Co.
  2. 2. Stage-Setting Concepts / Assumptions • The goal of management • The measurement of success • Management economics vs. accounting • Oxenfeldt’s rule • The nature of “sunk costs” • The “value” of an investment • The cost of maintaining productive capability • The cost of owners’ investment © 2012 D. T. Hicks & Co.
  3. 3. The Goal of Management Two ViewsInsure the Short-Term Enrichment of the Company’s Temporary OwnersAdvance the Long-Term Wealth Creating Ability of the Organization © 2012 D. T. Hicks & Co.
  4. 4. Measurement of SuccessLong-Term Ability to Generate anAttractive Return on the Owners’ Investment in the Business A superior, long-term, sustainable return on Investment © 2012 D. T. Hicks & Co.
  5. 5. Management Economics vs. AccountingAccounting is a backward looking discipline – itobserves the world from the stern of the ship andmeasures its wakeManagement economics is a forward looking discipline– it observes the world from the bow of the ship andhelps navigate the vessel toward its desired destination Accounting is for counting beans, management economics is for growing them. © 2012 D. T. Hicks & Co.
  6. 6. Oxenfeldt’s Rule“An error in measuring the magnitude of aneffect usually is far less serious than mistakesdue to wholly overlooked consequences.” - Dr. Alfred R. Oxenfeldt © 2012 D. T. Hicks & Co.
  7. 7. Oxenfeldt’s RuleThree blindfolded runners are about to run a220-yard race: • Runner #1 does not know there are hurdles • Runner #2 knows there are 36” hurdles – but only knows to within ±12” where they are • Runner #3 knows there are 36” hurdles – and knows exactly where they are Which runner is in “big trouble?” © 2012 D. T. Hicks & Co.
  8. 8. Hicks’ Rule“It’s always better to estimate the right thing thanto precisely measure the wrong thing.” - Douglas T. Hicks, CPA, CMC © 2012 D. T. Hicks & Co.
  9. 9. Fundamental Economic PremisesSunk Costs Are IrrelevantAt any point in time, an investment should bemeasured by its value, not its original costCosts required to maintain a company’sexisting productive capability are legitimatebusiness costsOwners’ investment in a business is not “freemoney” © 2012 D. T. Hicks & Co.
  10. 10. Accounting’s View of Capital InvestmentA company’s investments are valued at theiroriginal cost less any accumulated depreciationor amortizationThe only “above the line” capital related costson a company’s books are depreciation andamortization © 2012 D. T. Hicks & Co.
  11. 11. Depreciation Expense• Take the original (sunk) cost of a capital asset• Select one of the allowable chronological lives of that capital asset• Select one of the allowable depreciation methods for that capital asset• Apply the selected life and method to the irrelevant, sunk cost of the asset to arrive at depreciation expense Does this arrive at a meaningful measure of cost? © 2012 D. T. Hicks & Co.
  12. 12. Depreciation ExpenseWhat if the company recently purchased all new assetsand is using the double-declining balance method?What if the company just emerged from Chapter 11 and itscapital assets have no value on its books?What if the company’s capital assets are old and alreadyfully depreciated? © 2012 D. T. Hicks & Co.
  13. 13. Depreciation Expense For decision making purposes, accountingdepreciation expense is an irrelevant, inaccurate, and misleading concept and should be ignored.HOWEVER…some provision must be made for the costs required to maintain a company’s existing productive capability © 2012 D. T. Hicks & Co.
  14. 14. The Capital Preservation Allowance The funds that must be collected as part of a company’s ongoing revenue to preserve its existing capital base The on-going accumulation of the funds required to maintain the company’s establishedvolume of business and technological position in the industry – like a “sinking fund” © 2012 D. T. Hicks & Co.
  15. 15. The Capital Preservation Allowance Sinking Fund $2,000 $1,500 Expenditure $1,000 Requirements$(000) Sinking Fund $500 Contributions $0 Sinking Fund Balance ($500) 1 2 3 4 5 6 7 8 9 10 ($1,000) Years © 2012 D. T. Hicks & Co.
  16. 16. The Capital Preservation Allowance The two ‘drivers’ of the need to fund the preservation of capital assets… Time The assets become obsolete Usage The assets wear out © 2012 D. T. Hicks & Co.
  17. 17. The Capital Preservation Allowance One additional complicating factor… LeasesAn ongoing – usually time-driven – cost of preserving the assets © 2012 D. T. Hicks & Co.
  18. 18. The Capital Preservation Allowance • Time-driven: – Office equipment – Technology • Usage-driven: – Production equipment • Leases: – Both of the above © 2012 D. T. Hicks & Co.
  19. 19. The Capital Preservation Allowance Time-Driven Usage-Driven What if volume drops by 20%? © 2012 D. T. Hicks & Co.
  20. 20. The Capital Preservation Allowance No change Volume Down from Down from Down 20% $170,000 $350,000 © 2012 D. T. Hicks & Co.
  21. 21. Investment in Capital AssetsAt any point in time, how much does an ownerhave invested in his or her capital assets? • The amount paid for them? • Their net book value? • Their fair market value? © 2012 D. T. Hicks & Co.
  22. 22. Investment in Capital AssetsWould you be willing to make the exchange? © 2012 D. T. Hicks & Co.
  23. 23. Investment in Capital AssetsWhat is the basis for forward-looking decisions; $1,000,000 or $750,000? © 2012 D. T. Hicks & Co.
  24. 24. Investment in Capital AssetsWhat is the basis for forward-looking decisions; $0 or $300,000? © 2012 D. T. Hicks & Co.
  25. 25. Cost of CapitalRemember Oxenfeldt’s rule… “An error in measuring the magnitude of an effect usually is far less serious than mistakes due to wholly overlooked consequences.” © 2012 D. T. Hicks & Co.
  26. 26. Cost of Capital Interest Expense Owners’ Value of Target ROI Company Assets Return on Assets Required to Meet ROI Target © 2012 D. T. Hicks & Co.
  27. 27. Cost of Capital Owners’ Target Profit Return on Assets Required to Meet ROI Target © 2012 D. T. Hicks & Co.
  28. 28. Cost of Capital © 2012 D. T. Hicks & Co.
  29. 29. Cost of Capital © 2012 D. T. Hicks & Co.
  30. 30. Cost of Capital Equipment © 2012 D. T. Hicks & Co.
  31. 31. Profit Measurement Closely track Return on Assets © 2012 D. T. Hicks & Co.
  32. 32. Profit Measurement $400,000 Cost of Capital included Which should be the primary measure of value?EVA is a registered trademark of Stern Stewart & Co. © 2012 D. T. Hicks & Co.
  33. 33. Profit Measurement © 2012 D. T. Hicks & Co.
  34. 34. Profit MeasurementEVA is a registered trademark of Stern Stewart & Co. © 2012 D. T. Hicks & Co.
  35. 35. Summary• Depreciation expense is a meaningless measurement• A Capital Preservation Allowance provides a true measure of the future funds required for a company to remain in business – Future capital requirements are a combined function of time and usage, not simply time• Profit as a percentage of sales is a misleading measure of a sale’s value to a company – especially for a manufacturer• Cost of Capital is a fundamental measure needed to understand a sale’s value to a company – especially for a manufacturer• Profit as a Percentage of Value-Added and Profit as a Percentage of Activity Cost are simple surrogate measures of a sale’s value © 2012 D. T. Hicks & Co.

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