Manufacturing Costs Direct materials Materials used in the final product. Direct labor Labor costs that goes to fabrication of a product. Manufacturing Overhead In particular, indirect materials, indirect labor, maintenance and repairs on production equipment, heat and light, property taxes, depreciation, insurance on manufacturing facilities, and overtime payment. • Non-manufacturing Costs Overhead Heat and light, property taxes, depreciation, and similar items associated with selling and administrative functions. Marketing Advertising, shipping, sales travel, sales commissions, and sales salaries. Administrative Executive compensation, general accounting, public relations, and secretarial support.
Matching Concept: The costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized. • Period costs: Those costs that are charged to expenses in the period in which the expenses are incurred. Examplesof periodic costs are all general and administrative expenses, selling expenses, insurance, and income tax expenses. Therefore, advertising costs, executive salaries, sales commissions, public relations costs, and other non-manufacturing costs would all be period cost. Such costs are not related to the production and flow of manufactured goods, but deducted from revenue in the income statement. • Product costs: Those costs involved in the purchase or manufacturing of goods. In the case of manufactured costs consist of direct materials, direct labor, and manufacturing overhead. Product costs are not viewed as expenses; rather they are the cost of creating inventory.Thus, product costs are considered an asset until goods are sold.
Cost Classification for Predicting Cost Behavior • Volume index Operating cost respond in some way to changes in its operating volume. • Cost Behaviors Fixed costs Variable costs Mixed costs In the car case, Depreciation, occur from passage of time (fixed portion) and also More miles are driven a year, loses its Market value (variable portion), cost of electrical power (lighting, number of machine hours worked). • Average unit costs
Volume Index • Definition: The unit measure used to define “volume” Based on production inputs (tons of coal processed, direct labor hours used, or machine hours worked). • Examples: • Automobile – “miles” driven • Electricity Generating plant – “kWh” produced • Stamping machine – “parts” stamped
Fixed Costs • Definition: The costs of providing a company’s basic operating capacity are known as its fixed costs or capacity costs. Must have a relatively wide span of output for which costs are expected remain constant. • Fixed cost do not change within a given time period although volume may change. For car example, the annual insurance, property tax, license fee. • Cost behavior: Remain constant over the relevant range.
Variable Costs • Definition: Costs that vary depending on the level of production or sales. In manufacturing, direct labor and material costs are major variable costs. • Cost behavior: Increase or decrease proportionally according to the level of volume
Practice Problem • You have 3000 units to produce. • Total labor cost = $20,000 • Total material cost = $25,000 • Total overhead cost = $15,000 • Total fixed cost = $40,000 • What is the average cost per unit? Average cost = ($100,000)/3,000 = $33.33/unit
Developing Project Cash Flow Statement • Cash flow statement • + Net income • +Depreciation • Capital investment • + Proceeds from sales of • depreciable assets • Gains tax • Investments in working • capital • + Working capital recovery • + Borrowed funds • Repayment of principal • Net cash flow Operating activities Income statement Revenues Expenses Cost of goods sold Depreciation Debt interest Operating expenses Taxable income Income taxes Net income + Investing activities + Financing activities
Example 9.1 When Projects Require only Operating and Investing Activities • Project Nature: Installation of a new computer control system • Financial Data: • Investment: $125,000 • Project life: 5 years • Working capital investment: $23,331 • Salvage value: $50,000 • Annual Revenues: $100,000 • Annual additional expenses: • Labor: $20,000 • Material: $12,000 • Overhead: $8,000 • Depreciation Method: 7-year MACRS • Income tax rate: 40% • MARR: 15%
Questions • (a) Develop the project’s cash flows over its project life. • (b) Is this project justifiable at a MARR of 15%? • (c) What is the internal rate of return of this project?
When Projects Require Working Capital Investments • Working capital represents the amount carried in cash, accounts receivable, and inventory that are needed for the operation of the project • Working Capital includes the stocks of finished and semi-finished goods that will be economically consumed in the near future or will be made into a finished consumer good in the near future. • How to treat working capital investments: just like a capital expenditure except that no depreciation is allowed.
(a) Step 1: Depreciation Calculation • Cost Base = $125,000 • Recovery Period = 7-year MACRS
(a) Step 2: Gains (Losses) associated with Asset Disposal • Salvage value = $50,000 • Book Value (year 5) = Cost Base – Total Depreciation • = $125,000 - $ 91,533 • = $ 33,467 • Taxable gains = Salvage Value – Book Value • = $50,000 - $ 33,467 • = $16,533 • Gains taxes = (Taxable Gains) (Tax Rate) • = $16,533 x (0.40) • = $6,613
Cash Flow Diagram including Working Capital $23,331 Working capital recovery $44,745 $81,619 $48,245 $43,145 $42,245 1 2 3 4 5 0 $125,000 Investment in physical assets $23,331 $23,331 Investment in working capital $23,331 5 1 2 3 4 0 Years $23,331 $23,331 Working capital recovery cycles
Question (b): • Is this investment justifiable at a MARR of 15%? • PW(15%) = -$148,331 + +$43,145(P/F, 15%, 1) + . . . . + $104,950 (P/F, 15%, 5) = $31,423 > 0 • Yes, Accept the Project ! $104,950 $48,245 $44,745 $42,245 $43,145 0 1 2 3 4 5 Years $148,331
Question (C): IRR =IRR(B2:B7,0.10) IRR = 22.55%