Write 2-3 paragraphs on the below topic and respond to two peer posts:
Stellar Packaging Products is considering diversifying its product line offerings into candy and other food bag packaging. This would require a major investment outlay for machinery and equipment. Give one example of different costs that would be considered relevant and one that would be considered irrelevant in making a future business decision for a company, and justify your choices.
For this discussion:
- Support your position.
- Select two peer posts and comment on the content of their posts. Does your selection differ from that of your peers? If so, how does that response contrast to your own?
Peer Post 1:
There are times that companies look to make large scale decisions on expansion that can fundamentally change the focus and direction of the business and these types of decisions can not be taken lightly. The capital budgeting process can be used to assist if these decisions are the right ones to make at the given time for that company. Capital budgeting decisions generally fall into two large categories; screening decisions and preference decisions (Garrison, Noreen, & Brewer, 2015). Screening decisions are made by determining if a capital decision meets certain criteria and the decision is a yes or no decision (Garrison et al, 2015). Preference decisions are made by choosing from a few opportunities that may exist and the decision is one of “which option”, not a yes or no decision (Garrison et al, 2015).
It is also important to recognize and evaluate the time value of money. Capital investments that promise earlier cash flow are more important to conduct or invest in that investments that require a longer time frame to realize the cash flow (Garrison et al, 2015). If Stellar wants to diversify its product line, it has three tools to utilize for evaluation of the decision to invest in the needed machinery. The three methods are Payback Period, Internal Rate of Return (IRR), and Net Present Value (NPV) (Gad, 2016).
Payback Period is the easiest method to use. The payback period method simply looks at the length of time that the investment will be paid back (Gad, 2016). For example, if Stellar purchases a dynamic machine that removes $10000 of direct labor per year and the cost of that machine in $50000 – the payback period is 5 years. This method is most effective in very simple investments and not usually utilized if the investment is even slightly complex (Marzec, 2016).
IRR is a comparison tool used to evaluate between a few investment options (Marzec, 2016). IRR is computed by dividing the profit by the expected expenditure (Marzec, 2016). This rate is then compared to a hurdle rate or minimum rate that is acceptable and if the IRR is above the hurdle rate, then the investment is worth considering (Marzec, 2016). If the cost of capital is more than the IRR , then the project is not worth pursuing. For example, if Stellar is going to buy these new machines, but the IRR is 4% and the cost of capital is 5% – it would be a bad idea to pursue that investment of capital.
NPV is the most accurate and detailed way to evaluate investment of capital and it combines two forms of value (Marzec, 2016). NPV evaluates how much cash will flow in due to the investment of capital and lays that number across the cash that will flow out in order to make the investment (Marzec, 2016). NPV takes many factors into account that simpler evaluation methods do not such as inflation. NPV acknowledges the time value of money and that money is worth more today than in the future. As a result, NPV discounts future cash outflows to create an like-kind comparison (Gad, 2016).
When reviewing these investment decisions, cost of capital is a major factor in the decision making process. If capital has a high cost like 9% it will be more difficult to see the return on the investment regardless of the method used to compute it, so keeping capital costs low is very important. Other prospective costs to consider in this type of decision would be the new purchase cost, annual operating costs and the out of pocket costs like repair (Garrison et al, 2015). Costs that can not be recovered are called sunk costs, which are costs that have already been incurred and can not be recovered (Garrison et al, 2015).
Gad, S. (2016). Capital budgeting: Capital budgeting decision tools. Retrieved from http://investopedia.com
Garrison, G. H., Noreen, E. W., & Brewer, P. C. (2015). Managerial accounting (15th ed.). New York City, NY: McGraw-Hill Education.
Marzec, E. (2016). Three primary methods used to make budgeting decisions. Retrieved from http://smallbusiness.chron.com
Peer Post 2:
Stellar Packaging Products is considering expanding production by adding a new product line. The company needs to examine the costs involved and decide if the new product line is going to cover its own expenses and bring more revenue to the company as a whole. Different costs are involved such as purchasing new equipment/machine, hiring a new production manager, hiring extra workers, purchase new raw material, renting new factory buildings, selling and administrative expenses, etc. However, all of the costs are not relevant in decision making because some of the costs are not going to change regardless of whether the new product line is added or not. For instance, if the new product line is going to be accommodated in the same factory building with other production activities, then no extra renting expenses will be incurred. Costs like this are irrelevant in decision making. Sunk cost is a cost that has already been incurred and cannot be recovered (Garrison, Noreen, & Brewer, 2015), so sunk cost is also irrelevant.
The choice faced by Stellar Packaging Products is an example of capital budgeting decisions. Capital budgeting decisions include screening and preference decisions. (Garrison, Noreen, & Brewer, 2015) Whether or not to add a new product line falls under screening decisions, which relates to whether a proposed project is acceptable. (Garrison, Noreen, & Brewer, 2015) Companies usually set their standard (benchmark) against which projects are evaluated. For example, the Stellar Packaging Products might decide that if the internal rate of return is higher than 15%, they will approve the project. Another type of capital budgeting decision is preference decision, which is used to select from several acceptable alternatives. (Garrison, Noreen, & Brewer, 2015) In preference decisions, only those costs and benefits that differ between alternatives are relevant. It includes avoidable (differential) cost and opportunity cost. A differential cost is a difference in costs between any two alternatives, and it’s also referred to as avoidable cost because such cost from one alternative can be eliminated by choosing another alternative. For example, you are planning to either travel by train or driving a car. If you choose train, then you can avoid gas costs. If you choose to drive, you can avoid train ticket fees. An opportunity cost is the potential benefit that is given up when one alternative is selected over another. For example, if you choose to drive, you give up the benefit of reading and relaxing on the train during the trip.
Time is also an important factor in decision making for two reasons. First, money has time value. The same amount of dollars is worth more today than years later (Garrison, Noreen, & Brewer, 2015) due to inflation and opportunity costs of potential investment. Second, the payback period is important to cash flow and operations of a company. Sometimes a company needs to choose less profitable projects with shorter payback period over more profitable projects with longer payback period. The benefit is that the company can recover its cash investment faster so it has enough cash reserve for operation or further investment.
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2015). Managerial accounting(15th ed.). New York,, NY: McGraw-Hill Education.