Decisions, decisions…. Life is full of decisions.
Should I travel or should I buy a house?
Should I get a job straight out of school or should I go to uni?
Should I enjoy a Saturday morning sleep in, or should I get up and go to the gym?
Sometimes you can do both, you could work part-time and study part-time; or you could have your sleep in and go to the gym in the afternoon. Other times, there is only one option available to you – you may already have plans in the afternoon, which would mean sleeping in would automatically exclude your gym visit that day.
Chapter 8 is all about decisions, and the various tools and processes that managers can use to help them make the best decision possible.
Managers need to make decisions almost every day, not only in their own personal life, but big decisions which often involve large amounts of money. The hardest part about making any kind of decision is not knowing what the future will bring.
This really resonates with me right now, as I feel like I am having a bit of a midlife crisis about what I want to do when I “grow up”. Despite giving this first semester of uni my absolute best over the last 11 weeks, I’m still doubting whether or not I made the right choice, and am considering not coming back next semester. As much as I love the idea of being a registered tax agent and financial planner, it’s going to take me 6-8 years to finish my degree part-time. Is it worth sacrificing potential income earnt from employment or time with my kids, just to have an enjoyable career in my 40’s?
Looking back over the past few months at how much time and income I have lost; it is quite easy for me to predict what the next few years will look like for my family if I continue with my uni degree. However, even in my situation there are variables. My husband’s business could start earning a lot more money which would eliminate the need for me to work part-time. This would mean that I could get a lot more of my uni work done during school hours. I could win the lotto, and not have to worry about working or studying ever again, spending the rest of my days sipping cocktails on the beach. The thing is we don’t know what the future is going to bring, but when we make decisions, we have to predict the future as best as we can.
Managers also need to be able to predict the future in order to make the best decisions for their companies, but rather than consulting a lady with cards at the local markets, they use accounting. They use various ratios and calculation methods to analyse a firm’s past performance, hoping that the same trend will continue in the foreseeable future. Unfortunately, things don’t always work like that, but it’s the best they can do.
The decisions managers make can be short-term such as what products a retail outlet should have on the shelves at Christmas time, or long-term such as whether or not to open up a second store.
Before managers can make any kind of decision though, they need to weigh up the expected costs and the expected income.
However, not all income and costs are necessarily relevant to the decision making process, and a good manager will need to be able to discern the difference… they should only include those costs which can actually be changed by the decision, if they’re going to stay the same regardless, then it’s no point worrying about them.
My beloved Granny passed away several years ago now, but I
will always remember the plaque she kept displayed on her writing desk:
“God give me the serenity to accept the things I cannot change, courage to change the things I can, and the wisdom to know the difference”.
Managers need the wisdom to know the difference between the costs they can and can’t change with their decisions. Luckily, there are some guidelines in place to help them.
Sunk costs are those costs which cannot be changed – either they have been paid already, or there is no way we can get out of paying it in the future; basically there is nothing you can do about it. When making business decisions these costs should be ignored. I think as humans, we can find this a difficult concept to grasp. Although we like to think we are logical and rational, we are often governed by our emotions and ego, and we do not like to feel like our activities have been a waste of time. For example, last year myself and a family member went halves in buying approximately 600 baby onesies. They were ex-stock from another business which had closed down and we were hoping to make a profit by reselling them online and at the markets. Unfortunately, the products were not very popular (which is probably why the other business closed down) and we did not sell very many at all. As a result, I currently have several boxes of baby clothing in my garage. After a few failed attempts, I was happy to just give up and donate the clothes to charity. However, my family member keeps wanting to pay fees to go to the markets, hoping to have a different outcome next time. Their view is that if we just give up, we have lost money. Whereas, since learning about sunk costs, I realised that whether we continue with the business or not, we have still spent that initial outlay and cannot change it. The only thing that should affect our decision when we go to the markets is whether we can make more revenue at that particular market than the cost of the stallholder fee (plus other associated costs like petrol to get there, etc).
Managers also need to distinguish between which costs will actually be affected by the decision and which will stay the same regardless. For example, imagine if I were deciding on a market to sell my baby clothes at, and there were two different markets being held on the same day, which each had a stallholder fee of $60. In that case, I would disregard the $60 fee, as it would be the same no matter which option I chose. However, if one had a $60 fee and one had a $80 fee, I could consider the additional $20 as a differential or incremental cost.
Managers also need to consider whether a cost is avoidable or unavoidable.
If I had the option to not sell at any market that weekend, then the market fee becomes an avoidable cost. However, I may be required to work a certain amount of hours each week in order to receive subsidised daycare fees and working at the markets may contribute to those hours – in which case it becomes an unavoidable cost. Unavoidable costs should also be disregarded in the decision making process.
Finally, managers need to look at the opportunity cost. People can often fail to consider the opportunity cost, because it is not actually incurred, however opportunity costs are a very real part of decision making. It basically looks at, in order to achieve Outcome A, this means I have to sacrifice Outcome B or Outcome C. When I have been studying this semester, my costs are not just my uni fees and my textbooks, it is also the loss of income as I have not been able to work as much. Although I have not actually spent this money, it is still a very real cost to me. Opportunity cost basically looks at if I don’t make this decision, what is the next best decision? Missing out on being able to make this next best decision is the opportunity cost. It’s making sure firms (and at times individuals) make the best use of their resources.
After determining which costs to consider, there are various methods that managers can then use to assist with their decision making.
One of these is the contribution margin. A product’s contribution margin is expressed in dollar terms (or whatever it’s country’s currency may be), where as the contribution margin ratio is a percentage. The contribution margin tells us how much of a product’s revenue contributes to fixed costs and profits after the variable costs have been taken out. I’m still struggling to understand a bit why the amount contributed to fixed costs and profit is grouped as a single figure. I would have thought it was better to look at these separately. Say for example, if I were selling my baby onesies online and paying $40/month for a shopify store. The $40/month is paid whether I sell any baby onesies or not. The onesies cost me $1 each, and I am selling them for $10 each. Out of this I also have to pay postage ($3) and Shopify transaction fees ($1). When calculating the variable costs, I don’t calculate the $1 original cost as this is now sunk. So my variable costs are $4, which would leave me with a $6 contribution margin per onesie. However, I would still need to sell a minimum of 7 onesies per month before my fixed website costs were repaid, and even at this point I would not have repaid my initial investment. I feel that a weakness of using contribution margin is that it does not recognise the break even point, though I do recall Maria mentioning this in her video, so this must be something that is learnt further along in the degree.
Something I found interesting is that the contribution margin focuses solely on the interests of equity investors, because it is looking at profitability. However, there are many others with an interest in the firm as well.
Employees would most likely be happy if the company they worked for had to operate with lower contribution margins if this meant that their pays were higher.
Customers would be happy if the business they frequent had lower contribution margins because they lowered their prices.
My current employer is constantly pushing staff to complete their work at a faster and faster rate, however this is at the expense of very low staff morale and a high staff turnover rate.
This is why good managers need to look at so much more than just productivity, profit and numbers, however contribution margins are able to help prevent them from making a bad decision which would have a negative contribution.
Contribution margins also help managers to make good product mix decisions, such as what products to include and how much of each. When I applied to university at CQU, I received notice of my acceptance almost immediately. However, prior to that, I had also been accepted at University of the Sunshine Coast. When I applied at USC, it took several weeks to hear back. At the time, I found myself wondering if this was because I applied to CQU as a distance student, but USC I applied as an on-campus student. A university could take on distance students with little extra cost, and no limitations such as class sizes. Whereas, in the case of on-campus students, they would be a lot more limited and would need to ensure that they did not take on more students than could adequately fit in their classrooms. I also imagine that they would receive a higher contribution margin from distance students, as they would also then have less associated costs such as direct contact hours, materials and the costs of operating a classroom.
The concept of the time value of money made a lot of sense to me and it reminded me of the old saying “A bird in the hand is worth two in the bush”… or it is better to have something now that is certain, than something in the future that is only a maybe. However, one thing I noticed is that it did not refer to inflation at all. Prior to reading this study guide, if someone talked to me about the time value of money, I would have thought that inflation was what they were referring to. $100 today is going to have more purchasing power than what $100 will in 5 years time. However, as I read over this section again, I realised that it was more talking about how much our money increases by due to investing. For example, the interest rate on my ING saver account is 2.8%. If I’m planning to buy a new handbag in 1 years time that costs $102.80, I would only need to put $100 in the bank now. Therefore the current value of $102.80 is $100. (I know that’s not exactly correct, due to compounding interest being paid monthly, but I’m not mathematical enough to work it out properly!)
I found the idea that cash flow in 40 years time is almost worthless today to be a bit perplexing… if this is true, why does our society place so much importance on superannuation? I personally don’t put anything extra into my super because I don’t want to wait another 24-29 years to get it back… I would much rather invest in things such as property or shares that I can sell today if I need to… however, I also know that there are many others who do not share my point of view on this.
To be honest, I found the calculations such as Accounting Rate of Return, Internal Rate of Return and Net Present Value quite hard to get my head around. I’m going to try to explain them as best as I can, though I feel I have far more questions for this section than what I do “light bulb moments”.
Accounting rate of return = (Average net profit/Initial investment) x 100
This may have been a better measure for me to use, rather than the contribution margin, when looking at the profitability of my baby onesies, as it compares the profit against the initial investment. Though I’m still unsure whether the initial investment would be the total investment or the investment per onesie?
I don’t understand why depreciation is taken off first when calculating the net profit. Depreciation annoys me because it is not a real expense, and I believe it should not be deducted when calculating profit for decision making purposes. Depreciation is more about how it is written off over a number of years for tax purposes, and the amount will vary by the effective life chosen or whether they use prime cost or diminishing value method. The real expense is the purchase of the equipment.
Also, it seems like you basically choose whichever option will pay back the highest percentage, however shouldn’t we be looking at dollar figures as well? If an investment of $100 returns $100 (100%), and an investment of $1000 returns $500 (50%) wouldn’t you still rather choose the second option?
When I read that the Internal Rate of Return uses expected future cash flow rather than accounting profits, I felt like I would prefer this. I feel like cash flow is more “real” as it is the money that actually goes in and out of a firm’s accounts. Even in the case of accrual accounting, there will be income that is entered on the income statement, however for whatever reason does not end up being paid.
I still laugh though when I read the statement “The IRR method has the big advantage that it is easy to understand”… as I did not feel that I understood this very well at all! I even went away and did my step 9 to see if I would understand it but I still don’t… other than the fact that you want it to be higher than your discount rate… I found it quite easy to calculate, but what it actually means… no idea…
The Net Present Value initially also went right over my head. I tried looking up Investopedia for help, and found the following formula:
Hmmm… not any clearer sorry!
However, I did understand the sentence from the study guide which said “The larger the positive amount of NPV the greater the amount of added value for a firm; the larger the negative amount of NPV, the greater the amount of value it would destroy for a firm.”
So essentially, reject projects with negative NPV, accept positive NPV where possible, and the higher the NPV the better!
I then went back and read over Investopedia again, and I think I may get it now.
Net Present Value = Income less expenses over the life of the investment, discounted back to today’s value of money. When discounting money back to today’s value, it’s not the percentage you expect to earn on this particular project, it’s the percentage we would have earnt with the next best alternative (so comparing it to the opportunity cost). If the number is positive, it’s better than the alternative, and so we should do it! If we don’t know the discount rate of alternative uses, we should just use 10% as a standard rate, and this will mean we can easily compare NPV’s with eachother!
Thankfully, I did find the payback period very easy to understand. Basically, it’s how long before the firm recovers the cost. I used to do something similar when selling products online, but with the number of products, instead of the number of years. For example, with the baby onesies, if I was making $5 profit per onesie, I would know that I would need to sell 8 to pay my monthly shopify fees of $40. Once I had sold 8, I would then be able to start paying back the initial purchase. If this amount were $600, I would then need to sell another 120 to pay this back. Any onesies sold after that would be profit. These figures are made up, and I did unfortunately not actually make a profit, however I’m just more demonstrating that this was my thought process.
Although, I am wondering if it would be quicker to work out the payback period using the ARR? Ie. if this was 10%, it would take 10 years to equal 100%? Just a thought…
In closing, I just want to make a few comments that are not directly related to this chapter, but the unit as a whole.
Firstly, I am more than a little excited to be completing my final KCQ’s for the semester. Returning to uni after 15 years was extremely daunting – and at the beginning of the semester when I saw what the assessment entailed I was most unimpressed. I was here to study accounting – not blogging, or “creative writing” as I called it when complaining to my husband. However, 11 weeks down the track, I am so grateful that we had to do it this way. Being forced to read every single chapter of the study guide and actually think about it, helped me to understand the material in a way I never thought possible.
Martin, the dedication and passion you have for both your students and your content are inspirational, and I have really appreciated the support and encouragement you have shown throughout this unit! It is clear to see that you go above and beyond and that you genuinely want us all to succeed! I also loved the way that you had regular due dates spread throughout the semester. It really helped me to stay on track and work on my assessments regularly. Otherwise, I would have been at risk of leaving everything to one big last minute rush (like I have done with economics!)
I still haven’t made up my mind whether I want to continue with uni next semester or not… But if I do, I know that I will be thrilled when I have you for a lecturer again in future subjects!! Thank you 😊