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Howell, R.A. and S.R. Soucy. 1987. Capital investment in the new manufacturing environment. Management Accounting (November): 26-32.

Summary by Jennifer Zelski
Master of Accountancy Program
University of South Florida, Fall 2001

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Introduction

Making a major investment in automation requires an analysis of the costs and benefits to ensure that all the benefits of an investment outweigh all of the costs before investing. Traditionally, this analysis has been simple and easy to calculate. But as the timing, scope and uncertainty of the costs and benefits associated with investments have changed, a change in the capital investment model for determining these costs and benefits must be made.

Changes in Investments

Traditionally, most of the benefits related to an investment were easily measured in reduced costs or greater capacity. These benefits were also realized within a relatively short time period, usually 2-4 years. Plus, the investments did not entail the significant costs that are required to invest in automation today.

Now, investments require a greater amount of cash disbursements over a longer period of time. The benefits associated with these investments are mostly indirect and intangible in nature. Most new systems provide benefits of higher quality, reliability, faster delivery or higher customer satisfaction. These benefits are harder to measure than the traditional direct cost benefits.

Investments can be broken into three different levels. The first level includes investments that produce only direct benefits, such as reduced labor costs. The second level includes the direct benefits of level one investments, plus indirect benefits, such as a reduction in administrative costs. While the third level includes direct benefits, indirect benefits and intangible benefits, such as flexibility and competitive advantage. Different criteria should be used to evaluate each level of investment to be certain that all benefits are included in the evaluation.

Changes in the Capital Investment Model

The traditional evaluation model is a discounted cash flow analysis that incorporates investments, operating cash flows, terminal value and a discount rate. While a discounted cash flow method is still appropriate, the inputs must be adjusted to properly reflect the value of an investment with a longer return period, intangible benefits and greater uncertainty.

Managers often exclude or use extremely conservative terminal values. Terminal value is the cash value of an investment at the end of its useful life or the analysis period. This can be difficult to estimate, especially when using longer return periods, but failing to give a terminal value to an investment can seriously distort an evaluation. To compensate for the uncertainty related to estimates of terminal value, cash flows and discount rates, management accountants should use probability and sensitivity analysis to provide confidence that an investment decision would not change due to an incorrect assumption.

While the determination of a discount or hurdle rate is not changed due to the new manufacturing environment, its impact on an investment evaluation has changed. Due to the fact that the new environment creates longer-term returns, the discount rate now has a greater impact on the analysis. If management uses an overly conservative rate, investments with longer payback periods incorrectly appear less valuable than those with shorter payback periods.

Another aspect of the traditional model that needs to change is the assumption that no investment will result in current operating conditions staying at status quo. Often times, a company’s decision not to invest can result in a loss of competitive position due to the fact that competitors are making investments. A loss of competitive position due to not investing can result in a decrease in cash flows. Thus, we need to avoid comparing cash flow changes from an investment against current cash flow. We need to instead compare the investment cash flows against “no investment” cash flows, the cash flows that would result from not investing and possibly losing competitive position. This “no investment” cash flow will often decrease over time indicating an increasing loss of market share or sales due to inadequate technology and quality. This concept is referred to as the “moving baseline” because we no longer compare investment cash flows to a constant (current) cash flow, but instead compare it to a decreasing (“no investment”) cash flow stream. This results in a faster payback period for investments than that calculated using the traditional model so underestimating the “no investment” operations can undervalue an investment.

Post-Investment Audits

An important aspect of investment analysis is the post-investment audit. This involves evaluating the accuracy of cash flow and discount rate estimates used in the capital investment model. This should include an overall evaluation of every area of performance against the forecasts, comparing the financial cash flows and the operating benefits against the estimates of each. This creates a control mechanism, by holding those involved in the estimation process accountable for the results of the investment. If those involved know that future investment results will be audited, they will not try to sway the results of the analysis by inflating or deflating estimates. This creates a more accurate and sound analysis.

Conclusion

When analyzing the value of an investment or project, be sure to include measurements of all the costs and benefits associated with the investment. Failure to recognize any of these measurements could result in a poor decision. Keep in mind that factors affecting investment decisions are changing with the times. As this analysis should be the job of management accountants, make sure to discuss the possible benefits and costs of the project with all members of the organization that might be affected by it. We may not be able to recognize all of the consequences of the investment from the accounting perspective.

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