Management And Accounting Web

Moving Baseline Examples From Sinason*

Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida

Investment Management Summary | Investment Management Main Page

Sinason provides two examples to illustrate the moving baseline concept associated with investment managment.

Example 1: Equipment Replacement

Data for Existing Equipment

Year X0 (Present) Year X1 Year X2 Year X3
Estimated average units production per hour 90 87 84 83
Required production to meet demand 81 84 87 93
Machine age in years 2 3 4 5
Class estimated by engineering 3 3 4 5
Maintenance costs estimated $1,500 $1,500 $2,000 $3,000
Overtime required per week to meet demand
= (Production requirements รท Estimated production)(40 hours)
0 0 1.43 4.82
Overtime cost based on
($50 per hour)(Hours per week)(52 weeks)
0 0 $3,718 $12,532
Incremental cost, i.e., cost in addition to current operating costs for maintenance and overtime. $1,500 $1,500 $5,718 $15,532

Data for New Equipment Year X0 (Present) Year X1 Year X2 Year X3
Estimated incremental cash flows, i.e., savings compared to old equipment. $5,000 $10,000 $15,000 $25,000
Cost of new equipment $60,000
Salvage value of old equipment 0
Cost of non-investment, i.e., or cost avoided if the new equipment is purchased. $1,500 $1,500 $5,718 $15,532
Combined cash flow (53,500) 11,500 20,718 40,532

Conventional Present Value Analysis

Year

Cash Flow Discount Factor
(8% Cost of Capital)
Discounted Cash Flow
0 $(55,000) 1.000 $(55,000)
1 10,000 .9259 9,259
2 15,000 .8573 12,859
3 25,000 .7938 19,845
NPV $(13,037)

Conclusion based on conventional analysis: Do not invest in the new equipment since the cost of non-investment is not recognized.

Moving Baseline Present Value Analysis

Year

Cash Flow Discount Factor Discounted Cash Flow
0 $(53,500) 1.000 $(53,500)
1 11,500 .9259 10,648
2 20,718 .8573 17,761
3 40,532 .7938 32,174
NPV $7,083

Conclusion based on moving baseline analysis: Invest in the new equipment. The difference results from recognizing the cost of non-investment.


Example 2: Investment in New Technology

Data Year X0 (Present) Year X1 Year X2 Year X3
Present market share projections without
the investment in the new technology.
20% 19.9% 19.5% 19.0%
Revenue projections without the
investment in the new technology.
$1,000,000 $995,000 $975,000 $950,000
Decrease in cash flow from declining;
market share if investment is not made.
0 $5,000 $25,000 $50,000
Cash flow from investment. $(250,000) $(20,000) $80,000 $190,000
Combined cash flow. $(250,000) $(15,000) $105,000 $240,000

Conventional Present Value Analysis

Year

Cash Flow Discount Factor
(8% Cost of Capital)
Discounted Cash Flow
0 $(250,000) 1.000 $(250,000)
1 (20,000) .9259 (18,518)
2 80,000 .8573 68,534
3 190,000 .7938 150,822
NPV $(49,162)

Conclusion based on conventional analysis: Do not invest in the new technology since the decreases in cash flows caused by the declining market share are not recognized.

Moving Baseline Present Value Analysis

Year

Cash Flow Discount Factor
(8% Cost of Capital)
Discounted Cash Flow
0 $(250,000) 1.000 $(250,000)
1 (15,000) .9259 (13,888)
2 105,000 .8573 90,017
3 240,000 .7938 190,512
NPV $16,641

Conclusion based on moving baseline analysis: Invest in the new technology after recognizing the decreases in cash flows caused by the declining market share if the investment is not made.

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* Sinason, D. H. 1991. A dynamic model for present value capital expenditure analysis. Journal of Cost Management (Spring): 40-45. (Summary).

Related summaries:

Cherry, K. 1993. Why aren't more investments profitable? Journal of Cost Management (Summer): 28-37. (Summary).

Engwall, R. L. 1988. Investment evaluation methodologies. Journal of Cost Management (Spring): 40-44. (Summary).

Engwall, R. L. 1988. Cost/benefit analysis. Journal of Cost Management (Fall): 64-70. (Summary).

Engwall, R. L. 1989. Investment justification issues. Journal of Cost Management (Spring): 50-53. (Summary).

Gold, B. 1976. The shaky foundations of capital budgeting. California Management Review (Winter): 51-60. (Summary).

Hayes, R. H. and W. J. Abernathy. 2007. Managing our way to economic decline. Harvard Business Review (July-August): 138-149. (This is a reprint of their 1980 article with a retrospect by Hayes on page 141). (Summary).

Heard, E. 1996. Investment justification: The cost justification charade. Journal of Cost Management (Summer): 60-65. (Summary).

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

Kite, D. 1995. Capital budgeting: Integrating environmental impact. Journal of Cost Management (Summer): 11-14. (Summary).

Lyons, B., A. Gumbus and D. E. Bellhouse. 2003. Aligning capital investment decisions with the balanced scorecard. Journal of Cost Management (March/April): 34-38. (Summary).

Martin, J. R. 1994. A controversial issues approach to enhance management accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).

Martin, J. R. Not dated. Investment management. Management And Accounting Web. InvestmentManageSum

Primrose, P. L. 1992. Is anything really wrong with cost management? Journal of Cost Management (Spring): 48-57. (Summary).