Marginal cost pricing
The marginal costs of a service are the additional costs that a public service organisation would actually incur if they undertook some additional activity.
Thus, for small increases in service activity, the labour and overhead costs might remain unchanged but consumables costs would increase. In certain specific circumstances it may be appropriate and acceptable to base pricing decisions on the marginal costs of the service provided rather than the total cost. Hence the price may be set at a level which exceeds the marginal cost but is below the total cost.
MANAGEMENT ACCOUNTING METHODS
There are a number of management accounting methods which are relevant to operational and tactical decision making and these are discussed below.
Relevant costing
This was discussed in C hapter 7 and we saw that the basic principle here is that decisions should be based only on those costs which are relevant to that particular decision. The principle is that decisions should be based only on those costs that change as a result of the particular course of action chosen.
The more complex a decision is, the more difficult it may be to establish which costs are relevant and which are not but an attempt must be made.
The distinction between relevant and non- relevant costs is summarised in Table 8.2.
Thus, relevant costing is of great importance in a variety of operational decision making, in particular to make or buy decisions. However, the process of judging what costs are or are not relevant is not always clear- cut, and judge- ment is needed. This is illustrated in Case study 8.1.
TABLE 8.2
Relevant costs for decision making
Relevant Costs Non- Relevant Costs
• Variable/marginal costs
• Incremental fixed costs • Committed costs
• Opportunity costs • Notional costs
• Sunk costs
CHAPTER 8 Operational decision making 135
CASE STUDY 8.1
Operational decisions and relevant costing
The buildings maintenance department of a local authority has a section that manufactures a variety of PVC doors and windows for use in maintaining its own housing stock. It has been approached by a private customer regarding the urgent manufacture of an agreed volume of two items.
The department wishes to put forward a price for this contract and needs to establish the relevant costs associated with each item.
Basic information
The following information is available about each item.
Material resource requirements
Doors Windows Both
Direct material W ( units) Direct material X ( units)
1,000 1,000
200 –
1,200 1,000
Direct material Y ( units) 500 600 1,100
Direct material Z ( units) – 200 200
Labour resource requirements
Doors Windows Both
Direct labour type A ( hours) 100 50 150
Direct labour B type ( hours) 20 – 20
Direct labour costs
Labour costs per hour £
Direct labour A 25
Direct labour B 30
Direct materials availability and costs Material Units already
in stock Book value of units
in stock (£/ unit) Realisable
value (£/unit) Replacement cost (£/unit) W
X
0 600
– 12.00
– 11.00
16.00 15.00
Y 1,200 13.00 10.00 14.00
Z 0 – – 13.00
(continued)
Overhead costs
Doors Windows
Variable overhead (£) Fixed overhead (£)
2,000 5,000
1,500 4,000
Total overhead (£) 7,000 5,500
The following information should also be noted:
• Material W would need to be purchased as there are no existing stocks.
• Material X is used regularly by the department and if units of X are required for this job, they would need to be replaced to meet other demands.
• Sufficient material Y is in stock due to previous over- buying. No other use could be found for material Y and if not used on this job it would have to be sold off as scrap.
• There is no material Z in stock and the lead time for its supply is so long that it could not be obtained in time for the completion of this contract. How- ever, the department does have another material J which could be used as a substitute but is currently needed for a different item and would have to be replaced. Supplies of material J can be obtained quickly at a cost of £19/ unit.
• The employees in labour pool B are currently short of work and could easily absorb this contract into their existing workload.
• Manufacture of item Beta would require the purchase of a new machine at a cost of £5,000. The machine would have no use at the end of the contract and would be scrapped.
• Manufacture of item Alpha would require the use of an existing machine which is currently lying idle. The machine costs £20,000 to purchase and is being depreciated over a ten- year period.
Relevant costs
The relevant costs for each item are as follows:
Doors
Amount Relevant
unit cost (£) Total
cost (£) Explanation
Direct 100
labour A 25 2,500 Must be acquired at going
rate Direct
labour B 20 Nil Nil Slack capacity so no cost
Direct 1,000
material W 16 16,000 No stocks – must be
purchased
CHAPTER 8 Operational decision making 137
Amount Relevant
unit cost (£) Total
cost (£) Explanation Direct
material X 1,000 15 15,000 Stocks must be replenished by new purchases
Direct 500
material Y 10 5,000 Only alternative use is for
scrap – therefore scrap value Direct
material Z – 19 Nil None needed
Machine
costs Nil Depreciation is a non- cash
and sunk cost Overhead
costs 2,000 Variable only
Relevant
costs 40,500
Windows
Amount Relevant unit cost (£)
Total cost (£)
Explanation
Direct
labour A 50 25 1,250 Must be acquired at going
rate Direct
labour B Nil 200
Nil Nil Not needed
No stocks – must be purchased
Direct
material W 16 3,200
Direct
material X – 15 – Not needed
Direct
material Y 600 10 6,000 Only alternative use is for scrap – therefore scrap value
Direct 200
material Z 19 3,800 Substitute material J at a
replacement cost New machine Machine
costs 5,000
Overhead
costs 1,500 Variable only
Relevant
costs 20,750
The relevant costs have been established as being £40,500 ( doors) and £20,750 ( windows). Thus, the department needs to price the prospective contract above those figures.
Capital investment appraisal
In this section some techniques are outlined which can be used to appraise and evaluate public sector capital projects. First, the basis of the technique will be described and then its applicability in the public sector will be considered. The techniques discussed can be classified twofold:
• Financial appraisal – discounted cash flow ( DCF)
• Economic appraisal – cost–benefit analysis (CBA)
The techniques of economic appraisal are probably more suited to strategic cap- ital investments and will be discussed in C hapter 9. In this chapter, we will discuss financial techniques. There are various approaches to capital investment appraisal which are outlined below:
Payback
The payback period is both conceptually simple and easy to calculate and is commonly used in commercial organisations. The payback period is the time taken to recover the initial investment. So, a £1 million investment that will make a surplus of £200,000 a year has a payback period of five years. Invest- ments with a shorter payback period are preferred to those with a long period.
In theoretical terms, the payback approach has a number of weaknesses:
• It attaches no value to cash flows after the end of the payback period.
• It makes no adjustments for risk.
• It is not directly related to wealth maximisation as is net present value ( NPV; see below).
• It ignores the time value of money ( see below).
• The “ cut- off” period may be arbitrary.
Accounting rate of return ( ARR)
The accounting rate of return is a very simple rate of return on an investment project, calculated as:
Average return (over a period of years)
ARR= ×100
Project investment
Average means arithmetic mean, and the profit number used is operating profit from the particular project.
ARR is most often used internally when selecting projects. While ARR over- comes some of the weaknesses of payback, it still has the following problems:
• ARR does not take into account the time value of money – the value of cash flows does not diminish with time as is the case with NPV and Inter- nal rate of return ( IRR).
• It does not adjust for the greater risk to longer- term forecasts.
• It tends to favour higher- risk decisions because future profits are insuffi- ciently discounted for risk, as well as for time value, whereas use of the payback period leads to overly conservative decisions.
CHAPTER 8 Operational decision making 139
Discounted cash flow ( DCF)
The main weakness of the above approaches is that the only issue considered here is the size of the various cash flows associated with a project and they ignore what is termed the “ time value of money” since the timing of the cash flows is not considered. Thus, they assume that £100 received or paid in year 1 is equivalent to £100 received in year 2 and so on. However, economics teaches that money has a time value as well as a magnitude and argues that £100 re- ceived in year 1 has a greater value than £100 in year 2 ( which has greater value than £100 in year 3, etc.). Similarly, £100 spent in year 1 has a higher cost than
£100 spent in year 2. This is for two main reasons:
• the future is uncertain and £100 receivable today is preferable to £100 in a year’s time when one may no longer be able to enjoy the benefit of that £100.
• £100 today can be invested to produce a return which will be in excess of
£100 in a year’s time.
This basic principle of time value of money leads to the discounted cash flow ( DCF) approach which takes account of both the magnitude and the timing of the cash flows involved when evaluating capital projects. In public service organisations it is this DCF approach which should be used for the financial appraisal of projects. It is not possible here to give a full explanation of the DCF approach and the interested reader is referred to the many excellent books on the subject, but an attempt is made here to give a brief explanation of the rationale of the method.
With DCF, cash flows, whether they are inflows or outflows, in whatever time period they occur are converted to a common point of reference, namely a present value. Present value is essentially the converse of compound interest.
Assuming an interest rate of 10%, then if £100 is invested, it has a potential fu- ture value of £110 in a year’s time. The converse is that £110 receivable in a year’s time has a present value of £100. Similarly, £121 receivable in two years’ time has a present value of £100. Thus, all cash flows can be converted to a present value.
When inflows and outflows are combined, the present value becomes an NPV.
Let us look at a simple practical example. An organisation is considering two possible projects involving investment in new equipment both of which have a capital cost of £100,000. The organisation can borrow money at 10% to pur- chase the equipment. Both types of equipment have a four- year life and will be used to manufacture different products. There will be production costs associ- ated with the manufacture of the products and revenues from the sales of the products. The financial implications are shown in Table 8.3.
Three points should be noted about these results:
• In terms of total cash flows, project Y has a larger positive net cash flow than project X;
• Both projects have a positive NPV;
• Project X has a larger NPV of cash flows than project Y. This is because the larger positive cash flows in project X occur earlier in the lifespan of the project and thus generate higher present values than cash flows occur- ring later in the project.
DCF techniques provide two decision rules for the financial appraisal of poten- tial capital projects:
• In purely financial terms, projects which show a positive NPV should be un- dertaken, while those which have negative NPVs should not be undertaken.
In this case, project X should be undertaken but project Y should not.
• Where several competing projects have positive NPVs but only one can be undertaken ( e.g. because of limited investment funds available), the project with the highest positive NPV should be chosen.
The results of a DCF analysis will be significantly affected by the discount rate used in the analysis. In the above example, for simplicity, a discount rate of 10% was used. In commercial companies, the investment discount rate is derived from the interest rates the company might have to pay to fund the investment from differ- ent sources. Thus, a company would calculate its weighted average cost of capital
TABLE 8.3
Use of discounted cash flow Project Data
Project X Project Y
Year Production Costs
Sales Revenues
Net Cash Flow
Production Costs
Sales Revenues
Net Cash Flow
£ £ £ £ £ £
1 −20,000 60,000 40,000 −25,000 38,000 13,000
2 −30,000 65,000 35,000 −35,000 65,000 30,000
3 −30,000 65,000 35,000 −20,000 65,000 45,000
4 −20,000 36,000 16,000 −20,000 62,000 42,000
−100,000 226,000 126,000 −100,000 230,000 130,000 Project Analysis
Project X Project Y
Year Net Cash
Flow Discount
Factor Net Present Value
Net Cash
Flow Discount
Factor Net Present Value
1 40,000 1.00 40,000 13,000 1.00 13,000
2 35,000 0.91 31,850 30,000 0.91 27,300
3 35,000 0.83 29,050 45,000 0.83 37,350
4 16,000 0.75 12,000 42,000 0.75 31,500
Total 126,000 112,900 130,000 109,150
CHAPTER 8 Operational decision making 141 ( WACC) as its discount rate. For public services it is different. Public service organ- isations in the United Kingdom are expected to use the discount rate set down by HM Treasury which is referred to as the test discount rate ( TDR). The TDR is a rate which aims to value what is termed the social time preference of society. This is a measure of a society’s willingness to postpone private consumption now in order to consume it later and is calculated by HM Treasury. Currently, the TDR is set at 3.5% for most projects but other rates might be employed in specific services ( Green Book). Similar financial regimes will exist in other countries.
When we look at the applicability of DCF in public service organisations, we see several different applications:
• Some public service organisations such as service providers may find it necessary to appraise potential capital investments in a manner similar to the above. They would need to set the capital costs of a new project and the associated running costs against the income likely to be generated from the project. An example might be a new piece of medical equipment which would attract additional patients and hence additional funds.
• In another public service organisation, the generation of additional revenues may not be the main reason for capital investment. However, DCF may still be relevant in the situation where a public service organisation decides to in- vest large sums in computerised energy management systems. DCF can show the present value of energy savings made against the capital costs involved.
• In many public service organisations, the costs of a capital investment will need to be set against the service benefits that the investment will bring.
This will be discussed further in the section on cost– benefit analysis, but it will suffice to say that DCF can be of relevance by being a technique which reduces all of the cash flows associated with projects to a single figure ( an NPV) which simplifies the decision- making process.
Technical aspects of DCF
Within the public sector, guidance is usually available on the appraisal of cap- ital investments in public services. Typically, such guidance might discuss the following points:
• Timescales of appraisals – the cash flows from projects usually will have a fairly limited life and thus any financial appraisal would probably not cover a period greater than 25 years. However, the economic benefits will flow for a much greater period and thus the economic appraisal may cover a much longer time period – possibly up to a hundred years.
• Discount rate – a s already noted, in public services the discounting calcu- lation should be undertaken using the discount rate set out under finance ministry guidance for public sector investments.
• Inflation – the valuation of costs or benefits should be expressed in “ real terms” or “ constant prices” ( i.e. at “ today’s” general price level), as opposed to “ nominal terms” or “ current prices”. If thought necessary and material, the effect of expected future inflation in the general price level should be removed by deflating future cash flows using the relevant deflator. Leaving aside general inflation perhaps of more relevance is specific price inflation where particular
prices are expected to increase at significantly higher or lower rate than gen- eral inflation. In these cases, this relative price change should be calculated.
Some examples where relative price changes may be material to an appraisal include high- technology products, prices which may be expected to fall in real terms and fuel prices, where the resource supply is scarce.
• Risk and uncertainty – issues of risk and uncertainty in public services management are discussed in detail in Chapter 12. However, the basic dis- tinction between the terms is that risk exists where there is a probability, based on past experience, that can be attached to an event. Uncertainty is where there is no such probability available. In investment appraisals, there is always likely to be some difference between what is expected, and what eventually happens because of biases, risks and uncertainties. Two issues need to be looked at critically:
• Inherent bias – there is a demonstrated, systematic, tendency for project appraisers to be overly optimistic. This is a worldwide phenomenon that affects both the private and public sectors. Adjusting for such optimism should provide a better estimate, earlier on, of key project parameters.
Such adjustments for optimism may be reduced as more reliable estimates of relevant costs are built up, and project- specific risk work is undertaken.
• Rigour – in assessing uncertainty, an expected value is a useful starting point for understanding the impact of risk and uncertainty between dif- ferent options. But however well these are identified and analysed, the fu- ture is inherently uncertain. So, it is also essential to consider how future risks and uncertainties can affect the choice between options. Sensitivity analysis is fundamental to appraisal. It is used to test the vulnerability of options to unavoidable future risks and uncertainties. Therefore, the need for sensitivity analysis should always be considered and, in practice, dispensed with only in exceptional cases. Scenarios should be chosen to draw attention to the major technical, economic and political risks and uncertainties upon which the success of a proposal depends.
As a consequence of the above phenomena, risk management strategies should be adopted for the appraisal process. Appraisers should calculate an expected value of all risks for each option, and consider how exposed each option is to future uncertainty. Before and during implementation, steps should be taken to prevent and mitigate both risks and uncertainties.
It is vitally important to be transparent about the potential impact of risks and bias on proposals. Relating back to the behavioural aspects of man- agement accounting in Chapter 6, this is an area where risks and uncer- tainties can be underestimated in an attempt to get a project approved.