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Assignment 8 Data Block (Dollars in thousands of $) Development Costs Revenue without new software Revenue With new software COGS % Marketing & Sales Cloud Service Depreciation %. 3 year MACRS Tax rate 0 $1,000 1 2 3 $6,000 $6,000 30% $500 $150 33.33% 20% $6,400 $8,000 30% $750 $200 44.45% 20% $7,000 $10,000 30% $1,000 $300 14.81% 20% 7.41% Assignment 8: Income Statement General Phone Apps (GPA) is evaluating a proposal to internally develop a software capability that is intended to enhance their application (app) development process by automating testing and simplifying product conversion among different operating systems. Since it will be cloud based, it also will facilitate group development projects and enable employees to more easily work from different locations. This is not a product to be sold, but rather it will assist internal development of their app software, so it is depreciable. The development and conversion process is estimated to take one year in year 0, and cost $1,000,000. This investment includes all programming training, loading of existing products and testing the resulting conversion. An internal prototype has been completed that evaluated the feasibility and created a macro design of the proposed system (sunk costs). The estimated data for the proposal is shown below: Data Block (Dollars in thousands of $) Development Costs Revenue without new software Revenue With new software COGS % Marketing & Sales Cloud Service Depreciation %. 3 year MACRS Tax rate 0 $1,000 1 2 3 $6,000 $6,000 30% $500 $150 33.33% 20% $6,400 $8,000 30% $750 $200 44.45% 20% $7000 $10,000 30% $1,000 $300 14.81% 20% The above costs are only for the proposal and will not be incurred if the proposal is rejected. A three-year time horizon is to be used for the evaluation, although the software is expected to be used much longer. Threeyear MACRS depreciation has been chosen for the projects development and implementation cost. Note that the evaluation of the proposal is based on the difference that the proposal will make, since the goal is to evaluate the proposal. A similar situation is in discussion questions 8-6a and 8-6b. Submit a spreadsheet containing an Income Statement that shows the change in income resulting from this proposal. Use the standard Income statement format that includes totals for COGS, SG&A, EBIT and Net Earnings. No recommended decision is expected in this assignment as this requires a proposal cash flow statement that is next week's topic. CHAPTER 8: PROPOSAL COSTS AND INCOME STATEMENTS The previous chapter looked at criteria that senior management use to evaluate proposals. In these, the cash flow was given. In this and the upcoming chapters, a process to determine cash flows is presented. The terminology and concepts from chapter 5 are used for this with the major change being accounting statements that cover multiple future years. The following reviews and expands on the cost concepts from chapter 5. COST CATEGORIES Costs come in many flavors that are often handled differently. The first categories to be considered are expenses, costs and overhead. Expenses Items classified as expenses do not change when the volume of production or services change. Because of this, they are considered fixed costs. These refer to costs of facilities, marketing, and management expenses that are not affected in the short run by a change in quantity of production of services. They are items included in the Sales, General and Administrative (SG&A) category on the income statement. In proposals, expenses are considered as constant for a single time-period, normally a year. Costs Costs depend on the volume of production or services and include labor, materials, shipping, and any overhead that go with these. They are variously referred to as costs, costs-ofgoods-sold (COGS), or variable costs. These also can include sales costs if salespersons are paid on commission (volume sold). To determine if a cost is a variable cost, ask whether it is dependent on the quantity produced or sold. That is, would it be incurred if no production happened (workers laid off, etc.)? Overhead or Indirect Costs Overhead, that can be part of both expenses and/or costs, confuses this somewhat. Overhead, sometimes referred to as indirect costs, are the extra costs not included in the price of labor and material costs. For instance, any costs to procure and move production material are an indirect cost of the materials. If a part cost $15.00, the overhead (indirect costs) might be $5.00 making the material cost portion of the cost of goods sold = $20. Employee benefits or taxes based on the number of hours worked are indirect costs of labor. If production stops, these overhead costs stop. If production increases, these increase as well. SG&A expenses are overhead as well but they continue in the current year even if production decreases or increases, Overhead costs that are not depended on the quantity produced such as building repairs, office personnel. Marketing, etc. go into the Expense or SG&A category. A COG overhead is commonly stated as a percentage. If for a particular process, the overhead rate is 30%, and the direct cost of labor and materials in a unit of product is $20, the total cost of a unit of product is $20 plus the overhead of 30% of $20 ($6). Alternatively the computation is $20 * (1 + 30%) = $26. 1 Some organizations compute separate percentages for labor overhead and materials overhead that are updated annually. COGS = Material x (1 + Material Overhead %) + Labor x (1 + Labor overhead %) The activity based costing approach tries to allocate overhead cost items previously lumped together into separate variable cost items. Cost drivers are determined and used to allocate the overhead. For instance, the weight and size of a product can be used to assign lift truck (and operator) costs to a particular product. The goal is to avoid the misallocation of overhead and make the determined cost as accurate as possible. Sunk Cost Past costs are useful to evaluate what has been done, and to form estimates for the future. However, past costs should not be used to justify continuing down the same path. In this situation, they are considered \"sunk costs\" in that they have been spent and cannot be retrieved; they are history. Past costs include R & D expenses, past machine purchases, training, etc. The fact that an organization has spent a million dollars on a product, process or project does not justify continuing to spend $500,000 more if future benefits are only $400,000. A savings of $100,000 could be attained by not spending the $500,000. The original $1 million is sunk and irrelevant to the proposal to continue. The decision on future spending should be dependent only on future benefits. For instance, the decision on whether keep trying to get a software system working should not be dependent on how much you have spent to purchased it and in getting it to work. The only relevant consideration is how much it will take in the future to get it working versus starting over with another vendor's software. This is stated in the old adage, \"Don't throw good money after bad money\". The correct question is whether future benefits justify future costs. For projects that are on time, on schedule and on cost, this is easy to show because all the benefits remain. For projects running over cost and over schedule, new estimates are needed of future costs using the knowledge gained form past efforts. A way of deciding this is to ask the question, if I was starting anew with the knowledge that was gained from past efforts, what would the decision be? Opportunity Cost Opportunity costs are the benefits of alternatives that one has to forego to accept a proposal. Standard financial statements do not include opportunity costs as they reflect the future as opposed to real past data. They are included in proposals. Consider a building that could be rented for $50,000 annually instead of using it for a proposal. The $50,000 is an opportunity cost that should be included in the costs and or cash flow of the proposal. In other words, just because the building is owned and presently unused, it is not free if some other use could be made of it. Again, opportunity costs are not included in normal accounting statements, only in proposals. Marginal Costs and Revenues It is important to know whether the cost, revenue, or profit of the next unit of product or service that is sold will be the same as the previous one. If the profit per unit sold is $5 if 100 are sold or 5 cents per unit, if overtime or added investment are required to produce more than 100 units, the 5 cent cost will likely increase. 2 A similar question is whether the next dollar of investment will have the same effect as the previous dollar. If $100,000 were invested in a process last year and this directly resulted in an increase of revenues of $40,000, it is not assured that investing another $100,000 this year will produce another $40,000. For instance, the market may not be there, or costs may not be reduced as much by further investment. The marginal change in costs or revenues due to additional investment is typically not constant and often diminishes at some point. This goes under the label of diminishing marginal returns. Time Span or Horizon A financial proposal focuses on the future, and the number of years in the future has to be chosen. Usually a company policy will state this as conditional on the size of the investment. Small investments may have a time horizon of as little of one or two years. Three and five years are common lengths. However, large investments such as in new products, facilities, etc. may have time horizons as long as 10-20 years. Sometimes the time span is determined by the number of years that the IRS allows for depreciating an asset that is a topic discussed later in the chapter. A second factor in selecting a time horizon arises when mutually exclusive alternatives exist. To be accurately compared, all alternatives need to have the same time-span. This is usually accomplished by lengthening the shorter time span by repeating an acquisition to make it equal to the longer time span. If a proposal offers two mutually exclusive machines, one that will last ten years and the other five, the second one would be purchased a second time in year 6. Salvage values would normally be included as part of the replacement. FINANCIAL ANALYSIS OF PROPOSALS Formulating a financial proposal is composed of two parts. One is to construct an income statement that details the operational benefits for the years of the proposals time horizon. The second is to construct a cash flow statement that includes all required investments and non-operational benefits. Formulating these two parts is not always a sequential process. In reality, not only does the income statement provide information for the cash flow statement, but often insights from formulating the cash flow statement results in alterations to the income statement. For instance, investments entered in the cash flow statement affect depreciation in the income statement. The use of spreadsheets with linked cell addresses greatly facilitates this iterative process. This chapter will focus on the income statement. For proposals, it is a forecast of the future. Income statements detail the revenue and costs associated with producing and selling a product or service, and the resulting Net Income. PROPOSAL INCOME STATEMENTS The financial analysis of proposals starts with an income statement. Figure 8-1 is a generic income statement for proposals. This statement is for five years, but it can vary based on the time span used to evaluate proposals. Although the income statement was discussed in chapter 5, it will be reviewed here with added explanations of how each line item is used in proposals. Keep in mind that with proposals, the focus is on forecasted changes caused or enabled by a proposal. 3 All the subtotals shown in the generic income statement should be included if the proposal is approval from a CFO or other financial personnel is needed. That is, do not try to be creative or use personal preferences with financial statement design. Look at a company's financial statements and use similar terminology. Focus on the reader. Recall that income statements reflect income from operations or from the sale of a product or service. Therefore, income statements do not include any financial activities such as the purchase and sale of assets, or any financing transactions. They are recorded on the cash flow statement that we will discuss in chapter 9. Proposal financial statements only reflect the changes due to a proposal. Following is a description of each line item that summarizes the descriptions stated back in chapter 5 where accounting statements were introduced. These will be followed by a detailed example. Figure 8-1: Generic Format of a Proposal Income Statement Revenue Income statements start with revenue. Proposal income statements show revenue change attributed to the proposal. If a proposal will not affect revenues (only involves cost changes), revenue (changes) would be all zero. This can cause confusion because of all the negative gross margins, EBITs and net incomes. Therefore, it can be beneficial to temporarily insert a revenue number and then remove it when the income statement is completed. 4 The determination of the revenue requires a sales forecast over the time horizon of a proposal, typically of quantity sold and the price of each. Quantitatively, revenue is a simple multiplication of quantity time price for each year. The difficult part is the forecast is the sales quantity, and it is often the most unreliable part of a proposal. The quantity sold of a product or service is notoriously unreliable because it is dependent not only on the quantity produced, but also on customer's evaluations, comparison to competitive products and services, and the effectiveness of the marketing efforts. This, the quantity sold is not a decision of the company. The \"Four P's\" of marketing (price, product, promotion and placement) can affect this but the external market makes the ultimate decision of what to buy and how many. The sales forecasts sometimes can start with a test market and small investments, sometimes done before a financial proposal is completed. This enables more accurate forecasting of future sales. More information is always beneficial although waiting for better information may mean missing an opportunity and referred to as \"paralysis by analysis\". Cost of goods sold Costs to produce a product or service are detailed into labor, materials and overhead. COGS could be specified as a dollar amount or a percent of revenues. If the revenue change in a particular year is $1 million and COGS averages 60% of revenues, the COGS change would be $600,000. Thus for each year, the COGS dollar amount is calculated by multiplying the COGS percentage times the revenue in each year to get the COGS for the year. Cost accounting departments typically have detailed cost information that can be used for estimating future costs. Gross margin The variable costs to produce the products or serve the customers are subtracted from revenue to get the gross margin. Selling, General, and Administrative (SG&A) Next, the selling, general, and Administrative costs related to the proposal are deducted. These costs are not directly affected by the quantity that is sold. That is, they will be budgeted and spent within a particular year no matter what quantities of product are sold or customers served in that year. They include the cost of a sales force, marketing, administrative staff and expenses, research and development (R&D), human resource management, accounting, finance, etc. Depreciation expense The income statement attempts to report the profitability of an organization in a particular month, quarter, or year. Recording the total cost of a major investment in only one year when it is actually used for many years, would not accurately convey the profits in a particular year. Therefore, investments are pro-rated over the life of the investment in some manner (there are several). This is labeled depreciation. Depreciation is a cost category that reduces taxes and therefore increases earnings. Sometimes it is placed within the SG&A category and sometimes it is listed separately. Depreciation is a large topic and has a separate section below. It is defined within two volume of United States tax code and five-volumes of I.R.S. regulations. Depreciation and 5 income taxes are complicated by congressional action granting special exemptions, etc. If depreciation has a substantial effect on the cash flow of a proposal, tax accountants and lawyers should be fully involved. Earnings before interest and taxes (EBIT) Depreciation and SG&A are deducted from the gross margin to get the earnings before interest and taxes (EBIT). Interest Interest is not included in proposals because it is included in the MARR. Therefore, no line item for interest is included. Taxes Taxes are calculated by multiplying a tax percentage times the EBIT. The result can be taxes owed (debit) or a tax credit. Tax debits are deducted from EBIT to get Net Income. Tax credits result from a negative EBIT. These are found commonly in proposals where some years have negative net earnings. Proposals that involve only costs have tax credits in all years. It is assumed for proposal analyses that the company will have taxes due form activities other than the proposal and that proposal tax credits can be used to reduce these. Recall that proposals address only the changes due to the proposal. If a company is losing money overall, this assumption may not be valid. Only the CFO or tax department can inform you of the relevant tax rate. Taxes are levied by many governmental levels. There are federal, state, and sometimes local income taxes. Income earned in foreign countries is treated differently, which can affect company transfer of parts and services. In addition, there typically are property taxes as well. Some states award tax abatements to encourage companies to locate in their area. Sometimes there are tax incentives to invest such as federal investment tax credits and Section 179 deductions. Some companies have a policy that all proposals use a specified rate that is typically updated annually. In contrast to person taxes, the business tax laws let companies deduct most all costs. This includes materials, salaries and wages, rent, interest, advertising, depreciation, amortization, and taxes from other jurisdictions. In fact, all costs in the income statement are tax deductible since they reduce taxable income. Note that dividends to shareholders are not found on the income statement and are not deductible. There are tax brackets for corporate income just as there are for personal income. The marginal tax rate focuses on the last tax dollar paid. It is the tax rate of the bracket for the new income level. For example, a proposal may move a corporation to a different tax level from the $10-15 million level of 35% to the $15-$18.3 level of 38%. The 38% rate should be used in technology proposals. Again, the CFO and/or company policy has the final say on this. Most large corporations do not pay anywhere close to the top rates. Net Income The taxes are subtracted from EBIT to get the bottom line net earnings. If the EBIT is negative, taxes will be a positive tax credit. For instance, if in a year the EBIT is a negative $1,000 and the tax rate is 25%. The taxes are a positive $2500 and the net income is only a negative $750. Thus, the taxes increased the Net Income (reduced the loss) from -$1,000 to $750. 6 DEPRECIATION CALCULATION Depreciation can be confusing because the IRS regulations are extensive. Some investments are depreciable and some are not. Moreover, there are alternative methods for determining depreciation. It should be noted that depreciation is different from depletion. The latter is applicable to minerals, oil, gas, timber and other natural deposits. This may affect proposals but is not discussed here. Investments that are, or are not depreciable The internal revenue service rules concerning depreciable assets are numerous and beyond the scope of this book. Always check with a tax accountant when in doubt as there are many special considerations and interpretations. \"Only your tax accountant knows!\" The basics are as follows and even these are not always clear-cut. To be depreciable, a purchased asset must be something productive that is consumed (worn-out) or loses value over time. The asset must be acquired to produce a product or provide a service and be used more than one year. Machines, buildings and other productive assets are the most commonly depreciated items. Moreover, the cost of changes made to enable the use of new assets is also depreciable. Therefore, the value of the investment that is depreciated includes not only its purchase price, but also costs such as freight, site preparation, and installation. Money spent on employees such as training is not depreciable as it, at least technically, does not lose its value over time and employees take it with them when they leave a company. A building constructed for production purposes is depreciable, typically over a 20-year time span. However, the land on which the building is built is not depreciable, as it is not expected to \"wear out\" or revert to its original state. It is less clear as to whether changes made to land are deductible. Depreciation is normally allocated with the same time span as the asset that is being improved. However, the land that is being \"improved\" is not depreciable. The general rule is that improvements that permanently upgrade the land are not depreciable. Removing an existing facility normally would not be depreciable as the building is permanently gone. However, improvements necessary to use the land for new productive purposes are deductible. Therefore, a driveway leading to a new facility probably is depreciable, typically over a 15 year time span. IRS has a separate set of rules for items such as land used for agricultural purposes, and rental property that typically are depreciable. Investments made to upgrade or refurbish capabilities or prolong the investment's use also are depreciable. This does not include regular maintenance and training required to keep a process operational. Research and development (R & D) for new products are not depreciable as they are investments in a product, not an asset to provide a product or service. On the other hand, R & D expenses incurred to develop a new production process and put it into operation may be depreciable. Only two methods of calculating depreciation will be presented here. Some company's use straight-line for proposals as it is easily understandable. Others use \"Modified Accelerated Cost Recovery System\" (MACRS) as it is commonly used for tax purposes. Since taxes are an 7 important consideration in most companies, MACRS is probably the most commonly used. These two methods are discussed below. Other methods exist but are not commonly used. Straight-Line Depreciation Straight-line depreciation is quite straight forward as the investment cost is spread equally over the useful life. The depreciation is based on the investment cost minus the salvage value. Salvage value is the value of a resource that is received when it is sold or otherwise disposed. It is like a trade-in car. A salvage value can be positive or negative. Selling an asset would be a positive cash flow, and things like teardown or cleanup would result in a negative cash flow. The investment minus the salvage value is divided by the forecasted years of use. If a $1 million asset has a forecasted life of five years and the salvage value at its end of five years is $300,000, the annual depreciation is = ($1,000,000 - $300,000) / 5 = $140,000 annually. Alternatively, a depreciation percentage for each year can be calculated by dividing one hundred percent by the number of years. For instance, the percentage for a 10-year investment is 100% / 10 = 10% and then the depreciation in each year is 10% of the investment cost minus the salvage value. Or, the percentage for a 5-year investment is 100% / 5= 20% per year. Figure 8-4 illustrates this However, straight-line depreciation does not reflect the time value of money as the costs and revenues of later years are not the same value today. In addition, the salvage or resale value diminishes faster in earlier years. Anyone who has bought a new car has witnessed that the greatest decline in resale value occurs in the first year (or even first mile driven after purchasing). Additionally, tax laws are designed to encourage investment, and do this by allowing a greater proportion of the cost of the asset to be deducted earlier in an investment's lifespan. This leads to the MACRS depreciation method. Modified Accelerated Cost Recovery System (MACRS) Depreciation With MACRS, the early years have higher percentages than in later years, which is the \"acceleration\" in the name of this approach. MACRS depreciation is the most commonly used depreciation for an organization's accounting statements and therefore it is commonly used in proposals. The IRS requires MACRS for tax purposes although exceptions have been added to the tax laws. Extensive information on the MACRS depreciation can be found at the IRS website: http://www.irs.gov/publications/p946/ch04.html#en_US_2012_publink1000107509. This is extensive and regularly changes. For instance, congress passed a bill in the waning hours of 2014 that made it possible for corporations to accelerate the depreciation of assets even faster than MACRS. Only the financial manager will know exactly which IRS rules are relevant to a particular proposal. Many companies ignore everything but the basics in financial proposals. If this is followed in all proposals, comparisons among proposals are still accurate. An example of an IRS rule that will be ignored here is that the depreciation rates are different when an asset is sold before the end the depreciation cycle. That is, if an asset is sold or retired in less years than the depreciation cycle, only half of the depreciation in the assets' last year can be deducted. This is referred to as the \"half-year rule\" or \"50% rule.\" Again, such exceptions will not be considered here. The financial manager should be consulted to determine if any IRS exceptions to MACRS should be considered. 8 One part of the IRS website that is particularly relevant to proposals is the table of depreciation percentages that are used to calculate the depreciation for each year of an asset's life span. This is shown in figure 8-2. Figure 8-2: MACRS Straight-Line Depreciation Figure 8-3 contains the IRS rates for time-spans from 1 through 21. Note in this rate table that for a three-year depreciated asset there are four years of depreciation, for a five year depreciated asset, there are six years of depreciation and the same holds for other asset classes. The IRS looks at investments as having occurred at the midpoint of each year and that the first and last year percentages are for a half year. Therefore, in a five-year depreciation timeframe there are four full years (years two through five) and two half years (one and six) that sum to five years (and the depreciation percentages do sum to 100%). Figure 8-3: MACRS Depreciation Percentages 9 An associated table in the IRS regulations shows the appropriate time span to use for depreciating various types of assets. The years of each category determine the column used in the MACRS rates table. This is in figure 8-4. Figure 8-4: MACRS Depreciation Categories If a heavy use machine worth $1,000,000 and a salvage value of $250,000 in year 3 is to be depreciated over 3 years using MACRS, the calculations would be as follows. Year 1: 33.33% * $1,000,000 = $333,330 Year 2: 44.45% * $1,000,000 = $444.500 Year 3: 14.81% * $1,000,000 = $148,100 Year 4: 7.41% * $1,000,000 = $74,100 The percentages sum to 100% and the depreciations sum to $1,000,000. A video segment that reviews depreciation calculations can be found at Depreciation. Accounting for non-depreciable purchases Investments that cannot be depreciated are accounted for in at least two ways. In some cases, they are entered as an expense item in the Sales, General and Administrative section of an income statement. This is commonly done if they are small and reoccurring as this reduces income taxes. Small business can use the section 179 of the IRS code to include investments as expenses in certain cases. If non-depreciable investments are one-time expenses, they usually are recorded only in the cash flow statement to reflect that they are investments, not operating expenses. The cash flow statement for proposals is discussed in the next chapter. In general, tax accountants should be consulted for questionable areas and concerning company policies concerning depreciation. A technology manager should be spending his/her 10 time maintaining currency in their discipline, not tax accounting. The goal here is to provide sufficient knowledge to have a useful conversation with a tax accountant or tax lawyer. EXAMPLE: NATIONAL BOOK AND PERIODICAL SALES (NBPS) To illustrate the formulation an income statement, the following case will be used. National Book and Periodical Sales (NBPS) is considering a proposal to offer a proprietary electronic book reader. The preliminary plan was prepared by a consulting firm for $250,000 in 2012. The result of the study was a recommendation to get into the electronic book market by offering an electronic reader and books. Following are the estimates for this strategy. The needed investment will be made over two years. An investment of $2.4 million will be made initially to develop a prototype production facility for producing the electronic books and periodicals. The prototype is sufficient for the initial year of sales, and a second investment of $2.0 million will be needed in year 1 to expand this production capability. Both investments will be depreciated using MACRS over five years. The electric reader would be sold at cost to promote its adoption. Additional space will be needed for a production facility that is estimated at $100,000 annually over the life of the proposal. The cost to service/support the readers is a constant $250,000 annually. Training of staff throughout the organization will be needed initially at an estimated cost of $500,000. Note that such training is an investment but is not depreciable. It is forecasted that $10 million worth of electronic books will be sold in the first year and this will increase by 15% annually. The COGS for electronic books is forecast at 40% of revenues. The tax rates are 30% for income and 15% for capital gains. The above description can be converted to a data block as shown in figure 8-5. Data blocks help to define the precise meaning of the data and are especially useful when working in a group, as is common for proposals. In this data block, note how the costs are assigned to each year. The COGS $ are calculated by multiplying the COGS percentage of 40% times the revenue. The income statement can be composed with this data. 11 Figure 8-5: Data Block for National Book and Periodical Supply (NBPS) NBPS Income Statement: Initial The initial entries in the income statement are shown in figure 8-6. Revenue is calculated by entering the year-1 sales of $10 million and then entering equations for years 2-5 that increase this each year. (year 2 revenue = year 1 revenue * (1 + 15%) ). The COGS is determined by multiplying the resulting revenues by the 40%. If COGS are entered as negative, than the revenues are added to COGS to get the gross margin. The expenses in S.G. & A. are the space and customer service center and are constant for all years. Figure 8-6: Beginning Income Statement for NBPS A video segment that discusses the above parts of the NBPS income statement can be viewed at NBPS Introduction. NBPS Income Statement: Depreciation The use of a five-year MACRS depreciation for the NBPS case is shown in figure 8-7. The depreciation percentages are taken from figure 8-4 above and for each year, they are 12 multiplied times the two investment amounts. Since NBPS is using a five-year time horizon, only depreciation amounts for those years are calculated. Figure 8-7: MACRS 5-year Depreciation for $1 Million Investment The depreciation amounts then are posted to the NBPS proposal income statement in figure 8-8. Note particularly that no entries are recorded in year 0. The investment made in year one is spread over five years using depreciation. All other data items occur in the future starting in year 1. Figure 8-8: NBPS Income Statement with MACRS Depreciation Next, the income tax is determined by multiplying the tax rate times the EBIT for each year. The resulting proposal income statement for the NBPS case using a tax rate of 30% is shown in figure 8-9. The taxes are deducted from the EBIT to get the Net Income. Figure 8-9: Completed Proposal Income Statement for NBPS A video segment showing the calculations for depreciation and taxes can be viewed a: NBPS Depreciation. 13 Cannibalization Proposals evaluate only at the incremental change caused or enabled by a proposal. The changes due to the proposal can affect existing products and processes. A common situation is that a technology change results in a new product offering(s) that will cause the sales of present product(s) or model(s) of a product to decline. This is referred to as \"cannibalization\". The new product cannibalizes the sales of the existing product. This will be illustrated using the following revision of the NBPS case. Some employees at NBPS expressed a concern that the electronic book proposal did not include any consideration of potential loss in sales of the existing print business. To address this, the following data was collected. Printed book sales in the present year will be $100 million and are expected to decline by 5% a year starting in year 1. If the electronic reader is not implemented, sales are expected to be level for all five years so the decrease is a cumulative change due to the electronic reader. The data block in figure 8-10 has this new information appended to it. The sales of printed books in year-1 will be 8% less than the $100 million in year-0, so will be $100,000,000 * (1 - 8%) = $92,000,000. The year two sales will be $92,000,000 * (1 - 8%) = $84,640,000, and similarly for the remaining years. Figure 8-10: Cannibalization of Printed Book Sales However, this is the total sales and the proposal analysis needs the change in sales due to the electronic book proposal. Therefore, the difference has to be calculated. In year one, the reduction is $100,000,000 - $92,000,000 = $8,000,000. In year two the reduction is an additional $92,000,000 - $86,640,000 = $7,360,000 in sales. Therefore, in year 2 the total reduction is the year one reduction plus the year two reduction or $8,000,000 + $7,360,000 = $15,360,000. This can be computed more easily by subtracting a particular year's sales from the year 0 sales. For instance, year 2 is $100,000,000 -$84,640,000 = $15,360.000. The 14 remaining years are computed similarly and are shown in figure 8-12. The effect of the cannibalization of printed book sales is included in the income statement shown in figure 8-11. A line was added for lost revenue in printed book sales. In addition, a line \"net revenue\" was added to combine the revenue changes. The reduction in the printed book sales then leads to a reduction in COGS for the printed books not produced. Lines were added to include this. Particularly note that the COGS for the printed books are positive since production of books not produced reduces cost and a reduction in costs would be a positive value. Figure 8-11: NBPS Income Statement Including Cannibalization This completes the income statement for NBPS. A video that looks at the NBPS Cannibalization can be found at NBPS Cannibalization. Following are some additional topics that may affect income statements. PURCHASE VERSUS LEASE Leasing a machine means that the lessee does not own it. However, there are two types of leases; capital and operational. Equipment on a capital lease is recorded as though it is owned by the company, and it becomes the purchasing company's property at the end of the lease. It is essentially a \"rent-to-own situation and is recorded on the company's balance sheet throughout the lease. For an operational lease, the periodic costs are recorded as an expense in SG&A and they are not depreciable. LEARNING CURVES If you were new to Excel in this course, consider how long it took you to use the FV function the first time, and how long it takes now. This reduction in time is described as a learning curve. Costs normally decline over time due to added knowledge concerning product design, process design, and employee skills and knowledge. Military contracts often include a provision where production costs are expected to reduce by a given percentage based on the number of 15 units produced. A common approach to calculating this is to specify a percentage by which overall costs should diminish each time production quantities double. If a 70% learning curve is used and the first plane, ship, weapon etc. costs $1 million, then the second unit should cost 70% of this or $700,000 since production doubled from one to two. When production doubles from two to four, the cost should decrease again to be 70% of $700,000 or $490,000. That is the fourth unit would cost $490,000. At unit eight, the costs should be 70% of $490,000 or $343,000 each. This is illustrated in figure 8-12. Figure 8-12: Example of a Learning Curve Calculation The equation below can be used to determine the cost of a particular unit for a particular learning curve percentage. Cost/Time for nth unit = = First Unit * nth unit ^ (LOG(percentage) / LOG(2)) For the above 70% learning curve where the first unit cost $1 million, the 128 th unit would cost: = 1000000 * 128 ^ (LOG(70%) / LOG(2)) = $82,354.30 Using a 70% learning curve percentage with a product that took 122 hours to process the first unit, the 100th unit would be forecasted to take: = 122 * 100 ^ (LOG(90%) / LOG(2)) = 60.6 hours This cost forecasting approach is commonly used by the military in awarding contracts where new products and new production processes are involved. A video showing the learning curve calculations can be viewed at Learning Curves CONCLUDING COMMENTS All the data for proposals reflects the future so they are estimates or forecasts and determining these estimates can easily lead to the proverbial \"analysis paralysis\" where nothing gets done. There is a point where one has to say \"good enough!\" and move on. Reality changes so fast that a very good estimate today may be only average tomorrow. The 80/20 rule applies as 80% of the accuracy sometimes can be obtained with 20% of the effort that would be needed to get 100% accuracy. 16 Be aware that even though the numbers are all estimates (some very rough estimates), somewhere along the proposal approval process, an accountant will check every calculation to make sure that every addition, subtraction, etc. is perfect. Spreadsheets help with this, but are not foolproof. Another pair of eyes is usually needed. One needs to avoid being in front of an investment panel and have the accountant note errors. This could turn out to be the proverbial \"straw that broke the camel's back\". Sometimes you simply have to venture a guess for costs, but several sources are typically available for cost estimates. External sources are available such as trade groups or professional organizations that collect and publish this data. Standard costs are sometimes available externally, but also internally from a company's cost accounting department. Accountants have historical costs that often can be used or altered to fit. They also normally have established overhead rates for materials and labor. The upcoming chapter develops the cash flow needed for the evaluation criteria. 17 SOLVED PROBLEMS 1. J. Butler, LLC is considering the investment of $1,500,000 in a production facility expansion in 2012 that will be depreciated using five-year MACRS. The expectation is that this will enable sales to increase 25% annually starting with the $3,500,000 in 2013. Year 2014 will have sales 25% larger than 2013, 2015 will have sales 25% larger than 2014, etc. Without the improvements, sales will stay constant at $3,500,000 in all years. The product sells for $8.75 each and the variable cost per unit is $5.50. Both are expected to be constant for the coming years. The proposal will require a marketing and sales person to be added each year with the first addition in year 2013. (two total in 2014, three total in 2015, and four total in 2016). The cost of each added person including benefits are budgeted at $100,000 annually each. SG&A costs are expected to be an increase of $50,000 annually (constant at $50,000 for all years). Prepare an income statement for the proposed improvement for the years 2013-2016. Assume a tax rate of 20%. 2. Ronaldo Products, Inc. has developed a new \"luxury\" product that is expected to take sales away from the \"premium\" product. The luxury product will sell for $980 each and the premium line will sell for $699 each. The unit costs to produce each product are $615 for the luxury model and $526 for the premium model. Forecasted sales, unit sales price, and unit COGS for each product are shown in figure 8-13 for years 2014-16. Determine the gross margin for each year that would be used to evaluate the luxury model proposal. Figure 8-13: Sales Prices and Unit COGS for Ronaldo Products Inc. 3. Tesch Telescopes, Inc. is introducing a new robotic production process for polishing lenses for their telescopes. The cost for the first production lot of 100 lenses was 457 hours. If an 85% learning curve is followed, determine the total time to produce the first 1,000 lenses. 18 Solutions to Solved Problems Figure 8-14: Solution to Solved Problem 8-1 19 Figure 8-15: Solution to Solved Problem 8-2 20 Figure 8-16: Solution to Problem 8-3 21