Investment Management Conclusion

This Summary includes notes from 13 summaries related to Investment Management.

1. Martin, J. 1983. Management accounting: A powerful method of influencing
behavior. Cost and Management (December): 4-9.
On page 7 of this article I summarized an old, but still unresolved capital budgeting
issue as follows:
"Conflict between DCF and AC models. When performance evaluation for capital
budgeting projects is based on the accrual accounting (AC) model (i.e., ROI and RI),
managers may be reluctant to use the conceptually correct discounted cash flow
(DCF) models (i.e., net present value (NPV) and internal rate of return (IRR)) for
choosing projects. The first years ROI based on accrual accounting or tax
depreciation methods (i.e., straight line, sum-of-the-years digits, declining balance, or
the accelerated cost recovery system) will normally be well below the internal rate of
return (IRR) expected, even when actual cash flows match predictions.
The remedy is to use net book value based on compound interest depreciation as the
denominator in the ROI calculation. Then the ROI used to evaluate actual
performance will agree with the IRR expected, as long as actual cash flows match
predictions. This approach provides the correct behavioral signals to management by
eliminating the inconsistency between the DCF decision model and the AC
performance evaluation model. An alternative approach involves restating DCF
predicted results in an accrual accounting format so that subsequent performance can
be evaluated with the AC model." (End of article note.)
An example illustrates the idea.
This method is also referred to as the annuity method of depreciation.

Depreciation for year i = Cash flow for year i - (IRR)(book value at the start of year
i).
Where i ranges from 1 to the number of years in the life of the investment.
Cost of Project $7,132 Two year life, Annual net cash inflow $4,000.
IRR = 8% (See table below).
Present Value Analysis
Year Cash Flow
Discount Factor
(8% Cost of Capital)
Discounted Cash Flow
0 $(7,132) 1.000 $(7,132.00)
1 4,000 .9259 3,703.60
2 4,000 .8573 3,429.20
NPV

$0
Interest Return Year 1 = ($7,132)(.08) = $571.00
Depreciation Year 1 = $4,000 - 571 = $3,429.00
Interest Return Year 2 = ($7,132 - 3,429)(.08) = $296.24
Depreciation Year 2 = $4,000 - 296.24 = $3,703.76
Comparison of Compound Interest depreciation with Straight line and Sum-of-the-
years-digits. Assume actual cash flows are equal to expected cash flows.

Compound Interest Straight Line Sum-of-years-digits
Year 1 2 1 2 1 2
Actual net cash
inflow
$4,000 $4,000 $4,000 $4,000 $4,000 $4,000
Depreciation 3,429 3,704 3,566 3,566 4,755 2,377
Net income $571 $296 $434 $434 $(755) $1,623
ROI* 8% 8% 6% 12% -11% 68%
* Net Income
Net Book value:
571/7132 296/3704 434/7132 434/3566 (755)/7132 1623/237
Now assume actual cash flows are not equal to expected cash flows. Under the
compound interest method, a net cash inflow in a given year that is different from the
expected amount will cause the ROI to be different from the estimated IRR. For
example, suppose the net cash inflow for year 2 above is $3,900. The ROI drops to
5.3% as illustrated below.

Compound Interest Method
Year 1 2
Actual net cash inflow $4,000 $3,900
Depreciation 3,429 3,704
Net income $571 $196
ROI* 8% 5.3%
* Net Income Net Book value 571/7132 196/370
Why the Compound Interest Method is not used.
1. Hard to understand and not consistent with external reporting.
2. The depreciation charge increases over the life of the asset. This seems to violate
the
matching concept.
3. There is a possibility of negative depreciation in some years.
2. Howell, R. A. and S. R. Soucy. 1987. Capital investment in the new
manufacturing environment. Management Accounting (November). (Summary).
When investing in automation, managers need to understand and perhaps redesign and
simplify the manufacturing process before new investments are considered.
Whats new in terms of the investment environment?
According to Howell & Soucy, new investments in automation
1. Are more risky, i.e., involve more uncertainty.
2. Require large cash outlays.
3. Require longer periods to implement.
4. Require larger engineering and software costs.
5. Involve more complexity.
6. Cash returns are received over a longer time period including longer
periods of negative cash flows.
7. Involve benefits that are more indirect and intangible, e.g., come in the form of
improved quality, delivery, throughput, flexibility, customer satisfaction as well
as cost reductions.
They argue that the discounted cash flow model is still appropriate, but the inputs
used in the analysis need to be reconsidered. They also discuss different levels of
investments from robots to flexible manufacturing systems
to Greenfield factories and suggest that the criteria needed to justify investments at
each level is different.
Some recommendations for investment analyst:
1. Should not exclude or excessively discount the terminal value of an investment.
2. Should not use incorrect or artificially high discount rates.
3. Should use the moving baseline concept.
4. Conduct post investment audits. Audit the cash flows and other benefits
and explain reasons for differences in expected and actual results.
5. Management accountants should not rely exclusively on existing cost
systems to justify investments. Must consider other benefits beyond the
financial information.
The moving baseline concept : Dont evaluate the investment against the status quo.
Instead, analyze the investment against what is likely to happen to the companys
competitive position and cash flows if the investment is not made. They illustrate this
with Figures 3 and 4 in the paper.
3. Sinason, D.H. 1991. A dynamic model for present value capital expenditure
analysis. J ournal of Cost Management 5 (Spring): 40-45. (Summary).
Sinason argues that the old capital budgeting model is static and that a new dynamic
moving baseline model is needed that incorporates the non-investment forecast. The
analysis includes estimating the effects of such things as: 1) how the competition
might react and potential decreases in market share, 2) increased maintenance costs
for the existing investment, 3) increased inventory costs, e.g., resulting from existing
longer cycle time for the old equipment or process, 4) losses resulting from not
improving quality, e.g., scrap, spoilage, rework and customer dissatisfaction that
could be avoided if the new investments were implemented. He provides two
examples to illustrate the moving baseline approach that are similar to the example
provided by Howell and Soucy.
(Sinason's Moving Baseline examples).
4. From Engwall, R. L. 1989. CIM/JIT investment justification. J ournal of Cost
Management, 3 (Fall): 35-39.
Engwall includes a discussion of many of the points mentioned in the Howell/Soucy
paper above, but adds a discussion of how benefits, risks and effects change for
different levels of investment. I summarized these ideas in the exhibit below and filled
in the two middle rows based on the implications of his discussion.
Investment
Level
Purpose Benefits Risk Effects
Impact on
organization
Time
perspective
1. Stand
alone -
Robots
Replacement Tangible Small Local Minimum Short term
2. Cells -
FMC
Change Tangible Large Local Larger Longer
3. Linked
islands
- FMS*
Change Mixed Larger System Substantial Longer
4. Full
integration
- CIM*
Change Intangible
Very
large
System
wide
Very
Extensive
Long term
* FMS refers to flexible manufacturing systems. CIM refers to computer integrated
manufacturing.
Note: The MADM is also mentioned in this paper. See the discussion from the CAM-I
conceptual design below.
5. Shields M. O. and S. M. Young. 1991. Managing product life cycle costs: An
organizational model. J ournal of Cost Management (Fall): 39-51. (Summary).
Strategies for implementing Cost Management Systems (CMS)
1. Revolutionary - All parts of the company are changed simultaneously.
2. Evolutionary - One part of the company is changed at a time.
3. Green Field - A pilot company is started based on the new model.
6. McNair, C. J., W. Mosconi and T. Norris. 1988. Meeting the Technology
Challenge: Cost Accounting I n A J I T Environment. (Chapter 10) Montvale. NJ:
National Association of Accountants.
In a section of this chapter labeled "Capital Assets and Project Justification" they
begin with the following quote from a 1986 paper by Dilts and Russell. "A lot of
management uses a capital budgeting model like a drunk uses a lamppost - for
support, rather than illumination."
They discuss several problems with traditional capital budgeting models:
1. The qualitative long-term benefits of many advanced manufacturing
techniques, such as quality and responsiveness are not included in the model.
2. Management intuition is not included in the model in a formal manner.
3. The model focuses only on the quantifiable benefits of a project.
4. Opportunity costs are excluded from the model.
5. The discounted cash flow (DCF) model is typically used to rationalize
investment decisions that have already been made.
6. Investments in JIT, FMS and CIM represent investments that impact the
companys strategy and culture and cannot be rationalized by DCF techniques.
7. Analytic techniques can be used to reduce uncertainty but in the end
management intuition makes or breaks an organization.
7. Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's
Advanced Manufacturing: The CAM-I Conceptual Design. (Chapter 7) Boston:
Harvard Business School Press.
Chapter 7 provides a discussion of three competitive investment strategies outlined in
the exhibit below. Technological risk is high for the proactive technological leaders
while market share risk is low. Market share risk is high for reactive firms that wait
until the technology shows clear profit potential before entering the market. However,
technological risk is low for the reactive firm. Responsive firms have a more balanced
set of risks.
THREE COMPETITIVE INVESTMENT STRATEGIES
Three Competitive Investment Strategies
Strategy How to Implement Type of Risk
Proactive To become a
technological leader a
company needs to
develop and use the
leading edge
Technological risk is high. The
company may invest in technology that
fails to provide the expected
advantage. However, the potential
profitability is high.
technology.
Responsive Invest after the
technology has been
proven but not widely
used.
Technological risk is lower, but still
present. Market share risk, i.e., risk of
losing market share to the
technological leader is also present and
varies with the response time.
Potential profitability is lower than for
the technological leader.
Reactive Wait and buy the
technology when it is
available "off the
shelf".
Market share risk is high, but
technological risk is very low.
Potential profitability is lower than for
proactive and responsive firms.
The Multiple Attribute Decision Model
Chapter 7 also includes a method of analyzing investments referred to as the Multiple
Attribute Decision Model (MADM). The approach is outlined below. See theEngwall
1988 summary for more on the MADM approach to investment analysis.
1. Define the critical factors:
Financial quantitative - e.g., NPV, ROI, operating margin, level of investment,
level of savings.
Non-financial quantitative - e.g., throughput time, process yield, schedule
attainment, lead time.Qualitative - e.g., the process, basic R&D, technological and
product obsolescence.

2. Weight the critical factors. Must sum to 100%.

3. Assign a value to prioritize the critical factors from most important to least
important.

4. Assign a risk level.

5. Calculate a value = (Weight)(Value)(Risk).
The highest value is the best project.
For a somewhat similar approach to investment analysis see the Lyons, Gumbus &
Bellhouse summary.
8. and 9. Hayes & Wheelwright 1979 HBR articles:
Hayes, R. H. and S. C. Wheelwright. 1979. Link manufacturing process and product
life cycles. Harvard Business Review (January-February): 133-140. (Summary).
Hayes, R. H. and S. C. Wheelwright. 1979. The dynamics of process-product life
cycles. Harvard Business Review (March-April): 127-136. (Summary).
Hayes and Wheelwright provide a broader discussion of competitive strategy using
what they refer to as a product-process matrix. The following illustration provides a
graphic view of investment alternatives.

In the second article, Hayes and Wheelwright build on the product-process matrix and
provide a discussion of strategy choices that are similar to the discussion in Chapter 7
of the CAM-I conceptual design. Firms in cell A (See below) fit into the CAM-I
proactive technological leader category, but leave the market early to pursue more
innovations. Firms in the B cell are also technological leaders, but stay in the market
throughout the product's life cycle. Firms in cell C are either responsive or reactive
depending on how long they wait to enter the market. Firms in cell A would have high
technological risk, but low market share risk. Firms in the B cell would have less
technological risk, but perhaps higher market share risk if they don't continue to be
innovative. Firms in cell C have lower technological risk, but higher market share
risk.

10. Engwall, R. L. 1989. Need for change. J ournal of Cost Management 3
(Summer): 51-54.
Engwall argues that making the right investment decisions requires:
1. A change in the corporate culture.
2. A change in the organizational structure.
3. A change in human resource management.
4. An integrated approach to investment analysis including people, technology and
product
and process quality issues.
5. Elimination of the short-term investment mentality.
People at all levels need to be involved in the decision making process. Engwall
recommends an idea he refers to as "sociointegration" which represents a blending of
social and technical systems where the organization becomes horizontal (flat) rather
than a hierarchical (vertical top down). The idea includes a consensus-team building,
bottom up approach.
11. Hayes, R.H., S.C. Wheelwright and K. B. Clark. 1988. Dynamic
Manufacturing. (Chapter 3) New York: The Free Press.
These authors discuss several problems with the capital budgeting model.
Problems of Implementation:
1. Managers assume that the base case is the status quo. This causes a disinvestment
spiral (i.e., deferred investments), that causes reduced profitability and reduces the
incentive to invest. This status quo assumption also implies that an investment can be
delayed with no penalty other than that contained in the discount rate. (This relates to
the moving baseline idea discussed by Howell/Soucy and Sinason.)
2. Managers fail to incorporate non-financial, or non-quantifiable considerations that
biases decisions against investments that impact the quality and reliability of the
companys products, delivery speed and the time required to introduce new products.
3. Using hurdle rates (i.e., discount rates) that are too high, i.e., hurdle rates that are
well above the companys long term cost of capital even after adjustments for risks.
Problems of the Underlying Theory:
1. The capital budgeting model is based on a project by project analysis, i.e., it does
not recognize and incorporate the interdependencies between investment projects.
Taken to its logical extreme, one should combine a new investment with all previous
and future investments. There are many interdependencies between investments in
JIT, CAD, FMS and CIM. The full advantages of such a series of investments only
materialize when all are in place. DCF project by project analyses imply that none of
the investments are justifiable. (Evaluating all investment projects as a whole is
the portfolio concept.)
2. Projects with different lifetimes are difficult to compare using the DCF model.
Decisions should be based on the long term strategic impact on the health and vigor of
the firm.
3. The DCF model ignores the differences between pure R&D experimental study
type investments and less uncertain equipment replacements. R&D projects may
create a high degree of learning in an organization that creates new options for the
future. Many such investments resemble the ante in poker. A player does not expect
any return from the ante since it only allows one to stay in the game.
Problems Associated with Human Behavior:
1. The assumptions of DCF techniques are not understood by many who should be
involved in the decisions. But failure to include lower level people may hide
important implementation and coordination issues.
2. The DCF model creates a bias towards large projects. But the secret to building a
world class company often lies in making many small investments over a long period
of time.
Recommendations:
1. Analyze how a capital investment might create a competitive advantage, i.e., how it
affects the companys products and capabilities and how it will affect the companys
commercial and technical capabilities.
2. Compare these expected effects with competitors capabilities.
3. Examine how the investment fits with the strategic directions of the company and
major functional areas. Investments should be viewed as part of a sequence of
investments and opportunities that take the company down a particular strategic path.
12. Martin, J. R. 1994. A controversial issues approach to enhance management
accounting education. J ournal of Accounting Education. (Winter).(Summary).
Critics argue that the DCF model ignores the synergistic linked benefits of
investments that must be considered as a portfolio to achieve an integrated strategy.
For example, a company may decide to pursue a proactive strategy in some areas in
which the company competes, (i.e., attempt to become a technological leader), a
responsive strategy in other areas (i.e., invest after the technology has been proven),
and a reactive strategy in the remaining areas (i.e., buy technology off the shelf). By
analyzing investments on an individual basis, an integrated strategy cannot be
achieved. Another criticism is that the traditional capital budgeting approach is static
in the sense that operating and competitive conditions are assumed to remain constant
regardless of the investment decision. What is needed is a dynamic moving baseline
approach that incorporates the effects of not investing into the analysis. For example,
if a company chooses not to invest in a computer integrated manufacturing system,
what will be the effect on the company's competitive position in terms of quality,
reliability, flexibility, customer responsiveness and market share? Intangible factors
are frequently more important than the identifiable cash flows.
Arguments for the defense of traditional capital budgeting are based on the idea that
the technique is valid if it is used correctly. The approach is not based on the
assumption that intangible, non-quantifiable factors should be ignored in the
investment process. The traditional capital budgeting approach includes the
recommendation that all important factors should be considered in the investment
decision including quantitative financial, quantitative non-financial and also
qualitative factors. Companies that only consider quantitative financial data are
simply misusing the technique. In addition, advocates of the portfolio idea seem to
ignore the fact that investment analysis is not costless. Taken to the extreme, an
investment proposal would have to be considered in terms of the interdependencies
between all current, all past, and all future investments. There is clearly a practical
limit to the number of investment projects that can be evaluated simultaneously. The
portfolio approach is perhaps sound in theory, but not feasible in practice.
13. Effect of Front End Investments on the PLC - Adapted from Chapter 7 of the
CAM-I Conceptual Design, Figure 7.2

References
Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced
Manufacturing: The CAMI Conceptual Design. Boston: Harvard Business School
Press. (Summary).
Engwall, R. L. 1989. Investment justification issues. Journal of Cost
Management (Spring): 50-53. (Summary).
Engwall, R. L. 1989. Need for change. Journal of Cost Management (Summer): 51-
54.
Hayes, R. H. and S. C. Wheelwright. 1979. Link manufacturing process and product
life cycles. Harvard Business Review (January-February): 133-140. (Summary).
Hayes, R. H. and S. C. Wheelwright. 1979. The dynamics of process-product life
cycles. Harvard Business Review (March-April): 127-136. (Summary).
Hayes, R. H., S. C. Wheelwright and K. B. Clark. 1988. Dynamic Manufacturing:
Creating the Learning Organization. New York: The Free Press.
Howell, R. A. and S. R. Soucy. 1987. Capital investment in the new manufacturing
environment. Management Accounting (November): 26-32. (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. 1983. Management Accounting: A powerful method of influencing
behavior. Cost And Management (November-December): 4-9 and in French 10-15.
Martin, J. R. 1994. A controversial issues approach to enhance management
accounting education. Journal of Accounting Education (Winter): 59-75. (Summary).
McNair, C. J., W. Mosconi and T. Norris. 1988. Meeting The Technology Challenge:
Cost Accounting In A JIT Environment. Montvale, NJ: National Association of
Accountants.
Shields M. D. and S. M. Young. 1991. Managing product life cycle costs: An
organizational model. Journal of Cost Management (Fall): 39-51. (Summary).
Sinason, D.H. 1991. A dynamic model for present value capital expenditure
analysis. Journal of Cost Management (Spring): 40-45. (Summary).


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