Material Mix Variances

 

                                                                      Material Mix Variances

Material mix variance is a type of variance in cost accounting that measures the impact of using a different mix of materials than what was planned or expected. It is calculated by comparing the standard mix ratio of the materials to the actual mix ratio of the materials used in production, and then multiplying the difference by the standard cost of the materials.

 

The standard mix ratio represents the proportion of each material that should be used in a particular product or production process to achieve the desired quality and quantity. The actual mix ratio represents the proportion of each material that was actually used in production.

 

If the actual mix ratio differs from the standard mix ratio, this can result in a material mix variance. If the actual mix ratio uses more of the higher cost material than expected, this will result in an unfavorable variance. On the other hand, if the actual mix ratio uses more of the lower cost material than expected, this will result in a favorable variance.

 

Analyzing material mix variances can provide insight into factors that impact production costs, such as changes in raw material prices, production processes, or product design. This information can be used to identify opportunities for cost savings and process improvements.

 

Let's say a company produces 1,000 units of a product and uses two materials: Material A and Material B. The standard mix ratio for the materials is 60% Material A and 40% Material B. The standard quantity of Material A required per unit is 4 KG, and the standard cost per KG of Material A is INR  4. The standard quantity of Material B required per unit is 3 KG, and the standard cost per KG of Material B is INR 3.

 

The actual mix ratio for the materials used in production is 70% Material A and 30% Material B. The actual quantity of Material A used is 2,500 KG, and the actual quantity of Material B used is 1,000 KG.

 

Using this information, we can calculate the material mix variance as follows:

 

Actual Mix Proportion = 70% Material A and 30% Material B

Standard Mix Proportion = 60% Material A and 40% Material B

Difference = (70% - 60%) Material A + (30% - 40%) Material B = 10% Material A - 10% Material B

Standard Total Cost = (2,500 KG of Material A x INR4 per KG) + (1,000 KG of Material B x INR3 per KG) = INR 13,000

Material Mix Variance = (10%) x (INR 13,000) = INR 1,300 favorable variance

 

This means that the company used more of Material A than expected, resulting in a favorable variance of INR 1,300. The variance can be analyzed to determine the reasons for the change in the material mix, such as changes in supplier pricing or product design, and corrective actions can be taken to optimize the material mix and improve profitability.

Pre Money and Post Money

                                        "Pre-money" and "Post-money"

 

"Pre-money" and "post-money" are terms used to describe a company's valuation before and after an investment, respectively.

 

Pre-money valuation refers to the value of a company before any investment has been made. It includes all of the company's assets, liabilities, and intellectual property. For example, if a company is valued at INR10 million before an investment, that is its pre-money valuation.

 

Post-money valuation, on the other hand, refers to the value of the company after an investment has been made. It includes the pre-money valuation plus the amount of the investment. For example, if a company raises INR 2 million in investment and has a pre-money valuation of INR10 million, its post-money valuation would be INR 12 million.

 

Here's an example to help illustrate this concept:

 

Let's say a startup called XYZ is seeking INR 1 million in funding to help grow their business. An investor offers to invest INR 1 million in exchange for a 20% equity stake in the company.

 

Before the investment, XYZ is valued at INR 4 million. This is their pre-money valuation.

 

After the investment, the value of the company will be INR 5 million (INR 4 million pre-money + INR 1 million investment). This is their post-money valuation.

 

In this example, the investor's 20% equity stake is worth INR 1 million (20% of the post-money valuation of INR 5 million).

Standard Format of Cost Sheet for Charger Manufacturing Company

 The company can change it according to their circumstances 

Equity NPV

 

                                                                          Equity NPV

Equity NPV (Net Present Value) is a financial metric that represents the present value of the expected cash flows that will accrue to the equity owners of a business or project, after accounting for all relevant expenses and the cost of capital.

 

In other words, Equity NPV represents the difference between the present value of the expected cash inflows to the equity owners (such as dividends, capital gains or other distributions), and the present value of the cash outflows (such as investment costs, operating expenses, taxes, etc.) required to generate those cash inflows. The calculation of Equity NPV takes into account the time value of money, which means that future cash flows are discounted to reflect their current value.

 

The Equity NPV is a key metric used in capital budgeting and investment analysis to determine whether an investment or project will generate a positive return for the equity owners. If the Equity NPV is positive, the investment or project is expected to generate more cash inflows than outflows, and thus is deemed to be a good investment. Conversely, if the Equity NPV is negative, the investment or project is expected to generate less cash inflows than outflows, and thus is deemed to be a poor investment.

 

It's worth noting that Equity NPV is different from the traditional NPV, which represents the present value of the expected cash flows to all investors (including both equity and debt holders) of a business or project. The Equity NPV only considers the expected cash flows to equity owners, and is therefore a more focused metric that helps assess the return on equity investment.

 

Assume that a company is considering a new project that requires an investment of INR 10,00,000 upfront. The project is expected to generate cash inflows for equity shareholder of INR 2,00,000 per year for the next 5 years. The company's cost of capital (or required rate of return) for this type of investment is 10%.

 

To calculate the Equity NPV, we would follow these steps:

 

1.      Estimate the cash inflows: The expected cash inflows for each year are INR 2,00,000.

 

2.      Calculate the present value of each cash inflow: We would use the discounted cash flow (DCF) method to calculate the present value of each cash inflow, which takes into account the time value of money. Using a discount rate of 10%, the present value of the cash inflows for each year are as follows:

 

Year 1: INR 2,00,000 / (1+10%)^1 = INR 1,81,818

Year 2: INR 2,00,000 / (1+10%)^2 = INR 1,65,289

Year 3: INR 2,00,000 / (1+10%)^3 = INR 1,50,262

Year 4: INR 2,00,000 / (1+10%)^4 = INR 1,36,602

Year 5: INR 2,00,000 / (1+10%)^5 = INR 1,24,143

3.      Calculate the present value of all the cash inflows: We would add up the present value of all the cash inflows to get the total present value of expected cash inflows over the 5-year period:

Total PV of cash inflows = INR 1,81,818 + INR 1,65,289 + INR 1,50,262 + INR 1,36,602 + INR 1,24,143 = INR 7,58,114

 

4.      Subtract the initial investment: We would then subtract the initial investment of INR 10,00,000 from the total present value of expected cash inflows:

Equity NPV = Total PV of cash inflows - Initial investment

Equity NPV = INR 7,58,114 - INR 10,00,000

Equity NPV = -INR 2,41,886

 

In this example, the Equity NPV is negative, which means that the project is not expected to generate a positive return for the equity owners after accounting for all relevant expenses and the cost of capital.

The Multi-Period Excess Earnings Method (MPEEM)

 

                                The Multi-Period Excess Earnings Method (MPEEM)

The Multi-Period Excess Earnings Method (MPEEM) is a valuation approach used to estimate the fair value of intangible assets. It is a variation of the excess earnings method, which is used to determine the value of a business based on the expected future earnings that exceed a reasonable rate of return on the company's net tangible assets.

 

The MPEEM method involves estimating the cash flows that will be generated by the intangible asset over its useful life, and then calculating the present value of these cash flows. The cash flows are calculated by estimating the excess earnings that the intangible asset is expected to generate over and above a normal rate of return on tangible assets. This excess earnings are then projected over a number of periods into the future, using appropriate growth rates and discount rates.

 

To estimate the excess earnings, the MPEEM method involves a number of steps. First, the intangible asset's historical earnings are adjusted to remove any earnings attributable to tangible assets. This adjustment is made to reflect the fact that tangible assets have their own normal rate of return, which should be accounted for separately. Next, a reasonable rate of return on tangible assets is estimated, which is subtracted from the intangible asset's adjusted earnings to arrive at the excess earnings.

 

The excess earnings are then projected into the future, using a suitable growth rate, which takes into account the expected growth of the industry or market in which the intangible asset operates. Finally, the present value of the projected excess earnings is calculated, using a discount rate that reflects the risk associated with the intangible asset.

 

The MPEEM method is often used to value intangible assets such as patents, trademarks, customer relationships, and non-compete agreements. It is particularly useful when the intangible asset generates cash flows that are expected to be stable over a number of years. However, the MPEEM method does have some limitations, such as the need to make assumptions about future growth rates and discount rates, which can be difficult to estimate accurately.

 

 

Suppose a company owns a patent on a new technology that it expects to generate significant revenues over the next 10 years. The company wants to determine the fair value of the patent for accounting purposes. The MPEEM method could be used to value the patent as follows:

 

1. Estimate the excess earnings: The Company would begin by estimating the expected cash flows generated by the patent over the next 10 years. To calculate the excess earnings, the company would subtract a reasonable rate of return on tangible assets from the estimated cash flows. For example, if the company estimates that the patent will generate $1 million in cash flows each year over the next 10 years and the reasonable rate of return on tangible assets is 8%, the excess earnings would be $200,000 ($1 million - 8% x $12.5 million). Assuming $ 12.5 million total value of company’s tangible asset.

 

2. Project the excess earnings: The excess earnings would then be projected into the future, using a suitable growth rate. For example, if the company expects the industry to grow at a rate of 4% per year over the next 10 years, it might use a growth rate of 3% for the patent. The projected excess earnings over the next 10 years would be $2.3 million ($200,000 x (1.03)^10).

 

3. Calculate the present value of the excess earnings: The present value of the projected excess earnings would be calculated using a discount rate that reflects the risk associated with the patent. For example, if the company estimates that a suitable discount rate for the patent is 10%, the present value of the excess earnings over the next 10 years would be $1.5 million ($2.3 million / (1.10)^10).

 

4. Add the present value of the excess earnings to the value of tangible assets: Finally, the present value of the excess earnings would be added to the value of the company's tangible assets to arrive at the total value of the company. For example, if the company's tangible assets are worth $10 million, the total value of the company would be $11.5 million ($10 million + $1.5 million).

 

This is a simple example, and the actual calculations used in the MPEEM method can be much more complex depending on the specifics of the intangible asset and the company's circumstances. However, this example gives a general idea of how the MPEEM method can be used to value an intangible asset.

Treatment of tax amortization benefit in DCF method to calculate fair value of intangible asset

 

The tax amortization benefit is a factor that needs to be considered in the discounted cash flow (DCF) method for calculating the fair value of an intangible asset. In the DCF method, the cash flows generated by the intangible asset are projected over its useful life, and these cash flows are then discounted back to their present value using a discount rate that reflects the risk associated with the asset.

 

The tax amortization benefit arises from the tax deductions that a company can claim for the amortization of the intangible asset over its useful life. This benefit reduces the company's taxable income and therefore lowers its tax liability. The treatment of the tax amortization benefit in the DCF method depends on the assumptions that are made about the tax rate, the useful life of the intangible asset, and the timing and amount of the tax deductions.

 

One approach is to include the tax amortization benefit in the cash flows that are projected for the intangible asset, using the expected tax rate and the expected timing and amount of the tax deductions. This approach effectively adds the present value of the tax amortization benefit to the fair value of the intangible asset.

 

Alternatively, the tax amortization benefit can be reflected in the discount rate that is used in the DCF method. This approach assumes that the benefit is already incorporated into the cash flows, and adjusts the discount rate to reflect the tax savings that result from the amortization deductions. The adjustment to the discount rate depends on the expected tax rate, the useful life of the intangible asset, and the expected timing and amount of the tax deductions.

 

Overall, the treatment of the tax amortization benefit in the DCF method requires careful consideration of the assumptions that are made about the tax implications of the intangible asset, and the approach that is used should be appropriate for the specific circumstances of the asset and the company.