Unit 8: Tax Planning for Managerial Decisions-II - Subjective Questions

Meaning: A make-or-buy decision determines whether a business should produce a product, component, or service internally or acquire it from an external supplier.

Important factors:

• Relevant costs: Compare avoidable production costs with the supplier's purchase price. Fixed costs that will continue under both alternatives should generally be ignored.
• Variable costs: Consider direct materials, direct labour, variable overhead, and other costs that change with the decision.
• Avoidable fixed costs: Include fixed costs that can be eliminated if production is discontinued.
• Opportunity cost: If internal facilities can be used for another profitable purpose, the lost contribution from that alternative is a relevant cost of making.
• Quality and reliability: Examine the supplier's quality standards, delivery record, and ability to meet specifications.
• Capacity availability: Determine whether the company has sufficient production capacity and whether buying would release capacity for a more profitable use.
• Strategic considerations: Consider confidentiality, dependence on suppliers, long-term contracts, employee impact, and continuity of supply.

The decision should be based on relevant financial costs together with qualitative and strategic considerations.

The relevant cost approach compares the costs that will change under the two alternatives.

For the make alternative, relevant cost is generally:

For the buy alternative:

A company should buy when the supplier's price is lower than the relevant cost of making. It should make when the relevant cost of making is lower than the supplier's price.

The maximum acceptable purchase price is:

For example, if avoidable production costs are $80,000 and the released capacity can generate an opportunity contribution of $10,000, the maximum acceptable purchase cost is $90,000. Any supplier price below this amount is financially attractive, provided quality and supply conditions are satisfactory.

Relevant costs are future costs that differ between the make and buy alternatives. They influence the decision.

Examples include:

• Direct material costs that can be avoided by buying.
• Direct labour costs that can be eliminated or reassigned.
• Variable manufacturing overhead.
• Fixed costs that disappear when production is stopped.
• Opportunity cost of using production capacity for the component.

Irrelevant costs do not change between the alternatives and should not affect the decision.

Examples include:

• Historical or sunk costs already incurred.
• Depreciation that continues regardless of the decision.
• Allocated head-office overhead that cannot be avoided.
• Book value of existing machinery when it has no alternative use.

The distinction prevents management from being influenced by accounting allocations or past costs that cannot be changed. However, an apparently fixed cost becomes relevant if it can actually be avoided or if the related asset can be sold or used elsewhere.

The relevant cost of making is calculated as follows:

• Variable production cost: 12 = $120,000
• Avoidable fixed cost: $20,000
• Total relevant cost of making: $140,000

The cost of buying is:

Comparison:

Therefore, the company should buy the component from the supplier. The financial advantage of buying is $10,000, assuming that quality, delivery, and supplier reliability are acceptable.

Opportunity cost is the contribution lost when a scarce resource is used for one alternative instead of the next best alternative.

If the company has idle capacity, the opportunity cost of making a component may be zero. In that case, the decision is usually based on avoidable manufacturing costs compared with the purchase price.

If the company operates at full capacity, making the component may prevent it from producing another product. The contribution that could have been earned from the displaced product must be added to the cost of making.

The relevant cost of making is therefore:

For example, if making a component costs $50,000, but the capacity could instead generate a contribution of $15,000, the effective relevant cost of making is $65,000. Buying is preferable when the purchase price is below $65,000.

Thus, capacity utilization can change the decision even when production costs remain unchanged.

A repair-or-replace decision evaluates whether an existing machine or asset should continue to be used after repair or be replaced with a new asset.

Financial factors:

• Cost of repairing the existing asset.
• Purchase and installation cost of the new asset.
• Expected operating and maintenance costs under each alternative.
• Difference in productivity and output capacity.
• Disposal or salvage value of the existing asset.
• Tax effects of disposal, replacement, depreciation, and capital allowances.
• Expected useful life and residual value.
• Present value of future cash flows where the alternatives have different timing.

Non-financial factors:

• Reliability and downtime risk.
• Product quality and technological capability.
• Availability of spare parts and technical support.
• Safety and environmental compliance.
• Employee training requirements.
• Effect on customer service and production schedules.

Past costs and the book value of the old asset are generally irrelevant unless they create a tax consequence or disposal effect. The decision should compare future relevant cash flows.

The book value of an old machine represents an accounting amount based on its historical cost less accumulated depreciation. It is usually a sunk cost because it has already been incurred and cannot be changed by repairing or replacing the machine.

For decision-making, management should focus on:

• Future repair and operating costs.
• Cost of acquiring and operating the replacement.
• Disposal proceeds from the old machine.
• Tax consequences of disposal.
• Opportunity cost of continuing to use the existing asset.

The book value may become relevant indirectly when:

• Disposal creates a taxable gain or deductible loss.
• Tax depreciation or capital allowance depends on the asset's tax written-down value.
• The asset has an alternative use or can be sold for an amount that differs from its book value.

Even in these cases, the relevant amount is the future cash-flow effect, such as sale proceeds and tax impact, rather than the book value itself.

Cost of repairing and retaining the old machine:

Cost of replacing the machine:

The replacement alternative is cheaper by:

Therefore, the company should replace the machine, producing an estimated financial saving of $3,000 over the three-year period. The conclusion should also be reviewed for differences in capacity, quality, reliability, maintenance risk, and tax consequences.

Repair-or-replace normally concerns an individual asset, such as a machine, vehicle, or equipment unit. The issue is whether to restore the existing asset or acquire a new one.

Renew-or-renovate usually concerns a broader facility, property, production unit, or operating arrangement. The decision is whether to renew or reconstruct the existing facility or renovate and improve it.

Key differences include:

• Scope: Repair-or-replace focuses on an asset; renew-or-renovate often involves a facility or operating system.
• Investment size: Renovation or renewal generally requires larger and more complex capital expenditure.
• Time horizon: Facility decisions usually have a longer useful life.
• Operational disruption: Renovation may interrupt operations for a considerable period.
• Strategic impact: Renewal may introduce new technology, capacity, or a different production layout.
• Evaluation method: Both require comparison of future relevant cash flows, but renew-or-renovate decisions often require discounted cash-flow analysis, risk analysis, and consideration of long-term strategic benefits.

Both decisions should exclude sunk costs and include relevant disposal, tax, operating, and opportunity costs.

A renew-or-renovate decision should consider the following factors:

• Capital expenditure: Compare the cost of renewing the facility with the cost of renovation, including installation and professional fees.
• Future operating costs: Evaluate expected savings in energy, labour, maintenance, and production costs.
• Additional capacity: Determine whether either alternative increases output or removes production bottlenecks.
• Useful life: Compare the expected service life and residual value of each option.
• Downtime: Estimate lost contribution during construction, renovation, installation, and commissioning.
• Tax consequences: Consider capital allowances, depreciation effects, tax on disposal, and investment incentives.
• Technological suitability: Assess flexibility, automation, compatibility, and risk of obsolescence.
• Safety and compliance: Include environmental, health, building, and regulatory requirements.
• Location and infrastructure: Consider access to suppliers, labour, transport, utilities, and customers.
• Financing and risk: Examine interest costs, inflation, construction risk, and uncertainty in future benefits.

The alternatives should be assessed using incremental cash flows and, where the timing differs, discounted cash-flow techniques.

Discounted cash-flow analysis compares the present value of future incremental cash flows under each alternative.

The procedure is:

• Estimate the initial investment for renewal and renovation.
• Forecast annual operating savings or additional costs.
• Include changes in working capital and any temporary loss of contribution during implementation.
• Estimate disposal proceeds and terminal values.
• Include relevant tax effects and capital allowances.
• Select an appropriate discount rate reflecting the company's cost of capital and project risk.
• Calculate the net present value for each alternative.

The net present value is:

where is the incremental cash flow in period , is the discount rate, and is the initial investment.

The alternative with the higher positive NPV is financially preferable. Management should also consider non-financial issues such as disruption, safety, flexibility, and strategic fit.

The comparison should be based on the present value of the expected savings less the initial investment.

The four-year present value annuity factor at 10% is approximately .

Renovation:

Renewal:

On the assumptions provided, both alternatives have negative NPVs. Renovation has the higher NPV because is greater than . Therefore, renovation is financially preferable if the company must choose one of the two options.

However, management should verify the analysis by considering terminal values, different useful lives, downtime, maintenance risk, capacity, and strategic benefits.

A shut-down decision determines whether a business, department, product line, or plant should temporarily cease operations or continue operating during a period of low demand or losses.

In the short run, a company should continue operations when the contribution earned from operations is greater than the avoidable costs of continuing. It should shut down when shutting down reduces the loss.

The basic comparison is:

Equivalently, continue when:

A reported accounting loss does not automatically justify shutdown because some fixed costs may continue during shutdown. If fixed costs are unavoidable, continuing operations may help cover part of those costs.

The decision must also consider restart costs, loss of customers, employee retention, contractual penalties, asset deterioration, seasonal demand, and long-term strategic effects.

Short-run shut-down decision:

• Some fixed costs cannot be avoided immediately.
• The company should continue if revenue covers variable costs and any fixed costs that are avoidable by continuing.
• Contribution toward unavoidable fixed costs is beneficial.
• The analysis generally focuses on temporary suspension during weak demand.

Long-run shut-down decision:

• Most or all costs become avoidable over time.
• The company should continue only if total revenue is sufficient to cover total economic costs and provide an acceptable return.
• Long-term issues such as asset disposal, employee obligations, market position, and restart feasibility become important.

For the short run:

For the long run, management generally requires:

Thus, a temporary accounting loss may be acceptable in the short run, while a persistent inability to cover total relevant costs may justify permanent closure.

First, calculate the contribution:

The division's accounting result is:

Although the division reports a loss of $20,000, only $30,000 of fixed costs can be avoided by shutting down.

If the division continues, it contributes $60,000 toward fixed costs. If it shuts down, the company saves only $30,000 of fixed costs and loses the $60,000 contribution.

The effect of continuing compared with shutting down is:

Therefore, the division should continue operating, provided there are no significant qualitative disadvantages. Shutting down would increase the company's total loss by $30,000.

Contribution is sales revenue less variable costs. It represents the amount available to cover fixed costs and profit.

Avoidable fixed costs are fixed costs that disappear when operations are shut down, such as directly attributable supervision, rent under a cancellable lease, or certain maintenance costs.

Unavoidable fixed costs continue even after shutdown, such as head-office allocations, long-term lease commitments, insurance, or security costs.

The relevant comparison is:

• If contribution is greater than avoidable fixed costs, continue operations.
• If contribution is less than avoidable fixed costs, shut down temporarily may reduce the loss.
• Unavoidable fixed costs do not affect the basic short-run choice because they are incurred under both alternatives.

This approach ensures that management does not close a division merely because it reports an accounting loss caused by allocated or unavoidable fixed costs.

A purely financial analysis may suggest shutting down, but management may continue operations because of wider business considerations.

Important factors include:

• Customer relationships: Closure may cause customers to move permanently to competitors.
• Market presence: Continuing operations may protect market share and distribution channels.
• Employee retention: Shutdown may result in the loss of skilled employees who are difficult to recruit later.
• Restart costs: Reopening may involve recruitment, training, repairs, and regulatory approvals.
• Supplier relationships: Closure may damage access to scarce materials or favourable terms.
• Contractual obligations: Long-term customer or supplier contracts may create penalties.
• Seasonal demand: A temporary decline may be followed by predictable high demand.
• Reputation and social responsibility: Closure can affect brand image and local employment.
• Strategic capability: The operation may support other products, research, or distribution activities.

These factors should be quantified where possible and incorporated into the financial analysis as expected cash flows or risk adjustments.

Tax planning ensures that the decision is based on after-tax incremental cash flows rather than accounting costs alone.

Relevant tax considerations include:

• Tax deductibility: Repair expenditure may be deductible immediately, while replacement expenditure may be treated as capital expenditure.
• Capital allowances: A new asset may qualify for depreciation allowances or investment incentives.
• Disposal tax effects: Selling an old asset may create a taxable gain or deductible loss.
• Timing of deductions: The timing of tax relief affects present value.
• Indirect taxes: Recoverable or non-recoverable sales taxes, customs duties, and transaction taxes may affect cost.
• Financing effects: Interest deductions and tax treatment of leases may influence the replacement choice.

The relevant after-tax cash flow can be expressed as:

A decision that appears cheaper before tax may be less attractive after tax if it loses valuable allowances. Management should therefore compare the present value of after-tax cash flows for each alternative.

Tax considerations can materially change the relative attractiveness of renewal and renovation.

• Capital allowances: Renewal may qualify for larger or faster capital allowances than renovation.
• Revenue deductions: Certain renovation repairs may be deductible immediately if they preserve existing capacity rather than create a new asset.
• Disposal consequences: Disposal of the old facility may create a taxable gain, balancing charge, or deductible loss.
• Investment incentives: Governments may provide tax credits or accelerated allowances for energy-efficient or technologically advanced assets.
• Timing of tax relief: Earlier tax deductions increase the present value of tax savings.
• Indirect taxes: Transfer taxes, construction taxes, and recoverable input taxes should be included appropriately.
• Depreciation differences: Accounting depreciation itself is normally not a cash cost, but tax depreciation can create cash tax benefits.

The analysis should calculate after-tax cash flows for both alternatives and discount them at an appropriate rate. Tax benefits should be included only when the company can use them, for example, when sufficient taxable income exists.

The decision rule is based on the present value of future relevant cash flows.

For the repair alternative:

For the replacement alternative:

where:

• and are initial repair and replacement costs.
• and are future operating costs.
• and are terminal or disposal values.
• and are useful lives.
• is the relevant discount rate.

The alternative with the lower present value cost is preferable. If useful lives are unequal and the asset will be replaced repeatedly, management should use an equivalent annual cost:

This prevents a shorter-lived alternative from appearing cheaper merely because its analysis covers fewer years.