Intermediate accounting concepts and applications

Intermediate Accounting

If you were put in the place of Steve Gasper, would you argue for the cost from market testing to be included as a cash outflow?

Danforth & Donnalley is trying to decide whether or not to move forward with a new product called Blast and is correctly analyzing its expected cash outflow. However, although Rainey has included the initial cost for the test marketing of Blast in the Detroita area in his calculations, Steve Gasper ought to dispute this. The $500,000 for test marketing should be viewed as a sunk cost which has already been incurred prior to this current capital budgeting decision and cannot be recovered. Therefore, this sunk cost should not be a part of the new cash outflow calculatons as explained by the following discussion on capital budgeting.

Capital budgeting is a forward-looking process. As such, capital budgeting decisions to determine if a potential investment is worth pursuing should always be made based only on relevant cash flows associated with the project. So, the real question is whether the cost of test marketing is relevant to the capital budgeting decision. The answer is no because relevant cash flows are incremental cash flows on an after-tax basis. This means that these incremental cash flows will occur if an investment is undertaken, but won't occur if the investment isn't taken on. In this instance, Danforth & Donnalley has already incurred the test marketing expenses for Blast, so test marketing will remain as an expense regardless of the capital budgeting decision to accept or reject going through with the introduction of Blast.

One may be confused because the $500,000 cost of test marketing is expensive and seems to be ignored in the capital budgeting process. However, the issue is one of timing in this case. If test marketing was still under consideration, it should absolutely be part of the cash outflow calculation to determine the best capital budgeting decision. but, after the test marketing has been conducted, it has no impact on what should be done in the future. However, the sunk cost of test marketing still indirectly impacts the capital budgeting decision because it will lower future costs which are reflected by the outflow calculations. Thus, the cost isn't really being ignored; it's simply considered in a different way.

2. Would you suggest that the product be charged for the use of excess production facilities and building?

Is excess capacity really free? This is actually a very complicated question, particularly in the case of Danforth & Donnalley. At first glance, one could say that no incremental cash flows for capacity of Blast will be incurred since this product can use Lift-Off's excess capacity of 45%. The case states that these facilities are suitable for production of Blast and no new plant facilities would be required. Therefore, it would not be appropriate to allocate a portion of the book value of the plant to the Blast project. Given this simple scenario, Danforth & Donnalley would not incur incremental cash flows related to production facilities and building and, therefore, would not charge Blast for them. However, present and future opportunity costs must also be considered to make the right calculation.

In the present, Danforth & Donnalley needs to determine if Lift-Off's excess capacity is can be sold off or rented. Donnalley states that rental income potential is $2 million, but the company has a strict policy of not renting or leasing of any of its production facilities. Therefore, due to this current rental/lease restriction, present opportunity costs should not be allocated to Blast. Although Donnalley argues that the firm is likely to take on projects that would otherwise be rejected under normal circumstances if projects are not allocated charges for facilities, he is incorrect. The company would be incurring these costs anyway.

Next, Danforth & Donnalley should analyze future opportunity costs related to decision to take on Blast using the excess capacity of Lift-Off. The most obvious question is whether the firm will run out of capacity sooner than it would if had not taken on the Blast project. This is a very relevant question because if the company would run out of capacity more quickly by taking on Blast, one of two things could happen. New capacity would have to be bought or built when capacity runs out or production would have to be cut back on one of the product lines, leading to a loss in cash flows that would have been generated by the lost sales runs. Thus, Blast would result in incremental cash flows for facilities and these should be included in cash outflow calculations.

However, the case states that Blast will require only 10% of Lift-Off's plant capacity. Yet, Lift-Off has excess capacity of 45%. This indicates that Blast may not lead to the need to add capacity in the future. However, this is something that the Danforth & Donnalley executives should explore further with detailed market forecasts. The case states that Blast is very different from conventional powdered products and may well generate tremendous demand requiring more capacity in the 15 years of time considered.

In summary, even when considering present and future opportunity costs, Blast does not appear to lead to incremental cash flows for production facilities and the cost of the excess capacity should be considered free in this particular scenario.

3. Would you suggest that the cash flows resulting from erosion of sales from current laundry detergent products be included as a cash inflow? If there were chances of competition introducing a similar product if you do not introduce Blast, would this affect your answer?

Product cannibalization occurs when a new product introduced by a firm competes with and reduces sales of the firm's existing products. In this case, Blast is likely to cannibalize the sales of Lift-Off and Wave. Based on a strict capital budgeting interpretation, cash flows resulting from lost sales Lift-Off and Wave should not be included as a cash inflow because they are not incremental. In other words, if the project is not accepted, the cash flows will occur anyway.

However, the laundry detergent market is extraordinarily competitive and it seems prudent to assume that a competitor will introduce a product similar to Blast. Thus, the market erosion of Lift-Off and Wave is likely to happen regardless of whether Danforth & Donnalley move forward with Blast. Thus, if cash flows from sales erosion are not considered, this practice may result in the rejection of a project which would be acceptable to a competitor, resulting in the subsequent introduction of this product by competition. Hence, the sales erosion of the existing product lines may no longer be dependent upon the introduction of Blast. The firm now loses sales to a competitor rather than to itself.