Nestle Case Study Adopted

AAF001-6 FIANACIAL

ANALYSIS

ASSESSMENT 2

A CASE STUDY OF MANAGEMENT ACCOUNTING IN NESTLE

An Pham 1318758

1 Contents

1 Contents

1 Contents ........................................................................................................................ 1

2 Executive summary ........................................................................................................ 2

3 Background .................................................................................................................... 3

3.1 Company ................................................................................................................ 3

3.2 Challenges, strategy and policy .............................................................................. 3

4 Overview of management accounting ........................................................................... 5

5 An analysis of the organisation ...................................................................................... 6

5.1 Define relevant costs .............................................................................................. 6

5.2 Decision on capital investment ................................................................................ 7

5.2.1 Payback ........................................................................................................... 8

5.2.2 Net present value (NPV) .................................................................................. 8

5.2.3 Discounted payback......................................................................................... 9

5.2.4 Accounting rate of return (ARR) ....................................................................... 9

5.2.5 Internal rate of return (IRR) .............................................................................. 9

6 Strengths and weakness .............................................................................................. 10

7 Conclusion ................................................................................................................... 11

8 References .................................................................................................................. 12

9 Appendix ...................................................................................................................... 13

9.1 Appendix 1: Relevant costs ................................................................................... 13

9.1.1 Scenario 1: Upgrading the machine system in host countries ........................ 13

9.1.2 Scenario 2: Research a new flavour for a new Nestle drink in Vietnam .......... 13

9.1.3 Scenario 3: Make or buy decision .................................................................. 14

9.1.4 Scenario 4: Keep or retain a product .............................................................. 14

9.2 Appendix 2: Capital decision making .................................................................... 16

9.2.1 Payback method: ........................................................................................... 16

9.2.2 Net present value ........................................................................................... 17

9.2.3 Discounted payback....................................................................................... 17

9.2.4 Accounting rate of return (ARR) ..................................................................... 18

9.2.5 Internal rate of return (IRR) ............................................................................ 18

2 Executive summary

2 Executive summary

This report demonstrates how management accounting is applied in practice and company

Nestle is chosen to demonstrate management accounting techniques. Relevant costs and

capital making decision are discussed with examples. Moreover, information about Nestle is

introduced to illustrate how management accounting can help Nestle to solve the companys

issues.

3 Background

3 Background

3.1 Company

Nestle is one of the top raking food and beverage multinational companies in the world.

Founded in 1866, the company operates in a variety of products, including foods, beverage,

healthcare, nutrition and pet products (Nestle, 2014). Nestle has its headquarter in

Switzerland, but it sells products over America, Europe and Asia and Africa market. Recruiting

more than 333 000 employees and generating over 92 billion of sales in 2013, Nestle is one

of the leading consumer good companies besides Coca Cola, Pepsi, Kraft and Unilever NV

(Forbes, 2014).

3.2 Challenges, strategy and policy

Nestle still has major challenges in the food and beverage industry, including its intensive

investment in researches, local diversification and healthy strategy as wells as the pressure

of cutting price from competitors and economic recession. These lead to an increasing

concern on how management accounting can help the company to cut the costs of products

and what the decision should be made in terms of investment but still give the company a

healthy growth.

On one hand, Nestle has challenges from its competitors, such as Coca Cola, Wall Mart and

other key supermarkets in each country from the food industry. Nestle has to develop better

strategies distinguish itself from its competitors. Moreover, Nestle is a multinational company

and is following the diversification strategy which means the company develops its products

to tailor to the tastes and flavours of the country it is operating in. Thus, these require more

investment in researches, but the company has to find a way to cut costs and make their

product price more competitive, or otherwise it will result in the increase of liabilities and risk

of bad loans.

Furthermore, cutting costs is another concern of Nestle while it has to face with the increasing

power of private own label which are cheap and quite reliable (MaketLine, 2014). Inflation

rates and world economic downturn also effect Nestle price products. Consequently, these

will put pressure on Nestle to cut price but still have to produce good products. However, a

4 Background

cost analysis and a management system of how to deal with these changes have to be

developed.

On the other hand, due to the strong competition of competitors, such as Coca and Pepsi,

Nestle has found the niche of the coffee market and introducing it as a core competitive range

products to its own portfolio (Economiest, 2012). Nestle has been buying local companies

and buying cheap material from developing countries, such as China, India and Vietnam

(Young, 2013; Askew, 2014). This leads to the need of large financial support, project of

relevant risks and how to manage the costs.

5 Overview of management accounting

4 Overview of management accounting

Management accounting is a part of accounting which helps companies in evaluating its

operating activities and set future goals (Dyson, 2004). According to (CIMA, 2005),

management accounting is the use of financial management to provide information which help

companies to have better decision making in planning and controlling to maximise profit for

the stakeholders of the companies.

The main function of management accounting includes planning, control, cost accounting,

decision making, financial management and auditing (Dyson, 2004). Compared with financial

accounting, management accounting more focus on decision making about what will happen

in the future rather than a record of transitions of what happened in the past which is the core

difference between management accounting and financial accounting. Furthermore,

management accounting does not have legal requirement and its approach is more flexible.

Management accounting can help a company to set a short term or a long term planning,

budgets and judgement on capital investment based on the information provided by financial

accounting. It also helps to conduct a risk and sensitivity analysis and help to balance the

effects of internal and external factors. However, management accounting cannot replace the

function of financial accounting and cannot be audited. Neither can it give an accurate

prediction of future performance (Sahaf, 2009). Methods of management accounting include

techniques to define costs, including relevant costs, cost-volume-profit and full costing.

Techniques of budgeting and making capital investment are also included.

6 An analysis of the organisation


There are two techniques provided to solve the challenges of Nestle when applying

management accounting. Relevant costing is introduced to solve the issues in a short term

and the capital decision making technique is used to deal with long term issues which are

described below.

5.1 Define relevant costs

According to Weygandt et al. (2010) identifying the relevant costs of the project is important

in management accounting because it helps in decision making of buying or selling products.

Moreover, fixed assets such as equipment in the manufacturing process need to be

determined whether it is relevant or not and whether it needs to be bought if it is used for only

one purpose only. Hence, it adds up to the costs of projects of the company is carrying on.

Nestle as described above is intensively carrying on many projects to tailor its products to the

host countries in which company is selling products. Due to the rigorous competition of its

competitors and the pressure of cutting costs, relevant costs in management accounting are

important in Nestls decision making and consider what costs should be included and using

that to calculate the profit.

Moreover, relevant costs can be a useful tool for short term planning. It can be used as a

handy tool for make or buy decision, outsourcing and whether they should make special sales

on specific products. Furthermore, Nestle as manufacture needs to consider the costs when

order materials to conduct profit analysis. The relevant costing technique can help Nestle to

cut costs by making right decision, such as a decision on whether they should keep or stop

producing products. It also helps them to manage their capacity and resources more

effectively.

In order to do that, a clear list of relevant and irrelevant costs needs to be set up. Attention

should be paid to distinguish relevant costs and irrelevant costs, such as sunk, common and

committed costs. For instance, modifying Nestle products to suit to consumers tastes is an

expensive process and it requires more researches. Hence, it increases the costs of R&D.

However, the costs of researchers could not be relevant costs if Nestle already recruited its

researchers, and they are doing other researches for different purposes. Materials and the

expense for labours could be relevant costs if Nestle had to recruit more staff for one project


only. Calculations of different scenarios and example of how to apply relevant costs to practice

is demonstrated in appendix 1.

Nestls relevant costs can be distorted by common costs and irrelevant costs. These things

will affect the final price, possible discounts for consumers and reduce the product line if it is

needed. However, timing issue is another aspect that Nestl should pay attention to, or

otherwise, it will affect the profitability by losing opportunities to charge more or giving Nestls

competitors advantages. These include seasonal opportunities, such as Christmas or New

Year celebration, a sudden increase or decrease in demand and the commitment to the supply

chain.

After analysing the relevant costs, Nestle can find out the contribution and judge the benefits.

If the contribution is marginal and the risks of the research project are high, Nestle can

consider taking the project out or keeping it.

5.2 Decision on capital investment

Being a multinational company also means that Nestle has to invest heavily in building

relationship with its distribution channels in the host markets, but it also keeps an eye on the

supply chain. As a manufacture, Nestle has recently bought material and has been planning

on extending its assets in developing countries, such as building plants and machinery and

recruiting more staff in India and China. Capital investment decision plays an important role in

the future of the company. Management accounting is needed to evaluate the short term and

long term risks and helps to control and measure possible effects of its extending in capital

investment.

To make a capital investment judgement, firstly, it is important to evaluate the finance needed

(Agar, 2005). In this case, Nestle should not overestimate the value of the assets. Risks should

be considered, especially with timing issues or when the money is under evaluated. The

increase in inflation rates and its possible influences on cash flow should be put into concern.

Secondly, what kinds of fund can finance the project is another thing that Nestle should pay

attention to. Finally, the shareholder and debt provider also care about the return profit of the

company and risks associated when it comes to affect them. In order to measure the

investment plan and to use it as indicators for risk associated, methods of evaluating are

included in the figure 1 below:


Figure 1: Indicators for capital investment decision. Source: Dyson (2004)

The calculations of how Nestle can use these techniques to make an investment decision are

described in Appendix 2

5.2.1 Payback

Although it is a simple method to calculate the amount of time needed to pay back the

investment costs, the disadvantages of them should be considered whether it could outweigh

the advantages, for example timing concerns is one of the major problems.

5.2.2 Net present value (NPV)

By including cash flow in the formula, this technique is more accurate to calculate the

profitability of the project in the future. Time value is considered, but the downside is that it is

difficult to measure accurately the interest rates and cash flow for each year.


5.2.3 Discounted payback

Discounted Cash Inflow = Actual Cash Inflow

(1 + i)n

By considering the present value of cash flow, discounted payback is used to measure the

amount of time needed for investors to take back their investment. However, its accuracy

depends on how accurate the discount rate and the actual cash inflow are.

5.2.4 Accounting rate of return (ARR)

=Average annual net profit before interest and tax

Capital employed100

This technique is used to calculate how many percentage of profit will be brought back after

the investment was invested. Because the formulation includes net profit, some errors could

occur due to not take or take depreciation into account and timing issues.

5.2.5 Internal rate of return (IRR)

= Positive rate + (Positive NPV

Positive NPV + Negative NPV )

This technique is used to measure the desirability of an investment; the higher IRR means the

better profit it could get. Liquidity and time value are concerned; however, mutually exclusive

projects are not recommended to use (Dyson, 2004).

These techniques above have their own advantages and disadvantages. However, when

Nestle considers about the long term benefits, what types of loans or funds that Nestle uses

to finance its projects need to be considered. Moreover, the accuracy of these estimated profit

and cash flow should be paid attention because this could affect the whole project and the

decision to invest in a project.

10 Strengths and weakness

6 Strengths and weakness

By focusing the two main issues that Nestle wants to improve, including cutting costs and

investing capital, this report considered ways of how Nestle can use management accounting

to enhance the efficiency of its process. The demonstration is clearly stated in each method

by using practical examples in appendix.

However, due to the limitation of Nestle information accessing, the figures and numbers

illustrated in Appendix are estimated, and it could be unrealistic. As a result, detailed

information to provide risk assessment for the company might not be enough. Sources of

finance and associated risks of each method are not discussed thoroughly. The techniques

provided are simple compared to the current level of Nestls management accounting system.

In reality, the company is facing much more complicated situation which requires more

techniques to deal with each scenario.

11 Conclusion

7 Conclusion

In order to solve the current issues of Nestle, two management accounting techniques are

introduced. However, caution should be paid attention when considering about the associated

advantages and disadvantages of each method.

12 References

8 References

Agar, C.F. (2005) Capital Investment & Financing: a practical guide to financial evaluation. Butterworth-Heinemann.

Askew, J. (2014) The rise of Vietnam: Interview: Nestle expects to accelerate Vietnam

growth. Just-food, 12th June. Available from: http://www.just-food.com/interview/nestle-expects-to-accelerate-vietnam-growth_id127038.aspx [Accessed 24/12/2014].

Cima (2005) CIMA official terminology 2005. Oxford: Elsevier.

Dyson, J.R. (2004) Accounting for non-accounting students. Harlow :Prentice Hall Financial

Times

6th ed.

Economiest (2012) Food for thought. Economist, 15th Dec. Available from:

http://www.economist.com/news/special-report/21568064-food-companies-play-ambivalent-part-fight-against-flab-food-thought?zid=293&ah=e50f636873b42369614615ba3c16df4a [Accessed 24/12/2014].

Forbes (2014) The world's biggest public companies. Forbes, May. Available from:

http://www.forbes.com/global2000/list/#page:1_sort:0_direction:asc_search:nestle_filter:All%20industries_filter:All%20countries_filter:All%20states [Accessed 24/12/2014].

Maketline (2014) Company profile: Nestle S.A. Market Line

Nestle (2014) Nestle Good Food, Good life. Nestle. Available from:

http://www.nestle.co.uk/aboutus/history [Accessed 24/12/2014].

Sahaf, M.A. (2009) Management Accounting: Principles & Practice. Dehil: Vikas Publishing

House Pvt Ltds.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E. (2010) Managerial Accounting: Tools for

Business Decision Making. Johm Wiley & Sons.

Young, D. (2013) Nestle grows China coffee investment. South China Morning Post, 8th

April. Available from: http://www.scmp.com/business/companies/article/1209822/nestle-grows-china-coffee-investment [Accessed 24/12/2014].

13 Appendix

9 Appendix

9.1 Appendix 1: Relevant costs

Example of different Nestle scenarios and how to calculate the relevant costs are described

above

9.1.1 Scenario 1: Upgrading the machine system in host

countries

Nestle wants to import new machine which is used to package and label products to replace

an old machine in China. The new machine can improve the efficiency of working and take

less labour. The Nestle administrators in China want to calculate the relevant costs and see

whether the company could save money and increase the efficiency of the manufacturing

products when purchasing the new machine and selling the old one. List of relevant costs

are listed below and irrelevant costs are also included to avoid confuse:

Relevant costs:

Direct material:

o Plastic

o Stickers

o Film

o Foils

o Boxes or Cartons

o Adhesive Tapes

Direct labour: costs/per hour

Variable overhead:

o Oil

o Electricity

Interests rates when borrowing money to buy new machine

Shipping costs

Costs of new machine

Irrelevant costs:

Book value of old machine

Salary to pay the administrators

Renting fee for the building

The administrators can use these information to measure and see the benefits or drawbacks

if they replace the old machine with the new one.

9.1.2 Scenario 2: Research a new flavour for a new

Nestle drink in Vietnam

The director of Nestle in Vietnam wants to introduce a new coffee flavour in Vietnam due to

a lot of complains from their customers. Customers said that the current flavour is rather

14 Appendix

strange and bitter than the coffee drink they normally drink. The research and development

department is in charged for this responsibility. However, before they just have the

equipment to research on food and healthcare, if they want to research on a new favour for

coffee they have to buy new equipment and software. And there is no guarantee that the firm

will develop further new flavour in the future. The director wants to consider the costs to

carry on that project and wonder whether it might bring benefits to the company. The

relevant costs in this case include:

Testing machine (Test on drink)

Software designed for testing drink

Material: coffee, flavourings and preservatives

Interest rates if they have to borrow money to buy new equipment

Shipping costs

9.1.3 Scenario 3: Make or buy decision

Relevant costs is useful for Nestle to consider the better scenario when choosing two

options between producing internally and outsourcing externally. For example, if Nestle has

17000 units of instant coffee want to sell in Vietnam (the currency is Vietnam Dong (VND)).

They received an offer by another manufacture with a really good price. Below is the

calculation between two options:

Relevant costs to manufacture

Relevant costs to purchase

Selling price per unit 40000 VND 40000 VND

Cost per unit

Coffee 2000 VND

Flavouring 500 VND

Packaging 500 VND

Dried milk 200 VND

Flour 100 VND

Direct labour 5000 VND

Manufacturing overhead

15000 VND

Selling and administration

6000 VND

29300 VND 32000 VND

Contribution per unit 10700 VND 8000 VND

Table 1: Contribution costs between two options

As we can see from the table 1, the option to produce internally bring more profit than the

second options. Hence, the Nestle use relevant costs to judge which option brings more

benefits.

9.1.4 Scenario 4: Keep or retain a product

Because Nestle has a diverse product range, from food to healthcare and the company

operates in many countries, they need to consider the possibility of a product bringing more

15 Appendix

profit in the case of producing more or stopping manufacturing. The solution for that is to

calculate the contribution margin of a product using relevant techniques and compare the

differences between keep it or drop it options. The below example is a calculation of a Nestle

A yoghurt product which is 700000 units to show whether the product should be kept or

retained:

Keep A yoghurt on manufacturing

Drop A yoghurt

thousand thousand

Sales 700 0

Variable expenses (*)

Total direct labour 120 0

Total variable manufacturing expense 240 0

Shipping costs 15 0

Total variable expenses 375 0

Contribution margin 325 0

Fixed expenses (**)

Overhead 85 85

Salary of managers 100 100

Depreciation 30 30

Advertising 200 200

Storage rent space 45 45

Administrative expense 20 20

Total fixed expenses 480 480

Net operating loss -155 -480

Note:

(*) The variable expense is calculated by multiplying cost per unit with 700000 units

(**) The fixed expenses are not relevant costs and it is not included in the contribution

margin. However, the fixed expense is used to calculate the total fixed expense and net

operating loss

In this this case, keeping the product results in a loss of 155,000 in contribution margin.

However, after deducting fixed expense which the firm has to pay regardless of keeping or

stopping producing A yoghurt, the company will receive more loss if they drop A yoghurts

than they can receive in in the case they retain the product. Hence, relevant costing

techniques helps the firm make decision in retaining or dropping a product.

16 Appendix

9.2 Appendix 2: Capital decision making

Nestle is considering to invest 91 million to manufacture nutrition and health care products

in Egypt. If it will be in operating soon, it might takes years for the company to payback the

investment costs. To calculate the payback period, investment costs and estimated cash

flow are demonstrated in the table below:

million million

Cost of investment 91

Expected net cash flow

Year 1 8

2 10

3 15

4 25

5 35

6 50

7 70 213

Net return 122

9.2.1 Payback method:

Year Net cash flow

Cumulative ent cash flow

million million

0 -91

1 8 -83

2 10 -73

3 15 -58

4 25 -33

5 35 2

6 50 52

7 70 122

Cumulative net cash flow are presented in the table above in order to calculate the payback

time. As it can been seen on the table, in year 4 the total cash flow received is 58 million.

33 million pound is needed to equal the original costs of investment. Hence, payback

period calculated are shown below:

Payback= 4 years +33

35 12

17 Appendix

= 4 years 9 months

9.2.2 Net present value

Nestle decides to estimate the interest rates for the next 7 months is 8%. Hence the

discounted factors and net present value are calculated using:

Discounted factor = 1

(1 + 0.08)n

Then the net present value = future value * discounted factor

N is the amount of time the project estimates to endure. Therefore, we have the net present

value calculated which is shown in the table below:

Year Net cash flow

Discounted factor

Present value

million million

0

1 8 0.926 7.41

2 10 0.857 8.57

3 15 0.794 11.91

4 25 0.735 18.38

5 35 0.681 23.82

6 50 0.630 31.51

7 70 0.583 40.84

Total present value 142.4372

Less the investment costs 91

Net present value 51.43725

The net present value of the cash flow after 7 years is around 51 million which is lower than

the future net value (122 million). This should be put into consideration when the investors

want to compare the profitability of this project.

9.2.3 Discounted payback

Based on the net present value we calculated above, the discounted payback is calculated:

= 5 years +20.92

31.51 12 = 5 8

18 Appendix

The discounted payback of Nestls project is longer than payback that we calculated above.

Hence, this should be put into consideration when Nestle make the decision whether they

should invest or not.

9.2.4 Accounting rate of return (ARR)

The estimated profit before interest and taxation for Nestle project in Egypt is presented

below:

Project life 7 years

million million

Cost of investment 91

Expected profit before interest and tax

Year 1 20

2 25

3 32

4 47

5 51

6 62

7 83

Total 320

=320

7= 45.71 (Million pound)

=45.71

91 100 = 50.23%

9.2.5 Internal rate of return (IRR)

8% and 20% are selected to calculate the IRR. The net present value when using two

discounted factors are described below:

Year Net cash flow

Discounted factors

Present value

8% 20%

million million million

1 8 0.926 0.83333 7.41 6.67

2 10 0.857 0.69444 8.57 6.94

3 15 0.794 0.5787 11.91 8.68

4 25 0.735 0.48225 18.38 12.06

5 35 0.681 0.40188 23.82 14.07

19 Appendix

6 50 0.630 0.3349 31.51 16.74

7 70 0.583 0.27908 40.84 19.54

Total present values 142.44 84.69

Initial cost 91.00 91.00

Net present value 51.44 -6.31

= 8% + (51.44

51.44+6.31 (20% 8%)) = 10.6%

As we can see, 10.6% is the rate of growth that Nestle expects to generate. It also means

that it will be profitable if Nestle does not require rate of return higher than 10.6%. The rate

of return is also useful to compare how profitable it is between the two projects. The project

has higher internal rate of return is more preferable.

Nestle Case Study Adopted

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