A CASE STUDY OF

MANAGEMENT
ACCOUNTING IN
NESTLE
An Pham
1318758
AAF001-6 FIANACIAL
ANALYSIS
ASSESSMENT 2
 Contents 1

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
 Executive summary 2

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 company’s
issues.
 Background 3

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
 Background 4

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.
 Overview of management accounting 5

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.
 An analysis of the organisation 6

5 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 Nestlé’s 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
 An analysis of the organisation 7

only. Calculations of different scenarios and example of how to apply relevant costs to practice
is demonstrated in appendix 1.

Nestlé’s 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 Nestlé should pay attention to, or
otherwise, it will affect the profitability by losing opportunities to charge more or giving Nestlé’s
competitor’s 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:
 An analysis of the organisation 8

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.
 An analysis of the organisation 9

5.2.3 Discounted payback

Actual Cash Inflow

Discounted 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

𝐴𝑅𝑅 = 100
Capital employed

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 NPV
𝐼𝑅𝑅 = Positive rate + ( ∗ 𝑟𝑎𝑛𝑔𝑒 𝑜𝑓 𝑟𝑎𝑔𝑒𝑠)
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.
 Strengths and weakness 10

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 Nestlé’s management accounting system.
In reality, the company is facing much more complicated situation which requires more
techniques to deal with each scenario.
 Conclusion 11

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.
 References 12

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_filt
er: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].
 Appendix 13

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
 Appendix 14

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 Relevant
costs to costs to
manufacture 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 15000 VND
overhead
Selling and 6000 VND
administration
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
 Appendix 15

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
Drop A
yoghurt on
yoghurt
manufacturing

£ 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.
 Appendix 16

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:

Net cash Cumulative

Year ent cash
flow
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:

33
Payback= 4 years + 35 ∗ 12 𝑚𝑜𝑛𝑡ℎ𝑠
 Appendix 17

= 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:

1
Discounted factor =
(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:

Net cash Discounted Present

Year
flow factor 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:
20.92
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑝𝑎𝑦𝑏𝑎𝑐𝑘 = 5 years + ∗ 12 𝑚𝑜𝑛𝑡ℎ𝑠 = 5 𝑦𝑒𝑎𝑟𝑠 8 𝑚𝑜𝑛𝑡ℎ𝑠
31.51
 Appendix 18

The discounted payback of Nestlé’s 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
𝑇ℎ𝑒 𝑎𝑛𝑢𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡𝑠 = = 45.71 (Million pound)
7

45.71
𝑇ℎ𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = ∗ 100 = 50.23%
91

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:

Net cash Discounted

Year Present value
flow factors

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
 Appendix 19

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

51.44
𝐼𝑅𝑅 = 8% + (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.