The “Monthly Average“ method might be the currently prevailing method to conduct “Investment Plan Evaluation”, Budgeting and CashBudgeting, but that doesn’t mean that it is trouble free.
Let’s not stand a lot on the fact that thru this method, Interest during a month can only be either Income or Expense, but not both. For me, the most important thing to notice is that we create a simulation in which everything is assumed to happen on the first day of each month, from that day on nothing happens, and so there is a constant daily Bank account balance, on which to calculate Interest. Anyone can see that this has no connection to reality.
The biggest consequence of that is that thru the “Monthly Average method”, a collection that takes place on May 5th has the same impact with another one that takes place on May 15th, or May 25th, because they are all herded under the title of “Collections of May”. The problem can be summarized under the title of “Time Value of Money”, or in other words, the ability of money to create new money (a.k.a. Interest). The more time that money spends in the Bank account, the more money (Interest) it creates.
Ironically enough, the recipe that was meant to cure that problem was the “Net Present Value” method. Even though that specific problem is actually taken care of in a satisfactory way (but only in “Bond Based scenarios” – never in “Company based scenarios”), as we have previously seen, new problems of greater importance were created by the solution. This is a case where the medicine creates new and more lethal problems than the sickness that it cures.
Another consequence of the “Monthly Average method” is that any subsequent “What if” scenario can only be examined in time increments of whole months. For example: a scenario where days of credit to the customer (from sales) from 30 days become 60 or 90, it has meaning. If the change is from 30 days to 40 or 45 or 50, then that cannot be calculated.
So we see that by using a method that is a step back to NPV in the evolution of Financial Analysis calculation methods, the Accounting & Finance professionals are conducting “Investment Plan Evaluation”, Budgeting and CashBudgeting, in a manner less problematic, but one that still leaves a lot to be desired.
Stick around, and we are going to see the problems in the “Internal Rate of Return” method, which in reality is just a variation on the theme of the “Net Present Value” method.
