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ACCA F5 PERFORMANCE MANAGEMENT REVISION PACK

2016

F5 Performance Management

2016
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Contents

Part A Specialist Cost and Management Accounting Techniques

3

1. Costing Techniques Recap

3

2. Activity Based Costing

5

3. Target Costing

8

4. Life Cycle Costing

10

5. Throughput Accounting

13

6. Environmental Accounting

20

Part B Decision Making Techniques

22

7. Cost Volume Profit (CVP) Analysis

22

8. Limiting Factor Analysis

31

9. Pricing Decisions

38

10. Short Term Decisions

48

11. Risk and Uncertainty

53

Part C Budgeting and Control

67

12. Budgetary Systems

67

13. Quantitative Analysis

72

14. Standard Costing

78

15. Variance Analysis

81

16. Planning and Operational Variances

99

17. Performance Analysis

102

Part D Performance Measurement and Control

105

18. Performance Management Information Systems

105

19. Sources of Management Information

108

20. Performance Measurement in Private Sector Organisations

111

21. Performance Analysis Additional

143

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Part A Specialist Cost and Management Accounting Techniques

1. Costing Techniques Recap

Costing: It is the process of determining the costs of products, services or activities

Direct Cost: A cost that can be traced back in full to a product, service or department.

Indirect Production Cost: Also known as Overheads. It is a cost that cannot be directly linked in full to the actual production of goods/ provision of services. Example: Rent of factory where five different products are manufactured.

Indirect Non Production Cost: Also referred to as Overheads. It is a cost incurred in a support function that is not directly involved in the manufacturing process or provision of the main service. Example: Marketing expenses of a television sets manufacturer.

Traditional Costing Systems:

Absorption Costing: a form of costing in which the costs of products are calculated by adding an amount for indirect production costs (overheads) to the direct costs of production.

Marginal Costing: a form of costing where only the direct costs are considered relevant for the cost of a product. Fixed costs are treated as Period Costs.

Absorption Costing

Marginal Costing

Per Unit Product Cost Calculation $

$

Direct Material Direct Labour Other Direct Expenses Absorbed Production Overheads (Step 5) Full Production Cost

X

Direct Material

X

X

Direct Labour

X

X

Other Direct Expenses

X

X

Variable Production Cost

X

X

 

$

$

Sales Less : Full production cost of sale (Full production cost per unit x number of units) Less/Add: Under/Over absorbed (Step 6) Production overheads Gross Profit Less : Fixed non-production overhead Less : Variable non production cost Profit

xx

Sales Less : Variable production cost (Variable production cost per unit x units sold) Gross contribution Less : Variable non production cost

xx

(x)

(x)

(x)/x

xx

(x)

xx

Contribution

xx

(x)

Less : Fixed non-production overhead

(x)

(x)

Less : Fixed production overhead

(x)

xx

Profit

xx

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Absorption Costing Recap:

Step 1: Allocate direct costs to a cost unit or cost centre. Step 2: Apportion general overheads amongst the cost centres, on a fair basis. Step 3: Re-apportion the costs of service cost centres’ amongst the production cost centres on a fair basis. Step 4: Determine Absorption rate for each production cost centre using the formula:

Estimated Fixed Production Overheads

Budgeted Activity Level

With one of the following bases for activity level:

% of direct material cost

% of direct labour cost

% of prime cost

Rate per machine hour

Rate per labour hour

Rate per unit

Step 5: Absorbed Production Overheads: Actual activity level x Absorption rate Step 6: Under/ Over Absorption: Absorbed Production Overheads Actual Overheads Expenditure Under-absorbed: Absorbed production overheads < Actual overheads expenditure Over-absorbed: Absorbed production overheads > Actual overheads expenditure

Arguments for Absorption Costing System:

Used for financial reporting purposes to comply with the Accounting standards and inventory valuations.

Helpful in cases where companies attempt to set selling prices based on the full cost of production or sales of each product.

Best practice in case of a company selling multiple products, to determine profitability of each product.

Arguments for Marginal Costing System:

Provides more useful information for managers in decision making process as contribution calculated under this system is directly proportionate to the sales volume; which gives a more accurate picture of the impact of sales volume on cashflows and profits.

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2. Activity Based Costing

Introduction:

The simplest method of dealing with the fixed production costs is to assume that all of the production overheads can be treated together and a single overhead absorption rate per labour hour, or cost per machine hour, derived.

With production processes becoming highly automated the conventional way of treating fixed overheads, using an over-simplified base is not good enough, especially for organisations manufacturing multiple products. Companies need to know the causes of overhead and they need to try to assign costs to products or services on the basis of the resources they consume.

To get a more accurate estimate of what each unit costs to produce, it is necessary to examine what activities are necessary to produce each unit, because activities usually have a cost attached. This is the basis of Activity Based Costing (ABC).

The ABC Process:

1. Identify a distinct ‘fixed’ overhead cost, also termed as a Cost Pool.

2. Identify the activity that causes this cost. This activity is the ‘Cost Driver’.

3. For each cost pool, calculate an absorption rate per cost driver.

4. For each product, charge the overheads cost based on the use of the relevant cost driver by the product.

Traditional absorption costing

Production overheads Allocated/apportioned to Production cost centre Production cost centre Absorbed from cost centres
Production overheads
Allocated/apportioned to
Production cost centre
Production cost centre
Absorbed from cost centres into:
Product costs

Activity based costing

Production overheads Allocated/apportioned to Activity (cost pool) Activity (cost pool)
Production overheads
Allocated/apportioned to
Activity (cost pool)
Activity (cost pool)
Absorbed from cost centres into: Product costs
Absorbed from cost centres into: Product costs
Absorbed from cost centres into: Product costs

Absorbed from cost centres into:

Product costs

Absorbed from cost centres into: Product costs
Absorbed from cost centres into: Product costs
Absorbed from cost centres into: Product costs
Absorbed from cost centres into: Product costs

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Example:

An organisation manufactures 3 different products. In a year, its Fixed Production Overheads comprise of:

Cost Pool Machine Handling Costs

$20,000

Cost Driver 500 machine hours

Production Scheduling Costs

$14,000

100 production runs

Total Fixed Overheads

$34,000

100 labour hoours

Assuming that the manufacturing of Product A requires:

20 labour hours

15 machine hours

4 production runs

Under the traditional Absorption costing method, Fixed Overheads cost for Product A will be:

$34,000

x 20 labour hours

100 labour hours

= $6,800

Under the ABC method, the working will change to:

Machine Handling

Production Scheduling

Arguments for ABC:

$20,000

x 15 machine hours

500 machine hours

$14,000

x 4 production runs

100 production runs

= $600

= $560

= $1,160

Based on the information made available, the following types of decision making processes will be supported:

Pricing on mark-up basis for individual products will become fair as the cost of production is assessed more accurately.

Promoting or discontinuing products, activities or parts of business as there will be better indication of where cost savings can be made.

Developing new ways or products to do business.

Arguments against ABC:

Cost drivers may not be very easy to identify or quantify.

Cost of implementing this system may be more than benefits derived.

It’s an adaptation of the Absorption costing method and decision making is more effective based on Marginal Costing information.

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Past Paper Analysis

Past Paper Analysis

Activity based costing

June 08 Q 4 June 10 Q 1 Dec 10 Q 4 June 14 Q 1 June 15 Q 1

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Introduction:

3. Target Costing

Traditionally the selling price of a product is determined by adding a profit mark-up to the Product cost. But an organisation may not be able to find customers who might want to buy at that price as the product may not have the features customer’s value or the competitors’ products might be cheaper, or at least offer better value for money. This flaw is addressed by target costing.

Target Costing:

Target costing is very much a marketing approach to costing as it involves setting a selling price for the product by reference to the market. From this the desired profit margin is deducted to arrive at a target cost.

Target Costing Process:

1. Determine product specification and possible sales volume.

2. Decide on a Target Selling Price at which the product can be successfully sold.

3. Estimate Target Profit.

4. Calculate Target Cost: Target Selling Price Target Profit

5. Based on product specification and costs level, determine the estimated Production Cost.

6. Calculate Target Cost Gap: Estimated Production Cost Target Cost

7. Make efforts to reduce the Target Cost Gap, before production commences

Closing the Target Cost Gap:

Establishment of multifunctional teams consisting of marketing people, cost accountants, production managers, quality control professionals and others. These teams are vital to the design and manufacturing decisions required to determine the price and feature combinations that are most likely to appeal to potential buyers of products.

An emphasis is on the planning and design stage to ensure that the design is not needlessly expensive to make. Here are some of the decisions, made at the design stage, which can affect the cost of a product:

Reducing components

Arranging cheaper labour/ training existing staff

Acquiring new and efficient technology etc.

The total target cost can be split into broad cost categories based on functions to ensure better control over costs. The product has to be developed using Value Engineering Techniques.

Value engineering aims to reduce costs by identifying those parts of a product or service which do not add value – where ‘value’ is made up of both:

Use value (the ability of the product or service to perform its function)

Esteem value (the status that ownership or use confers)

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For example, if you are selling perfume, the design of its packaging is important. The perfume could be sold in a plain glass bottle, and although there will be no damage to the use value, the esteem value will be damaged. The company would be unwise to try to reduce costs by economising too much on packaging.

Target Costing in Service Industries:

Because of the characteristics and information requirements, it is difficult to use Target Costing in service industries. Examples of service businesses include:

(a)

Mass service e.g. the banking sector, transportation (rail, air), mass entertainment

(b)

Either / or e.g. fast food, teaching, hotels and holidays, psychotherapy

(c)

Personal service e.g. pensions and financial advice, car maintenance

There are five major characteristics of services that distinguish services from manufacturing. Intangibility Unlike goods there is no substantial material or physical aspects to a service.

Inseparability/simultaneity.

Variability/heterogeneity.

Perishability

No transfer of ownership.

Challenges:

Many services are created at the same time as they are consumed. (Think of dental treatment.) No service exists until it is actually being experienced/ consumed by the person who has bought it.

It is hard to attain precise standardisation of the service offered.

Services are time bound. The services of a dentist are purchased for a period of time.

Services do not result in the transfer of property but only access to or a right to use a facility.

Services do not have any material content (tangibility) making it difficult to reduce target cost gap through material cost reduction.

Services vary each time resulting in there being an estimated average cost for each service but not a specific standard cost that can be reduced.

Past Paper Analysis

Past Paper Analysis

Target costing

Dec 01 Q 1 Dec 09 Q 2 June 12 Q 2 Dec 15 Q 1

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Introduction:

4. Life Cycle Costing

Under traditional costing methods, only the current costs, comprising of marginal costs plus a share of fixed costs, are considered. But other costs, without which the goods could not have been made, such as Research & Development costs, are ignored.

When seeking to make a profit on a product it is essential that the total revenue arising from the product exceeds total costs, whether these costs are incurred before, during or after the product is produced. This is addressed by lifecycle costing.

Lifecycle Costing:

There are four principal lessons to be learned from lifecycle costing:

All costs should be taken into account when working out the cost of a unit and its profitability.

Attention to all costs will help reduce the cost per unit and will help an organisation achieve its target cost.

Many costs will be linked. For example, more attention to design can reduce manufacturing and warranty costs.

Costs are committed and incurred at very different times. A committed cost is a cost that will be incurred in the future because of decisions that have already been made. Costs are incurred only when a resource is used.

Stages of Life cycle (product life cycle)

The development stage

The product has a research and development stage where costs are incurred but no revenue is generated.

Examples: R&D costs; Capital Expenditure decisions

The introduction stage The product is introduced to the market. The organisation will spend on advertising to bring the product or service to the attention of the potential customers.

Examples: Operating costs; Marketing and advertising; Set up and expansion of distribution channels

The growth stage At this stage, the product becomes well-known in the market. Due to increase in demand, it captures a bigger market and starts to make a profit. At this stage, cost of the initial investment is progressively recovered.

Examples: Costs of increasing capacity; Maybe learning effect and economies of scale; Increased costs of working capital

The maturity stage

At this stage, demand for the product stabilises or the rate of growth slows

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down. It continues to be profitable. Expenses for marketing and distribution can be minimised at this stage. In order to sustain the demand, the product may be differentiated / modified.

Examples: Incur costs to maintain manufacturing capacity; Marketing and product enhancement costs to extend maturity

The decline / saturation stage

A point comes where large / adequate quantities of the product have been sold in the market and the product, therefore, reaches a saturation point. At this stage the demand for the product starts to fall and marketing costs are cut down. The product may start making loss at this stage. The organisation may decide to discontinue the production and to develop a new product.

Examples: Asset decommissioning costs; Possible restructuring costs; Remaining warranties to be supported

restructuring costs; Remaining warranties to be supported The Importance of early stage in Lifecycle: Organisations

The Importance of early stage in Lifecycle:

Organisations operating within an advanced manufacturing technology environment find that approximately 90% of a product's life cycle cost is determined by decisions made early within the cycle at the design stage. Life cycle costing is therefore particularly suited to such organisations and products.

Cost reduction at the planning, design and development stage of a product's life cycle, rather than during the production process, is one of the most important ways of reducing product cost.

Benefits of Life cycle costing:

The potential profitability of product can be assessed before major development of the product is carried out and costs incurred and non-profit-making products can be abandoned.

Techniques can be used to reduce costs over the life of the product

Pricing strategy can be determined before the product enters production.

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Attention can be focused on reducing the research and development phase to get the product to market as quickly as possible.

By monitoring the actual performance of products against plans, lessons can be learnt to improve the performance of future products.

Support to Management:

An understanding of the product life cycle can also assist management with decisions about:

Pricing: As a product moves from one stage in its lifecycle to the next, a change in pricing strategy might be necessary to maintain the market share and recover the costs incurred over the lifecycle.

Performance management: Understanding the changes in the financial performance of the product as it moves from one stage to another and being prepared for the changes.

Decision-making: Helps with decision about making new investments in the product (new capital expenditure) or withdrawing a product from the market.

Service Life Cycles:

In Service lifecycles, the R & D stages do not exist in the same way and will not have the same impact on subsequent costs. However consideration should be given in advance about how to carry out the services and arrange them so as to minimise cost.

Project Life Cycles:

Products that take years to produce are usually called projects, and discounted cash flow calculations are invariably used to cost them over their life cycle in advance. They are monitored very carefully over their life to make sure that they remain on schedule and that cost overruns are not being incurred.

Customer Life Cycles:

Customers also have life cycles, and an organisation will wish to maximise the return from a customer over their life cycle. The aim is to extend the life cycle of a particular customer by encouraging customer loyalty.

The initial cost is high but once customers get used to a supplier they tend to use them more frequently, bringing in the benefit to the company.

The projected cash flows over the full lives of customers or customer segments can be analysed to highlight the worth of customers and the importance of customer retention.

Past Paper Analysis

Past Paper Analysis

Life-cycle costing

Dec 08 Q 4 Dec 11 Q 4 June 13 Q 3

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5. Throughput Accounting

The theory of constraints

The theory of constraints is applied within an organisation by following what are called ‘the five focusing steps.’ These are a tool developed to help organisations deal with constraints, otherwise known as bottlenecks, within the system as a whole (rather than any discrete unit within the organisation.) The steps are as follows:

Step 1: Identify the system’s bottlenecks

Often, in exam questions, you will be told what the bottleneck resource is. If not, it is usually quite simple to work out. For example, let’s say that an organisation has market demand of 50,000 units for a product that goes through three processes: cutting, heating and assembly. The total time required in each process for each product and the total hours available are:

Process

Cutting

Heating

Assembly

Hrs per unit

2

3

4

Total hours available

100,000

120,000

220,000

The total time required to make 50,000 units of the product can be calculated and compared to the time available in order to identify the bottleneck.

Process

Cutting

Heating

Assembly

Hrs per unit

2

3

4

Total hours required for 50,000 units

100,000

150,000

200,000

Total hours available

100,000

120,000

220,000

Shortfall in hours

0

30,000

0

It is clear that the heating process is the bottleneck. The organisation will in fact only be able to produce 40,000 units (120,000/3) as things stand.

Step 2: Decide how to exploit the system’s bottlenecks

This involves making sure that the bottleneck resource is actively being used as much as possible and is producing as many units as possible. So, ‘productivity’ and ‘utilisation’ are the key words here.

Step 3: Subordinate everything else to the decisions made in Step 2

The main point here is that the production capacity of the bottleneck resource should determine the production schedule for the organisation as a whole? Idle time is unavoidable and needs to be accepted if the theory of constraints is to be successfully applied. To push more work into the system than the constraint can deal with results in excess work-in-progress, extended lead times, and the appearance of

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what looks like new bottlenecks, as the whole system becomes clogged up. By definition, the system does not require the non-bottleneck resources to be used to their full capacity and therefore they must sit idle for some of the time.

Step 4: Elevate the system’s bottlenecks

Normally, elevation will require capital expenditure. However, it is important that an organisation does not ignore Step 2 and jumps straight to Step 4, and this is what often happens. There is often untapped production capacity that can be found if you look closely enough. Elevation should only be considered once exploitation has taken place.

Step 5: If a new constraint is broken in Step 4, go back to Step 1, but do not let inertia become the system’s new bottleneck

When a bottleneck has been elevated, a new bottleneck will eventually appear. This could be in the form of another machine that can now process less units than the elevated bottleneck. Eventually, however, the ultimate constraint on the system is likely to be market demand. Whatever the new bottleneck is, the message of the theory of constraints is: never get complacent. The system should be one of ongoing improvement because nothing ever stands still for long.

In the context of an exam question,, you are more likely to be asked to show how a bottleneck can be exploited by maximising throughput via the production of an optimum production plan. This requires an application of the simple principles of key factor analysis, otherwise known as limiting factor analysis or principal budget factor.

LIMITING FACTOR ANALYSIS AND THROUGHPUT ACCOUNTING

Once an organisation has identified its bottleneck resource, as demonstrated in Step 1 above, it then has to decide how to get the most out of that resource. Given that most businesses are producing more than one type of product (or supplying more than one type of service), this means that part of the exploitation step involves working out what the optimum production plan is, based on maximising throughput per unit of bottleneck resource.

In key factor analysis, the contribution per unit is first calculated for each product, then a contribution per unit of scarce resource is calculated by working out how much of the scarce resource each unit requires in its production. In a throughput accounting context, a very similar calculation is performed, but this time it is not contribution per unit of scarce resource which is calculated, but throughput return per unit of bottleneck resource.

Throughput is calculated as ‘selling price less direct material cost.’ This is different from the calculation of ‘contribution’, in which both labour costs and variable overheads are also deducted from selling price. It is an important distinction because the fundamental belief in throughput accounting is that all costs except direct materials costs are largely fixed therefore, to work on the basis of maximising contribution is flawed because to do so is to take into account costs that cannot be controlled in the short term anyway.

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One cannot help but agree with this belief really since, in most businesses, it is simply not possible, for example, to hire workers on a daily basis and lay workers off if they are not busy. A workforce has to be employed within the business and available for work if there is work to do. You cannot refuse to pay a worker if he is forced to sit idle by a machine for a while.

Example Beta Co produces 3 products, E, F and G, details of which are shown below:

1

 

E

F

G

$

$

$

Selling price per unit

120

110

130

Direct material cost per unit

60

70

85

Maximum demand (units)

30,000

25,000

40,000

Time required on the bottleneck resource (hours per unit)

5

4

3

There are 320,000 bottleneck hours available each month. Calculate the optimum product mix each month.

A few simple steps can be followed:

1. Calculate the throughput per unit for each product.

2. Calculate the throughput return per hour of bottleneck resource.

3. Rank the products in order of the priority in which they should be produced, starting with the product

that generates the highest return per hour first.

4. Calculate the optimum production plan, allocating the bottleneck resource to each one in order, being

sure not to exceed the maximum demand for any of the products.

It is worth noting here that you often see another step carried out between Steps 2 and 3 above. This is the

calculation of the throughput accounting ratio for each product. Thus far, ratios have not been discussed, and while I am planning on mentioning them later, I have never seen the point of inserting this extra step in when working out the optimum production plan. The ranking of the products using the return per

factory hour will always produce the same ranking as that produced using the throughput accounting ratio, so it doesn’t really matter whether you use the return or the ratio.

 

E

F

G

$

$

$

Selling price per unit

120

110

130

Direct material cost per unit

60

70

85

Throughput per unit

60

40

45

Time required on the bottleneck resource (hours per unit) 5

4

3

Return per factory hour

$12

$10

$15

Ranking

2

3

1

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It is worth noting that, before the time taken on the bottleneck resource was taken into account, product E appeared to be the most profitable because it generated the highest throughput per unit. However, applying the theory of constraints, the system’s bottleneck must be exploited by using it to produce the products that maximise throughput per hour first (Step 2 of the five focusing steps). This means that product G should be produced in priority to E.

In practice, Step 3 will be followed by making sure that the optimum production plan is adhered to throughout the whole system, with no machine making more units than can be absorbed by the bottleneck, and sticking to the priorities decided.

When answering a question like this in an exam it is useful to draw up a small table, like the one shown below. This means that the marker can follow your logic and award all possible marks, even if you have made an error along the way.

Product

No. of units

Hrs per unit

Total hrs

T/put per hr

Total t/put

G

40,000

3

120,000

$15

$1,800,000

E

30,000

5

150,000

$12

$1,800,000

F

12,500

4

50,000

$10

$5000,000

 

$4,100,00

Each time you allocate time on the bottleneck resource to a product, you have to ask yourself how many hours you still have available. In this example, there were enough hours to produce the full quota for G and E. However, when you got to F, you could see that out of the 320,000 hours available, 270,000 had been used up (120,000 + 150,000), leaving only 50,000 hours spare.

Therefore, the number of units of F that could be produced was a balancing figure 50,000 hours divided by the four hours each unit requires ie 12,500 units.

The above example concentrates on Steps 2 and 3 of the five focusing steps. I now want to look at an example of the application of Steps 4 and 5. I have kept it simple by assuming that the organisation only makes one product, as it is the principle that is important here, rather than the numbers. The example also demonstrates once again how to identify the bottleneck resource (Step 1) and then shows how a bottleneck may be elevated, but will then be replaced by another. It also shows that it may not always be financially viable to elevate a bottleneck.

Example Cat Co makes a product using three machines X, Y and Z. The capacity of each machine is as follows:

Machine

Capacity per week

X

800

Y

600

Z

500

2

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The demand for the product is 1,000 units per week. For every additional unit sold per week, net present value increases by $50,000. Cat Co is considering the following possible purchases (they are not mutually exclusive):

Purchase 1 Replace machine X with a newer model. This will increase capacity to 1,100 units per week and costs $6m.

Purchase 2 Invest in a second machine Y, increasing capacity by 550 units per week. The cost of this machine would be $6.8m.

Purchase 3 Upgrade machine Z at a cost of $7.5m, thereby increasing capacity to 1,050 units.

Required:

Which is Cat Co’s best course of action?

Answer First, it is necessary to identify the system’s bottleneck resource. Clearly, this is machine Z, which only has the capacity to produce 500 units per week. Purchase 3 is therefore the starting point when considering the logical choices that face Cat Co. It would never be logical to consider either Purchase 1 or 2 in isolation because of the fact that neither machines X nor machine Y is the starting bottleneck. Let’s have a look at how the capacity of the business increases with the choices that are available to it.

X

Y

Z

Demand

Current capacity per week

800

600

500*

1,000

Buy Z

800

600*

1,050

1,000

Buy Z & Y

800*

1,150

1,050

1,000

Buy Z, Y & X

1,100

1,150

1,050

1,000*

* = bottleneck resource

From the table above, it can be seen that once a bottleneck is elevated, it is then replaced by another bottleneck until ultimately market demand constrains production. At this point, it would be necessary to look beyond production and consider how to increase market demand by, for example, increasing advertising of the product.In order to make a decision as to which of the machines should be purchased, if any, the financial viability of the three options should be calculated.

Buy Z

Additional sales = 600 - 500 = 100 units

$'000

Benefit: 100 x $50,000

5,000

Cost

(7,500)

Net cost

(2,500)

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Buy Z & Y

Additional sales = 800 - 500 = 300 units

Benefit : 300 x $50,000

15,000

Cost ($7.5m + $6.8m)

(14,300)

Net benefit

700

Buy Z, Y & X

Additional sales = 1,000 - 500 = 500 units

Benefit: 500 x $50,000

25,000

Cost ($7.5m = $6.8m + $6m)

Net benefit

(20,300)

4,700

The company should therefore invest in all three machines if it has enough cash to do so.

The example of Cat Co demonstrates the fact that, as one bottleneck is elevated, another one appears. It also shows that elevating a bottleneck is not always financially viable. If Cat Co was only able to afford machine Z, it would be better off making no investment at all because if Z alone is invested in, another bottleneck appears too quickly for the initial investment cost to be recouped.

RATIOS

There are three main ratios that are calculated: (1) return per factory hour, (2) cost per factory hour and (3) the throughput accounting ratio.

(1) Return per factory hour Throughput per unit/product time on bottleneck resource. As we saw in Example 1, the return per factory hour needs to be calculated for each product.

(2) Total factory costs/total time available on bottleneck resource. The ‘total factory cost’ is simply the ‘operational expense’ of the organisation referred to in the previous article. If the organisation was a service organisation, we would simply call it ‘total operational expense’ or something similar. The cost per factory hour is across the whole factory and therefore only needs to be calculated once.

(3) Return per factory hour/cost per factory hour.(throughput accounting Ratio) In any organisation, you would expect the throughput accounting ratio to be greater than 1. This means that the rate at which the organisation is generating cash from sales of this product is greater than the rate at which it is incurring costs. It follows on, then, that if the ratio is less than 1, this is not the case, and changes need to be made quickly.

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How to improve a throughput accounting ratio (TPAR):

Reduce the bottleneck

Increase the selling price

Buy cheaper materials

Reduce the conversion costs etc

Important:

Products and/or divisions can be ranked according to TPAR. The TPAR should be greater than one for a product to be viable. Priority should be given to the products generating the highest TPARs.

Alternatively the products generating highest TP contribution per unit of constraint should be given priority.

Concepts of throughput accounting/Assumptions

In the short run, all costs except materials are fixed.

The ideal inventory level is zero and so unavoidable, idle capacity in some operations must be accepted(JIT system is preferred)

WIP is valued at material cost only, as no value is added and no profit earned until a sale takes place

Closing stock is referred as unsynchronized production

Difference between traditional costing and throughput accounting

Traditional Costing

Throughput accounting

Labour costs and variable overheads are treated as

All costs other than materials are seen as fixed in

variable costs.

the short term.

Inventory is valued at total production cost.

Inventory is valued at material cost only.

Value is added when an item is produced.

Value is added when an item is sold.

Product profitability can be determined by deducting

Profitability is determined by the rate at which

a product cost from selling price.

money is earned.

Past Paper Analysis

Past Paper Analysis

Throughput accounting

June 09 Q 1 June 11 Q 5 Dec 13 Q 2 Dec 14 Q 2

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6. Environmental Accounting

Environmental accounting is becoming increasingly topical in the modern business environment due to increased regulation and media coverage

Environmental management accounting (EMA)

The generation and analysis of both financial and non-financial information in order to support environmental management processes

Why environmental costs are important

Identifying environmental costs associated with individual products and services can assist with pricing decisions

Ensuring compliance with regulatory standards

Potential for cost savings

Government support

Reputation & goodwill

Typical environmental costs

Consumables and raw materials

Transport and travel

Waste disposal

Energy consumption

Recycled material

Water usage

Pollution

Important

The majority product or of environmental costs are already captured within accounting systems. it is often difficult to pinpoint and allocate them to a particular service

Methods of Environmental accounting in different organizations

1. Input/output analysis

This method operates on the principal that what comes in must go out. Output is split across sold and stored goods and waste.

Measuring these categories in physical quantities and monetary terms forces businesses to focus on environmental costs.

Flow diagrams are often used to illustrate how the input is split across different output such as stored goods and waste.

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2. Environmental activity-based costing

Two costs are relevant:

Environment -related costs such as costs relating to a sewage plant or an incinerator are attributed to joint environmental cost centers.

Environmental -driven costs such as increased depreciation or higher staff wages are allocated to general overheads.

Examples of environmental cost drivers include volume of emissions and the cost of complying with environmental

3. Flow cost accounting

Material flows through an organization are divided into three categories

Material

System and delivery

Disposal

The values and costs of each material flow are calculated. This method focuses on reducing costs and having a positive effect on the environment

4. Life-cycle costing

Environmental costs are considered from the design stage right up to the last stage costs such as decommissioning and waste removal etc.

This may influence the design of the product itself, saving on future costs.

Past Paper Analysis

Past Paper Analysis

Environmental accounting

Dec 13 Q 1c

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Part B Decision Making Techniques

7. Cost Volume Profit (CVP) Analysis

Cost-volume-profit analysis looks primarily at the effects of differing levels of activity on the financial results of a business

In any business, or, indeed, in life in general, hindsight is a beautiful thing. If only we could look into a crystal ball and find out exactly how many customers were going to buy our product, we would be able to make perfect business decisions and maximise profits.

Take a restaurant, for example. If the owners knew exactly how many customers would come in each evening and the number and type of meals that they would order, they could ensure that staffing levels were exactly accurate and no waste occurred in the kitchen. The reality is, of course, that decisions such as staffing and food purchases have to be made on the basis of estimates, with these estimates being based on past experience.

While management accounting information can’t really help much with the crystal ball, it can be of use in providing the answers to questions about the consequences of different courses of action. One of the most important decisions that needs to be made before any business even starts is ‘how much do we need to sell in order to break-even?’ By ‘break-even’ we mean simply covering all our costs without making a profit.

This type of analysis is known as ‘cost-volume-profit analysis’ (CVP analysis) and the purpose of this article is to cover some of the straight forward calculations and graphs required for this part of the Paper F5 syllabus, while also considering the assumptions which underlie any such analysis.

THE OBJECTIVE OF CVP ANALYSIS

CVP analysis looks primarily at the effects of differing levels of activity on the financial results of a business. The reason for the particular focus on sales volume is because, in the short-run, sales price, and the cost of materials and labour, are usually known with a degree of accuracy. Sales volume, however, is not usually so predictable and therefore, in the short-run, profitability often hinges upon it. For example, Company A may know that the sales price for product x in a particular year is going to be in the region of $50 and its variable costs are approximately $30.

It can, therefore, say with some degree of certainty that the contribution per unit (sales price less variable costs) is $20. Company A may also have fixed costs of $200,000 per annum, which again, are fairly easy to predict. However, when we ask the question: ‘Will the company make a profit in that year?’, the answer is ‘We don’t know’. We don’t know because we don’t know the sales volume for the year. However, we can work out how many sales the business needs to make in order to make a profit and this is where CVP analysis begins.

Methods for calculating the break-even point The break-even point is when total revenues and total costs are equal, that is, there is no profit but also no loss made. There are three methods for ascertaining this break-even point:

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1 The equation method

A little bit of simple math can help us answer numerous different cost-volume-profit questions.

We know that total revenues are found by multiplying unit selling price (USP) by quantity sold (Q). Also, total costs are made up firstly of total fixed costs (FC) and secondly by variable costs (VC). Total variable costs are found by multiplying unit variable cost (UVC) by total quantity (Q). Any excess of total revenue over total costs will give rise to profit (P). By putting this information into a simple equation, we come up with a method of answering CVP type questions. This is done below continuing with the example of Company A above.

Total revenue total variable costs total fixed costs = Profit (USP x Q) (UVC x Q) FC = P (50Q) (30Q) 200,000 = P

Note: total fixed costs are used rather than unit fixed costs since unit fixed costs will vary depending on the level of output.

It would, therefore, be inappropriate to use a unit fixed cost since this would vary depending on output.

Sales price and variable costs, on the other hand, are assumed to remain constant for all levels of output in

the short-run, and, therefore, unit costs are appropriate.

Continuing with our equation, we now set P to zero in order to find out how many items we need to sell in order to make no profit, ie to break even:

(50Q) (30Q) 200,000 = 0 20Q 200,000 = 0 20Q = 200,000

Q = 10,000 units.

The equation has given us our answer. If Company A sells less than 10,000 units, it will make a loss; if it sells exactly 10,000 units, it will break-even, and if it sells more than 10,000 units, it will make a profit.

2 The contribution margin method

This second approach uses a little bit of algebra to rewrite our equation above, concentrating on the use of the ‘contribution margin’. The contribution margin is equal to total revenue less total variable costs. Alternatively, the unit contribution margin (UCM) is the unit selling price (USP) less the unit variable cost (UVC). Hence, the formula from our mathematical method above is manipulated in the following way:

(USP x Q) (UVC x Q) FC = P (USP UVC) x Q = FC + P UCM x Q = FC + P

Q = FC + P UCM

So, if P=0 (because we want to find the break-even point), then we would simply take our fixed costs and divide them by our unit contribution margin. We often see the unit contribution margin referred to as the

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‘contribution per unit’. Applying this approach to Company A again:

UCM = 20, FC = 200,000 and P = 0.

Q

= FC

UCM

Q

= 200,000

20

Therefore Q = 10,000 units

The contribution margin method uses a little bit of algebra to rewrite our equation above, concentrating on the use of the ‘contribution margin’.

3 The graphical method With the graphical method, the total costs and total revenue lines are plotted on a graph; $ is shown on the y axis and units are shown on the x axis. The point where the total cost and revenue lines intersect is the break-even point. The amount of profit or loss at different output levels is represented by the distance between the total cost and total revenue lines. Figure 1 shows a typical break-even chart for Company A. The gap between the fixed costs and the total costs line represents variable costs.

Alternatively, a contribution graph could be drawn. While this is not specifically covered by the Paper F5 syllabus, it is still useful to see it. This is very similar to a break-even chart, the only difference being that instead of showing a fixed cost line, a variable cost line is shown instead.

Hence, it is the difference between the variable cost line and the total cost line that represents fixed costs. The advantage of this is that it emphasises contribution as it is represented by the gap between the total revenue and the variable cost lines. This is shown for Company A in Figure 2.

Finally, a profitvolume graph could be drawn, which emphasises the impact of volume changes on profit (Figure 3). This is key to the Paper F5 syllabus and is discussed in more detail later in this article.

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Figure 1

F5 Performance Management 2016 Figure 1 Figure 2 Page 25 of 147

Figure 2

F5 Performance Management 2016 Figure 1 Figure 2 Page 25 of 147

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Figure 3

F5 Performance Management 2016 Figure 3 Ascertaining the sales volume required to achieve a target profit

Ascertaining the sales volume required to achieve a target profit

As well as ascertaining the break-even point, there are other routine calculations that it is just as important to understand. For example, a business may want to know how many items it must sell in order to attain a target profit.

Example 1 Company A wants to achieve a target profit of $300,000. The sales volume necessary in order to achieve this profit can be ascertained using any of the three methods outlined above. If the equation method is used, the profit of $300,000 is put into the equation rather than the profit of $0:

(50Q) (30Q) 200,000 = 300,000 20Q 200,000 = 300,000 20Q = 500,000

Q = 25,000 units.

Alternatively, the contribution method can be used:

UCM = 20, FC = 200,000 and P = 300,000.

Q = FC + P UCM

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Q = 200,000 + 300,000

20

Therefore Q = 25,000 units.

Finally, the answer can be read from the graph, although this method becomes clumsier than the previous two. The profit will be $300,000 where the gap between the total revenue and total cost line is $300,000, since the gap represents profit (after the break-even point) or loss (before the break-even point.)

A contribution graph shows the difference between the variable cost line and the total cost line that

represents fixed costs. An advantage of this is that it emphasises contribution as it is represented by the

gap between the total revenue and variable cost lines.

This is not a quick enough method to use in an exam so it is not recommended.

Margin of safety The margin of safety indicates by how much sales can decrease before a loss occurs, ie it is the excess of budgeted revenues over break-even revenues. Using Company A as an example, let’s assume that budgeted sales are 20,000 units. The margin of safety can be found, in units, as follows:

Budgeted sales break-even sales = 20,000 10,000 = 10,000 units.

Alternatively, as is often the case, it may be calculated as a percentage:

Budgeted sales break-even sales/budgeted sales. In Company A’s case, it will be 10,000/20,000 x 100 = 50%.

Finally, it could be calculated in terms of $ sales revenue as follows:

Budgeted sales break-even sales x selling price = 10,000 x $50 = $500,000.

Contribution to sales ratio

It is often useful in single product situations, and essential in multi-product situations, to ascertain how

much each $ sold actually contributes towards the fixed costs. This calculation is known as the contribution to sales or C/S ratio. It is found in single product situations by either simply dividing the total contribution by the total sales revenue, or by dividing the unit contribution margin (otherwise known as contribution per unit) by the selling price:

For Company A: $20/$50 = 0.4

In multi-product situations, a weighted average C/S ratio is calculated by using the formula:

Total contribution/total sales revenue

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This weighted average C/S ratio can then be used to find CVP information such as break-even point, margin of safety etc.

2

As well as producing product x described above, Company A also begins producing product y. The following

information is available for both products:

Example

Product x

Product y

Sales price

$50

$60

Variable cost

$30

$45

Contribution per unit

$20

$15

Budgeted sales (units)

20,000

10,000

The weighted average C/S ratio can be once again calculated by dividing the total expected contribution by the total expected sales:

(20,000 x $20) + (10,000 x $15) /(20,000 x $50) + (10,000 x $60) = 34.375%

The C/S ratio is useful in its own right as it tells us what percentage each $ of sales revenue contributes towards fixed costs; it is also invaluable in helping us to quickly calculate the break-even point in $ sales revenue, or the sales revenue required to generate a target profit. The break-even point can now be calculated this way for Company A:

Fixed costs / contribution to sales ratio = $200,000/0.34375 = $581,819 of sales revenue.

To achieve a target profit of $300,000:

Fixed costs + required profit /contribution to sales ratio = $200,000 + $300,000/0.34375 = $1,454,546.

Of course, such calculations provide only estimated information because they assume that products x and y are sold in a constant mix of 2x to 1y. In reality, this constant mix is unlikely to exist and, at times, more y may be sold than x. Such changes in the mix throughout a period, even if the overall mix for the period is 2:1, will lead to the actual break-even point being different than anticipated. This point is touched upon again later in this article.

Contribution to sales ratio is often useful in single product situations, and essential in multi-product situations, to ascertain how much each $ sold actually contributes towards the fixed costs.

Table 3: Figure 3 continued

Product x

Product y

Sales price

$50

$60

Variable cost

$30

$45

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Product x

Product y

Contribution per unit

$20

$15

Budgeted sales (units)

20,000

10,000

C/S ratios

0.4

0.25

Weighted average C/S ratio

0.34375

Product ranking (most profitable first)

1

2

 

Cumulative

Cumulative

Contribution

profit/loss

Revenue

revenue

Product

$'000

$'000

$'000

$'000

(Fixed costs)

0

(200)

0

0

X 400

200

1,000,000 1,000,000

Y 150

350

600,000

1,600,000

In order to draw a multi-product/volume graph it is necessary to work out the C/S ratio of each product being sold.

Multi-product profitvolume charts

When discussing graphical methods for establishing the break-even point, we considered break-even charts and contribution graphs. These could also be drawn for a company selling multiple products, such as Company A in our example. The one type of graph that hasn’t yet been discussed is a profitvolume graph. This is slightly different from the others in that it focuses purely on showing a profit/loss line and doesn’t separately show the cost and revenue lines. In a multi-product environment, it is common to actually show two lines on the graph: one straight line, where a constant mix between the products is assumed; and one bow-shaped line, where it is assumed that the company sells its most profitable product first and then its next most profitable product, and so on. In order to draw the graph, it is therefore necessary to work out the C/S ratio of each product being sold before ranking the products in order of profitability. It is easy here for Company A, since only two products are being produced, and so it is useful to draw a quick table (prevents mistakes in the exam hall) in order to ascertain each of the points that need to be plotted on the graph in order to show the profit/loss lines.

See Table 3.

The graph can then be drawn (Figure 3), showing cumulative sales on the x axis and cumulative profit/loss on the y axis. It can be observed from the graph that, when the company sells its most profitable product first (x) it breaks even earlier than when it sells products in a constant mix. The break-even point is the point where each line cuts the x axis.

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Limitations of cost-volume-profit analysis

Cost-volume-profit analysis is invaluable in demonstrating the effect on an organisation that changes in volume (in particular), costs and selling prices, have on profit. However, its use is limited because it is based on the following assumptions: Either a single product is being sold or, if there are multiple products, these are sold in a constant mix. We have considered this above in Figure 3 and seen that if the constant mix assumption changes, so does the break-even point.

All other variables, apart from volume, remain constant, ie volume is the only factor that causes revenues and costs to change. In reality, this assumption may not hold true as, for example, economies of scale may be achieved as volumes increase. Similarly, if there is a change in sales mix, revenues will change. Furthermore, it is often found that if sales volumes are to increase, sales price must fall. These are only a few reasons why the assumption may not hold true; there are many others.

The total cost and total revenue functions are linear. This is only likely to hold a short-run, restricted level of activity.

Costs can be divided into a component that is fixed and a component that is variable. In reality, some costs may be semi-fixed, such as telephone charges, whereby there may be a fixed monthly rental charge and a variable charge for calls made.

Fixed costs remain constant over the 'relevant range' - levels in activity in which the business has experience and can therefore perform a degree of accurate analysis. It will either have operated at those activity levels before or studied them carefully so that it can, for example, make accurate predictions of fixed costs in that range.

Profits are calculated on a variable cost basis or, if absorption costing is used, it is assumed that production volumes are equal to sales volumes.

Past Paper Analysis

Past Paper Analysis

CVP analysis

Dec 12 Q 1 Dec 15 Q 4

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8. Limiting Factor Analysis

1. If there is a single limiting factor-Optimal plan is made based on ranking (Contribution per limiting factor -7 steps)

2. If there are multiple limiting factor-Linear programming approach is used. It is a mathematical approach and is best understood through an exam question

LINEAR PRGRAMMING

To understand linear programming in detail the following scenario is relevant:

Suppose a profit-seeking firm has two constraints: labour, limited to 16,000 hours, and materials, limited to 15,000kg. The firm manufactures and sells two products, X and Y. To make X, the firm uses 3kg of material and four hours of labour, whereas to make Y, the firm uses 5kg of material and four hours of labour. The contributions made by each product are $30 for X and $40 for Y. The cost of materials is normally $8 per kg, and the labour rate is $10 per hour.

The first step in any linear programming problem is to produce the equations for constraints and the contribution function, which should not be difficult at this level.

In our example, the materials constraint will be 3X + 5Y ≤ 15,000, and the labour constraint will be 4X + 4Y ≤ 16,000.

You should not forget the non-negativity constraint, if needed, of X,Y ≥ 0.

The contribution function is 30X + 40Y = C

Figure 1: Optimal production plan

function is 30X + 40Y = C Figure 1: Optimal production plan Plotting the resulting graph

Plotting the resulting graph (Figure 1, the optimal production plan) will show that by pushing out the contribution function, the optimal solution will be at point B the intersection of materials and labour constraints.

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The optimal point is X = 2,500 and Y = 1,500, which generates $135,000 in contribution. Check this for yourself (see Working 1). The ability to solve simultaneous equations is assumed in this article.

The point of this calculation is to provide management with a target production plan in order to maximise contribution and therefore profit. However, things can change and, in particular, constraints can relax or tighten. Management needs to know the financial implications of such changes. For example, if new materials are offered, how much should be paid for them? And how much should be bought? These dynamics are important.

Suppose the shadow price of materials is $5 per kg (this is verifiable by calculation see Working 2). The important point is, what does this mean? If management is offered more materials it should be prepared to pay no more than $5 per kg over the normal price. Paying less than $13 ($5 + $8) per kg to obtain more materials will make the firm better off financially. Paying more than $13 per kg would render it worse off in terms of contribution gained. Management needs to understand this.

There may, of course, be a good reason to buy ‘expensive’ extra materials (those costing more than $13 per kg). It might enable the business to satisfy the demands of an important customer who might, in turn, buy more products later. The firm might have to meet a contractual obligation, and so paying ‘too much’ for more materials might be justifiable if it will prevent a penalty on the contract. The cost of this is rarely included in shadow price calculations. Equally, it might be that ‘cheap’ material, priced at under $13 per kg, is not attractive. Quality is a factor, as is reliability of supply. Accountants should recognise that ‘price’ is not everything.

How many materials to buy? Students need to realise that as you buy more materials, then that constraint relaxes and so its line on the graph moves outwards and away from the origin. Eventually, the materials line will be totally outside the labour line on the graph and the point at which this happens is the point at which the business will cease to find buying more materials attractive (point D on the graph). Labour would then become the only constraint.

We need to find out how many materials are needed at point D on the graph, the point at which 4,000 units of Y are produced. To make 4,000 units of Y we need 20,000kg of materials. Consequently, the maximum amount of extra material required is 5,000kg (20,000 15,000). Note: Although interpretation is important at this level, there will still be marks available for the basic calculations.

WORKINGS

Working 1:

The optimal point is at point B, which is at the intersection of:

3X + 5Y = 15,000 and 4X + 4Y = 16,000

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Multiplying the first equation by four and the second by three we get:

12X + 20Y = 60,000 12X + 12Y = 48,000

The difference in the two equations is:

8Y = 12,000, or Y = 1,500

Substituting Y = 1,500 in any of the above equations will give us the X value:

3X + 5 (1,500) = 15,000 3X = 7,500

X = 2,500

The contribution gained is (2,500 x 30) + (1,500 x 40) = $135,000

Important Definitions:

1. Shadow price: the amount of contribution generated by having one extra unit of the binding constraint- it’s the maximum premium the company could pay by having one extra unit of the limited resource at optimal point

2. Slack: the best utilization of resource is not the full utilization of resource; if a resource is not binding at the optimal point it will have slack

3. Surplus: when the resource use is more than the minimum required, it is said to have surplus

Working 2: Shadow price of materials (from the above example) To find this we relax the material constraint by 1kg and resolve as follows:

3X + 5Y = 15,001 and 4X + 4Y = 16,000

Again, multiplying by four for the first equation and by three for the second produces:

12X + 20Y = 60,004 12X + 12Y = 48,000 8Y = 12,004

Y = 1,500.5

Substituting Y = 1,500.5 in any of the above equations will give us X:

3X + 5 (1,500.5) = 15,001 3X = 7,498.5

X = 2,499.5

The new level of contribution is: (2,499.5 x 30) + (1,500.5 x 40) = $135,005

The increase in contribution from the original optimal is the shadow price:

135,005 135,000 = $5 per kg.

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Example 2:

Consider the following past exam paper question in detail to improve on your concepts:

2016 Example 2: Consider the following past exam paper question in detail to improve on your

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F5 Performance Management 2016 Past Paper Analysis Limiting Factor Analysis June 08 – Q 2 June

Past Paper Analysis

Past Paper Analysis

Limiting Factor Analysis

June 08 Q 2 June 10 Q 3 Dec 10 Q 3 June 14 Q 2

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9. Pricing Decisions

Influences on Price: Price of a product is decided after taking into account many factors apart from Cost.

Price Sensitivity

If customers of the product can pass on the burden of the cost to someone else, they will not be price sensitive. E.g. A customer will travel business class if his/ her company is bearing the expenses but will reconsider if he/ she has to spend own money.

Price Perception

E.g. if the price of sugar is increased and the customer perceives that the price will further increase, they will stock-up on the product.

Quality

Customers may consider high prices to be a reflection of the high quality of the product

Competitors

Some companies show unified increase in price (e.g. petrol) but in others a change in price, may start a price war (e.g. mobile network services).

Suppliers

If a company increases the price of its products, the suppliers may start providing the raw material at a higher price too.

Inflation

Prices have to reflect the increase in material and labour cost.

Newness

Pricing will depend upon reference points and in the case of new products’ a company may have to look at other markets where the product/ similar product has been launched.

Incomes

If customers have more income, their focus is quality and accessibility of product but if income decreases, focus is on price.

Product Range

Price can be spread over a complete product range to maintain profitability. E.g. sell ink pens cheaper but make up for profit in the price of ink.

Ethics

Does the company want to exploit the market by increasing prices when there is a short term shortage of the product in the market?

Market: Price is determined by the type of market, the company operates in:

• Multiple buyers and sellers • No power saturation Perfect Competition
• Multiple buyers and
sellers
• No power saturation
Perfect
Competition
Oligopoly • Few companies offering same product have power to influence price • Form cartels
Oligopoly
• Few companies offering
same product have
power to influence price
• Form cartels
• One seller with the power to influence price Monopoly Monopolistic Competition •Multiple suppliers with
• One seller with the
power to influence price
Monopoly
Monopolistic
Competition
•Multiple suppliers with
similar products.
•Customer preference
dictates who holds the power

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Competition: If competitors cut prices, a company can react in the following possible ways:

prices, a company can react in the following possible ways: Maintain exitsing prices Raise Price and

Maintain exitsing prices

Raise Price and use extra revenue for non price counter attack

Non Price Counter Attack: maintain

price but improve product/ promotion.

Reduce price

Demand:

Economic theory argues that the higher the price of a good, the lower will be the quantity demanded.

However there are two extremes to this theory:

A company is able to sell a fixed quantity (Q) of the product, regardless of
A company is able to sell a fixed quantity (Q) of the product, regardless of

A company is able to sell a fixed quantity (Q) of the product, regardless of any price (P). This is termed as completely inelastic demand as change in price does not affect the quantity demanded.

A

company is able to sell limitless quantity (Q) of

the product at a set price (P). This is termed as completely elastic demand as change in price will substantially affect the quantity demanded.

A more normal situation is the downward-sloping

A

more normal situation is the downward-sloping

demand curve which shows that demand will increase as prices are lowered. Demand is therefore elastic.

Price Elasticity of Demand: It is a measure of the change in sales demand that would occur for a given change in the selling price.

PED =

The change in quantity demanded as a percentage of original demand The change in sales price as a percentage of the original price

PED > 1 than demand is elastic: impact on quantity demanded is greater due to change in price

PED< 1 than demand is inelastic: impact on quantity demanded due to change in price is nominal

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Elasticity and Pricing:

Very Inelastic Demand

As price will have no impact on quantity demanded, company should focus on quality, service, product design etc to attract customers.

Inelastic Demand

As price has nominal impact on demand, increase the price so that revenue increases and costs reduce due to smaller quantity being produced.

Elastic Demand

Find right balance to ensure that the revenue earned is greater than the costs incurred.

Very Elastic Demand

Try and control elasticity by creating customer preferences through quality, service etc.

Demand Influencers:

Price of other goods

Substitutes: Increase in price of one product will lead to customers moving towards the substitute available.

Complements: Increase in demand for one product will give rise to demand of complementary product.

Increase in Income

Normal goods: more income more demand

Inferior goods: more income less demand

Necessities: demand rises up to a certain point and then remains unchanged, because there is a limit to what consumers can or want to consume.

Tastes or fashion

A change in tastes or fashion will alter the demand for a good, or a particular variety of a good.

Expectations

Stock up may occur if customers expect the prices to rise and this will lead to more demand.

Obsolescence

Many products and services have to be replaced periodically because of obsolescence.

Demand/ Price Influencers Organisation Specific

Product Life Cycle: Demand varies over the life cycle of a product.

Introduction Phase: The price has no impact on demand at the initial stage, when there is little or no competition in the market.

Growth: Prices will have to be reduced as competition increases, to maintain demand.

Maturity: Prices can be stabilised unless the competitors reduce their prices.

Decline: Prices may fall due to lower demand or prices can be increased if the competition withdraws from the market and you are the only one offering the product.

Quality: If the product is of good quality, the demand may be high regardless of price.

Marketing: The 4 P’s of marketing are demand influencers:

Price

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Product

Place: of purchase. If goods are not easily accessible, customers will turn to substitutes.

Promotion: developing a brand name and using a variety of promotional tools will lead to increased demand for the product.

Demand Equation:

lead to increased demand for the product. Demand Equation: Example: The current price of a product

Example:

The current price of a product is $18. At this price the company sells 100 items a month. One month the company decides to raise the price to $22, but only 75 items are sold at this price.

Determine the demand equation.

Solution

Step 1: Find the price at which demand would be nil

Assuming demand is linear, each increase of $4 in the price would result in a fall in demand of 25 units. For demand to be nil, the price needs to rise from its current level by as many times as there are 25 units in 100 units (100/25 = 4) ie to $18 + (4 x $4) = $34.

Using the formula above, this can be shown as a = $18 + ((100/25) x $4) = $34

Step 2: Calculate b

Change in price Change in quantity

100 -75

75

Step 3: Substitute the known value for ‘b’ into the demand function to find ‘a’

P

= a - (0.05Q)

18

= a - (0.05 x 100)

18

= a - 5

b =

$22- $18 = 4

= 0.05

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a = 23

The demand equation is therefore P = 23 0.05Q

Step 4: Check your equation

We can check this by finding Q when P is $18.

18 = 23 (0.05Q)

0.05Q = 23 18

0.05Q = 5

0.05

Q =

5

= 100

The Total Cost Function:

Cost behaviour can be modelled using equations.

Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x Quantity sold (Q)]

The following graph demonstrates the total cost function.

The following graph demonstrates the total cost function. Errors in using these models:  Assume that

Errors in using these models:

Assume that fixed costs remain constant when in reality there is a concept of Step Fixed Costs

Assume that Variable Cost per unit remains constant when in reality they change due to economies/ diseconomies of scale or Volume Based Discounts (discounts given for bulk transactions)

The Profit-Maximizing Price/Output Level

Profits are maximized when marginal cost (MC) = marginal revenue (MR).

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Microeconomic theory and profit maximisation

Profit Maximisation is the process by which a firm determines the price and output level that returns the greatest profit. There are two common approaches to this problem.

The Total revenue (TR) Total cost (TC) method is based on the fact that profit equals revenue minus cost.

is based on the fact that profit equals revenue minus cost. From the graph, it is

From the graph, it is evident that the difference between total costs and total revenue is greatest at point Q. This is the profit maximising output quantity.

The Marginal revenue (MR) Marginal cost (MC) method is based on the fact that total profit in a perfect market reaches its maximum point where marginal revenue equals marginal cost.

maximum point where marginal revenue equals marginal cost. Profits are maximised at the point where MC

Profits are maximised at the point where MC = MR, ie at a volume of Qn units. If we add a demand curve to the graph, we can see that at an output level of Qn, the sales price per unit would be Pn.

Determining the Profit-Maximising Selling Price: Using Equations

The optimal selling price can be determined using equations (ie when MC = MR).

Price: Using Equations The optimal selling price can be determined using equations (ie when MC =

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Example:

It has been determined based on research that if a price of $400 is charged for product G, demand will be 12,000 units. Demand will rise or fall by 20 units for every $1 fall/rise in the selling price. The marginal cost of product G is $120. Calculate the profit-maximising selling price for product G. Solution:

The following step-by-step approach can be applied to most questions involving algebra and pricing.

Step 1: Establish the demand function (find the values for ‘a’ and ‘b’)

b =

change in price

=

$1

= 0.05

change in quantity

20

a = $400 + [(12,000 /20) x $1] = $1,000

Step 2: Establish MC (the marginal cost). This will simply be the variable cost per unit

MC = $120 (given)

Step 3: State MR, assuming MR = a 2bQ

MR = $1,000 (2 x 0.05) Q = $1,000 0.1Q

Step 4: To maximise profit, equate MC and MR to find Q

$120 = $1,000 0.1Q

Q = ($1,000 - $120) x (10/1) = 8,800 is profit maximising demand

Step 5: Substitute Q into the demand function and solve to find P (the optimum price)

P = a bQ = $1,000 (0.05 x 8,800) = $560

Price Strategies

Full cost plus pricing: Calculate full cost of product and add desired profit to determine selling price.

Profit is expressed as either:

a percentage of the full cost (a profit 'mark-up') or

a percentage of the sales price (a 'profit margin').

Example:

 

Mark-Up

Margin

 

%

$

%

$

Variable production costs

 

600

 

600

Other variable costs

 

200

 

200

Production overheads absorbed

 

800

 

800

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Non-production overheads absorbed

 

300

 

300

Full cost

100

1,900

80

1,900

Profit (added to full cost)

25

475

20

475

Selling price

125

2,375

100

2,375

Advantages:

Quick, simple and cheap method to set product price.

As profit % is added to full cost, all the expenses are easily recovered.

Disadvantages:

Ignores profit maximisation combination of price and demand.

In reality the price has to be adjusted to market and demand conditions.

Relies on budgeted output volume to determine appropriate absorption rate for overheads.

Suitable basis for overhead absorption rate has to be selected.

Marginal Cost plus Pricing (Mark-Up Pricing): A mark-up or profit margin is added to the marginal cost in order to obtain a selling price.

The method of calculating sales price is similar to full-cost pricing, except that marginal cost is used instead of full cost.

Advantages:

Simple and easy to calculate.

Mark up % can be varied to reflect demand conditions.

Focuses attention on the contribution of the product, which is a key factor in decision making.

Useful in industries where the Variable cost per unit is easily available.

Disadvantages:

Apart from demand, other relevant market factors, like prices set by competitors etc. are ignored.

Ignores fixed overheads in pricing decisions.

Market Skimming Prices: Charging a high price when the product is introduced in the market for the first time, with the hope of skimming the market for profits. The price of the product is adjusted at a later date.

This is an appropriate approach for:

When the product is new and different.

When its demand elasticity is unknown.

When a company is trying to resolve its liquidity issues.

When a company is aware of market segments that are willing to pay more.

When a product has a short lifecycle and its costs are to be recovered as soon as possible.

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Market Penetration Prices: Introducing a product at low costs to establish its stronghold in the market.

This is an appropriate approach for:

When a company is trying to discourage new entrants in the market.

When a company wishes to push a product to its growth and maturity stage quickly.

When a company can enjoy great economies of scale at high sales volume.

Product demand is highly elastic and so low prices will generate a lot of demand.

Complementary Products Pricing: Setting a single pricing policy for goods that are complementary i.e. are normally bought together. E.g. Computer games console and computer games.

Loss Leader: is when a company sells a low price for one product to attract customers and ends up selling complementary products with high profit margins. This is also termed as ‘Captive Product Pricing’.

Product Lines Pricing: Setting a consistent pricing policy for a group of products that are related to each other. E.g. same policy for shampoos, skin care products etc. of the same brand.

Price Discrimination (Differential Pricing): Charging different prices to different groups of buyers for the same product.

Some bases for price discrimination is:

Market Segment: students get discounted tickets on public transport.

Product Version: Add-ons/ extras for mobile phones, that are not reflected in the original price of the phone but offered as a separate package.

Place: Seating arrangements in cinema halls, with expensive tickets for more comfortable seats.

Time: Off peak travel discounts.

Relevant Cost Pricing (Minimum Pricing): Calculating a minimum price of the product/ order, at which the company will neither be better off, nor worse off. If sold at more than the minimum price, the company will enjoy a profit.

The minimum price calculated must take into account the following:

Incremental cost of producing and selling the product

Opportunity costs in the form of resources uses to produce and sell the product

To earn a profit, the company needs to sell the product/ order at a price higher than the minimum price.

Past Paper Analysis

Past Paper Analysis

Pricing Decisions

Dec 09 Q 5 June 11 Q 2 June 15 Q 4

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10. Short Term Decisions

Relevant Costs: Are incremental future cash flows, arising as a direct consequence of a decision.

Sunk costs, Committed costs and non-cash expenses like depreciation are irrelevant costs.

Relevant Costs for Material:

are irrelevant costs. Relevant Costs for Material: Relevant Costs for Labour:  If labour is re-assigned

Relevant Costs for Labour:

If labour is re-assigned tasks to take up new project or product, the variable cost of labour, variable overheads and the contribution foregone are relevant for decision making.

Relevant Costs for Machinery:

Purchase cost of machinery is irrelevant unless specifically bought for a product/ job.

The rent of a machine hired for a job, is relevant.

User Cost: is the fall in resale value of owned assets, due to use of the machinery in a specific job.

Opportunity Costs

The value of a benefit given up, in order to avail the benefit from an alternative.

For example, if a material is in short supply, it may be transferred from the production of one product to that of another product. The opportunity cost is the contribution lost from ceasing production of the original product.

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Make or Buy Decisions:

Normally applied in the following circumstances:

Whether a company should manufacture its own components, or else buy the components from an outside supplier

Whether a construction company should do some work with its own employees, or whether it should sub-contract the work to another company

Whether a service should be carried out by an internal department or whether an external organisation should be employed

Without limiting factors the relevant costs for the make or buy decision will be the differential costs between the two options.

Example

A company makes two components F and P, for which costs in the forthcoming year are expected to be as

follows.

 

F

P

Production (units)

1,000

2,000

Unit marginal costs

$

$

Direct materials

4

5

Direct Labour

8

9

Variable production overheads

2

3

Directly attributable fixed costs per annum and committed fixed costs:

Incurred as a direct consequence of making F

$1,000

Incurred as a direct consequence of making P

$5,000

A sub-contractor has offered to supply units of F & P for $12 and $21 respectively.

Should the company make or buy the components?

Solution

 

F

P

$

$

Unit variable cost of making

14

17

Unit variable cost of buying

12

21

2

4

Annual requirements (units)

1,000

2,000

$ $

Extra variable cost of buying (per annum)

(2,000)

8,000

Fixed costs saved by buying

(1,000)

(5,000)

Extra total cost of buying

(3,000)

3,000

The company would save $3,000 pa by sub-contracting component W (where the purchase cost would be less than the marginal cost per unit to make internally) and would save $2,000 pa by subcontracting component Z (because of the saving in fixed costs of $8,000).

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Outsourcing:

This is the use of external suppliers for finished products, components or services. This is also known as contract manufacturing or sub-contracting.

Reasons for Outsourcing:

Hiring specialists ensures the quality of the end product and efficiency.

Outsourcing leads to spare resources that can be effectively utilised in other core areas.

Company’s offering outsourcing services have the capacity and flexibility to meet ad-hoc variations in the demand.

There isn’t enough work to justify the recruitment of resources for a specific function.

Companies rely on outsourcing facilities for administrative and maintenance tasks.

The performance of ‘outsourcers’ has to be monitored and measured to make sure quality and targets are not compromised upon.

Joint Products:

Joint products are two or more products which are output from the same processing operation, but which are indistinguishable from each other up to their point of separation. Each product post separation has a substantial sales value.

A joint product is regarded as an important saleable item, and so it should be separately costed. The profitability of each joint product should be assessed in the cost accounts.

The point at which joint products become separately identifiable is known as the split-off point or separation point.

Costs incurred prior to this point of separation are common or joint costs, and these need to be allocated (apportioned) in some manner to each of the joint products.

Problems in accounting for joint products are basically of two different sorts.

How common costs should be apportioned between products, in order to put a value to closing inventory and to the cost of sale (and profit) for each product.

Whether it is more profitable to sell a joint product at one stage of processing, or to process the product further and sell it at a later stage.

Example A Company produces two joint products, S and T from the same process.

Joint processing costs of $150,000 are incurred up to split-off point, when 100,000 units of S and 50,000 units of T are produced.

The selling prices at split-off point are $1.25 per unit for S and $2.00 per unit for T.

The units of S could be processed further to produce 60,000 units of a new chemical, Splus, but at an extra fixed cost of $20,000 and variable cost of 30c per unit of input.

The selling price of Splus would be $3.25 per unit. Should the company sell S or Splus? Solution

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The only relevant costs/incomes are those which compare selling S against selling Splus. Every other cost is irrelevant: they will be incurred regardless of what the decision is.

 

S

Splus

Selling price per unit

$1.25

$3.25

$

$

$

Total sales Post-separation processing costs

125,000

Fixed

20,000

195,000

 

Variable

30,000

50,000

Sales minus post-separation (further processing) costs

125,000

145,000

It is $20,000 more profitable to convert S into Splus.

Shut Down Decisions

Discontinuance or shutdown problems involve the following decisions.

Whether or not to close down a loss making / expensive product line, department or other activity.

Permanent or temporary closure?

Employees affected by the closure must be made redundant or relocated, perhaps after retraining, or else offered early retirement.

It is possible, however, for shutdown problems to be simplified into short-run decisions, by making one of the following assumptions.

Non-current asset sales and redundancy costs would be negligible.

Income from non-current asset sales would match redundancy costs and so these capital items would be self-cancelling.

In such circumstances the financial aspect of shutdown decisions would be based on short-run relevant costs.

Example: Company V makes four products, P, Q, R and S. The budget for next year is as follows:

 

P

Q

R

S

Total

$000

$000

$000

$000

$000

Direct materials

300

500

400

700

1,900

Direct labour

400

800

600

400

2,200

Variable overheads

100

200

100

100

500

800

1,500

1,100

1,200

4,600

Sales

1,800

1,650

2,200

1,550

7,200

Contribution

1,000

150

1,100

350

2,600

Directly attributable fixed costs

(400)

(250)

(300)

(300)

(1,250)

Share of general fixed costs

(200)

(200)

(300)

(400)

(1,100)

Profit/(loss)

400

(300)

500

(350)

250

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'Directly attributable fixed costs' are cash expenditures that are directly attributable to each individual product. These costs would be saved if operations to make and sell the product were shut down.

Required: State with reasons whether any of the products should be withdrawn from the market.

Answer

From a financial viewpoint, a product should be withdrawn from the market if the savings from closure exceed the benefits of continuing to make and sell the product. If a product is withdrawn from the market, the company will lose the contribution, but -will save the directly attributable fixed costs.

Product P and product R both make a profit even after charging a share of general fixed costs.

On the other hand, product Q and product S both show a loss after charging general fixed costs, and we should therefore consider whether it might be appropriate to stop making and selling either or both of these products, in order to eliminate the losses.

Effect of shutdown

P

Q

R

S

 

$000

$000

$000

$000

Contribution forgone

(1,000)

(150)

(1,100)

(350)

Directly attributable fixed costs saved

400

250

300

300

Increase/(reduction) in annual cash flows

(600)

100

(800)

(50)

Although product S makes a loss, shutdown would reduce annual cash flows because the contribution lost would be greater than the savings in directly attributable fixed costs.

However, withdrawal of product Q from the market would improve annual cash flows by $100,000, and withdrawal is therefore recommended on the basis of this financial analysis.

Decision recommended: Stop making and selling product Q but carry on making and selling product S.

Past Paper Analysis

Past Paper Analysis

Short term decision making

June 09 Q 4 Dec 11 Q 1 Dec 14 Q 3 June 12 Q 1 Dec 07 Q 4 Dec 13 Q 1a

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11. Risk and Uncertainty

Risk permeates most aspects of corporate decision-making (and life in general), and few can predict with any precision what the future holds in store.

Risk can take myriad forms ranging from the specific risks faced by individual companies (such as financial risk, or the risk of a strike among the workforce), through the current risks faced by particular industry sectors (such as banking, car manufacturing, or construction), to more general economic risks resulting from interest rate or currency fluctuations, and, ultimately, the looming risk of recession. Risk often has negative connotations, in terms of potential loss, but the potential for greater than expected returns also often exists.

Clearly, risk is almost always a major variable in real-world corporate decision-making, and managers ignore its vagaries at their peril. Similarly, trainee accountants require an ability to identify the presence of risk and incorporate appropriate adjustments into the problem-solving and decision-making scenarios encountered in the exam hall. While it is unlikely that the precise probabilities and perfect information, which feature in exam questions can be transferred to real-world scenarios, a knowledge of the relevance and applicability of such concepts is necessary.

The basic definition of risk is that the final outcome of a decision, such as an investment, may differ from that which was expected when the decision was taken. We tend to distinguish between risk and uncertainty in terms of the availability of probabilities

Risk is when the probabilities of the possible outcomes are known (such as when tossing a coin or throwing a dice); uncertainty is where the randomness of outcomes cannot be expressed in terms of specific probabilities.

However, it has been suggested that in the real world, it is generally not possible to allocate probabilities to potential outcomes, and therefore the concept of risk is largely redundant. In the artificial scenarios of exam questions, potential outcomes and probabilities will generally be provided, therefore a knowledge of the basic concepts of probability and their use will be expected.

Attitudes to risk

Risk seeker

A decision maker interested in the best outcomes no matter how small the chance that they may occur.

Risk neutral

A decision maker concerned with what will be the most likely outcome.

Risk Averse

A decision maker who acts on the assumption that the worst outcome might occur.

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PROBABILITY

The term ‘probability’ refers to the likelihood or chance that a certain event will occur, with potential values ranging from 0 (the event will not occur) to 1 (the event will definitely occur). For example, the probability of a tail occurring when tossing a coin is 0.5, and the probability when rolling a dice that it will show a four is 1/6 (0.166). The total of all the probabilities from all the possible outcomes must equal 1, ie some outcome must occur.

A real world example could be that of a company forecasting potential future sales from the introduction of a new product in year one (Table 1).

Table 1: Probability of new product sales

Sales

$500,000

$700,000

$1,000,000

$1,250,000

$1,500,000

Probability

0.1

0.2

0.

0.2

0.1

From Table 1, it is clear that the most likely outcome is that the new product generates sales of £1,000,000, as that value has the highest probability.

INDEPENDENT AND CONDITIONAL EVENTS

An independent event occurs when the outcome does not depend on the outcome of a previous event. For example, assuming that a dice is unbiased, then the probability of throwing a five on the second throw does not depend on the outcome of the first throw.

In contrast, with a conditional event, the outcomes of two or more events are related, ie the outcome of the second event depends on the outcome of the first event. For example, in Table 1, the company is forecasting sales for the first year of the new product. If, subsequently, the company attempted to predict the sales revenue for the second year, then it is likely that the predictions made will depend on the outcome for year one. If the outcome for year one was sales of $1,500,000, then the predictions for year two are likely to be more optimistic than if the sales in year one were $500,000.

The availability of information regarding the probabilities of potential outcomes allows the calculation of both an expected value for the outcome, and a measure of the variability (or dispersion) of the potential outcomes around the expected value (most typically standard deviation). This provides us with a measure of risk which can be used to assess the likely outcome.

EXPECTED VALUES AND DISPERSION

Using the information regarding the potential outcomes and their associated probabilities, the expected value of the outcome can be calculated simply by multiplying the value associated with each potential outcome by its probability. Referring back to Table 1, regarding the sales forecast, then the expected value of the sales for year one is given by:

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Expected value

= ($500,000)(0.1) + ($700,000)(0.2)

+ ($1,000,000)(0.4) + ($1,250,000)(0.2)

+ ($1,500,000)(0.1)

= $50,000 + $140,000 + $400,000

+ $250,000 + $150,000

= $990,000

In this example, the expected value is very close to the most likely outcome, but this is not necessarily always the case. Moreover, it is likely that the expected value does not correspond to any of the individual potential outcomes. For example, the average score from throwing a dice is (1 + 2 + 3 + 4 + 5 + 6) / 6 or 3.5, and the average family (in the UK) supposedly has 2.4 children. A further point regarding the use of expected values is that the probabilities are based upon the event occurring repeatedly, whereas, in reality, most events only occur once.

In addition to the expected value, it is also informative to have an idea of the risk or dispersion of the potential actual outcomes around the expected value. The most common measure of dispersion is standard deviation (the square root of the variance), which can be illustrated by the example given in Table 2, concerning the potential returns from two investments.

Table 2: Potential returns from two investments

Investment A

Returns

Probability of return

Investment

B

Returns

Probability of return

8%

0.25

5%

0.25

10%

0.5

10%

0.5

12%

0.25

15%

0.25

To estimate the standard deviation, we must first calculate the expected values of each investment:

Investment A Expected value = (8%)(0.25) + (10%)(0.5) + (12%) (0.25) = 10%

Investment B Expected value = (5%)(0.25) + (10%)(0.5) + (15%) (0.25) = 10%

The calculation of standard deviation proceeds by subtracting the expected value from each of the potential outcomes, then squaring the result and multiplying by the probability. The results are then totalled to yield the variance and, finally, the square root is taken to give the standard deviation, as shown in Table 3.