A Comprehensive Cost-Volume-Profit Analysis under Uncertainty

Author(s): Zvi Adar, Amir Barnea, Baruch Lev

Source: The Accounting Review, Vol. 52, No. 1 (Jan., 1977), pp. 137-149
Published by: American Accounting Association
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THE ACCOUNTING REVIEW
Vol. LII, No. I
January 1977

A ComprehensiveCost-Volume-Profi
Analysis Under Uncertainty

Zvi Adar, Amir Barnea and Baruch Lev

ABSTRACT: This study presents a comprehensive approach to cost-volume-profit anal-
ysis under uncertainty. It combines the probability characteristics of the environmental
variables with the risk preferences of decision makers. The approach is based on recently
suggested economic models of the firm's optimal output decision under uncertainty,
which were modified here within the mean-standard deviation framework to provide for a
cost-volume-utility analysis allowing management to: (1) determine optimal output, (2)
consider the desirability of alternative plans involving changes in fixed and variable costs,
expected price and uncertainty of price and technology changes and (3) determine the
economic consequences of fixed cost variances.

C OST-volume-profit (CVP) analysis distributions, risk measures, such as the

is concerned with the optimal level
and mix of output to be produced
with available resources, namely, the
firm's short-run output decision. Various
cost accounting models have been de-
veloped within this broad decision frame-
work, such as breakeven analysis, trans-
fer pricing systems and mathematical
programming methods for choosing op-
timal sales mix and the optimal extent of
processing joint products. Initially all
CVP models were deterministic, as-
suming demand and cost structures to
be known with certainty. However, fol-
lowing the significant developments dur-
ing the last two decades in the area of
economic decision making under un-
certainty, attempts have been made to
relax the certainty assumption of CVP
models. These attempts [Hilliard and
Leitch, 1975; Jaedicke and Robichek,
1964; Morrison and Kaczka, 1969] took
the form of treating various variables,
such as volume of sales, product prices
and cost, as random. Assuming these
variables were subject to well-defined
137
probability of failing to achieve a speci-
fied profit level, were derived from prob-
ability and tolerance intervals.
From a decision theory perspective,
the CVP models can be viewed as differ-
ent simplification levels of the firm's
short-run output decision. Certainty
models probably represent the extreme
level of simplification, since they assume
that future values of the decision-relevant
variables are perfectly predictable. Avail-
able CVP models which incorporate un-
certainty simplify the decision process by
ignoring the decision makers' attitudes
toward risk, or equivalenty, assuming
risk neutrality. Obviously, given cost
considerations, any realistic decision
The comments of David Solomons, members of the
accounting workshop at the Wharton School, Univer-
sity of Pennsylvania and those of referees are acknowl-
edged gratefully.
ZviAcar, Amir Barnea and Baruch Lev
are members of the Faculty of Manage-
ment at Tel-Aviv University.
138
model must be simplified to some extent. 1
The decision makers' problem is to de-
termine the optimal level of simplifica-
tion. However, determination of the
optimal simplification, or equivalently,
evaluation of the different payoffs and
consequences of alternative simplified
models, requires the construction of
complete models. This is the main pur-
pose of the current study: to present a
comprehensive CVP analysis under un-
certainty by combining the probability
characteristics of the environmental vari-
ables with the risk preferences of decision
makers. Given the comprehensive model,
an improved evaluation of model simpli-
fication is made possible.
Combining uncertainty with risk pref-
ence function also provides new interest-
ing insights, such as the effect of fixed
cost changes on optimal short-run out-
put.2 As is well known, the basic premise
of conventional CVP models (a premise
which is, of course, derived from eco-
nomic optimization concepts under cer-
tainty) is the irrelevance of fixed costs in
determining optimal output, since they
do not affect marginal cost and revenues.3
As will be shown below, under uncer-
tainty and risk aversion, fixed cost
changes affect the firm's short-run out-
put decision. This and other insights can
be furthered by examining the following
decision model.
THE DECISION MODEL
Assume a single product, price-taker
firm whose profit function is:
ft = ( - c)x -k.(1
The firm thus produces the quantity x
at a fixed cost k, and variable cost C(x)
which, for simplicity, is assumed to equal
cx, i.e., constant marginal costs. The only
random element in the system is assumed
to be the selling price f, which is non-
negative and satisfies
The Accounting Review, January 1977
p E@)
= + U = p + a. (2)
The density function of a, f(i7), is known,
with E(a)= 0 and Var(a)=c.
Since price is random, so are the firm's
profits ;4 therefore,the generally accepted
firm objective of profit maximization is
no longer valid under uncertainty, as the
maximization of a random variable is
meaningless. Following the mainstream
of economic research under uncertainty
[e.g., Dhrymes, 1964; Leland, 1972; Lint-
ner, 1970;Sandmo,1971], we assume that
the firm's decision makers possess a Von
Neumann-Morgenstern utility of profit
function, U = U(ft), with U'(fi)> O (non-
satiation), U"(fi)<O (risk aversion) and
determine optimal output by maximiz-
ing the mathematical expectation of the
utility of profits, E{ U(if)} .5
1 See [Demski, 1972, chs. 2-3, and Feltham, 1972, ch.
5] for a comprehensive discussion of complete and
simplified decision models.
2 Fixed costs are, by definition, invariate with respect
to output changes within a relevant range, however, they
may vary across states of nature. Thus, for example, in
a depression property taxes might be lowered (or in-
vestment incentives increased) as a result of fiscal policy.
This point often is overlooked in the literature on CVP
analysis, which generally treats fixed resources and
fixed costs as synonyms. In the short run, some resources
(e.g.. plant) are fixed, yet the cost associated with these
resources generally will vary across states of nature.
Hence, we see the significance of the fixed-cost effect
on the short-run output decision.
3 The well-known concept of contribution margin"
(i.e., the difference between price and variable costs)
and the decision rules derived from it are based on this
premise. For example, a customer's order should be ac-
cepted if its contribution margin is positive.
4 Recall that the firm produces a single product, hence
it cannot insure" itself completely against the risk of
unexpected variations in product prices (represented by
vu). A multiproduct firm can eliminate (diversify) part
or all of the risk associated with random prices, depend-
ing on the correlations among price changes of different
products. We also assume that there are no insurance
markets for these purposes.
' Obviously the performance evaluation of decision
makers should be a function of both expected profit and
risk. This is analogous to the two-parameter evaluation
of portfolio performance e.g., Fama, [1972], except that
in our case the "price" of risk is derived from decision
makers' utility function.
Adar, Barnea and Lev
The comparative statics of this maxi-
mization problem recently was derived by
Sandmo [1971] and Leland [1972]. How-
ever, this general derivation does not lend
itself to the compact and simple frame-
work which is a major advantage of CVP
models (e.g., the general model cannot be
presented graphically, and it does not
provide a compact risk measure). Accord-
ingly, we adopt the Tobin-Markowitz-
Lintner "mean standard deviation"
framework6 and assume that decision
makers rank alternative pairs of ex-
pected profit, a, and standard deviation
of profit, As,according to the utility func-
tion
G(a,, 7-); Ga < 0, G'- > 0. (3)
The values of ft and ad are obtained
readily from (1) and (2):
7i = (pc)x -k. (4)
as = x a. (5)
Thus, both 7i and ad depend on output.
Obviously, given market and technologi-
cal conditions, not all (7, a.) combina-
tions are feasible to the firm. The set of
feasible (7, a.) combinations open to the
firm can be derived by substituting (5)
into (4), which yields:
= ban-k, (6)
r [ c)/],-k
where
b = (p-
Consequently, optimal firm behaviour
implies maximizing (3) subject to the
constraint (6).7 This maximization prob-
lem is equivalent, under certain circum-
stances, to the maximization of E[U(fi)]
with respect to output.8
By setting the Lagrangian
=
LGm(axiizn, )-e div th-ba + k], (7)
and maximizing, we derive the following
139
first- and second-order conditions:
G +?biO>b G, (8)
7T- ba + k = 0
G1 1 G12 b
D= G21 G22 -1 >0 (9)
b -1
where
G, = G'a, = 8G( )/8a,;
G2 = G' = 8G( )/08;
G = G"a, -= 02G( )/Oa0 7-;
= -= 2G( )/f, etc.
The ratio - G1/G2 in (8) is the slope of
the indifference curve of G( ), and b is
the slope of the linear constraint (6).
Condition (9) implies that the indiffer-
ence curves of G( ) are convex.
Figure 1 presents graphically this opti-
mal short-run output decision for the
firm. In the first quadrant, the optimal
* as*combination is determined at the
tangency point between the constraint
line originating from k and the indiffer-
ence curve II (i.e., the first-order con-
dition (8) of b = - G1/G2). Optimal out-
put, x*, is determined in the second and
fourth quadrants, using expressions (4)
and (5). Specifically, the slope of the
downward sloping straight line in the
second quadrant originating from the
intersection of the axes is au. Hence, by
expression (5), the downward perpen-
dicular (broken line) from a* intersects
6 The motives of this shift from the general to the
mean-standard deviation framework are the same as
those underlying the widespread use of the mean-
standard deviation portfolio model.
7 Note the role of the fixed cost, k, in the determination
of the feasible set (6).
8 As is well-known from the portfolio literature, this
equivalence holds when U(Tr)is quadratic, or when all
the moments of flu) depend solely on the mean and
standard deviation (e.g., when ia,the random element of
price is distributed normally). In other cases, this proce-
dure is only an approximation.
140 The Accounting Review, January 1977

FIGURE I
OPTIMAL SHORT-RUN OUTPUT

I II

III

x I (p_- C = (p -
~~~~~~~~hc)lia.I(,
x
a7T~~~~~

1 u I~~~~~~

I~~~~~~~~\ I

I I~~~~~~~~

this line at x*. The slope of the upward
sloping straight line in the fourth quad-
rant originating from k, is p- c. There-
fore, by expression (4), the horizontal
(broken) line from -* intersects this up-
ward sloping line at x*.9
Optimal production decision thus de-
pends on decision makers' risk attitudes
(the indifference map), as well as on the
fixed cost, k, and the slope of the con-
straint line, b, which can be interpreted
as the price of risk, in term of the expected
contribution margin (p-- c), per unit of
standard deviation of price, v.
COST-VOLUME-UTILITY ANALYSIS
The model developed in the preceding
section provides for an extension of con-
ventional CVP analysis to a cost-volume-
utility (CVU) analysis under price uncer-
9 Note that the lower part of the vertical axis measures
both output, x, and fixed cost, k. This procedure is used
in graphical models for compact presentation.
Adar, Barnea and Lev 141

FIGURE 2

Two ALTERNATIVE PLANS

7t

0~~~~~~
2~~~~~~~
0k
k~~~~~
''if (

k~~~~

N a~~~~~~~~~~~~~~~~X

tainty. Such a CVU model can be used
for an ex-ante examination of conse-
quences of various alternative plans
under management control. While CVP
analysis considers the consequences of
various price-quantity relationships on
profit, the scope of CVU analysis is ob-
viously broader. For example, suppose
that management considers an invest-
ment in market research intended to de-
crease price uncertainty, v. In Figure 2,
this plan is represented by a new con-
straint line k'al, with a lower intercept
and a higher slope than the current line
k'a0. This reflects an increase in fixed
cost (due to the increase in market re-
search) and decrease in v". Given man-
agement's particular preferences (re-
flected by the shape of the indifference
curves), it is obvious that the proposed
project should be rejected, since it re-
sults in a lower utility level at the new
optimum. In addition, the model shows
that the maximal increase in fixed costs
142
warranted by the proposed decrease in
price uncertainty, v", is (k2-0k), where
k2 is the intercept of a constraint line
parallel to k1 a' and tangent to the origi-
nal indifference curve.
The consequences of alternative plans
that affect expected price, marginal cost,
fixed costs and price uncertainty, or any
combination of those, can be evaluated
in a similar manner. Notice that the
effect of such plans on optimal output
can be determined readily in the second
or the fourth quadrants of Figure 2, de-
pending on the changes considered.'0
The construct of Figure 2 can be trans-
formed into a different graph providing
for a more efficient ex-ante examination
of alternative investment-production
plans. Specifically, in Figure 2 the firm is
indifferent between the two (b, k) com-
binations represented by constraints
k0aO and k2a2, since in both cases op-
timizing behavior yields an identical
utility level. Accordingly, it is possible to
present all (b, k) combinations derived
from a given indifference curve (i.e.,
yielding the same utility level G(u, -)
=GO) by an indifference locus T0 in a
(b, k) plane. Such an (indirect) isoutility
curve is presented in Figure 3. Note that
lower T loci reflect higher utility levels
and vice versa.11
The desirability ranking of alternative
investment-production opportunities
(i.e., combinations of k-fixed costs, and
b-risk-adjusted contribution margin)
open to the firm is determined readily
within the construct of Figure 3. Thus, for
example, it is clear that production plan
n is superior to m since it permits the firm
to achieve a higher level of utility. In a
long-run analysis, available technology
can be introduced into the b, k plane (see
the FF frontier in Figure 3). The optimal
production plan for the firm is deter-
mined at the tangency of this frontier and
the indifference curve T.
The Accounting Review, January 1977
THE FIXED COST EFFECT
Recall that under certainty, fixed cost
changes do not affect the firm's short-run
output decision, because these changes
are unrelated to production level (i.e.,
they do not affect marginal costs). How-
ever, changes in fixed costs affect the
firm's wealth (e.g., an increase in the in-
vestment tax credit will increase the
firm's wealth, or net equity, other things
being equal). Generally, such wealth
changes will affect decision makers' atti-
tudes toward risk and, hence, the firm's
output decision.'2 Specifically, suppose
the firm's behavior is characterized by an
attitude of "decreasing absolute risk
aversion," which implies that as the
firm's profits (or equivalently its wealth)
increase, its required marginal risk pre-
mium (i.e., the marginal difference be-
tween the mathematical expectation of
return and its certainty equivalent) de-
creases. In this case, a wealth decrease
(brought about by a fixed cost increase)
will increase the firm's required risk pre-
0
In the above example, where a change in a. is
examined, optimal output should be determined in the
4th quadrant, since the slope of the straight line, P- c, is
unaffected by the proposed plan. For proposed changes
in expected price and marginal cost, output should be
determined in the second quadrant, where the slope of
the downward sloping line is v".
1' Analytically, the construction of the indirect utility
function '(h, k) involves solving the first-order condi-
tions (8), expressing optimal a.*, 7* as functions of b and
k (similar to demand functions in consumer theory) and
substituting them in the utility function G( ), to derive
1(b, k)=G[a * (b, k), 7*(b, k)] (10)
It can be shown that the slope of an indifference curve of
'- is a,, while the intercept of the line tangent to it with
the vertical axis is - i-. (See Figure 3.)
12 It should be noted here that fixed cost may affect
the output decision in two ways. First, fixed costs may
vary over states of nature, thereby introducing a random
element into the decision. For simplification purposes,
we ignored this effect in the current study, assuming
fixed costs to be known at the time the output decision is
made, leaving price as the only random element in the
model (1). Second, fixed costs influence wealth and,
thereby, risk attitudes of decision makers. This effect is
discussed here.
Adar, Barnea and Lev 143

mium on risky projects, such as produc-
tion, and thereby will cause the firm to
cut output, and vice versa.
This result ("fixed cost effect") de-
pends on the shape of the indifference
curves. Figure 4 presents the case in
which the slope of the indifference
curves, - GI/G2, decreases as wealth, if,
increases (for given all level). Since this
slope reflects the subjective rate of sub-

FIGURE 3
THE DETERMINATION OF OPTIMAL INVESTMENT-
PRODUCTION PLAN
k

//

/~

=2

(Ti
144 The Accounting Review, January 1977

FIGURE 4
FIXED-COST EFFECT ON SHORT-RUN OUTPUT

I in~~~~~~~~~~~~~~~~~~ I I

x.I I I

\'I

stitution between 7 and al Figure 4 tudes are characterized by increasing

assumes decreasing risk aversion for
wealth increases. In this case, an increase
in fixed cost from k' to k2 causes a de-
crease in optimal output from x1 to x2.13
The proposed CVU model can, of course,
accommodate different attitudes to-
wards risk. When decision makers' atti-
risk aversion, the fixed-cost effect ob-
viously would be reversed (i.e., increase
in fixed cost induces production increase).
1 See the appendix for rigorous proof of these state-
ments and for a discussion of the relationships between
the slope of the indifference curves and the Arrow-Pratt
measure of absolute risk aversion.
Adar, Barnea and Lev
FIGURE5
EX-POST ANALYSIS OF FIXED-COST VARIANCE
I~ ~ ~ ~~~
it?-
Only in the unlikely case of constant risk
aversion will optimal output be un-
affected by fixed cost changes.14
The relationship between fixed costs
and optimal output suggests a new ap-
proach to ex-post analysis of fixed costs
variances indicating the economic con-
sequences of these variances. Conven-
tional variance analysis, on the other
hand, indicates only that there was a dif-
ference between expected and actual
145
~~~~~~~~~~
IIII'J
I a,
op
fixed costs. 5 Consider Figure 5 in which
planned (ex-ante) fixed costs were kV and
where the kPm represents the optimal
production plan. Optimal ex-ante out-
put, xP, is determined by the tangency
14 See Sandmo [ 1971 ] and Leland [ 1972 ] for formal
proof of these statements, using the Arrow-Pratt measure
of absolute risk aversion.
15 For example,
the "volume variance' does not re-
flect economic loss, i.e., the contribution margin lost by
producing under capacity or the cost involved in the
acquisition of inadequate capacity.
146
between the line kPm and indifference
curve I. Suppose now that during the
period, actual fixed costs increased to kV,
and for simplicity assume that all other
variables, p, c, au, remained constant. In
this case, there are two possibilities: (1)
if the firm could have changed the
planned output, it would have decreased
output from xP to xa, and the loss caused
by the unexpected increase in fixed costs
would be reflected by the decrease to a
lower utility level from I to II; (2) if the
firm already was committed to the
planned output, xP, the loss in utility
terms would be even larger reflected by
the decrease from indifference curve I to
III.
Naturally, it would be more meaning-
ful to express the loss resulting from the
fixed costs' variances in monetary rather
than utility terms. One possibility is to
express the consequences of variances in
terms of changes in expected profit for a
given risk level. Thus, in the above ex-
ample in which the fixed cost increase
(when output could not be changed) re-
sulted in a decrease from indifference
curve I to II1, the monetary loss
amounted to 7-P - 7-a dollars, given the
constant risk level, o4P(see Figure 5).
It should be noted that a comprehen-
sive development of a variance analysis
system under uncertainty requires an ex-
tension of the above, single-period CVU
model to a multiperiod one. Specifically,
the major objective of variance analysis-
the correction of processes found to be
out of control is meaningful only in a
multiperiod context, where information
from a past period may affect the deci-
sions in the current and future periods. 6
Such a multiperiod extension of the
model will not be attempted here. 17
RELATIONSHIP WITH AVAILABLE MODELS
As stated in the introduction, the rela-
tionship among the conventional, perfect
The Accounting Review, January 1977
certainty CVP models; later models
which allow for uncertainty in sales and
various cost items; and the model sug-
gested in the current study can be viewed
as different levels of simplification of the
complete short-run output decision
model. The choice of model, or equiva-
lently the optimal degree of simplifica-
tion, depends on the cost involved the
incremental cost associated with addi-
tional specification of model compo-
nents, e.g., a utility function, vs. the addi-
tional benefit resulting from improved
decisions. Obviously, this is a situation-
specific issue and little can be added to
the preceding general statement. How-
ever it should be noted that while con-
siderable problems obviously will be en-
countered in operationalizing the model
suggested above, i.e., specifying risk
preferences, there seems to be no escape
from facing these problems if manage-
ment wishes to consider the impact of un-
certainty on their decisions. Stated dif-
ferently, the applicability of available
approaches to CVP analysis (suppress-
ing decision-maker's risk preferences) is
largely illusory. Consider, for example,
the Jaedicke-Robichek [1964] CVP
model under uncertainty which provides
the decision maker with risk measures
associated with each price distribution
(e.g., the probability of failing to achieve
the breakeven level of sales). Manage-
ment's choice among alternative actions
presumably will be based, among other
things, on these risk differentials. But,
how much of a difference in risk is
needed to compensate for a larger profit
expectation? Obviously no CVP decision
analysis also will be useful in a single-
'6Variance
period context when the performance evaluation (re-
warding system) of decision makers is based on the rela-
tionship between expected and actual results.
1 See Demski [ 1967 ]; Dopuch, Birnberg and Demski
[1967] for a related discussion of adaptive behavior,
namely the impact of standard cost variance analysis on
stature standards and decisions.
Adar, Barnea and Lev
can be made without knowing the trade-
off between risk and expected profit;
namely, without at least partial informa-
tion on the decision maker's risk prefer-
ences. Therefore, CVP analysis, like
most other decision models, is largely
inapplicable when decision makers' at-
titudes towards risk are ignored com-
pletely.
Rather than avoiding the risk prefer-
ences issue (or, implicitly assuming risk
neutrality), it must be faced. On the con-
ceptual level, incorporation of various
plausible forms of utility functions into
the CVP model provides important in-
sights, such as the fixed-cost effect dis-
cussed. On the practical level, attempts
must be made to determine reasonable
approximations to decision-makers' risk
preferences. Such preferences can be de-
rived from an examination of the firm's
past record with respect to risky projects
(e.g., the accept-reject record of drilling
proposals, which usually incorporates
probabilistic forecast by geologists, in
the case of oil companies). 18 Or, prefer-
ences can be based on questionnaire-type
ranking by management of alternative
combinations of expected profit and some
measure of profit dispersion (a confi-
dence-interval, say). 9 In any case, it
seems reasonable that CVP analysis
based on some plausible utility function
will yield valuable insights regarding de-
cision consequences.
CONCLUDING REMARKS
A comprehensive approach to CVP
analysis under uncertainty was presented
above. Recently suggested economic
models of the firm's optimal output
decision were modified within the mean-
standard deviation framework to provide
for a cost-volume-utility analysis allow-
ing management to: (1) determine opti-
mal output (which cannot be done by
conventional CVP analysis), (2) con-
147
sider the desirability of alternative short-
run and long-run plans involving changes
in fixed and variable costs, expected price
and uncertainty of price and technology
changes and (3) determine the economic
consequences of fixed-cost variances.
It should be realized that the implica-
tions of the proposed approach reach
beyond the two areas discussed above
(CVP analysis and fixed-cost variance
analysis). Particularly, the effect of fixed-
cost changes under uncertainty on the
short-run output decision has obvious
implications to a wide range of cost
accounting problems, such as common-
cost allocation, joint product pricing and
transfer pricing systems for divisional-
ized firms. While under certainty, fixed
costs in all those cases are irrelevant for
decision making (e.g., transfer prices do
not include fixed costs); under uncer-
tainty a different attitude toward fixed
costs (and particularly, fixed cost alloca-
tion) is called for. It also should be noted
that the model presented above, assuming
price as the only source of uncertainty,
can be extended by considering addi-
tional sources, such as the uncertainty of
fixed and variable costs.
APPENDIX
Fixed-Cost Effect in the Two-
Parameter Case
In the discussion of Figure 4 (the fixed-
cost effect) it was stated that if, for a given
y,9 the slope of the indifference curves of
G( ) decreases as 7 increases, then fixed-
cost increases would induce the firm to
cut output, and vice versa. The proof to
this geometrical argument follows. By
18 Throughout this study we avoided the
problematic
issue of whose utility managers are maximizing (i.e.,
stockholders, their own, etc.). For our purposes it
suffices that the firm reveals consistent behavior patterns
when faced with risky choices.
19 See [Greer, 1974] for a recent attempt to determine
utility functions of firms.
148 The Accounting Review, January 1977

totally differentiating the first-order con- a, for a given Ad is:

ditions (8), we obtain:
H(-Gl G2)10
G11dan+ G12d- + bdx = idb = - 1G2[G1 (14)
2 - (G1lG2)G22].
G21da? + G22d - d= (11)
Now compare equations (13) and (14).
-bdW, + d2- = 7db - dk.
Since G2>0, and the expressions in
Equating db = 0 and solving for the brackets on the right-hand side of the
fixed-cost effect on optimal oy, we get: two equations are identical, then a fixed-
cost increase will decrease output [nega-
__7*
G12 + bG22 tive (13)] if the indifference curves de-
(12)
dk D crease when 7 increases [negative (14)].
where D is defined by (9). Since by (5) The preceding result is analogous to
07* =x*0, and at the optimum b =G1 Sandmo's [1971] proof that decreasing
G2 (8), the fixed-cost effect on optimal (increasing)absolute risk aversion implies
output is:
__ _X [G12 - (G1
/G2)G22] (13) ak k }
0Ok U D
In the particular case where U(fr) is
Given that D > 0 by the second-order quadratic, both results are identical since
condition (9) and au> 0, then the slope of the indifference curve of G( )
ax* is - 7,zRA, where, RA = -U" ()/U U(),
is the Pratt-Arrow measure for absolute
Ok <0
risk aversion. For other utility functions,
if the bracketed expression in (13), [G12 the difference between Sandmo's result
-(G1 G2)G22], is positive. This result is and ours can be explained fully by the
equivalent to the geometrical argument difference between his general, U(ft), and
used in the discussion of Figure 4, be- our particular mean-standard deviation,
cause the partial derivative of the slope G(az, 7), frameworks. Nevertheless, the
of the indifference curves with respect to fixed-cost effect holds in both cases.

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