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Syllabus structure
A: Pricing and Product Decisions
(30%)
(20%)
Pricing and
Decision
Making
Budgeting and
Management
Control
Responsibility
Centres
Important Topics
Transfer pricing
Pricing decision
Linear Programming
Budgeting
ROCE and RI
Learning Curve
PERFORMANCE
Management
LINEAR PROGRAMMING
Topics Covered
Meaning
Use
Slack and surplus
Sensitivity Analysis and Shadow price
Linear Programming
Mathematical programming is used to find the best or optimal solution to a problem that
requires a decision or set of decisions about how best to use a set of limited resources to
achieve a state goal of objectives.
Linear programming requires that all the mathematical functions in the model be linear
functions.
Linear Programming is used where more than one limiting factor is involved.
Example of LP Problem
Product Mix Problem
A manufacturer has fixed amounts of different resources such as raw material, labor, and
equipment.
These resources can be combined to produce any one of several different products.
The quantity of the ith resource required to produce one unit of the jth product is known.
The decision maker wishes to produce the combination of products that will maximize total
income.
Example of LP Problem
A Blending Problem
Blending problems refer to situations in which a number of components (or commodities) are
mixed together to yield one or more products.
Typically, different commodities are to be purchased. Each commodity has known characteristics
and costs.
The problem is to determine how much of each commodity should be purchased and blended
with the rest so that the characteristics of the mixture lie within specified bounds and the total
cost is minimized.
Steps
Determine the objective of the problem and describe it by a criterion function in
terms of the decision variables.
Find out the constraints.
Do the analysis which should lead to the selection of values for the decision
variables that optimize the criterion function while satisfying all the constraints
imposed on the problem.
Example
The N. D. Company produces two products: I and II. The total amount of raw
material available per day for both products is 15751b. The total storage space
for all products is 1500 ft2, and a maximum of 7 hours per day can be used for
production.
All products manufactured are shipped out of the storage area at the end of the day.
Therefore, the two products must share the total raw material, storage space, and
production time. The company wants to determine how many units of each product to
produce per day to maximize its total income.
Solution
The object is to maximize the equation:
Z = 13x1 + 11x2
subject to the constraints on storage space, raw materials, and production time.
Each unit of product I requires 4 ft2 of storage space and each unit of product II requires 5
ft2. Thus a total of 4x1 + 5x2 ft2 of storage space is needed each day. This space must be less
than or equal to the available storage space, which is 1500 ft2. Therefore,
4X1 + 5X2 1500
Similarly, each unit of product I and II produced requires 5 and 3 1bs, respectively, of raw
material. Hence a total of 5xl + 3x2 Ib of raw material is used.
Solution contd.
This must be less than or equal to the total amount of raw material available, which is 1575 Ib.
Therefore,
5x1 + 3x2 1575
Prouct I can be produced at the rate of 60 units per hour. Therefore, it must take I minute or 1/60 of an
hour to produce I unit. Similarly, it requires 1/30 of an hour to produce 1 unit of product II. Hence a
total of x1/60 + x2/30 hours is required for the daily production. This quantity must be less than or
equal to the total production time available each day. Therefore,
x1 / 60 + x2 / 30 7
or x1 + 2x2 420
Finally, the company cannot produce a negative quantity of any product, therefore x1 and x2 must each
be greater than or equal to zero.
Solution Contd.
The linear programming model for this example can be summarized
as:
Solution Contd.
Solution contd.
The shaded area of the figure comprises the area common to all the regions defined by the constraints and
contains all pairs of xI and x2 that are feasible solutions to the problem.
This area is known as the feasible region or feasible solution space. The optimal solution must lie within
this region.
There are various pairs of x1 and x2 that satisfy the constraints such as:
Slack
Slack- this is the amount of resource which is under utilized when the optimum plan is
implemented.
It occurs when the optimum point does not fall on a given resource line.
It is concerned with less than or equal to constraints.
However, 1500- [4(270) + 5(75)], or 45 ft2 of storage space, is not used. Thus the storage space is
not a constraint on the optimal solution; that is, more products could be produced before the
company ran out of storage space. Thus this constraint is said to be slack.
Surplus
Surplus- this is utilization of resources over and above minimum.
It is concerned with greater than or equal to constraints.
Simplex Method
When decision variables are more than 2, it is always advisable to use Simplex Method to avoid
lengthy graphical procedure.
The simplex method is not used to examine all the feasible solutions.
It deals only with a small and unique set of feasible solutions, the set of vertex points (i.e.,
extreme points) of the convex feasible space that contains the optimal solution.
Shadow price- the extra contribution that would arise if one more unit of that scarce resource
became available.
Thanks
Performance Management
PRICING DECISION
Topics Covered
Factors affecting profit
Volume
Volume
increase- per
unit cost
decreases
Price
Lower cost
helps in
setting lower
price
Price
Quantity
An elastic demand means that the quantity demanded is relatively responsive to changes in price.
An inelastic demand means that the quantity demanded is not very responsive to changes in price.
Imperfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Maturity
Decline
X=quantity
A and b are constants
MR=a-2bx
MR=MC
Pricing strategies
Total cost plus
Performance Management
TRANSFER PRICING
Topics Covered
Meaning of Decentralization
Meaning of transfer pricing
Purpose
Basis of Transfer Pricing
Objective of Transfer Pricing
Meaning of Decentralization
Delegation of decision-making to the subunits of an organization.
It is a matter of degree.
The lower the level where decisions are made, the greater is the decentralization.
Decentralization is most effective in organizations where subunits are autonomous and costs and
profits can be independently measured.
The benefits of decentralization include:
(1) decisions are made by those who have the most knowledge about local conditions;
(2) greater managerial input in decision- making has a desirable motivational effect; and
(3) managers have more control over results.
Purpose
Generate separate profit figures for each division and thereby evaluate
Transfer prices make managers aware of the value that goods and services have for other
segments of the firm.
Transfer pricing allows the company to generate profit (or cost) figures
for each division separately.
The transfer price will affect not only the reported profit of each centre,
but will also affect the allocation of an organizations resources.
The Price Must be Similar to Prices Other Companies Charge Each Other
Examine the prices other companies charge each other for similar products. This is a good guideline for
setting prices between divisions of your own company. Set the price near what the company-to-company
market dictates.
Negotiated transfer price: Senior management does not specify the transfer price. Rather,
divisional managers negotiate a mutually-agreeable price.
Decision -making
Perfectly competitive market
Optimum TP
Thanks
Performance Management
RESPONSIBILITY CENTERS
Topics Covered
Cost , profit and Investment Centers
Responsibility accounting
ROCE
Residual Income
Economic Value Added
Cost Centre
A cost centre is a business unit that is only responsible for the costs that it incurs. The manager
of a cost centre is not responsible for revenue generation or asset
Assigning costs to cost centres lets you determine where costs are incurred within the
organization.
If you plan costs at cost centre level, you can check cost efficiency at the point where costs are
incurred.
Profit center
A business unit or department which is treated as a distinct entity enabling revenues and
expenses to be determined so that profitability can be measured.
A large corporation with diversified interests in paper manufacturing, trucking, and fast food
may regard each of these three businesses as a profit centre.
Investment Centre
Department or an area of responsibility, where a manager controls revenues and associated costs,
assets, and liabilities. His or her performance is assessed largely on the basis of return on investment
(ROI) achieved.
The corporate headquarters or division in a large decentralized organization would be an example of
an investment centre.
Return on investment and residual income are two key performance measures of an investment
centre.
Responsibility accounting
Responsibility accounting is an underlying concept of accounting performance measurement systems.
The basic idea is that large diversified organizations are difficult, if not impossible to manage as a
single segment, thus they must be decentralized or separated into manageable parts.
These parts, or segments are referred to as responsibility centres that include: 1) cost centres, 2) profit
centres and 3) investment centres.
These elements include costs for a cost centre, a measure of profitability for a profit centre and return
on investment (ROI) for an investment centre.
ROCE
Return on capital employed establishes the relationship between the profit and the capital
employed.
It indicates the percentage of return on capital employed in the business and it can be used to
show the overall profitability and efficiency of the business.
Return on Capital Employed=(Adjusted net profits*/Capital employed)100
*Net profit before interest and tax minus income from investments.
Residual Income
Net income that an investment can earn over the minimum rate of return (timedeposit interest rate).
Residual income, unlike ROI, is an absolute amount of income rather than a rate
of return.
ROI
Residual
income
$100,000
=======
$20,000
20%
$100,000
=======
$20,000
15,000
---------$5,000
=======
Thanks
PERFORMANCE MANAGEMENT
LEARNING CURVE
Topics Covered
Meaning
Formula
Application
It is based on the observation that as complex and labor intensive procedures are repeated , unit
labor times tend to decrease.
Learning rate:
When cumulative output doubles, the cumulative average time per unit falls to a fixed percentage
of the previous average time.
This is called learning rate.
Example
Consider a product with the following data about the hours of labor required to produce
a unit:
Hours required to produce
1-st unit:
100
48
35
25
18
As more and more units are produced, the hours of labor required to produce
the most recent unit is lower and lower.
57
Hours Required
to Produce
Most Recent Unit
1
10
25
75
200
100
48
35
25
18
Hours Required
to Produce
Most Recent Unit
Learning Curve
110
100
90
80
70
60
50
40
30
20
10
0
25
50
75
100
125
150
175
200
225
Cumulative Production
58
59
Learning curve-Example
Incremental Qty.
Cumulative
Qty.
Cumulative
Time taken
100
100
80
160
64
256
51
408
16
41
656
The time taken for 2nd unit is 80% of time taken for 1st unit as 80% learning rate is applicable.
Learning Ratio
Learning curve ratio
= Average labour cost of first 2N units
Average labour cost of first N units
If the average labour cost for the first 500 units is $25 and first 1000 units is $20, the ratio is:
$20 x 100
$25
=80%
Every time output doubles, the average cost declines to 80% of the previous amount.
Month
Incremental number
of batches produced
each month
Incremental labour
hours taken to
produce the batches
June
200
July
152
August
267.52
September
470.8
October
1,090.32
November
16
2,180.64
1
1
2
200
152
267.52
1
2
4
200
352
619.52
Cumulative
average
hours per
batch
200
176
154.88
470.8
1090.32
136.29
1090.32
16
2180.64
136.29
16
2180.64
32
4361.28
Incremental
Cumulative
Incremental
Cumulative
number of
number of
total hours
total hours
batches
batches
Learning rate:
176/200 = 88%
154.88/176 = 88%
136.29/154.88 = 88%
Therefore the monthly rate of learning was 88%
x = cumulative production
y = hours required to produce the x-th unit
Then, y = ax-b
where a and b are parameters defined as follows:
64
x = cumulative production
y = hours required to produce the x-th unit
Then, mathematicians can show that the Learning Curve is
y = 100x-0.322
65
Hours Required
to Produce
Most Recent Unit
y = 100x -0.322
1
2
--4
--8
--16
--25
--32
--50
--64
--100
--128
--200
100.000
80.000
--64.000
--51.200
--40.960
--35.478
--32.768
--28.383
--26.214
--22.706
--20.972
--18.165
66
Application
1.
2.
Pricing
3.
Work scheduling
4.
Steady rate
5.
Experience curves
Application
1.
2.
Pricing
3.
Work scheduling
4.
Steady rate
5.
Experience curves
Study Tips
Be regular in studies. Study at least 11 hours per week.
Attempt at least two mock papers to timed conditions before the exam including reading time
of 20 minutes (Total 3 hrs and 20 minutes to complete).
Students have performed worse in calculating and explaining variances. Try to concentrate on
this topic specifically.
Timed conditions it is 1.8 minutes per mark (18 minutes for 10 mark, 45 minutes for 25 marks).
Dont forget to carry your scientific calculator in exam.
Thanks
KAPP Edge Solutions Pvt. Ltd.
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