Linear programming Range of applicability of dual prices • The dual price only applies as long as extra resources improve the optimal solution • i.e. the constraint line concerned moves out increasing the size of the feasible region and moving the optimal point. • Eventually other constraints become critical.
4. Pricing • Factors to consider when pricing. • Calculation aspects. • Pricing approaches .
Factors to consider when pricing • Costs • Competitors • Corporate objectives • Customers
Calculation aspects Price elasticity of demand (PED) • PED = % change in demand / % change in price. • PED >1 (elastic) revenue increases if the price is cut. • PED <1 (inelastic) revenue increases if the price is raised.
Calculation aspects Equation of a straight line demand curve • P = a – bQ • “a” = the price at which demand would fall to zero • “b” = gradient = change in price/change in demand • Calculate “b” first
Calculation aspects Equation of a cost curve • C = F + vQ • Volume based discounts
Pricing approaches • Cost plus pricing • Price skimming • Penetration pricing • Linking pricing decisions for different products • Volume discounts • Price discrimination • Relevant cost pricing
Cost plus pricing • Establish cost per unit – options include MC, TAC, prime cost • Calculate price using target mark-up or margin • Often used as a starting point even when using other methods
Cost plus pricing Advantages • Widely used and accepted. • Simple to calculate if costs are known. • Selling price decision may be delegated to junior management. • Justification for price increases. • May encourage price stability.
Cost plus pricing Disadvantages • Ignores link between price and demand. • No attempt to establish optimum price. • Which absorption method? • Does not guarantee profit • Which cost? • Inflexibility in pricing. • Circular reasoning.
Price skimming • Set a high initial price to „skim off‟ customers who are willing to pay extra. • Prices fall over time. • Suitability?
Penetration pricing • Set a low initial price to gain market share • If a high volume is achieved, the low price could be sustainable. • Suitability?
Linking pricing decisions for different products • Basic idea: product A is cheap to attract customers who then also buy the higher margin product B. • Key issue is the extent to which customer must buy the other products. • Suitability?
Volume discounts • Discount for individual large order. • Cumulative quantity discounts. • Suitability?
Price discrimination • Have different prices in different markets for the same product. • Suitability?
Relevant cost pricing • Price = net incremental cash flow. • Suitability?
5. Make v buy and other short term decisions • Relevant costing principles. • Make v buy decisions. • Shut down decisions. • Joint products – the further processing decision.
Relevant costing principles • Include – Future incremental cash flows. – Opportunity costs • Exclude – Depreciation. – Sunk costs. – Unavoidable costs. – Apportioned fixed overheads. – Financing cash flows (e.g. interest).
Make v buy Decision • Look at future incremental cash flows. • Watch out for opportunity costs – especially whether or not spare capacity exists and alternative uses for capacity. • Practical factors?
Shut down decisions Decision • Look at future incremental cash flows. – Apportioned overheads not relevant – Closure costs – e.g. redundancies. – Alternative uses for resources? • Practical factors?
Joint products The further processing decision • Look at future incremental cash flows: – sell at split off v process further and then sell. • Pre- separation (“joint”) costs not relevant – only include post split-off aspects.
6. Risk and uncertainty • Basic concepts. • Research techniques. • Scenario planning. • Simulation. • Expected values. • Sensitivity. • Payoff tables.
Basic concepts • Risk = variability in future returns. • Investors‟ risk aversion • Upside v downside • Risk v uncertainty • Risk = probability x impact
Research techniques • Desk research – Company records. – General economic intelligence. – Specific market data. • Field research – Opinion v motivation v measurement – Questionnaires, experiments, observation. – Group interviews, triad testing, focus groups.
Scenario planning 1 Identify high-impact, high-uncertainty factors. 2 Identify different possible futures. 3 Identify consistent future scenarios. 4 “Write the scenario” . 5 For each scenario identify and assess possible courses of action for the firm. 6 Monitor reality. 7 Revise scenarios and strategic options
Simulation 1 Apply probabilities to key factors in scenario analysis. 2 Use random numbers to select a particular scenario and calculate outcome. 3 Repeat until build up a picture of possible outcomes 4 Make decision based on risk aversion.
Expected values • EV = Σ outcome × probability. • Make decision based on best EV.
Expected values Advantages • Recognises that there are several possible outcomes. • Enables the probability of the different outcomes to be taken into account. • Leads directly to a simple optimising decision rule. • Calculations are relatively simple.
Expected values Disadvantages • probabilities used are subjective. • EV is the average payoff. Not useful for one-off decisions. • EV gives no indication of risk • Ignores the investor‟s attitude to risk.
Sensitivity • Identify key variables by calculating how much an estimate can change before the decision reverses. • Can only vary one estimate at a time.
Payoff tables • Prepare table of profits based on different decision choices and different possible scenarios. • Four different ways of making a decision. – 1 Expected values – 2 Maximax – 3 Maximin – 4 Minimax regret
7. Budgeting I • The purposes of budgeting. • Budgets and performance management. • The behavioural aspects of budgeting. • Conflicting objectives.
The purpose of budgets • Forecasting • Planning • Control • Communication • Co-ordination • Evaluation • Motivation • Authorisation and delegation
Budgets and performance management Responsibility accounting • Responsibility accounting divides the organisation into budget centres, each of which has a manager who is responsible for its performance. • The budget is the target against which the performance of the budget centre or the manager is measured.
Management by exception 1 Set up standard costs, prepare budgets and set targets. 2 Measure actual. 3 Compare actual to budget (e.g. via variances). 4 Investigate reasons for differences and take action.
Behavioural aspects of budgeting Key issues – Dysfunctional behaviour – want goal congruence. – Budgetary slack. Management styles (Hopwood) – Budget constrained – Profit conscious – Non-accounting
Target setting and motivation • Expectations v aspirations • Ideal target? • Targets should be: – communicated in advance – dependent on controllable factors – based on quantifiable factors – linked to appropriate rewards – chosen to ensure goal congruence.
Participation Advantages of participative budgets • Increased motivation • Should contain better information, • Increases managers‟ understanding and commitment • Better communication • Senior managers can concentrate on strategy.
Participation Disadvantages of participative budgets • Loss of control • Inexperienced managers • Budgets not in line with objectives • Budget preparation slower and disputes can arise • Budgetary slack • Certain environments may preclude participation
Conflicting objectives • Company v division • Division v division • Short-termism • Individualism
8. Budgeting II • Rolling v periodic. • Incremental budgeting. • Zero based budgeting (ZBB). • Activity based budgeting (ABB). • Feedforward control. • Flexible budgeting. • Selecting a budgetary system. • Dealing with uncertainty. • Use of spreadsheets.
Rolling v periodic budgeting Periodic budgets • The budget is prepared for typically one year at a time. No alterations once the budget has been set. • Suitable for stable businesses where forecasting is easy and where tight control is not necessary.
Rolling v periodic budgeting Rolling (continuous) budgets • A budget kept continuously up to date by adding another accounting period when the earliest period has expired. • Aim: to keep tight control and always have an accurate budget for the next 12 months. • Suitable if accurate forecasts cannot be made, or if need tight control.
Incremental budgeting • Start with the previous period‟s budget or actual results and add (or subtract) an incremental amount to cover inflation and other known changes. • Suitable for stable businesses where costs are not expected to change significantly. There should be good cost control and limited discretionary costs.
Zero based budgeting Preparing a budget from a zero base, justifying all expenditure. 1 Identify all possible services and then cost each service (decision packages) 2 Rank the decision packages 3 Identify the level of funding that will be allocated to the department. 4 Use up the funds in order of the ranking until exhausted.
Activity based budgeting • Use ABC for budgeting purposes: 1 Identify cost pools and cost drivers. 2 Calculate a budgeted cost driver rate 3 Produce a budget for each department or product by multiplying the budgeted cost driver rate by the expected usage.
Feed forward control • Feed-forward control is defined as the „forecasting of differences between actual and planned outcomes and the implementation of actions before the event, to avoid such differences. • E.g. using a cash-flow budget to forecast a funding problem and as a result arranging a higher overdraft well in advance of the problem.
Flexible budgeting • Fixed Budgets • Flexible Budgets • Flexed Budgets
Selecting a budgetary system Determinants • Type of organisation. • Type of industry. • Type of product and product range. • Culture of the organisation.
Changing a budgetary system Factors to consider • Time consuming • Are suitably trained staff are available to implement the change successfully? • Management time • Training needs. • Cost v benefits for the new system:
Incorporating risk and uncertainty • Flexible budgeting. • Rolling budgets. • Scenario planning. • Sensitivity analysis. • “What if” analysis using spreadsheets
9. Quantitative analysis • High-low. • Regression and correlation. • Time series analysis. • Learning curves.
High-low 1: Select the highest and lowest activity levels, and their costs. 2: Find the variable cost/unit. 3: Find the fixed cost, using either level. Fixed cost = Total cost at activity level – total variable cost.
Regression and correlation y = a + bx y b x n xy - x y 2 2 n n n x - ( x) n xy - x y r = 2 2 2 2 n x - ( x) ) (n y - ( y) )
Time series analysis • Four components: 1 the trend 2 cyclical variations 3 seasonal variations 4 residual variations. • Additive model Actual = Trend + Seasonal Variation • Multiplicative model Actual = Trend x Seasonal Variation
Learning curves • As cumulative output doubles, the cumulative average time per unit falls to a fixed % (the learning rate) of the previous average. • Y = ax b y = average cost per batch a = cost of first batch x = total number of batches produced b = learning factor (log LR/log 2)
10. Standard costing and basic variances • Standard costing. • Recap of basic variances from F2. • Labour variances with idle time. • Variance investigation.
Standard costing • A pre-determination of what a product is expected to cost under specific working conditions.
Standard costing Advantages – Annual detailed examination – Performance appraisal – Management by exception – Simplifies bookkeeping • Disadvantages / problems – Standards not updated – Cost – Unrealistic standards can demotivate staff
Types of standard • Attainable • Ideal • Basic • Current
Sales variances
Material variances
Labour variances (basic)
Variable overhead variances
Fixed overhead variances
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