Quantitative aids in budgeting

Learning curve theory

Learning curve theory may be useful for forecasting production time and
labour costs in circumstances where a work force makes a new product and
improves its efficiency with experience and learning.

Conditions
The theory of learning curves will only hold if the following conditions apply:
1. There is a significant manual element in the task being considered.
2. The task must be repetitive and complex.
3. Production must be at an early stage so that there is room for improvement.
4. There must be consistency in the workforce.
5. There must not be extensive breaks in production, or workers will ‘forget’
the skill.
6. Workforce is motivated.
Theory
As cumulative output doubles, the cumulative average time per unit falls to a given
percentage of the previous average time per unit.

The learning rate and learning effect

Where a learning curve applies, there is a learning rate and a learning effect.
The learning rate is expressed as a percentage value, such as an 80% learning
curve or a 70% learning curve.
The learning effect is that as the work force learns from experience how to make
the new product, there is a big reduction in the time to make additional units.

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Methods that can be used to deal with a learning curve scenario
There are two methods that can be used to deal with a learning curve scenario. Be
prepared to use either or both in the exam.
1. The tabular approach
2. The algebraic approach

The tabular approach

Set up a table and reduce the average time by the learning rate each time the output 
doubles.
Example
The time taken to produce the first unit is 100 hours. There is a learning rate of
75%.
How long will it take to produce an additional 7 units?
The algebraic approach
The formula for the learning curve is Y = ax^b
Where:
 Y is the cumulative average time per unit to produce x units
 x is the cumulative number of units
 a is the time taken for the first unit of output
 b is the index of learning (logLR/log2)
 LR is the learning rate as a decimal
For example an 80% learning curve
b = log 0.8/log 2.
b = 0.0969 = –0.322
0.3010
So Y = ax^-0.322
Another way of stating this is: Y = a [1/x^0.322]

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N.B
 This formula refers to time rather than labour cost. The formula can also
be used to calculate the labour cost per unit. The labour times are
calculated using the curve formula and then converted to cost.
 you should not round ‘b’ to less than three decimal places

Calculating the time for a specific unit

The formula approach is used to calculate the incremental time for any unit
where a learning curve applies. For example
1. To calculate the time to make the third unit:
 Calculate the cumulative average time for the first three units and
the total time for the first three units
 Calculate the cumulative average time for the first two units and
the total time for the first two units
 The time for the third unit is the difference in these two totals
2. To calculate the time to make the fifth unit:
 Calculate the cumulative average time for the first five units and
the total time for the first five units
 Calculate the cumulative average time for the first four units and
the total time for the first four units
 The time for the fifth unit is the difference in these two totals.

Limitations of the learning curve model
The model applies if: 
1. the process is labour intensive
Modern manufacturing can be very machine intensive. The learning effect w
ill not apply if machines limit the speed of labour. 
2. there are no breaks in production: 
A break in production may result in the learning effect being lost.
3. the product is new: 
The introduction of a new product makes it more probable that there will be 
a learning effect.

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 4. the product is complex: 
The more complex the product, the more probable that the
learning effect will be significant and the longer it will 
take for the learning effect to reach the steady state.
5. the process is repetitive: 
If the process is not repetitive, a learning effect will not be enjoyed.

It may also be difficult to identify the learning effect in practice. 

Example
Watch making company wishes to determine the minimum price it should charge a 
customer for a special order ofwatches. The customer has requested a quotation 
for 10 watches (1 batch), but might subsequently place an order for a further 10.
Material costs are K30 per watch. It is estimated that the first 
batch of 10watches will take 100 hours to manufacture and 
an 80% learning curve is expected to apply. Labour plus variable overhead
costs amount to K3 per hour. Setup costs are K1,
000 regardless of the number of watches made. 
The initial orders are 20.The company thinks that there would be a ready market fo
r this type of watch if it brought the unit selling price down to K45. 
Required
a. Calculate time for the second batch
b. What would be the profit on the first 140 ‘massproduction’watches after the 
first 20 watches assuming that marketing costs totalled K250?

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TUTORIAL QUESTION
Extreme Company is launched a new product XYZ in January 2015. 80% learning
curve applies to production of this new product item. As at 30 June 2015 30 units
of XYZ have been produced. Budgeted production in July 2015 is 5 units. The
time to make the very first unit of XYZ in January was 120 hours. The labour cost
is K10 per hour.

Required
(a) Calculate the time required to make the 31st unit.
(b) Calculate the budgeted total labour cost for July.

Time series

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A time series is a series of figures or values recorded over time.
The time series analysis forecasting technique is usually used to forecast sales.
Features of a time series
There are several features of a time series which it may be necessary to analyse in
order to prepare forecasts.
a. A trend
The trend is the underlying long-term movement over time in the values of
the data recorded.
 Increasing long-run trend
 Declining long-run trend
b. Seasonal variations or fluctuations
Seasonal variations are short-term fluctuations in recorded values, due to
different circumstances which affect results at different times of the year,
on different days of the week, at different times of day, or whatever.
Two examples of seasonal variations.
 Sales of ice cream will be higher in summer than winter.
 The telephone network may be heavily used at certain times of the day.

There are a number of ways of overcoming this problem of distinguishing

trend from seasonal variations. One such method is called moving
averages. This method attempts to remove seasonal (or cyclical) variations
from a time series by a process of averaging so as to leave a set of figures
representing the trend.
A moving average
A moving average is an average of the results of a fixed number of periods.
Since it is an average of several time periods, it is related to the mid-point of the
overall period.

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Example
Year Sales Units
20X0 390
20X1 380
20X2 460
20X3 450
20X4 470
20X5 440
20X6 500
Required
Take a moving average of the annual sales over a period of three years.

c. Cycles, or cyclical variations

Cyclical variations are fluctuations which take place over a longer time
period than seasonal variations.
It may take several years to complete the cycle.

Example
The sales of fashion items such as flared trousers could be said to be
cyclical. The last cycle took approximately 30 years (mid 1960s to mid
1990s) to complete.

d. Non-recurring, random variations.

These may be caused by unforeseen circumstances, such as a change in the
government of the country, a war, the collapse of a company, technological
change or a fire.

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Customer Profitability Analysis (CPA)

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Customer Profitability Analysis (CPA) is the analysis of the revenue streams and
service costs associated with specific customers or customer groups.‘
Customer profitability analysis – approach
The general approach to CPA is based on segmenting the customer base to
determine the revenues and costs attributable to each segment.
This is often combined with an activity-based costing (ABC) approach.

Once the profitable and non-profitable segments are identified, profitable

segments are maximised while non-profitable segments are reduced or
eliminated.
Key steps in customer profitability analysis process
A. Step 1 Customer segmentation
There are two basic approaches to customer segmentation:
 Demographic segmentation based on observable characteristics such
as geographic area, customer age, sex and income level.
 Psychographic segmentation based on customer needs and
behaviour such as customer values, attitudes and interests.
B. Step 2 – Revenue attributable to each segment
Once segments have been identified, the annual revenue is calculated per
segment. Adjustments to the price paid by the customer for a product or
service, such as discounts, service fees or product enhancement fees, must
be included to determine the true amount of revenue generated by each
customer and the aggregated amount calculated for the customer segment.

C. Step 3 – Use ABC to determine the cost attributable to each segment.

The annual cost is calculated per segment. This will involve both directly
attributable product or service costs and also customer costs, including
allocation of overheads, marketing, sales and distribution costs. It is these
customer costs which are often hidden, such as quality control and
inspection costs, order picking, order fulfilment and customer ordering costs.
ABC is an effective way to assign both types of costs to customers.

D. Step 4 – Analyse the profitable versus the less profitable or unprofitable

customer segments
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 The profitable customer segments will be those whose annual revenues
exceed annual costs. As the profitability of customer segments is likely to
vary from year to year, a more accurate analysis could involve calculating
profitability over the lifetime of each customer segment.
E. Step 5 – Develop strategies to maximise profits from profitable customers
and reduce or eliminate less profitable or non-profitable customers

For profitable customer segments, this step involves detailed planning

around the development of long term customer relationships for increased
revenues, and hence profitability such as customer retention and loyalty
programmes.

To address the least profitable or non-profitable customer groups, two main

actions are used as follows:
1. Elimination
Ceasing to supply these customers. This can be done by no longer
marketing to these customers, changing the product or service so that it is
no longer suitable, or raising prices.
2. Re-engineering
Turning the least profitable or non-profitable customer groups into
profitable ones by either increasing revenue or decreasing costs
attributable to these groups, or both. Examples include charging
additional fees for services or using differential prices, according to
customer segment.

F. Step 6 – Review the impact of the new strategies on the performance of the
customer segments
The implementation of any new strategy, for example, changes in pricing,
cost reduction or customer service, should be reviewed after an appropriate
period to determine the impact on customer profitability.

Customer Lifetime Value (CLV)

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This is the value generated by a customer over the lifetime of a customer’s
relationship to a company.
To calculate the CLV, companies need to make judgements about the duration of
the company’s relationship with the customer. This includes the likelihood,
frequency and amount of expected purchases over the lifetime of the customer.
To determine the present value of these future income streams, a discount rate
(usually the company’s cost of capital) is used. CLV estimates are particularly
useful to:
 companies with large variations in purchasing patterns by customers
 companies with high customer acquisition costs
 companies with high customer retention costs.
Advantages of CPA
1. Improved profitability by eliminating non-profitable customers and
maximising sales or services to profitable customers.
2. An understanding of the true costs of each customer segment, including
taking into account non-production costs when determining profitability.
Non-production costs can sometimes be more significant than production
costs.
3. It provides a method of identifying customer groups who are of lifetime
value to the company, and who are worth retaining or protecting.
4. Improved strategic decision making by providing useful information for
customer related decisions, including pricing, discounting and marketing
decisions.

Disadvantages of CPA
1. Companies may not have the data capture systems to produce an accurate
estimation of customer segmental revenues and costs.
2. There may be practical difficulties in calculating costs attributable to
each segment. Implementing ABC is often challenging for many
companies.

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3. CPA may overlook the combinations of products or services purchased
by customers. Customer profitability depends on the mix of products or
services bought. The danger is that the analysis will be used on specific
underperforming products or services, and will overlook the impact of
sales of other products to the customer.
4. Annual profitability may not be representative of lifetime value. The
costs of attracting and retaining a customer should be compared with the
lifetime earnings and not just with the customer’s annual earnings.

Key developments
1. Advances in information technology
This has allowed companies to improve the quality and quantity of
information concerning customer profitability, including information
on revenue, costs, retention and lifetime value. Many companies have
sophisticated customer profitability models and customer databases.
These can be designed for any type of business and to accommodate
different customer characteristics. Data can be aggregated by size of
customer, size of order, service complexity, post sale service
requirements, location or other factors. Information technology can
provide detailed information and analysis on individual customers or
groups of customers.
2. Managing customer value
Analysing customer profitability has evolved into managing the
overall value of customers. CPA now includes analysing customer
lifetime value and impact, as well as managing profitability through
analysis of customer segments and margins. Customer lifetime value
looks at the profitability of the customer over their lifetime.
Customers have an impact on other customers, company employees
and other groups through their transactions and communications. For
example, they can refer other customers to company offerings.

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