Section B. Decision Making Techniques - Tutor

Compiled by CA.
nirmal shrestha Decision Making Techniques
Section B
Decision making techniques
Introduction to Decision Making
The choice between two or more alternatives, decision making normally considers only the
short- term consideration of maximizing profitability. We base our decisions on relevant costs
and revenues.
CVP Analysis (Breakeven Analysis)
What is CVP (break-even) analysis?

An understanding of the relationship between the level of activity and costs and revenues.
CVP analysis is a technique which uses cost behaviour to identify the level of activity at which
we have no profit or loss (break-even point).
It can also be used to predict the profits or losses to be earned at varying activity levels (using the
assumed linearity of costs and revenues).
CVP analysis assumes that selling prices and variable costs are constant per unit regardless of the
level of activity and that fixed costs are just that – fixed.
In order to calculate these levels we need to consider the contribution provided by each unit of
production. Contribution is the term given to the difference between the selling price and the
variable costs which contributes first towards paying the fixed costs and then towards providing
profit.
How is the break-even point calculated?

If we are to calculate the break-even point let us first imagine that the fixed costs are a large hole
in the ground. What we need to find out is how many contributions it takes to fill that hole.
Similarly, the profit we require is the pile on top of the hole. How many contributions does it
take to reach the required height?
Formulae required:
Unit contribution = Selling price per unit – Variable cost per unit
Total Contribution = Unit contribution x volume
CS Ratio = C/S
¿ costs
Break-even point (units) =
Unit contribution
¿ costs
Break-even point ($) =
CS Ratio
Contribution target = Fixed costs + Target profit

performance management- acca f5 B.1
Compiled by CA. nirmal shrestha Decision Making Techniques
FC + Desired Profit
Sales to earn Desired Profit (Units) =
Unit contribution
FC + Desired Profit
Sales to earn Desired Profit ($) =
CS Ratio
FC + Desired Profit /(1−t)

Sales to earn Desired Profit after tax ($) =
CS Ratio
Margin of Safety ($) = Sales – BEP level sales
Sales−BEP level Sales MOS sales

Margin of Safety (%) =
Sales
OR Sales
Fixed Cost = BEP sales * CS Ratio
Profit = MOS Sales * CS Ratio
We can use these formulae to calculate our break-even point. Alternatively, we can use either a
traditional break-even chart or a profit/volume chart.
Break-even chart
Sales revenues
Cost and Total cost

revenues profit
Fixed Cost
Margin of safety
Sales activity
Break-even point
Profit/volume chart
A break-even chart shows the costs and revenues at a number of activity levels. It does not
however, show the amount of profit or loss at these levels. This is shown on the profit/volume
chart.

Total profit
profit
Break-even point
loss
Fixed costs (total loss)
From this chart we can read off the amount of profit or loss for any level of activity.
1. The x axis represents sales (units or values)
2. The y axis shows profits above the x axis and losses below.
3. When sales = zero, the net loss is equal to the fixed costs.
4. If variable cost per unit and total fixed costs are constant throughout the relevant range, the
profit/volume chart is shown as a straight line.
5. If there are\changes in either of these costs at various levels of activity, it will be necessary to
calculate the profit or loss at each point where the cost structure alters before plotting the points
onto the chart.
Limitations of break-even analysis

 Once costs and revenues have been determined, it is usually assumed that they will have a
linear relationship.
 Fixed costs will be constant over the relevant range
 Variable costs will vary in direct proportion to volume
 Selling price will remain unchanged
 The efficiency and productivity of the workforce remain constant.
The analysis covers either a single product or a mix of products at which it is assumed that the
proportion of each product will remain the same as volume increases or decreases.
In constructing a break-even chart, the sales and costs are likely to be valid only in a particular
range of activity. This is referred to as THE RELEVANT RANGE. Outside this range the same
cost and revenue relationships are unlikely to exist. E.g. An alteration in volume could affect the
level of fixed costs (stepped) or the rate of variable costs or selling prices (economies of scale).
Margin of safety
The margin of safety is the area between the break-even point and the maximum sales. This is
the area that the company can operate in and be certain of making a profit. It is usually classed as
the amount of sales that a company can afford to lose before it gets into a loss making situation.
It is usually expressed as a percentage (%) of sales.
It can be calculated as:
Sales−BEP level Sales MOS sales
Margin of Safety (%) =
Sales
OR Sales

Note: Sales are alternatively described as budgeted sales revenues or Actual Sales revenues.
Contribution / sales ratio
The above calculations are useful in calculating the break-even point of one unit of production. If
a company makes more than one product it may be better to calculate the C/S ratio.
Weighted average C/S ratio
Unit contribution
C/S ratio =
Unit sales price
Total contribution
OR Total sales
Practice Problems
1. Beauty Co makes two products, nail polish and lipsticks. Nail polish sales make up 30% of
total sales and their variable costs are 45% as a percentage of sales value. Lipsticks sales are
70% of the total sales and their variable costs are 40% as a percentage of sales value.
Total fixed costs are $400,000 for the company.
Required:
What is break-even level of sales revenues for the company?
Answers:
Break-even level of sales revenues = $683,761
2. A company maintains a margin of safety of 25% on its current sales and earns a profit of $
30 million per annum. If the company has a profit volume ratio of 40%, what is the current
sales?
Answers:
MOS = $75 million; Current sales = $ 300 million
3. A company has annual turnover of $200 million and an average c/s ratio of 40%.It makes
10% of profit on sales before charging depreciation and interest which amount to $10 million
and $15 million respectively. Find the annual fixed cost of the company.
Answers: $ 85 million
4. Sales for two consecutive months of a company are $380,000 and $420,000. The company's
net profits for these two months amounted to $24,000 and $40,000 respectively. There is no
change in C/S ratio or fixed costs. Find the c/s ratio of the company.
Answers: 40%
5. A company with a contribution / Sale ratio of 1 /3 and fixed cost of $3 million per month
should have a monthly sales of $ …………. million to maintain a margin of safety of 10%.
Answers: $10 million
6. B Ltd. has earned net profit of $1 million, and its overall P/V ratio and margin of safety are
25% and 50% respectively, What is the total fixed cost of the company?
Answers: $1 million
7. A company produces single product which sells for $20 per unit. Variable cost is $ 15 per
unit and Fixed overhead for the year is $ 630,000.

Required:
(a) Calculate sales value needed to earn a profit of 10% on sales.
(b) Calculate sales price per unit to bring BEP down to 120,000 units.
(c) Calculate margin of safety sales if profit is $ 60,000.
Answers: (a) $4.2 million; (b) $20.25 ; (c) 25%
8. A company has fixed cost of $90,000, Sales $300,000 and Profit of $60,000.
Required:
(i) Sales volume if in the next period, the company suffered a loss of $30,000.
(ii) What is the margin of safety for a profit of $90,000?
Answers: (a) $120,000; (b) $180,000
LIMITING FACTOR ANALYSIS

All companies have a maximum capacity for producing goods or providing services because
there is a limit to the amount of resources available. There is always at least one resource that is
more restrictive than others: this is known as a limiting factor.
Limiting factor decision
Where there is a factor of production that is limited in some way by:
1. Scarce raw materials.
2. Shortage of skilled labour.
3. Limited machine capacity.
4. Finance (see capital rationing in FM).
Aim: Maximize the contribution per unit of limiting factor
Steps:
1. Contribution per unit of sale.
2. Contribution per unit of scarce resource.
3. Rank in order of 2 - highest first.
4. Use up the resource in order of the ranking.
Assumption:
 Fixed cost is assumed to be the same whatever the production mix is selected, so that the
only relevant cost is the variable cost.
 The unit variable cost is constant at all levels of production and sales
 The estimates of sales demand for each product are known with certainty
Example 1 (a)
Neal Ltd produces two products using the same machinery. The hours available on this
machine are limited to 5,000. Information regarding the two products is detailed below:
Products (per unit data) M N
Selling price (£) 40 30
Variable cost (£) 16 15
Fixed cost (£) 10 8
Profit (£) 14 7
Machine hours 8 3
Bud. sales (units) 600 500
Required:
Calculate the maximum profit that may be earned.

Answers:
Total profit £7,988
Example 1 (b)
Using the previous example, Neal Ltd is now able to buy in the products at the following costs
Products (per unit data) M N
Purchase price (£) 24 21
Required:
What is the revised production schedule and the maximum profit earned?
Answers:
Revised Profit £10,596
Example 2 (a)
WXYZ Ltd makes four products W, X, Y and Z for which costs and sales in the next year are
expected to be as follows:
W X Y Z
Sales units 2,000 4,000 3,000 1,000
£ £ £ £
Direct materials 10 5 7.5 12.5
Direct labour 7 2 4.5 6.5
17 7 12 19
Sales price 29 11 18 39
Contribution 12 4 6 20
The company is having difficulty of obtaining the materials. Each product uses the same
material, and only one type of material is used in manufacture. The expected available
materials next year are 11,000 kilos. The material cost £5 per kilo.
An overseas manufacturer is willing to supply the items to the company at the following costs
per unit including delivery.
W X Y Z
Cost to buy 20.00 11.00 15.75 21.50
Required:
Which items should the company make internally, and which should it buy from the external
manufacturer?
Answers:
Make: X = 4,000 Units; Y = 3,000 Units; W = 1,250 Units; Total Contribution = £49,000
Buy: W = 750 units ; Z = 1,000 units; Total Contribution = £73,250
Example 2 (b)
Sutton produces four products. Relevant data is shown below for period 2.
Product M Product A Product R Product P
C/S ratio 5% 10% 15% 20%
Maximum sales value $200,000 $120,000 $200,000 $180,000
Minimum sales value $50,000 $50,000 $20,000 $10,000
The fixed costs for period 2 are budgeted at $60,000.
Required
Fill in the blank in the sentence below.
The lowest breakeven sales value, subject to meeting the minimum sales value constraints, is
$........…..
Answers:
Min. BEP Sales $130,000 (minimum sales) + $170,000 (from P) + $90,000 (from R) =
$390,000
LINEAR PROGRAMMING – MULTI LIMITING FACTORS

The aim of decision making is to maximise profit, assuming that the fixed cost does not change,
this would mean that we must maximise contribution. Alternatively, the aim may be minimise
cost to subsequently maximise profit.
Linear programming involves the construction of a mathematical model to represent the decision
problem where the activities of the problem constitute variables.
Steps
1. Define the problem (unknowns or variables)
2. Objective function
3. Constraints
4. Graph
5. Optimal solution
6. Shadow prices
Example 3
A company makes two products (R and S), within three departments (X, Y and Z). Production
times per unit, contribution per unit and the hours available in each department are shown
below:
Product R Product S Capacity (hours)
Contribution/unit £4 £8
Hours/unit8 Hours/unit
Department X 8 10 11,000
Department Y 4 10 9,000
Department Z 12 6 12,000
Required:
a) What is the optimum production plan in order to maximise contribution?
b) Calculate the slack for the department C.
c) Calculate shadow price for binding constraints.
Answers:
500 units of X and 700 units of Y.
The maximum contribution = £7,600.
1. Define the problem

Let x = number of units of R produced
Let y = number of units of S produced
2. Objective Function – maximise contribution = Z

Z = 4x + 8y
3. Subject to – constraints
(Dept A hrs) 8x + 10y ≤ 11000
(Dept B hrs) 4x + 10y ≤ 9000
(Dept C hrs) 12x + 6y ≤ 12000
(non-negativity) x, y≥0
4. Plotting the graph

If we know the constraints, we are able to plot the limitations on a graph identifying feasible and
non-feasible regions. The linearity of the problem means that we need only identify two points
on each constraint boundary or line. The easiest to identify will be the intersections with the x
and y-axes.
For example:
Dept A hrs – equating the formula 8x + 10y = 11,000
If x = 0 then y = -1,100 Co-ordinates (0, 1100)
If y = 0 then x = 1,375 (1375, 0)
And hence:
Dept B hrs – 4x + 10y = 9,000 (0, 900) (2250, 0)
Dept C hrs – 12x + 6y = 12,000 (0, 2000) (1000, 0)
By plotting the individual constraints, we build up an area of what is possible within all the
constraints ie the FEASIBLE REGION.
Identifying the optimal solution

1. The Iso-contribution (IC line) line is plotted identifying points of equal contribution. The
linear nature of the problem means that this line will be a straight line identifying an inverse
relationship between the two products.
The IC line is of importance because the relationship of the contribution earned by each product
is constant (ie £4 for R against £8 for S). This means that the gradient of the line will remain
constant as the total contribution figure gets larger or smaller.
If we ‘push out’ the IC line to the point where it leaves the feasible region, that point will be the
point of maximum contribution.
Steps
(i) Choose an arbitrary contribution figure (preferably one that can be easily plotted on the graph
just drawn).
Example contribution = Z = £3,200
(ii) What are the objective function values?
4x + 8y = 3,200
(iii) Translate those values into co-ordinates for plotting on the graph
Co-ordinates (0, 400) and (800, 0)
2. The optimal solution can now be found by interrogating the point at which the IC line leaves
the feasible region to identify the co-ordinates and hence the product mix and maximum
contribution.
The intersection or VERTEX identified is where two constraints meet, those constraints can be
solved simultaneously to identify the product mix.
a 8x + 10y = 11,000
b 4x + 10y = 9,000
(a – b) 4x = 2,000
x = 500
y = 700

Therefore, the optimal product mix is to make and sell 500 units of X and 700 units of Y. The
maximum contribution is (500 x 4 + 700 x 8) = £7,600.
This can be checked by seeing how much of the constraints are used up:
Dept hours used hours available
A 500 x 8 + 700 x 10 = 11,000 hours 11,000 hours
B 500 x 4 + 700 x 10 = 9,000 hours 9,000 hours
B 500 x 12 + 700 x 6 = 10,200 hours 12,000 hours
Slack and surplus

Departments A and B are fully utilized or what are termed binding constraints (i.e. they bind the
decision or output). Department C has 1,800 hours un-utilized and is to binding on the decision,
it is called a slack constraint.
SENSITIVITY ANALYSIS – SHADOW PRICE

An investigation to identify how the optimum solution will change with changes to individual
variables.
The SHADOW PRICE or dual price is the amount by which the total optimal contribution would
rise if an additional unit of input (hour) was made available.
Department X – shadow price of one hour
If one more hour was available (ie 11,001 hours now), the constraint of department A will relax
outward slightly which should improve the overall optimum solution. Solve the new constraint
equations:
Dept X 8x + 10y = 11,001
Dept Y 4x + 10y = 9,000
Revised solution
Revised contribution
Shadow price
Effects – As A increases by 1:
1. x
2. y
3. Contribution
4. Dept
Department Y – shadow price of one hour
If one more hour was available (ie 9,001 hours now), the constraint of department B will relax
outward slightly which should improve the overall optimum solution. Solve the new constraint
equations:
Dept X 8x + 10y = 11,000
Dept Y 4x + 10y = 9,001
4x + 0 = 1,999
Revised solution x = 499.75, y = 700.2
Revised contribution 499.75 x 4 + 700.2 x 8 = £7600.6
Shadow price £7,600.6 - £7,600.0 = £0.6/hour of dept Y
Effects – As Y increases by 1:

1 x decreases by 0.25
2 y increases by 0.20
3 Contribution increases by £0.6
Dept Z slack actually increases by 1.8 hours.
Department Z – shadow price of one hour
Department Z already has spare capacity, extra hours would not increase the contribution
generated by the optimum solution (they would not change the solution). They have no shadow
price.
Assumptions and limitations of linear programming

 Linear programming may be used when relationships are assumed to be linear and where an
optimum solution does in fact exist.
 Assumes contribution per unit for each product is constant irrespective of the total quantities
produced and sold
 Assumes utilisation of resource per unit for each product is constant irrespective of the total
quantities produced and sold
 Assumes that units produced and resources allocated are infinitely divisible.
 When there are a number of variables, it becomes too complex to solve manually and a
computer is required.
Example 4
Cantata operates a small machine shop. Next month he plans to manufacture two products, A
and B upon which the unit contribution is estimated to be £50 and £70 respectively.
For their manufacture both products require inputs of machine processing time, raw materials
and labour. Each unit of product A requires 3 hours of machine processing time, 16 units of
raw materials and 6 hours of labour. The corresponding per unit requirements for product B
are 10, 4 and 6 respectively. Cantata forecasts that next month he can make available 330
hours of machine processing time, 400 units of raw materials and 240 labour hours. The
technology of the manufacturing process is such that at least 12 units of product B must be
made in any given time.
Required:
How many units of product A and B should be produced in order to maximize contribution?
Answers:
10 units of product A and 30 units of B; Total Contribution = £2,600
Example 5
Tronto is a family-operated business that manufactures fertilisers. One of its products is a
liquid plant feed into which certain additives are put to improve effectiveness. Every 10,000
litres of this feed must contain at least 480g of additive A, 800g of additive B and 640g of
additive C. Tronto can purchase two ingredients (X and Y) that contain these three additives.
The information, together with the cost of each ingredient, is given as follows:
Ingredient X Ingredient Y
Additive A 2g 8g
Additive B 5g 10g
Additive C 10g 4g
Cost per litre £25 £50
Both ingredients require specialist storage facilities and as such no more than 120 litres each
can be held in stock at any one time.
Tronto’s objective is to determine how many litres of each ingredient should be added to every
10,000 litres of plant feed so as to minimise cost.
Answers:
40 litres of ingredient X and 60 litres of ingredient Y, or 80 litres of ingredient X and 40 litres
of ingredient Y; Cost = £4,000 for each.
PRICING
The pricing of products or services is one of the more difficult and more important decisions for
the organisation. The prices adopted by a company will have an immediate effect on the
profitability of an organisation and longer term implications on the marketing of the product.
FACTORS AFFECTING PRICING DECISIONS

There are several factors underlying all pricing decisions, including the following:
1. Organizational goals 2. Price and demand relationship
3. Competitors 4. Cost
5. Product mix 6. Quality
7. Inflation 8. Product life cycle
Ways of calculating the price

There are three ways in which we may calculate the price of the product:
1. Cost-plus pricing – marginal cost or full cost as a base.
2. Marketing based pricing – the aim to generate profit maximization in the longer term.
3. Demand based pricing – the application of economic theory to maximize profit in the short-
term.
COST-PLUS PRICING
The simplest form of pricing, it is still widely used particularly in the retail industry and in
specific job order situations. The price is based on the cost plus a margin.
Cost-plus pricing may be based on:

1. Full cost (calculated using absorption costing) or
2. Marginal / variable cost.
The rationale behind this method is that if the price is greater than the cost then a profit must be
made (providing that the expected volumes are achieved).
1. Full cost-plus pricing

Advantages of full cost-plus pricing strategy:
 Easy to use.
 Ensures that all costs are covered.
 Ensures that firm can generate profits and survive in the future.
 Avoids costs of collecting market information on demand and competitor activity.
 It is believed to establish stable prices.

Disadvantages of full cost-plus pricing strategy:
 It does not consider the demand pattern of the product.
 The absorption of overheads is a guess work therefore the strategy will produce different
selling prices using different bases.
 Takes no account of market conditions since its focus is entirely internal.
 By using a fixed mark-up it does not permit the company to respond to the pricing decisions
of its competitors.
 It is not appropriate for making special decisions involving use of spare capacity.
2. Marginal cost-plus pricing

Pricing strategy in which a profit margin is added to the budgeted marginal or variable cost of
the product.
Advantages
 This strategy ensures that fixed costs are covered.
 The size of the mark-up can be adjusted to reflect demand.
 Maximum capacity utilisation.
 Efficient and most economic use of scarce resources.
Disadvantages
 Ignore profit maximisation.
 Ignores fixed overheads. The price may not be high enough to ensure that a profit is made
after fixed overheads are covered.
 Lack of consideration of overall market and customers.
MARKETING APPROACHES
The aim is to maximise the profit over the length of the product’s life.
Product life cycle
Decline
Level of
activity
Growth Maturity
Introduction
Time
Question 1
What are the implications on profitability, cash flow and strategy of each stage in the product life
cycle?

Phase Introduction Growth Maturity Decline

Profitabilit Low but will Steady and Profits begin to fall, Profits falling and
y depend on rising profit boosted by Product may fall faster if
pricing levels launched with decommissioning
strategy. variations on the of product
original eg: different necessary
colours
Cash flow Steadily Accelerating Cash ‘cow’ Cash flow falling
Increasing to max point accelerated by
need to cover fixed
costs until they
step as product
sales fall.
Strategy Price Launch to Product relaunch Deliberate
Skimming – Different market drive to hold replacement of
profit level geographic sales levels product
occurs faster. areas, variety
Price of sizes
Penetration – versions to
if successful boost sales
volumes
causes profit
faster
Pricing strategies
For new markets – monopoly position
Market skimming
The price is set at a high level to generate maximum return per unit in the early units. The aim is
to sell to only that small part of the market which is not price sensitive. For market skimming to
be effective the company must have a barrier to entry in the form of a patent, brand,
technological innovation or other.
Features
1 Low volume, high price
2 Low initial investment in production capacity
3 Low risk, if strategy fails price can be dropped
Limitations of market skimming strategy
 It is only effective when the firm is facing an inelastic demand curve (market is not price
sensitive).
 Price changes by any one firm will be matched by other firms resulting in a rapid growth in
industry volume.
 Skimming encourages the entry of competitors.
 Skimming results in a slow rate of diffusion and adaptation. This results in a high level of
untapped demand. This gives competitors time to either imitate the product or leap frog it
with a new innovation.

Market penetration pricing
The price is set at a level which should generate demand from the whole market and by so doing
encourage an acceleration of the life cycle quickly into growth and maturity phases. Necessary if
the market skimming approach is not possible because of a lack of barriers to entry or high initial
development costs.
Features
1 Low price, mass market.
2 Substantial investment required.
3 High risk, the low price is used to deter other competitors.
Penetration pricing strategy is appropriate when:

 Product demand is highly price elastic so that demand responds to price changes.
 Substantial economies of scale are available.
 The product is suitable for a mass market and there is sufficient demand.
 The product will face competition soon after introduction.
Existing market – no monopoly position

Penetration pricing - see above
May also be used in an existing market.
Going rate pricing or average pricing

Where the product is a leading brand (in market share terms) and any change in price made that
company will lead to a change by other competitors. Competition will continue in other forms.
Example 6
Identify three industries/companies which use going rate pricing.
Answers:
Intel, Unilever, and Procter and Gamble.
Premium pricing
The product is able to command a premium due to specific and identifiable features of the
product. The premium may be payable for a number of differing reasons such as:
1. Prestige
2. Reliability
3. Longevity
4. Technology
5. Style
Example 7
Identify the manufacturers which use each feature to command a premium for their product.
Answers:
BMW, Bentleys, Iphones
Discount pricing (loss leaders)

The product is sold at a discount to encourage higher sales. This often has the effect of reducing
the image of the product because customers equate price with quality.
Example 8
Identify three industries/companies that use discount pricing.
Answers:
Supermarket economy range, 99p shops.
Complementary product pricing

Complementary products are products that are goods that tend to be bought and used together.
For example: computers and software. If sales of one increase, demand for the other will also
increase. Also referred to as joint demand.
Captive product pricing

Where products have complements, companies will charge a premium price where the consumer
is captured (family of brands).
Product line pricing

A product line is a group of products that are related to each other.
Product line pricing strategies include setting prices that are proportional to full or marginal cost
with the same profit margin for all products in the product line. Alternatively, prices can be set to
reflect demand relationships between products in the line so that an overall return is achieved.
Volume discounting
A volume discount is a reduction in price given for purchases of large volume. The objective is
to increase sales from large customers. The discount differentiates between wholesale and retail
customers. The reduced cost of a large order will compensate for the loss of revenues from
offering the discount.
Relevant cost pricing

Special orders may require a relevant cost approach to the calculation of the price. A relevant
cost approach is to identify a price at which the organisation will be no better off, but no worse
off, if it sells the item at that price. Any price in excess of this minimum price will add to net
profit.
A special order is a one-off revenue-earning opportunity. These may arise in the following
situations.
(a) When a business has a regular source of income but also has some spare capacity,
allowing it to take on extra work if demanded.
(b) When a business has no regular source of income and relies exclusively on its ability
to respond to demand.
Price discrimination
This is the practice of selling the same product at different prices to different customers.
Examples: off peak travel bargains; theatre tickets sold at different prices based on location so
that customers pay different prices for the same performance.
DEMAND BASED PRICING

The preparation of a price in relation to the demand for a product. This technique considers the
demand for a product at a given price by developing a demand curve.
Deriving the demand curve

Formula sheet extract
Demand curve
P = a − bQ
change ∈ price
b=
change∈quantity
a = price when Q = 0
Current Qty at Current Price

or = a¿ Current Price($ )+ ∗$ b
Change∈qty when price is changed by $ b
Example 9
A product sells 500 units at a price of £25 and 700 units at a price of £20.
Required:
Assuming a unitary demand curve, what is the formula for the demand curve?
Answers:
P = 37.50 – 0.025Q
Example 10
A company presently sells 20,000 units at £12.50 each. The managing director believes that
they will be more profitable if they sell 20% more unit at a price of £11 each.
Required:
(a) Derive the demand curve.
(b) Calculate the total revenue in each circumstance.
Is the managing director necessarily correct in her assumption?
Answers:
(a) P = 5 – 0.000375Q; (b) £250,000; £264,000
Factors influencing demand

The demand for a particular company’s goods will be influenced by 3 main factors:
1. The Product Life Cycle (PLC). If life cycle is short, a high price strategy is adopted.
2. Quality of the product. High quality of product can support a high price.
3. Marketing (Price is one of the 4 P’s). Can capture a higher market share by adopting a
particular pricing strategy.
Price elasticity of demand

Price elasticity of demand is the measure of the extent of change in market demand for a good in
response to a change in its price. When a small change in price results in more than a
proportionate change in demand, the product is said to be elastic, where a change in price results
in less than proportionate change in demand, we have price inelastic (e.g. salt). However, where
a change in price results in an equal change in demand, we have unitary elastic demand.
% change∈demand of good X
Elasticity of demand (PED) =
% change∈ price of good X
(Q 2−Q 1)/Q 1
Price elasticity of demand =
( P2−P1)/ P 1
If the PED is greater than one, the good is price elastic. Demand is responsive to a change in
price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price
elasticity = 2.0.

If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in
price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price
elasticity = 0.25.
If the PED is equal to one, the good has unit elasticity. The percentage change in quantity
demanded is equal to the percentage change in price. Demand changes proportionately to a price
change.
If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no
influence on quantity demanded. The demand curve for such a product will be vertical.
If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity
demanded fall to zero. This demand curve is associated with firms operating in perfectly
competitive markets.
Other factors affecting elasticity

 Availability of substitutes.
 Complementary products.
 Disposable income.
 Necessities.
 Tastes and fashions.
 Advertising and Marketing.
 Price.
 Local laws
Example 11
The price of a good is £1.20 per unit and the annual demand is 800,000 units. Market research
indicates that an increase in price of 10pence per unit will result in a fall in annual demand of
75,000 units.
Required:
What is the price elasticity of demand?
Answers: 1.125
Advantages of demand based pricing

1. A consideration of the market.
2. It considers only incremental costs.
3. Relationship between Price and Demand.
Limitations of demand based pricing

1. Degree of accuracy to determine price and demand relationship.
2. Accuracy to determine true variable / marginal cost.
3. Many companies aim to achieve a target profit, rather than the theoretical maximum profit.
4. Less focus on other factors such as quality, advertising, packaging, credit facilities and after
sales services also affect the quantity demanded of a product, not just the Price.
PROFIT MAXIMISING PRICE AND QUANTITY

It is important to understand cost behaviour in many business decisions. The rate of increase in
total cost as a consequence of increase in volume may increase or decline due to price changes,
inflation, and discount factors etc.

The same principle applies to the rate of increase in revenues as a result of increase in volume.
Profit maximising price and quantity can be determined by using the idea of marginal revenue
and marginal cost.
It can be determined by plotting marginal revenue and marginal cost curves and equating them
on the graph paper, the point of intersection shows the profit maximising price and quantity.
Hence, the profit maximising price and quantity will be at a point where:
Marginal revenue (MR) = marginal cost (MC)
SHORT TERM DECISIONS
CONTRIBUTION ANALYSIS
One aspect of decision making is closely linked to the impact of a change in the level of activity.
In these situations, the decision is based upon the variable costs or contributions generated. Fixed
costs are not affected by activity and hence can be ignored.
Make or buy decision
The decision to make a component or product ‘in-house’ or to buy from an outside supplier. The
underlying assumption of this decision is that all fixed costs of manufacture are general to the
organisation as a whole and hence only the marginal cost of making the component is relevant.
Decision criteria: Compare marginal cost of making to the purchase price (the marginal cost of
buying).
Example 12: Clemence Ltd produces a number of components, two of which it is considering
buying in, components X and Y.
Cost of making (£) X Y
Variable 14 28
Fixed 4 4
Total 18 32
Purchase price (from outside supplier) 17 25
Required:
Should Clemence Ltd make or buy in?
Answers: Variable Cost vs. Purchase price. Decision: X-Make; Y-Buy
Example 13: PCO Ltd is considering the alternatives of either purchasing a component from
an outside supplier or producing the component itself. The estimated costs to the company of
producing a component are as follows:
Direct labour 100
Direct materials 300
Variable overheads 50
Fixed overheads 200
650
The outside supplier has quoted a price of £400 for supplying the component.
Required:
Should PCO Ltd produce or buy the component from the supplier?
Answers: Decision: Buy savings of £50

OUTSOURCING
Outsourcing is the use of external suppliers for finished products, components or service. This is
also known as contract manufacturing or subcontracting.
Reasons for outsourcing

- Specialist contractors can offer superior quality and efficiency.
- Contracting out manufacturing services frees capital which can be invested in other core
activities.
- Contractors have the capacity and flexibility to start production very quickly to meet
sudden variations in demand.
- There is not enough work to keep internal staff fully occupied.
Outsourcing pros and cons
Advantages Disadvantages
Greater flexibility Possibility of choosing wrong supplier
Lower investment risk Loss of visibility and control over process
Improved cash flow Possibility of increased lead times
Concentrates on core competence Increase dependency
Enables more advanced technologies to be
used without making investment
Shutdown (discontinuance) decisions

The decision whether to shut down a part or segment of a business. The focus of the question is
the impact of the shutdown on the cost base. Revenue will be foregone but which costs will be
affected.
The avoidable costs include variable costs and specific fixed costs. Specific fixed costs are those
costs specific to the part or segment of the business to be shutdown. General fixed costs will not
be relevant.
The simplest way to consider such a problem is to re-draft any information in the form of a
marginal costing profit statement.
Any product that produces a positive contribution is worth undertaking as it will contribute to
profit, unless
 The company can use the capacity used by this product to produce another new product
with a higher contribution than that of this first product.
 The capacity used by this product can be used to produce more of the other existing
product with higher contribution.
Example 14
Jones Ltd operates three divisions within a larger company. The CEO has been shown the
latest profit statements and is concerned that division C is losing money.
You are required to advise her whether or not to close down division C.
Division A B C
(000s) (000s) (000s)
Sales 100 80 40
Variable costs 60 50 30
Fixed costs 20 20 20
Profit/(loss) 20 10 (10)
You are also informed that 40% of the fixed cost is product specific, the remainder being
allocated arbitrarily to the divisions from head office.
Required:
Should division C be shut down?
Answers: No. Shutdown will lower profits by 2,000.
Example 15
Fantum Ltd has three operating divisions. The expected financial results of each division next
year are as follows:
Division X Division Y Division Z
£ £ £
Sales 50,000 30,000 40,000
Variable costs (30,000) (18,000) (20,000)
Specific fixed cost (12,000) (10,000) (10,000)
Apportioned head office costs (5,000) (4,000) (5,000)
Profit or loss 3,000 (2,000) 5,000
Required:
Taking only the financial results next year into consideration, recommend whether or not
division Y should be closed down.
Answers: On the basis of this information, Division Y should remain open as it will make a
net additional to profit next year of £2,000.
Further processing decisions

A further processing decision may arise in a manufacturing company that produces an item in a
process or a sequence of processes. The output from a process might have a market value, and a
selling price. However, there might also be an opportunity to further process the output to
produce a finished item with a higher selling price.
The decision is whether to sell the item in its part-finished form, or whether to process it further
and sell the finished item.
The relevant cash flows are:
 The extra revenue obtained by further processing the item (incremental revenues), and
 The incremental costs of further processing.
The financial decision should be to further process the item if the extra revenue exceed the
incremental costs.
Example 16
CF Ltd manufactures two cleaning fluids, X and Y. The two fluids are manufactured in a joint
process. Every 8,000 litres of materials input to the joint process produces 4,000 litre of X and
3,200 of Y. The costs of processing are as follows:
£
Direct material 1,600
Direct labour 200
Variable production overheads 300
Fixed production overheads 2,000
Product X sells for £1.10 per litre and product Y for £0.75 per litre.
CF Ltd could put product X through another production process, where there is spare
production capacity. The further processing would produce another cleaning product, Zplus.
Every one litre of input to the further process will produce 0.90 litres of Zplus.

The costs of further processing would be:

Product X: 4,000 litres
Additional materials 400
Direct labour 40
Variable overheads 80
Fixed production overheads 400
920
Zplus would sell for £1.40 per litre
Required:
Using financial reasons only to justify the decision, should the company sell product X or
should it further process the product to make Z plus? Assume for the purpose of the analysis
that direct labour is a variable cost.
Answers:
Incremental revenue from further processing £ 640
Incremental gain from further processing £ 120
RELEVANT COST ANALYSIS

There are 3 components to a relevant cost:
1. Future
2. Cash flow
3. Arising as a direct result of the decision
Relevant costs Non-relevant costs
Opportunity cost Sunk cost
Incremental cost Committed cost
Variable cost Fixed O/H absorbed
Avoidable cost Depreciation (non-cash flows)
Opportunity cost
The benefit foregone by choosing one alternative in preference to the next best alternative.
Avoidable costs
Costs attached to a part or segment of a business which could be avoided if that part or segment
ceased to exist. Variable costs are normally considered avoidable, fixed costs normally not.
Fixed costs may be considered avoidable if arise within the single part or segment of the business
that is relevant. They are particularly applicable in shutdown decisions.
Identify which of the following costs are relevant to the decisions specified:
(a) The salary to be paid to a market researcher who will oversee the development of a new
product. This is a new post to be created especially for the new product but the £12,000 salary
will be a fixed cost.
Is this cost relevant to the decision to proceed with the development of the product?
(b) The £2,500 additional monthly running costs of a new machine to be purchased to
manufacture an established product. Since the new machine will save on labour time, the fixed
overhead to be absorbed by the product will reduce by £100 per month.
Are these costs relevant to the decision to purchase the new machine?
(c) Office cleaning expenses of £125 for next month. The office is cleaned by contractors and
the contract can be cancelled by giving one month’s notice.

Is this cost relevant to a decision to close the office?
(d) Expenses of £75 paid to the marketing manager. This was to reimburse the manager for the
cost of travelling to meet a client with whom the company is currently negotiating a major
contract.
Is this cost relevant to the decision to continue negotiations?
Answers
(a) The salary is a relevant cost of £12,000. Do not be fooled by the mention of the fact that it
is a fixed cost, it is a cost that is relevant to the decision to proceed with the future
development of the new product. This is an example of a directly attributable fixed cost.
A directly attributable fixed cost may also be called a product specific fixed cost.
(b) The £2,500 additional running costs are relevant to the decision to purchase the new
machine. The saving in overhead absorption is not relevant since we are not told that the total
overhead expenditure will be altered. The saving in labour cost would be relevant but we shall
assume that this has been accounted for in determining the additional monthly running costs.
(c) This is not a relevant cost for next month since it will be incurred even if the contract is
cancelled today. If a decision is being made to close the office, this cost cannot be included as
a saving to be made next month. However, it will be saved in the months after that so it will
become a relevant cost saving from month 2 onwards.
(d) This is not a relevant cost of the decision to continue with the contract. The £75 is sunk and
cannot be recovered even if the company does not proceed with the negotiations.
Example 17
A lecturer is being timetabled for the coming year. She has expressed a desire to teach in
London. The courses she alone can do, in a specific week, generate the following
contributions:
£
London 1,200
Croatia 1,500
Moscow 2,100
Required:
What is the opportunity cost of working in:
(a) London?
(b) Croatia?
(c) Moscow?
Answers:
(a) Moscow; (b) Moscow; (c) Croatia
Avoidable costs
Costs attached to a part or segment of a business which could be avoided if that part or segment
ceased to exist. Variable costs are normally considered avoidable, fixed costs normally not.
Fixed costs may be considered avoidable if arise within the single part or segment of the business
that is relevant. They are particularly applicable in shutdown decisions.
Variable costs

Those costs which vary proportionately with the level of activity. As seen above the variable
nature of the cost often makes it more likely to be relevant. We should already know that the
variable cost is useful for break-even analysis or any other form of contribution analysis.
Incremental costs
Those additional costs (or revenues) which arise as a result of the decision. This classification is
particularly useful for further processing decisions, but may be used as a basis for tackling any
relevant cost analysis.
ACCEPTING OR REJECTING ORDERS

Another type of decision is a decision whether or not to accept an order. The comparison here
should be between:
 The relevant costs of the order, including any opportunity cost of other opportunities
forgone as a consequence; and
 The incremental revenue from the order.
Other factors to consider

 Is there an alternative more profitable way of utilising spare capacity?
 Will fixed cost be unchanged if the order is accepted?
 Will accepting one order at below normal selling price lead other customers to ask for
price cuts?
Material costs flow chart

Is the
material in
stock?
YES NO
Purchase price is
Next question relevant
Is the
material in
YES Constant NO
Replacement cost is Use?
relevant Next question
Is the material
Has alternative
No alternative use use or need Has alternative use
disposal? Relevant cost = higher of
Scrap/disposal value is a) value in other use
relevant b) scrap/disposal value

Labour costs flow chart
Is the
Labor in
Permanent
YES employment? NO
Next question Hourly rate is relevant
Is the labor
fully
YES utilized? NO
Next question Nil value
Overtime
possible?
YES NO
Overtime rate is Opportunity cost is
relevant relevant
Example 18
Pantum Ltd is considering whether or not to undertake an order from a customer. It is trying to
establish the relevant costs of the order.
The order would require 3,000 kilos of material W. There are over 3,000 kilos already held in
inventory. Material W is no longer in regular use by the company and could be sold for scrap
at £1.5 per kilo. It could also be used as a substitute for material Z, which is in regular use for
making another product. Material Z can be purchased for £4 per kilo. To use material W as a
substitute for material Z, conversion costs of £1.6 per kilo would have to be spent on the
material W. One kilo of material W, after conversion, would be a substitute for one kilo of
material Z Skilled labour needed to fulfil the order would be specifically recruited for £50,000.
Unskilled labour needed to fulfil the order would be transferred from another department. The
cost of the labour time (3000 hours) would be £30,000 in wages. However, 1,500 of these
hours would be idle time if the order is not undertaken. The other 1,500 would be spent on
work that would provide a contribution of £5,000.
Required:
Identify the relevant costs of material and labour for this customer order.
Answers:
Material W (3000 kilos x2.4) 7,200
Skilled labour 50,000
Unskilled labour: 0
Use of idle time 0
Use of other time (50% x 30,000) + 5000 15,000
77,200
Example 19
You are the management accountant of Tricks, an organisation which has been asked to quote
for the production of a pamphlet for an event. The work could be carried out in addition to the
normal work of the company. Due to existing commitments, some overtime working would be
required to complete the printing of the pamphlet. A trainee has produced the following cost
estimate based upon the resources required as specified by the operations manager:
£
Direct materials:
- paper (book value) 4,000
- inks (purchase price ) 2,400
Direct labour:
- highly skilled 250 hours @ £4.00 1,000
- semi-skilled 100 hours @ £3.50 350
Variable overhead 350 hours @ £4.00 1,400
Printing press depreciation 200 hours @ £2.50 500
Fixed production costs 350 hours @ £6.00 2,100
Estimating department costs 400
12,150
You are aware that considerable publicity could be obtained for the company if you are able to
win this order and the price quoted must be very competitive.
The following notes are relevant to the cost estimate above:
(1) The paper to be used is currently in stock at a value of £5,000. It is of an unusual
specification (texture and weight) and has not been used for some time. The replacement price
of the paper is £9,000, whilst the scrap value of that in stock is £3,125. The store manager does
not foresee any alternative use for the paper if it is not used on the pamphlet.
(2) The inks required are presently not held in stock. They would have to be purchased in bulk
at a cost of £3,000. 80% of the ink purchased would be used in producing the pamphlet. There
is no foreseeable alternative use for the remaining unused ink.
(3) Highly skilled direct labour is in short supply, and the factory labour is already being
utilised at full capacity, therefore, to accommodate the production of the pamphlet, 50% of the
time required would be worked at weekends for which a premium of 25% above the normal
hourly rate is paid. The normal hourly rate is £4.00 per hour.
(4) Semi-skilled labour is presently under-utilized, and 200 hours per week are currently
recorded as idle time. If the printing work is carried out, 25 unskilled hours would have to
occur during the weekend, but the employees concerned would be given two hours-time off
during the week in lieu of each hour worked at the weekend.
(5) Variable overhead represents the cost of operating the printing press and binding machines.
(6) When not being used by the company, the printing press is hired to outside companies for
£6.00 per hour. This earns a contribution of £3.00 per hour. There is unlimited demand for this
facility.
(7) Fixed production costs are those incurred by and absorbed into production, using an hourly
rate based on budgeted activity.
(8) The cost of the estimating department represents time spent in discussions with the
organisation concerning the printing of its pamphlet.
Required:
Prepare a revised cost estimate using the opportunity cost approach, showing clearly the
minimum price that the company should accept for the order. Give reasons for each resource
valuation in your cost estimate.
Answers:
Total relevant cost (minimum price) £8,625 (2,500+3,000+1,125+1,400+600)

RISK AND UNCERTAINTY

INTRODUCTION
Decision making, particularly long-term decisions, has to be taken under the conditions of risk
and uncertainty
WHAT IS RISK AND UNCERTAINTY?

Uncertainty
Uncertainty simply reflects that there is more than one possible outcome for a given event but
there is little previous statistical evidence to enable the possible outcomes to be predicted.
Risk
Risk is where that uncertainty can be quantified in some way.
It is normal to quantify the risk in terms of a probability distribution, generally derived from
statistical data in the past.
Risk attitudes
Risk preference describes the attitude of a decision-maker toward risk – as there is a relationship
between risk and reward.
 Risk averse – a risk averse decision-maker considers risk in making decision, and will not
select a course of action that is riskier unless the expected return is higher and so justifies the
extra risk.
 Risk seeker – a risk seeker decision-maker also considers risk in making a decision.
A risk seeker, unlike a risk averse decision-maker, will take extra risks in the hope of earning
a higher return.
 Risk neutral – a risk neutral decision-maker ignores risk in making a decision.
A risk neutral decision-maker will select the course of action with the highest expected
return, regardless of risk
MARKET RESEARCH
Market research is a process of systematically and objectively gathering, recording and analysing
information. This information may relate to:
 customers;
 general trends in the market;
 competitors;
 government regulations;
 economic trends;
 technological advancements; and
 any other factors that constitute the business environment
Worst, most likely, and best outcome estimates

The choice between two or more alternative courses of action might be based on the worst, most
likely or best expected outcomes from each course of action. This choice will show the full range
of possible outcomes from a decision, and might help managers to reject certain alternatives
because the worst possible outcome might involve an unacceptable amount of loss.
This requires the presentation of a pay-off table.

Pay-off table (or matrix)
The pay-off matrix is a tabular layout specifying the result (pay-off) of each combination of
decision and the state of the world over which the decision maker has no control.
Example 20
Won Ltd is trying to decide the selling price for a product. Three prices are under
consideration and expected sales volume and costs are as follows:
Price per unit £4 £4.30 £4.40
Expected sale volume (unit)
Best possible 16,000 14,000 12,500
Most likely 14,000 12,500 12,000
Worst possible 10,000 8,000 6,000
Fixed costs are £20,000 and variable cost is £2 per unit.
Required:
Which price should be chosen?
Answers:
Best Possible = £4.30 (contribution £32,200); Most Likely = £4.40 (Contribution £28,800);
Worst Possible = £4 (contribution £20,000)
EXPECTED VALUE
The expected value ignores the degree of risk and focuses solely on the average return of the
event given repetition of the event.
Example 21
Too Ltd is trying to decide which of the three mutually exclusive projects to undertake. The
company has constructed the following payoff table or matrix.
Net profit if outcome turns out to be Worst Most likely Best
Project A 50 85 130
Project B 70 75 140
Project C 90 100 110
Required:
State which project would be selected using each of the:
(a) maxmin;
(b) maximax criteria; and
(c) minimax regret rule.
Answers:
(a) maxmin = Project C (90) ; (b) maximax criteria = Project B (140); (c) minimax regret
rule = project B(25)
Probability
The measurement of the outcomes in terms of their estimated likelihood of occurring.
Overall probability of an event must sum to 1.0 (or if you wish 100%). For example, if you toss a
coin there is a 0.5 (50%) probability of a head or a tail. Adding both outcomes total 1.0 (100%).
Expected values
A weighted average value of all the possible outcomes. It does not reflect the degree of risk, but
simply what the average outcome would be if the event were repeated a number of times.

A decision rule is to select the course of action with the highest expected value of profit or the
lowest expected value of cost.
Expected value formula
EV = ∑px
P = probability of an outcome
x = value of an outcome
Example 22
3D Ltd expects the following monthly profits:
Monthly profit Probability
£50,000 0.6
£35,000 0.4
Required:
Calculate the expected value of monthly profit.
Answers: £44,000
Example 23
Consider the following sales and probabilities.
Sale probabilities
£ %
20,000 25
25,000 40
30,000 15
35,000 20
Required:
What will be the expected value?
Answers: £26,500
Advantages of expected values

1. EV considers all the different possible outcomes and the probability that each will occur.
2. It recognises risk in decision, based on the probabilities of different possible results or
outcomes.
3. It expresses risk as a single figure.
Limitations of expected values

1. The EV shows a long term average, so that the EV will not be reached in the short term and is
therefore not very suitable for one-off decisions.
2. The accuracy of the results depends on the accuracy of the probability distribution used.
3. EV takes no account of the risk associated with a decision.
DECISION CRITERIA
Choosing between mutually exclusive courses of action on the basis of worst, most likely or best
possible outcome can be stated as decision rules.
The choice may be based on a maximax, maximin, or a minimax regret decision rule, and
expected value.
Maximax
The decision maker will select the course of action with the highest possible payoff (the best of
the best). The maximax decision rule is the decision rule for the risk seeker.
Maximize the maximum achievable profit.
Maximin decision rule

The decision maker will select the course of action with the highest expected return under the
worst possible conditions. This decision rule might be associated with a risk averse decision
maker.
Maximize the minimum achievable profit.
Minimax regret decision rule

The decision maker selects the course of action with the lowest possible regret. It aims at
minimizing the regret from making the wrong decision.
Regret is the opportunity cost of having made the wrong decision, giving the actual conditions
that apply in the future.
Example 24
Mr Fyvestall runs a market stall selling vegetables and fruit. He buys a product for £20 per
case. He can sell the product for £40 per case on his stall. The product is perishable and it is
not possible to store it, instead any cases unsold at the end of the day can be sold off as scrap
for £2 per case.
Purchase orders must be made before the number of sales is known. He has kept records of
demand over the last 150 days.
Demand / day Number of days
10 45
20 75
30 30
Required:
(a) Prepare a summary of possible net daily margins using a payoff table.
(b) Advise Mr Fyvestall:
(i) How many cases to purchase if he uses expected values.
(ii) How many cases to purchase if he uses maximin / maximax.
(iii) How many cases to purchase if he uses minimax regret.
Answers:
(b) (i) EV = £286 per day so buy 20 ; (b) (ii) Maximin buy 10, Maximax buy 30; (b) (iii)
Minimax regret buy 20
DECISION TREE ANALYSIS

A decision tree is a diagram showing several possible courses of action and possible events and
the potential outcomes for each course of action.
Each alternative course of action is represented by a branch, which leads to subsidiary branches
for further course of action or possible events.
Decision tree analysis is designed to illustrate the full range of alternatives that can occur, under
all possible given conditions.
The financial outcomes and probabilities are shown separately, and the decision tree is ‘rolled
back’ by calculating expected values and making decisions
Three step method

Step 1: Draw the tree from left to right, showing appropriate decisions and events / outcomes.
Step2: Evaluate the tree from right to left carrying out these two actions:
(a) Calculate an EV at each outcome point.
(b) Choose the best option at each decision point.
Step 3: Recommend a course of action to management.
Example 25
The following information relates to Seven Trees Ltd, a company which is considering
whether to develop and market a product.
Probability
Development
Being successful 0.75
Being unsuccessful 0.25
Estimated development costs would be $180,000
If successful, the product will be marketed with following probabilities:
Probability Profits/(Loss)
Being very successful 0.4 $540,000
Being moderately successful 0.3 $100,000
Being failure 0.3 ($400,000)
The above profits / losses figures include the effect of the development costs.
Required:
Draw a decision tree to illustrate the above problem, and recommend the best course of action.
Answers:
Based on expected values developed from the decision tree, the company should develop the
product as it is giving a positive sum of profits = $49,500 as opposed to do not develop a
product = 0.
Example 26
The 'Duke of York' is an independent cinema in Brightville. It is considering whether or not to
hire a movie to show in its cinema for one week. If the management decides to hire the movie,
it will be screened 20 times during the week. The cost of hiring the movie for the week is
$70,000.
You work as the cinema's accountant, and you have been asked to evaluate the financial
effects of the decision to hire the movie. You have made the following estimates:
(1) Customers
The entrance fee for every customer is $10. The number of customers watching the movie at
each screening is uncertain, but has been estimated as follows: there is a 50% probability 200
customers will attend the screening; a 30% probability 250 customers will attend, and 20%
probability 150 customers will come.
(2) Customer contribution for each sale of refreshments
The average contribution per customer earned from the sale of refreshments is also uncertain
but has been estimated as follows:
Probability $ average contribution per customer
40% probability $10 per customer
Required:
Prepare a decision tree to show the total contributions which could be generated from the
above scenario. Based on the expected values, determine if the movie should be hired.
Answers:
At the first and only decision point in our tree, we should choose the option to hire the movie
as EV equal to a positive contribution of $11,180 and not hiring the movie does not generate
any contribution at all.
SENSITIVITY ANALYSIS
Introduction
Sensitivity analysis is a method of risk or uncertainty analysis in which the effect on the expected
outcome of the change in values of key variables or key factors is tested. For example, in budget
planning, the effect on budgeted profit might be tested for changes in the budgeted sales volume,
or the budgeted sale price, material and labour costs, and so on.
There are several ways of using sensitivity analysis including:

 To estimate by how much costs and revenues would need to differ from their estimated
values before the decision would change.
 To estimate whether a decision would change if estimated sales were A% lower than
estimated, or estimated costs were B% higher than estimated. This is called ‘what if’
analysis. For example: what if the sales volume is 5% less than the expected volume?
Example 27
A company is considering launching a new product in the market. Profit estimates are as
follows:
$ $
Sales (10,000 units) 200,000
Variable costs:
Materials 120,000
Labour 20,000
140,000
Contribution 60,000
Fixed costs (all directly attributable) 50,000
Profit 10,000
The estimates of sales volume, sales price, variable costs and fixed costs are uncertain.
Sensitivity analysis can be used to calculate the extent to which the profitability of the product
depends on the accuracy of the estimates. We can calculate by how much each of these
variables would have to be ‘worse’ than estimated before the product became loss-making.
Profit can fall by $10,000 before the product ceases to be profitable. Profit would fall by
$10,000 if:
 sales volume is $10,000/$60,000 = 16.7% less than expected: this is because each 1%
fall in sales volume will reduce contribution by 1%
 the sales price is $10,000/$200,000 = 5% less than expected
 material costs are $10,000/$120,000 = 8.3% more than expected
 labour costs are $10,000/$20,000 = 50% more than expected
 fixed costs are $10,000/$50,000 = 20% more than expected.
Implementing sensitivity analysis

The starting point of sensitivity analysis is the original plan or estimate, giving an expected profit
or value.
Key variables that determine the profit or value are identified. Such variables include: sale price,
sales volume, completion time, material and labour costs, and so on.
The values of these key variables are altered to determine how much they would differ from their
estimated values before the decision would change.
In this way, the sensitivity of a decision or plan to changes in the value of the key variables can
be measured.
Advantages
1. It is not a complicated theory to understand
2. It forces managers to identify the underlying variables, indicate where additional information
would be most useful, and helps to expose confused and inappropriate forecasts
3. An indication is provided of those variables to which profitability or value is most sensitive.
And the extent to which those variables may change before the investment break-even.
4. It provides an indication of why a project might fail. Once these critical variables have been
identified, management should review them to assess whether or not there is a strong possibility
of events occurring which will lead to a negative NPV.
5. It serves as an aid in the preparation of contingency plans, should key parameters show
unfavorable variations ex-post.
Disadvantages
1. The method requires that changes in each key variable are isolated. But management is more
interested in the combination of the effects of changes in two or more variables. Looking at
factors in isolation is unrealistic since they are often inter-dependent.
2. It does not examine the probability that any particular variation in cost or revenue might occur.
3. It is not in itself a decision rule. Management must weigh the information provided by the
analysis in deciding whether the investment is worthwhile.
VALUE OF PERFECT INFORMATION (VPI)

If perfect information about the future were available, it would be very easy to make a decision
as the uncertainty and risk associated with it would be minimum.
Therefore, knowledge about cost of obtaining the perfect information is very important for
management point of view.
The price that one would be willing to pay in order to gain access to perfect information of an
uncertain outcome in decision making is known as Value of Perfect Information.
Mathematically VPI is the difference between the payoff under certainty and the payoff under
risk.
Example 28
A company wishes to go ahead with one of three mutually exclusive projects, but the profit
outcome from each project will depend on the strength of sales demand, as follows.
Strong demand Moderate demand Weak demand
Profit/(Loss) Profit Profit/(Loss)
$ $ $
Project 1 70,000 10,000 (7,000)
Project 2 25,000 12,000 5,000
Project 3 50,000 20,000 (6,000)
Probability of demand 0.1 0.4 0.5
What is the value to the company of obtaining this perfect market research information,
ignoring the cost of obtaining the information?
Answers:

EV of Project 1 = $7,500; EV of Project 2 = $9,800; EV of Project 3 = $10,000

Value of perfect information = $7,500 – ignoring the cost of obtaining the information.
Example 29
A company wishes to go ahead with one of two mutually exclusive projects, but the profit
outcome from each project will depend on the strength of sales demand, as follows.
Strong demand Moderate demand Weak demand
Profit Profit Profit/(Loss)
$ $ $
Project 1 80,000 50,000 (5,000)
Project 2 60,000 25,000 10,000
Probability of demand 0.2 0.4 0.4
The company could purchase market research information, at a cost of $4,500. This would
predict demand conditions with perfect accuracy.
What is the value to the company of obtaining this perfect market research information?
Answers:
Value of perfect information = $1,500
SIMULATION
Simulation is a quantitative technique that uses IT based computerized packages with built in
mathematical models for decision making under conditions of uncertainty. It evaluates various
courses of action based upon facts and assumptions.
Monte Carlo is a widely used method of simulation, where complex problem is solved by
simulating the original data with random number generators.
Usefulness of simulation:
 Medical diagnosis
 Gambling
 Air force trainings
 Traffic scheduling.
Example 30
A retailer deals in a perishable commodity. The daily demand and Supply are variables. The
data for the past 500 days show the following demand and supply:
Supply Demand
Availability No. of Demand No. of
(Kg.) Days (Kg.) Days
10 40 10 50
20 50 20 110
30 190 30 200
40 150 40 100
50 70 50 40
The retailer buys the commodity at $ 20 per kg. and sell it at $ 30 per kg. Any commodity
remains at the end of the day, has no saleable value. Moreover, the loss (unearned profit) on
any unsatisfied demand is $ 8 per kg.
Required
Given the following pair of random numbers, simulate 6 days sales, demand and profit.
(31 ,18); (63 , 84); (15 , 79 ); (07 , 32); (43, 75); (81, 27)
The first random number in the pair is for supply and the second random number is for
demand viz. in the first pair (31, 18), use 31 to simulate supply and 18 to simulate demand.
Answers:
During the simulated period of six days, the net profit of the retailer is $400.
Example 31
A bakery sells a popular brand of bread. Cost price per bread is $ 16 and selling price per
bread is $ 20. Shelf life of the bread is 2 days and if it is not sold within two days, then it has
no sale value at the end of second day. Daily demand based on past experience is as under:
Daily Demand 0 20 25 35 40 45
Probability .01 .15 .30 .40 .10 .04
Consider the following sequence of random numbers:
58, 80, 51, 09, 47, 26, 64, 43, 86, 35
Required
Using the sequence, simulate the demand for the next 10 days and find out the total profit or
loss for 10 days assuming 35 breads are purchased every day in the morning and there is an
opening stock of 5 breads (purchased the previous day) on the 1st day morning. Assume LIFO
basis (Last In First Out basis - where the fresh bread is sold first).
Answers:
Profit on Sale of one Bread $4
Total Profit for 10 Days is $ 680.
Cost of Bread in Stock at the end of the 10th Day is $160 (10 Breads × $16)

Past Question for Practice

CVP Analysis
December 2012
1. Hair Co manufactures three types of electrical goods for hair: curlers (C), straightening irons (S) and
dryers (D.) The budgeted sales prices and volumes for the next year are as follows:
C S D
Selling price $110 $160 $120
Units 20,000 22,000 26,000
Each product is made using a different mix of the same materials and labour. Product S also uses new
revolutionary technology for which the company obtained a ten-year patent two years ago. The budgeted
sales volumes for all the products have been calculated by adding 10% to last year’s sales.
The standard cost card for each product is shown below.
C S D
$ $ $
Material 1 12 28 16
Material 2 8 22 26
Skilled labour 16 34 22
Unskilled labour 14 20 28
Both skilled and unskilled labour costs are variable.
The general fixed overheads are expected to be $640,000 for the next year.
Required:
(a) Calculate the weighted average contribution to sales ratio for Hair Co. Note: round all workings to 2
decimal places. (6 marks)
(b) Calculate the total break-even sales revenue for the next year for Hair Co. Note: round all workings to
2 decimal places. (2 marks)
(c) Using the graph paper provided, draw a multi-product profit-volume (PV) chart showing clearly the
profit/loss lines assuming:
(i) you are able to sell the products in order of the ones with the highest ranking contribution to
sales ratios first; and
(ii) you sell the products in a constant mix. Note: only one graph is required. (9 marks)
(d) Briefly comment on your findings in (c). (3 marks)
Answers:
(a) WA C/S ratio = 35·75%
Hair Co
(a) Weighted average contribution to sales ratio (WA C/S ratio) = total contribution/total sales revenue.
Per unit: C S D
$ $ $
Selling price 110 160 120
Material 1 (12) (28) (16)
Material 2 (8) (22) (26)
Skilled labour (16) (34) (22)
Unskilled labour (14) (20) (28)
––– ––– –––
Contribution 60 56 28
––– ––– –––
Sales units 20,000 22,000 26,000
Total sales revenue $2,200,000 $3,520,000 $3,120,000
Total contribution $1,200,000 $1,232,000 $728,000
WA C/S ratio = $1,200,000 + $1,232,000 + $728,000/$2,200,000 + $3,520,000 + $3,120,000
= $3,160,000/$8,840,000 = 35·75%
(b) Break-even sales revenue = fixed costs/C/S ratio

Therefore break-even sales revenue = $640,000/35·75% = $1,790,209·70.
(c) PV chart
Calculate the individual C/S ratio for each product then rank them according to the highest one first.
Per unit: C S D
$ $ $
Contribution 60 56 28
Selling price 110 160 120
C/S ratio 0·55 0·35 0·23
Ranking 1 2 3
Product Revenue Cumulative Revenue Profit Cumulative Profit
(x axis co-ordinate) (y axis co-ordinate)
$ $ $ $
0 0 0 (640,000) (640,000)
Make C 2,200,000 2,200,000 1,200,000 560,000
Make S 3,520,000 5,720,000 1,232,000 1,792,000
Make D 3,120,000 8,840,000 728,000 2,520,000
(d) From the chart above it can be seen that, if the products are sold in order of the highest ranking first, break-
even will take place at a point just under $1,200,000 of sales revenue. The exact figure can be worked out by taking
the fixed costs of $640,000 and dividing them by Product C’s C/S ratio of 0·55, i.e. the exact BEP is $1,163,636.
This is substantially earlier than the break-even point which occurs if the products are all sold in a constant mix,
which is $1,790,209, as calculated in (b) above.
The reason for this is obviously because the more profitable product, C, contributes more per unit to fixed costs
when being sold on its own, than when a mix of products C, S and D are sold. The weighted average C/S ratio of all
three products is only 35·75%, compared to C’s C/S ratio of 55%. Obviously, then, break-even will occur earlier if
C is sold in priority. In reality, however, the mix of sales will vary throughout the year and Hair Co can neither
assume that the products are sold in a constant mix, nor that the most profitable can be sold first.
December 2015
2. Cardio Co manufactures three types of fitness equipment: treadmills (T), cross trainers (C) and rowing
machines (R). The budgeted sales prices and volumes for the next year are as follows:
T C R
Selling price $1,600 $1,800 $1,400
Units 420 400 380
The standard cost card for each product is shown below.

T C R
$ $ $
Material 430 500 360
Labour 220 240 190
Variable overheads 110 120 95
Labour costs are 60% fixed and 40% variable. General fixed overheads excluding any fixed labour costs
are expected to be $55,000 for the next year.
Required:
(a) Calculate the weighted average contribution to sales ratio for Cardio Co. (4 marks)
(b) Calculate the margin of safety in $ revenue for Cardio Co. (3 marks)
(c) Using the graph paper provided and assuming that the products are sold in a CONSTANT MIX, draw
a multi-product breakeven chart for Cardio Co. Label fully both axes, any lines drawn on the graph and
the breakeven point. (6 marks)
(d) Explain what would happen to the breakeven point if the products were sold in order of the most
profitable products first.
Note: You are NOT required to demonstrate this on the graph drawn in part (c). (2 marks)
Answers:
(a) Weighted average C/S ratio = 60·92%.
Weighted average contribution to sales ratio (WA C/S ratio) = total contribution/total sales revenue.
Per unit: T C R
$ $ $ $ $ $
Selling price 1,600 1,800 1,400
Material (430) (500) (360)
Variable labour (40%) (88) (96) (76)
Variable overheads (110) (120) (95)
–––– –––– ––––
Total variable costs (628) (716) (531)
–––––– –––––– ––––––
Contribution 972 1,084 869
–––––– –––––– ––––––
Sales units 420 400 380
Total sales revenue $672,000 $720,000 $532,000
Total contribution $408,240 $433,600 $330,220
WA C/S ratio = ($408,240 + $433,600 + $330,220)/($672,000 + $720,000 + $532,000)
= $1,172,060/$1,924,000 = 60·92%.
(b) Margin of safety
Margin of safety = budgeted sales – breakeven sales
Budgeted sales revenue = $1,924,000
Fixed labour costs = {(420 x $220) + (400 x $240) + (380 x $190)} x 0·6 = $156,360k.
Therefore total fixed costs = $156,360 + $55,000 = $211,360.
Breakeven sales revenue = fixed costs/weighted average C/S ratio
= $211,360/60·92% = $346,947
Therefore margin of safety = $1,924,000 – $346,947 = $1,577,053.
(c) Multi-product breakeven chart

Total revenue = $1,924,000; Total variable costs = $1,924,000 – $1,172,060 = $751,940

Therefore total costs = $211,360 + $751,940 = $963,300
(d) BEP if products sold in order of profitability
If the more profitable products are sold first, this means that the company will cover its fixed costs more quickly.
Consequently, the breakeven point will be reached earlier, i.e. fewer sales will need to be made in order to break
even. So, the breakeven point will be lower.
September 2016
3. A company makes and sells product X and product Y. Twice as many units of product Y are made and
sold as that of product X. Each unit of product X makes a contribution of $10 and each unit of product Y
makes a contribution of $4. Fixed costs are $90,000.
What is the total number of units which must be made and sold to make a profit of $45,000?
A. 7,500 B. 22,500 C. 15,000 D. 16,875
Answers: B
Two units of Y and one unit of X would give total contribution of $18.
Weighted average contribution per unit = $18/3 units = $6
Sales units to achieve target profit = ($90,000 + $45,000)/$6 = 22,500
Linear Programming
June 2014
4. Tablet Co makes two types of tablet computer, the Xeno (X) and the Yong (Y). X currently generates a
contribution of $30 per unit and Y generates a contribution of $40 per unit. There are three main stages of
production: the build stage, the program stage and the test stage. Each of these stages requires the use of
skilled labour which, due to a huge increase in demand for tablet computers over recent months, is now in
short supply. The following information is available for the two products:
Stage Xeno (X) Yong (Y)
Minutes per unit Minutes per unit
Build ($10 per hour) 24 20
Program ($16 per hour) 16 14
Test ($12 per hour) 10 4
Tablet Co is now preparing its detailed production plans for the next quarter. During this period it expects
that the skilled labour available will be 30,000 hours (1,800,000 minutes) for the build stage, 28,000
hours
(1,680,000 minutes) for the program stage and 12,000 hours (720,000 minutes) for the test stage. The
maximum demand for X and Y over the three-month period is expected to be 85,000 units and 66,000
units respectively. Fixed costs are $650,000 per month.

Due to rapid technological change, the company holds no inventory of finished goods.
Required:
(a) On the graph paper provided, use linear programming to calculate the optimum number of each
product which Tablet Co should make in the next quarter assuming it wishes to maximize contribution.
Calculate the total profit for the quarter. (14 marks)
(b) Calculate the amount of any slack resources arising as a result of the optimum production plan and
explain the implications of these amounts for decision-making within Tablet Co. (6 marks)
Answers:
(a) Optimum production plan
Define the variables
Let x = number of units of Xeno to be produced.
Let y = number of units of Yong to be produced.
Let C = contribution.
State the objective function
C = 30x+ 40y
State the constraints
Build time: 24x + 20y ≤ 1,800,000
Program time: 16x + 14y ≤ 1,680,000
Test time: 10x + 4y ≤ 720,000
Non-negativity constraints:
x, y ≥ 0
Sales constraints
x ≤ 85,000
y ≤ 66,000
Draw the graph
Build time:
If x = 0, y = 1,800,000/20 = 90,000
If y = 0, x = 1,800,000/24 = 75,000
Program time:
If x = 0, y = 1,680,000/14 = 120,000
If y = 0, x = 1,680,000/16 = 105,000
Test time:
If x = 0, y = 720,000/4 = 180,000
If y = 0, x = 720,000/10 = 72,000
Solve using the iso-contribution line
If y = 40,000, C = 40,000 x $40 = $1,600,000
If C = $1,600,000 and y = 0, x = $1,600,000/$30 = 53,333·33 Therefore profit = $1,290,000.

Moving the iso-contribution line out to the furthest point on the feasible region, the optimum production point is b.
This is the intersection of the build time constraint and the sales constraint for y. Solving the simultaneous equations
for these two constraints:
y = 66,000
24x + 20y = 1,800,000
24x + (20 x 66,000) = 1,800,000
24x + 1,320,000 = 1,800,000
24x = 480,000
x = 20,000
C = (20,000 x $30) + (66,000 x $40)
= $600,000 + $2,640,000 = $3,240,000
Fixed costs = 3 x $650,000 = $1,950,000.
Therefore profit = $1,290,000.
(b) Slack resources
Test time used = 7,733 hours.
Therefore slack hours = 4,267 hours.
Program time used = 20,733 hours.
Therefore slack hours = 7,267 hours.
The slack values for test time and program time mean that there are 4,267 and 7,267 hours of each respective
department’s time unutilised under the optimum production plan. If possible, this time could be used by the
organisation elsewhere or subcontracted out to another company.
December 2014
5. A linear programming model has been formulated for two products, X and Y. The objective function is
depicted by the formula C = 5X + 6Y, where C = contribution, X = the number of product X to be
produced and Y = the number of product Y to be produced.
Each unit of X uses 2 kg of material Z and each unit of Y uses 3 kg of material Z. The standard cost of
material Z is $2 per kg.
The shadow price for material Z has been worked out and found to be $2·80 per kg.
If an extra 20 kg of material Z becomes available at $2 per kg, what will the maximum increase in
contribution be?
A Increase of $96 B Increase of $56
C Increase of $16 D No change
Answers: B
By definition, a shadow price is the amount by which contribution will increase if an extra kg of material becomes
available. 20 x $2·80 = $56.

September 2016
6. CSC Co is a health food company producing and selling three types of high-energy products: cakes,
shakes and cookies, to gyms and health food shops. Shakes are the newest of the three products and were
first launched three months ago. Each of the three products has two special ingredients, sourced from a
remote part the world. The first of these, Singa, is a super-energising rare type of caffeine. The second,
Betta, is derived from an unusual plant believed to have miraculous health benefits.
CSC Co’s projected manufacture costs and selling prices for the three products are as follows:
Cakes Cookies Shakes
Per unit $ $ $
Selling price 5·40 4·90 6·00
Costs:
Ingredients: Singa ($1·20 per gram) 0·30 0·60 1·20
Ingredients: Betta ($1·50 per gram) 0·75 0·30 1·50
Other ingredients 0·25 0·45 0·90
Labour ($10 per hour) 1·00 1·20 0·80
Variable overheads 0·50 0·60 0·40
––––– ––––– –––––
Contribution 2·60 1·75 1·20
––––– ––––– –––––
For each of the three products, the expected demand for the next month is 11,200 cakes, 9,800 cookies
and 2,500 shakes.
The total fixed costs for the next month are $3,000.
CSC Co has just found out that the supply of Betta is going to be limited to 12,000 grams next month.
Prior to this, CSC Co had signed a contract with a leading chain of gyms, Encompass Health, to supply it
with 5,000 shakes each month, at a discounted price of $5·80 per shake, starting immediately. The order
for the 5,000 shakes is not included in the expected demand levels above.
Required:
(a) Assuming that CSC Co keeps to its agreement with Encompass Health, calculate the shortage of
Betta, the resulting optimum production plan and the total profit for next month. (6 marks)
One month later, the supply of Betta is still limited and CSC Co is considering whether it should breach
its contract with Encompass Health so that it can optimise its profits.
Required:
(b) Discuss whether CSC Co should breach the agreement with Encompass Health.
Note: No further calculations are required. (4 marks)
Several months later, the demand for both cakes and cookies has increased significantly to 20,000 and
15,000 units per month respectively. However, CSC Co has lost the contract with Encompass Health and,
after suffering from further shortages of supply of Betta, Singa and of its labour force, CSC Co has
decided to stop making shakes at all. CSC Co now needs to use linear programming to work out the
optimum production plan for cakes and cookies for the coming month. The variable ‘x’ is being used to
represent cakes and the variable ‘y’ to represent cookies.
The following constraints have been formulated and a graph representing the new production problem has
been drawn:
Singa: 0·25x + 0·5y ≤12,000
Betta: 0·5x + 0·2y ≤12,500
Labour: 0·1x + 0·12y ≤3,000
x ≤20,000
y ≤15,000
x, y ≥0

Required:
(c) (i) Explain what the line labelled ‘C = 2·6x + 1·75y’ on the graph is and what the area represented by
the points 0ABCD means. (4 marks)
(ii) Explain how the optimum production plan will be found using the line labelled ‘C = 2·6x + 1·75y’
and identify the optimum point from the graph. (2 marks)
(iii) Explain what a slack value is and identify, from the graph, where slack will occur as a result of the
optimum production plan. (4 marks) Note: No calculations are needed for part (c).
Answers:
(a) Shortage: 3,060
Contribution per gram of Betta and ranking
Cakes Cookies Shakes Shakes (contract)
$ $ $ $
Contribution per unit 2·60 1·75 1·20 1·00
Grams of Betta per unit 0·5 0·2 1 1
$ $ $ $
Contribution per gram 5·20 8·75 1·20 1·00
Rank 2 1 3 4
Under optimum production plan- Profit 45,358
(Step 3) Optimum production plan

Product Number to Grams per Total Cumulative Contribution Total
be produced unit Grams per Grams per Unit Contribution
Unit
Shakes 5,000 1.0 5,000 5,000 1.00 5,000
(contract)
Cookies 9,800 0.2 1,960 6,960 1·75 17,150
Cakes 10,080 0.5 5,040 12,000 2·60 26,208
Total contribution 48,358
Less fixed costs (3,000)
Profit 45,358
(b) Breach of contract with Encompass Health (EH)
It would be bad for business if CSC Co becomes known as a supplier who cannot be relied on to stick to the terms of
its agreements. This could make future potential customers reticent to deal with them.
Even more seriously, there could be legal consequences involved in breaching the contract with EH. This would be
costly and also very damaging to CSC Co’s reputation.

If CSC Co lets EH down and breaches the contract, EH may refuse to buy from them any more and future sales
revenue would therefore be lost. Just as importantly, these sales to EH are currently helping to increase the
marketability of CSC Co’s shakes.
This will be lost if these sales are no longer made. Therefore, taking these factors into account, it would not be
advisable to breach the contract.
(c) (i) This line is what is called the ‘iso-contribution line’ and it is plotted by finding two corresponding x and y
values for the ‘objective function’. At any point along this line, the mix of cakes and cookies will provide the same
total contribution, ‘C’.
Since each cake provides a contribution of $2·60 and each cookie provides a contribution of $1·75, the objective
function has been defined as ‘C = 2·6x + 1·75y’. This means that the total contribution will be however many cakes
are made (represented by ‘x’) at $2·60 each plus however many cookies are made (represented by ‘y’) at $1·75
each.
The area 0ABCD is called the ‘feasible region’. Any point within this region could be selected and would show a
feasible mix of production of cakes and cookies. However, in order to maximise profit, the optimum production mix
will be at a point on the edge of the feasible region, not within it.
(ii) The further the iso-contribution line is moved away from the origin, 0, the greater the contribution generated
will be.
Therefore, a ruler will be laid along the line, making sure it stays at exactly the same angle as the line, and the ruler
will then be moved outwards to the furthest vertex (intersection between two constraints) on the feasible region, as
represented by either point A, B, C or D. In this case, the optimum point is ‘C’, the intersection of the ‘labour’
constraint and the ‘demand for cakes’ constraint.
(iii) A ‘slack’ value could arise either in relation to a resource or in relation to production of a product. It means
that a resource is not being fully utilised or that there is unfulfilled demand of a product. Since the optimum point is
the intersection of the labour and the demand for cakes lines, this means that there will be three slack values. First,
there will be a slack value for cookies. This means that there will be unsatisfied demand for cookies since the
optimum point does not reach as far as the ‘demand for cookies’ line on the graph. Also, there will be slack values
for Betta and Singa, which means that both of these materials are not actually the binding constraints, such that
there will be more material available than is needed.
June 2008
7. Higgins Co (HC) manufactures and sells pool cues and snooker cues. The cues both use the same type of good
quality wood (ash) which can be difficult to source in sufficient quantity. The supply of ash is restricted to 5,400 kg
per period. Ash costs $40 per kg.
The cues are made by skilled craftsmen (highly skilled labour) who are well known for their workmanship. The
skilled craftsmen take years to train and are difficult to recruit. HC’s craftsmen are generally only able to work for
12,000 hours in a period. The craftsmen are paid $18 per hour.
HC sells the cues to a large market. Demand for the cues is strong, and in any period, up to 15,000 pool cues and
12,000 snooker cues could be sold. The selling price for pool cues is $41 and the selling price for snooker cues is
$69.
Manufacturing details for the two products are as follows:
Pool cues Snooker cues
Craftsmen time per cue 0·5 hours 0·75 hours
Ash per cue 270 g 270 g
Other variable costs per cue $1·20 $4·70
HC does not keep inventory.
Required:
(a) Calculate the contribution earned from each cue. (2 marks)
(b) Determine the optimal production plan for a typical period assuming that HC is seeking to maximise the
contribution earned. You should use a linear programming graph (using the graph paper provided), identify
the feasible region and the optimal point and accurately calculate the maximum contribution that could be
earned using whichever equations you need. (12 marks)
Some of the craftsmen have offered to work overtime, provided that they are paid double time for the extra hours
over the contracted 12,000 hours. HC has estimated that up to 1,200 hours per period could be gained in this way.
Required:

(c) Explain the meaning of a shadow price (dual price) and calculate the shadow price of both the labour
(craftsmen) and the materials (ash). (5 marks)
(d) Advise HC whether to accept the craftsmens’ initial offer of working overtime, discussing the rate of pay
requested, the quantity of hours and one other factor that HC should consider. (6 marks) (25 marks)
Answers:
(a) Contribution per cue
Pool cue Snooker cue
$ $
Selling price 41·00 69·00
Material cost at $40/kg (10·80) (10·80)
Craftsmen cost at $18/hr (9·00) (13·50)
Other Variable cost (1·20) (4·70)
–––––– –––––––
Contribution per cue 20·00 40·00
–––––– –––––––
(b) Formulation of the linear programming problem
Variables
Let P and S be the number of pool and snooker cues made and sold in any three month period.
Let C represent the contribution earned in any three month period
Constraints:
Craftsmen: 0·5P + 0·75S ≤ 12,000
Ash: 0·27P + 0·27S ≤ 5,400
Demand levels – Pool cues P ≤ 15,000
– Snooker cues S ≤ 12,000
Non negativity: P, S ≥ 0
Objective: Higgins seeks to maximise contribution in a three month period, subject to:
20P + 40S = C
The feasible region is identified as the area inside OABCDE.

The contribution line is identified as the dotted line. Pushing the contribution line outward increases the contribution
gained (theory of iso-contribution). The contribution line last leaves the feasible region at point D which is the
intersect of the skilled labour line and the maximum demand line for S.
Solving at point D:
Maximum demand S = 12,000 (1)
Craftsmen 0·5P + 0·75S = 12,000 (2)
Substituting S = 12,000 in equation (2)
0·5P + (0·75 x 12,000) = 12,000
0·5P + 9,000 = 12,000
0·5P = 12,000 – 9,000
0·5P = 3,000
P = 6,000
Therefore the maximum contribution is earned when 6,000 pool cues and 12,000 snooker cues are made and sold in
a three month period.
The contribution earned is
C = (20 x 6,000) + (40 x 12,000)
C = 120,000 + 480,000
C = $600,000
(c) Shadow prices
A shadow price is the value assigned to changes in the quantity of a scarce resource available, normally measured in
terms of contribution. If more critical scarce resource becomes available then the feasible region would tend to
expand and this means that the optimal point would tend to move outward away from the origin thus earning more
contribution. It is this increase in the contribution that is the shadow price measured on a per unit of scarce resource
basis.
Management can use the shadow price as a measure of how much they would be willing to pay to gain more of a
scarce resource. It represents the maximum they should be willing to pay for more scarce resource over and above
the normal price subject to any non-financial issues that may be present.

If the availability of a non-critical scarce resource increased then the feasible region would not tend to expand and
therefore no more contribution could be earned. In this case extra non-critical scarce resource has no value and a nil
shadow price.
Calculation of shadow prices:
Ash: This is a non-critical scarce resource and as such it has a shadow price of nil. Put simply we have slack (spare
material) of ash and therefore have no desire to pay more to get more of it.
Craftsmen: This is a critical scarce resource and if more became available then the feasible region would expand
and the optimal point would move outward thus earning more contribution. Assuming that just one more hour
becomes available it is necessary to find the new optimal point and measure the increase in contribution earned.
At point D, we re-solve based on the available craftsmen hours being one more than previously.
S = 12,000 (3)
0·5P + 0·75S = 12,001 (4)
0·5P + 0·75(12,000) = 12,001
0·5P + 9,000 = 12,001
0·5P = 3,001
P = 6,002
The new optimal solution would be where 12,000 snooker cues and 6,002 pool cues are made. This would earn an
extra $40 (2 x $20) in contribution.
The shadow price is therefore $40 per extra hour of craftsmen time.
(d) Acceptability of the craftmens’ offer.
Rate of pay
The rate of pay requested (double time) is on the face of it less than the shadow price and is therefore affordable by
Higgins Co. The business would be better off by accepting the offer.
However, it is common for overtime to be paid at time and a half ($27 per hour) and Higgins would be well advised
to negotiate on this point. Higgins takes the commercial risks in this business and would therefore be justified in
keeping the majority of the rewards that come with it. Equally it is a dangerous precedent to accept the first offer
and pay such a high rate for overtime, Higgins would have to ask itself what would happen next time an overtime
situation arose. It is also possible that double time, being so generous, encourages slow working in normal time so as
to gain the offer of overtime.
How many hours to buy?
The problem here is that as Higgins buys more craftsmen time, the craftsmen constraint line will move outward,
changing the shape of the feasible region. Once the craftsmen line reaches point F (see diagram) then there would be
little point buying any more hours since Higgins would then not have the materials (ash) to make more cues.
We need therefore to calculate the number of hours needed at point F.
At F
Maximum demand for S S= 12,000 (5)
Ash 0·27P + 0·27S = 5,400 (6)
0·27P + 0·27(12,000) = 5,400
0·27P + 3,240 = 5,400
0·27P = 2,160
P = 8,000
Point F falls where S = 12,000 and P = 8,000
The craftsmen hours needed at this point would be given by putting the above P and S values in the craftsmen
constraint formula.
Craftsmen hours = (0·5 x 8,000) + (0·75 x 12,000)
Craftsmen hours =13,000 hours
Therefore Higgins should only buy 1,000 hours (13,000 – 12,000).
In general terms Hig gins need only buy the number of hours that the business can use to make and sell more
product. If more ash can also be bought then more labour hours may be desirable.
Quality of work
Higgins should consider the quality of work. Overtime hours can force tiredness on craftsmen that have already
worked a full day. Tired people often produce sub-standard work. If quality is important then this could damage the
reputation of the business. Any other feasible points would be accepted

December 2010
8. The Cosmetic Co is a company producing a variety of cosmetic creams and lotions. The creams and lotions are sold
to a variety of retailers at a price of $23·20 for each jar of face cream and $16·80 for each bottle of body lotion.
Each of the products has a variety of ingredients, with the key ones being silk powder, silk amino acids and aloe
versa. Six months ago, silk worms were attacked by disease causing a huge reduction in the availability of silk
powder and silk amino acids. The Cosmetic Co had to dramatically reduce production and make part of its
workforce, which it had trained over a number of years, redundant.
The company now wants to increase production again by ensuring that it uses the limited ingredients available to
maximise profits by selling the optimum mix of creams and lotions. Due to the redundancies made earlier in the
year, supply of skilled labour is now limited in the short-term to 160 hours (9,600 minutes) per week, although
unskilled labour is unlimited. The purchasing manager is confident that they can obtain 5,000 grams of silk powder
and 1,600 grams of silk amino acids per week. All other ingredients are unlimited. The following information is
available for the two products:
Cream Lotion
Materials required: silk powder (at $2·20 per gram) 3 grams 2 grams
– silk amino acids (at $0·80 per gram) 1 gram 0·5 grams
– aloe vera (at $1·40 per gram) 4 grams 2 grams
Labour required: skilled ($12 per hour) 4 minutes 5 minutes
– unskilled (at $8 per hour) 3 minutes 1·5 minutes
Each jar of cream sold generates a contribution of $9 per unit, whilst each bottle of lotion generates a contribution of
$8 per unit. The maximum demand for lotions is 2,000 bottles per week, although demand for creams is unlimited.
Fixed costs total $1,800 per week. The company does not keep inventory although if a product is partially complete
at the end of one week, its production will be completed in the following week.
Required:
(a) On the graph paper provided, use linear programming to calculate the optimum number of each product
that the Cosmetic Co should make per week, assuming that it wishes to maximise contribution. Calculate the
total contribution per week for the new production plan. All workings MUST be rounded to 2 decimal places.
(14 marks)
(b) Calculate the shadow price for silk powder and the slack for silk amino acids. All workings MUST be
rounded to 2 decimal places. (6 marks) (20 marks)
Answers:
(a) Optimum production plan
Define the variables
Let x = no. of jars of face cream to be produced
Let y = no. of bottles of body lotion to be produced
Let C = contribution
State the objective function
The objective is to maximise contribution, C
C = 9x + 8y
State the constraints
Silk powder 3x + 2y ≤ 5,000
Silk amino acids 1x + 0·5y ≤ 1,600
Skilled labour 4x + 5y ≤ 9,600
Non-negativity constraints:
x, y ≥ 0
Sales constraint:
y ≤ 2,000
Draw the graph
Silk powder 3x + 2y = 5,000
If x = 0, then 2y = 5,000, therefore y = 2,500
If y = 0, then 3x = 5,000, therefore x = 1,666·7
Silk amino acids 1x +0·5y = 1,600
If x = 0, then 0·5y = 1,600, therefore y = 3,200
If y = 0, then x = 1,600
Skilled labour 4x + 5y = 9,600
If x = 0, then 5y = 9,600, therefore y = 1,920

If y = 0, then 4x = 9,600, therefore x = 2,400
Solve using iso-contribution line

If y =800 and x = 0, then if C = 9x + 8y
C = (8 x 800) = 6,400
Therefore, if y = 0, 9x = 6,400
Therefore x = 711·11
Using the iso-contribution line, the furthest vertex from the origin is point c, the intersection of the constraints for
skilled labour and silk powder.
Solving the simultaneous equations for these constraints:
4x + 5y = 9,600 x 3
3x + 2y = 5,000 x 4
12x + 15y = 28,800
12x + 8y = 20,000
Subtract the second one from the first one
7y = 8,800, therefore y = 1,257·14.
If y = 1,257·14 and:
4x + 5y = 9,600
Then 5 x 1,257·14 + 4x = 9,600
Therefore x= 828·58
If C = 9x + 8y
C = $7,457·22 + $10,057·12 = $17,514·34
(b) Shadow prices and slack

The shadow price for silk powder can be found by solving the two simultaneous equations intersecting at point c,
whilst adding one more hour to the equation for silk powder.
4x +5y = 9,600 x 3
3x + 2y = 5,001 x 4
12x + 15y = 28,800
12x + 8y = 20,004
Subtract the second one from the first one
7y = 8,796, therefore y = 1,256·57
3x + (2 x 1,256·57) = 5,001.
Therefore x = 829·29

C = (9 x 829·29) + (8 x 1,256·57) = $17,516·17
Original contribution = $17,514·34
Therefore shadow price for silk powder is $1·83 per gram.
The slack for amino acids can be calculated as follows:
(828·58 x 1) + (0·5 x 1,257·14) = 1,457·15 grams used.
Available = 1,600 grams.
Therefore slack = 142·85 grams.
June 2010
9. Cut and Stitch (CS) make two types of suits using skilled tailors (labour) and a delicate and unique fabric (material).
Both the tailors and the fabric are in short supply and so the accountant at CS has correctly produced a linear
programming model to help decide the optimal production mix.
The model is as follows:
Variables:
Let W = the number of work suits produced
Let L = the number of lounge suits produced
Constraints
Tailors’ time: 7W + 5L ≤ 3,500 (hours) – this is line T on the diagram
Fabric: 2W + 2L ≤ 1,200 (metres) – this is line F on the diagram
Production of work suits: W ≤ 400 – this is line P on the diagram
Objective is to maximise contribution subject to:
C = 48W + 40L
On the diagram provided the accountant has correctly identified OABCD as the feasible region and point B as the
optimal point.
Required:
(a) Find by appropriate calculation the optimal production mix and related maximum contribution that could
be earned by CS. (4 marks)
(b) Calculate the shadow prices of the fabric per metre and the tailor time per hour. (6 marks)

The tailors have offered to work an extra 500 hours provided that they are paid three times their normal rate of $1·50
per hour at $4·50 per hour.
Required:
(c) Briefl y discuss whether CS should accept the offer of overtime at three times the normal rate. (6 marks)
(d) Calculate the new optimum production plan if maximum demand for W falls to 200 units. (4 marks)
(20 marks)
Answers:
(a) The optimal production mix can be found by solving the two equations given for F and T.
7W + 5L = 3,500
2W + 2L = 1,200
Multiplying the second equation by 2·5 produces:
7W + 5L = 3,500
5W + 5L = 3,000
2W = 500
W = 250
Substituting W = 250 in the fabric equation produces:
2 x 250 + 2L = 1,200
2L = 700
L = 350
The optimal solution is when 250 work suits are produced and 350 lounge suits are produced. The contribution
gained is $26,000:
C = 48W + 40L
C = (48 x 250) + (40 x 350)
C = 26,000
(b) The shadow prices can be found by adding one unit to each constraint in turn.
Shadow price of T
7W + 5L = 3,501
2W + 2L = 1,200
Again multiplying the second equation by 2·5 produces:
7W + 5L = 3,501
5W + 5L = 3,000
2W = 501
W = 250·5
Substituting W = 250·5 in the fabric equation produces:
(2 x 250·5) + 2L = 1,200
2L = 1,200 – 501
L = 349·5
Contribution earned at this point would be = (48 x 250·5) + (40 x 349·5) = 26,004 which is an increase of $4.
Hence the shadow price of T is $4 per hour.
Shadow price of F
7W + 5L = 3,500
2W + 2L = 1,201
Again multiplying the second equation by 2·5 produces:
7W + 5L = 3,500·0
5W + 5L = 3,002·5
2W = 497·5
W = 248·75
Substituting W = 248·75 in the fabric equation produces:
(2 x 248·75) +2L = 1,201
2L = 1,201 – 497·5
L = 351·75
Contribution earned at this point would be = (48 x 248·75) + (40 x 351·75) = 26,010, which is an increase of $10.
Hence the shadow price of F is $10 per metre.

(c) The shadow price represents the maximum premium above the normal rate a business should be willing to pay
for more of a scarce resource. It is equal to the increased contribution that can be gained from gaining that extra
resource.
The shadow price of labour here is $4 per hour. The tailors have offered to work for $4·50 – a premium of $3·00 per
hour. At first glance the offer seems to be acceptable.
However, many businesses pay overtime at the rate of time and a half and some negotiation should be possible to
create a win/win situation. Equally some consideration should be given to the quality aspect here. If excessive extra
hours are worked then tiredness can reduce the quality of the work produced.
(d) If maximum demand for W falls to 200 units, the constraint for W will move left to 200 on the x axis of the
graph. The new optimum point will then be at the intersection of:
W = 200 and
2W + 2L = 1,200
Solving these equations simultaneously, if:
W = 200, then (2 x 200) + 2L = 1,200
Therefore L = 400.
So, the new production plan will be to make 400L and 200W
Pricing
June 2013
10. Cam Co manufactures webcams, devices which can provide live video and audio streams via personal
computers. It has recently been suffering from liquidity problems and hopes that these will be eased by
the launch of its new webcam, which has revolutionary audio sound and visual quality. The webcam is
expected to have a product life cycle of two years. Market research has already been carried out to
establish a target selling price and projected lifetime sales volumes for the product. Cost estimates have
also been prepared, based on the current proposed product specification. Cam Co uses life cycle costing
to work out the target costs for its products, believing it to be more accurate to use an average cost across
the whole lifetime of a product, rather than potentially different costs for different years. You are
provided with the following relevant information for the webcam:
Projected lifetime sales volume 50,000 units
Target selling price per unit $200
Target profit margin (35% selling price) $70
Target cost per unit $130
Estimated lifetime cost per unit (see note below for detailed breakdown) $160
Note: Estimated lifetime cost per unit:
$ $
Manufacturing costs
Direct material (bought in parts) 40
Direct labour 26
Machine costs 21
Quality control costs 10
Rework costs 3
–––
100
Non-manufacturing costs
Product development costs 25
Marketing costs 35
–––
60
––––
Estimated lifetime cost per unit 160
––––
The average market price for a webcam is currently $150.
The company needs to close the cost gap of $30 between the target cost and the estimated lifetime cost.
The following information has been identified as relevant:
1. Direct material cost: all of the parts currently proposed for the webcam are bespoke parts. However,
most of these can actually be replaced with standard parts costing 55% less. However, three of the
bespoke parts, which currently account for 20% of the estimated direct material cost, cannot be replaced,
although an alternative supplier charging 10% less has been sourced for these parts.
2. Direct labour cost: the webcam uses 45 minutes of direct labour, which costs $34·67 per hour. The use
of more standard parts, however, will mean that whilst the first unit would still be expected to take 45
minutes, there will now be an expected rate of learning of 90% (where ‘b’ = –0·152). This will end after
the first 100 units have been completed.
3. Rework cost: this is the average rework cost per webcam and is based on an estimate of 15% of
webcams requiring rework at a cost of $20 per rework. With the use of more standard parts, the rate of
reworks will fall to 10% and the cost of each rework will fall to $18.
Required:
(a) Recalculate the estimated lifetime cost per unit for the webcam after taking into account points 1 to 3
above. (12 marks)
(b) Explain the ‘market skimming’ (also known as ‘price skimming’) pricing strategy and discuss, as far
as the information allows, whether this strategy may be more appropriate for Cam Co than charging
one price throughout the webcam’s entire life. (8 marks)
Answers:
(a) Revised target cost $ 125.36
(b) Market skimming
Market skimming is a strategy that attempts to exploit those areas of the market which are relatively insensitive to
price changes. Initially, high prices for the webcam would be charged in order to take advantage of those buyers
who want to buy it as soon as possible, and are prepared to pay high prices in order to do so.
The existence of certain conditions is likely to make the strategy a suitable one for Cam Co. These are as follows:
– Where a product is new and different, so that customers are prepared to pay high prices in order to gain the
perceived status of owning the product early. The webcam has superior audio sound and visual quality, which does
make it different from other webcams on the market.
– Where products have a short life cycle this strategy is more likely to be used, because of the need to recover
development costs and make a profit quickly. The webcam does only have a two year life cycle, which does make it
rather short.
– Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash inflows. If
this were to be the case for the webcam, it would be particularly useful for Cam Co because of the current liquidity
problems the company is suffering. Similarly, skimming is useful to cover high initial development costs, which have
been incurred by Cam Co.
– Where barriers to entry exist, which deter other competitors from entering the market; as otherwise, they will be
enticed by the high prices being charged. These might include prohibitively high investment costs, patent protection
or unusually strong brand loyalty. It is not clear from the information whether this is the case for Cam Co.
– Where demand and sensitivity of demand to price are unknown. In Cam Co’s case, market research has been
carried out to establish a price based on the customers’ perceived value of the product. The suggestion therefore is
that some information is available about price and demand, although it is not clear how much information is
available.
It is not possible to say for definite whether this pricing strategy would be suitable for Cam Co, because of the
limited information available. However, it does seem unusual that a high-tech, cutting edge product like this should
be sold at the same price over its entire, short life cycle. Therefore, price skimming should be investigated further,
presuming that this has not already been done by Cam Co.
December 2014
11. The following circumstances may arise in relation to the launch of a new product:
(i) Demand is relatively inelastic
(ii) There are significant economies of scale
(iii) The firm wishes to discourage new entrants to the market
(iv) The product life cycle is particularly short
Which of the above circumstances favour a penetration pricing policy?
A (ii) and (iii) only B (ii) and (iv)
C (i), (ii) and (iii) D (ii), (iii) and (iv) only
Answer: A
June 2015
12. ALG Co is launching a new, innovative product onto the market and is trying to decide on the right
launch price for the product. The product’s expected life is three years. Given the high level of costs
which have been incurred in developing the product, ALG Co wants to ensure that it sets its price at the
right level and has therefore consulted a market research company to help it do this. The research, which
relates to similar but not identical products launched by other companies, has revealed that at a price of
$60, annual demand would be expected to be 250,000 units.
However, for every $2 increase in selling price, demand would be expected to fall by 2,000 units and for
every $2 decrease in selling price, demand would be expected to increase by 2,000 units. A forecast of the
annual production costs which would be incurred by ALG Co in relation to the new product are as
follows:
Annual production (units) 200,000 250,000 300,000 350,000
$ $ $ $
Direct material 2,400,000 3,000,000 3,600,000 4,200,000
Direct labour 1,200,000 1,500,000 1,800,000 2,100,000
Overheads 1,400,000 1,550,000 1,700,000 1,850,000
Required:
(a) Calculate the total variable cost per unit and total fixed overheads. (3 marks)
(b) Calculate the optimum (profit maximising) selling price for the new product AND calculate the
resulting profit for the period.
Note: If P = a – bx then MR = a – 2bx. (7 marks)
(c) The sales director is unconvinced that the sales price calculated in (b) above is the right one to charge
on the initial launch of the product. He believes that a high price should be charged at launch so that those
customers prepared to pay a higher price for the product can be ‘skimmed off’ first.
Required:
Discuss the conditions which would make market skimming a more suitable pricing strategy for
ALG, and recommend whether ALG should adopt this approach instead. (5 marks)
Answers:
(a) Variable cost per unit
Material cost = $2,400,000/200,000 = $12 per unit.
Labour cost = $1,200,000/200,000 = $6 per unit.
Variable overhead cost using high-low method: ($1,850,000 – $1,400,000)/(350,000 – 200,000) = $3 per unit.
Therefore total variable cost per unit = $21.
Fixed costs = $1,400,000 – (200,000 x $3) = $800,000
(b) Optimum price
Find the demand function
Demand function is P = a – bx, where P = price and x = quantity, therefore find a value for a and b firstly.
B = ΔP/ΔQ = 2/2,000 = 0·001 (ignore the minus sign as it is already reflected in the formula P = a – bx.)
Therefore P = a – 0·001x
Find value for ‘a’ by substituting in the known price and demand relationship from the question, matching ‘p’ and
‘x’ accordingly.
60 = a – (0·001 x 250,000)
60 = a – 250
310 = a
Therefore P = 310 – 0·001x.
Identify MC
MC = $21 calculated in (a)

State MR
MR = 310 – 0·002x
Equate MC and MR to find x
21 = 310 – 0·002x
0·002x = 289
x = 144,500
Substitute x into demand function to find P
P = 310 – (0·001 x 144,500)
P = $165·50
Calculate profit
Sales revenue = 144,500 x $165·50 = $23,914,750
Variable overheads = 144,500 x $21 = $3,034,500
Fixed overheads = $800,000
Therefore profit = $20,080,250
(c) Market skimming
As the sales director suggests, market skimming is a strategy which initially charges high prices for the product in
order to take advantage of those buyers who want to buy it as soon as possible, and are prepared to pay high prices
in order to do so.
If certain conditions exist, the strategy could be a suitable one for ALG Co. The conditions are as follows:
– Where a product is new and different, so that customers are prepared to pay high prices in order to gain the
perceived status of owning the product early. All we know about ALG Co’s product is that it is ‘innovative’, so it
may well meet this condition.
– Where products have a short life cycle this strategy is more likely to be used, because of the need to recover
development costs and make a profit quickly. ALG Co’s product does only have a three-year life cycle, which does
make it fairly short.
– Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash inflows. If
this is the case here, then skimming would be useful to help ALG Co cover the high initial development costs which
it has incurred.
– Where barriers to entry exist, which deter other competitors from entering the market; as otherwise, they will be
enticed by the high prices being charged. These might include prohibitively high investment costs, patent protection
or unusually strong brand loyalty. According to the information we have been given, high development costs were
involved in this case, which would be a barrier to entry.
– Where demand and sensitivity of demand to price are unknown. In ALG Co’s case, market research has been
carried out to establish a price. However, this information is based on the launch of similar but not identical
products, so it is not really known just how accurate it will be.
It is not possible to say for definite whether this pricing strategy would be suitable for ALG Co, because of the
limited information available. However, it could always be launched at a higher price initially to see what demand
is. It is far easier to lower a price after launch than to raise it. The optimum pricing approach in (b) above is based
on a set of assumptions which do not hold true in the real world. Also, as the data is derived from similar but not
identical products, it may not hold true for this particular product.
June 2013
13. TR Co is a pharmaceutical company which researches, develops and manufactures a wide range of drugs.
One of these drugs, ‘Parapain’, is a pain relief drug used for the treatment of headaches and until last
month TR Co had a patent on Parapain which prevented other companies from manufacturing it. The
patent has now expired and several competitors have already entered the market with similar versions of
Parapain, which are made using the same active ingredients.
TR Co is reviewing its pricing policy in light of the changing market. It has carried out some market
research in an attempt to establish an optimum price for Parapain. The research has established that for
every $2 decrease in price, demand would be expected to increase by 5,000 batches, with maximum
demand for Parapain being one million batches.
Each batch of Parapain is currently made using the following materials:
Material Z: 500 grams at $0·10 per gram
Material Y: 300 grams at $0·50 per gram

Each batch of Parapain requires 20 minutes of machine time to make and the variable running costs for
machine time are $6 per hour. The fixed production overhead cost is expected to be $2 per batch for the
period, based on a budgeted production level of 250,000 batches.
The skilled workers who have been working on Parapain until now are being moved onto the production
of TR Co’s new and unique anti-malaria drug which cost millions of dollars to develop. TR Co has
obtained a patent for this revolutionary drug and it is expected to save millions of lives. No other similar
drug exists and, whilst demand levels are unknown, the launch of the drug is eagerly anticipated all over
the world.
Agency staff, who are completely new to the production of Parapain and cost $18 per hour, will be
brought in to produce Parapain for the foreseeable future. Experience has shown there will be a
significant learning curve involved in making Parapain as it is extremely difficult to handle. The first
batch of Parapain made using one of the agency workers took 5 hours to make. However, it is believed
that an 80% learning curve exists, in relation to production of the drug, and this will continue until the
first 1,000 batches have been completed. TR Co’s management has said that any pricing decisions about
Parapain should be based on the time it takes to make the 1,000th batch of the drug.
Note: The learning co-efficient, b = –0·321928
Required:
(a) Calculate the optimum (profit-maximising) selling price for Parapain and the resulting annual
profit which TR Co will make from charging this price.
Note: If P = a – bQ, then MR = a – 2bQ (12 marks)
(b) Discuss and recommend whether market penetration or market skimming would be the most
suitable pricing strategy for TR Co when launching the new anti-malaria drug. (8 marks) (20
marks)
Hints:
TR Co
(a) Step 1: Establish the demand function
b = change in price/change in quantity
b = $2/5,000 units = 0·0004
The maximum demand for Parapain is 1,000,000 units, so where P = 0, Q = 1,000,000, so ‘a’ is established by
substituting these values for P and Q into the demand function:
0 = a – (0·0004 x 1,000,000)
0 = a – 400
Therefore a = 400
Demand function is therefore: P = 400 – 0·0004Q
Step 2: Establish the marginal cost
Total
$
Material Z 500 g x $0·10 50
Material Y 300 g x $0·50 150
Labour Working 1 6·6039
Machine running cost (20/60) x $6·00 2
Total marginal cost per batch 208·6039
Note: Fixed overheads have been ignored as they are not part of the marginal cost.
The marginal cost will now be rounded down to $208·60 per batch.
Working 1: Labour
The labour cost of the 1,000th unit needs to be calculated as follows as this is the basis TR Co will determine the
price for Parapain:
Learning curve formula: Y = aXb
‘a’ is the cost for the first batch: 5 hours x $18 = $90
If X = 1,000 batches and b = –0·321928, then
Y = 90 x 1,000–0·321928 = 9·7377411
Total cost for 1,000 batches = $9,737·7411
If X = 999 batches, then
Y = 90 x 999–0·321928 = 9·7408781

Total cost for 999 batches = $9,731·1372
Therefore the cost of the 1,000 batches ($9,737·7411 – $9,731·1372) = $6·6039
Step 3: Establish the marginal revenue function: MR = a – 2bQ
Equate MC and MR and insert the values for ‘a’ and ‘b’ from the demand function in step 1.
208·60 = 400 – (2 x 0·0004 x Q)
Step 4: Solve the MR function to determine optimum quantity, Q
208·60 = 400 – 0·0008Q
0·0008Q = 191·4
Q = 239,250 batches
Step 5: Insert the value of Q from step 4 into the demand function determined in step 1 and calculate the
optimum price
P = 400 – (0·0004 x 239,250)
P = $304·30
Step 6: Calculate profit
$
Revenue (239,250 batches x $304·30) 72,803,775
Variable costs (239,250 batches x $208·60) (49,907,550 )
Fixed costs (250,000 batches x $2) (500,000 )
–––––––––––
Profit 22,396,225
(b) Market penetration pricing

With penetration pricing, a low price would initially be charged for the anti-malaria drug. The ideology behind this
is that the price will make the product accessible to a larger number of buyers and therefore the high sales will
compensate for the lower prices being charged. The anti-malaria drug would rapidly become accepted as the only
drug worth buying, i.e. it would gain rapid acceptance in the marketplace.
The circumstances which would favour a penetration pricing policy are:
– Highly elastic demand for the anti-malaria drug, i.e. the lower the price, the higher the demand. There is no
evidence that this is the case.
– If significant economies of scale could be achieved by TR Co so that higher sales volumes would result in sizeable
reductions in costs. It cannot be determined if this is the case here.
– If TR Co was actively trying to discourage new entrants into the market, however in this case, new entrants cannot
enter the market anyway due to the patent.
– If TR Co wished to shorten the initial period of the drug’s life-cycle so as to enter the growth and maturity stages
quickly but there is no evidence the company wish to do this.
Market skimming pricing
With market skimming, high charges would initially be charged for the anti-malaria drug rather than low prices.
This would enable TR Co to take advantage of the unique nature of the product. The most suitable conditions for
this strategy are:
– The product has a short life cycle and high development costs which need to be recovered. There is no information
about the drug’s life cycle but development costs have been high.
– Since high prices attract competitors, there needs to be barriers to entry if competitors are to be deterred. In TR
Co’s case it has a patent for the drug and also the high development costs could act as a barrier.
– Where high prices in the early stages of a product’s life cycle are expected to generate high initial cash flows, this
will help TR Co recover the high development costs it has incurred.
Recommendation
Given the unique nature of the drug and the barriers to entry, a market skimming pricing strategy would appear to
be the far more suitable pricing strategy. Also, whilst there is demand curve data, it is unknown how reliable this
data is, in which case a skimming strategy may be the safer option.
14. September 2016

Which of the following statements regarding market penetration as a pricing strategy is/are
correct?
(1) It is useful if significant economies of scale can be achieved
(2) It is useful if demand for a product is highly elastic
A 1 only
B 2 only
C Neither 1 nor 2
D Both 1 and 2
Answer: D. Penetration pricing involves setting a low price when a product is first launched in order to obtain
strong demand. It is particularly useful if significant economies of scale can be achieved from a high volume of
output and if demand is highly elastic and so would respond well to low prices.
Short Term Decisions

December 2010
15. Sniff Co manufactures and sells its standard perfume by blending a secret formula of aromatic oils with diluted
alcohol. The oils are produced by another company following a lengthy process and are very expensive. The
standard perfume is highly branded and successfully sold at a price of $39·98 per 100 millilitres (ml).
Sniff Co is considering processing some of the perfume further by adding a hormone to appeal to members of the
opposite sex. The hormone to be added will be different for the male and female perfumes. Adding hormones to
perfumes is not universally accepted as a good idea as some people have health concerns. On the other hand, market
research carried out suggests that a premium could be charged for perfume that can ‘promise’ the attraction of a
suitor. The market research has cost $3,000.
Data has been prepared for the costs and revenues expected for the following month (a test month) assuming that a
part of the company’s output will be further processed by adding the hormones.
The output selected for further processing is 1,000 litres, about a tenth of the company’s normal monthly output. Of
this, 99% is made up of diluted alcohol which costs $20 per litre. The rest is a blend of aromatic oils costing $18,000
per litre. The labour required to produce 1,000 litres of the basic perfume before any further processing is 2,000
hours at a cost of $15 per hour.
Of the output selected for further processing, 200 litres (20%) will be for male customers and 2 litres of hormone
costing $7,750 per litre will then be added. The remaining 800 litres (80%) will be for female customers and 8 litres
of hormone will be added, costing $12,000 per litre. In both cases the adding of the hormone adds to the overall
volume of the product as there is no resulting processing loss.
Sniff Co has sufficient existing machinery to carry out the test processing.
The new processes will be supervised by one of the more experienced supervisors currently employed by Sniff Co.
His current annual salary is $35,000 and it is expected that he will spend 10% of his time working on the hormone
adding process during the test month. This will be split evenly between the male and female versions of the product.
Extra labour will be required to further process the perfume, with an extra 500 hours for the male version and 700
extra hours for the female version of the hormone-added product. Labour is currently fully employed, making the
standard product. New labour with the required skills will not be available at short notice.
Sniff Co allocates fixed overhead at the rate of $25 per labour hour to all products for the purposes of reporting
profits.
The sales prices that could be achieved as a one-off monthly promotion are:
– Male version: $75·00 per 100 ml
– Female version: $59·50 per 100 ml
Required:
(a) Outline the financial and other factors that Sniff Co should consider when making a further processing
decision. Note: no calculations are required. (4 marks)
(b) Evaluate whether Sniff Co should experiment with the hormone adding process using the data provided.
Provide a separate assessment and conclusion for the male and the female versions of the product. (15 marks)
(c) Calculate the selling price per 100 ml for the female version of the product that would ensure further
processing would break even in the test month. (2 marks)
(d) Sniff Co is considering outsourcing the production of the standard perfume. Outline the main factors it
should consider before making such a decision. (4 marks) (25 marks)
Answers:
(a) Sniff should consider the following factors when making a further processing decision.
– Incremental revenue. The new perfume, once further processed, should generate a higher price and the extra
revenue is clearly relevant to the decision.
– Incremental costs. A decision to further process can involve more materials and labour. Care must be taken to only
include those costs that change as a result of the decision and therefore sunk costs should be ignored. Sunk costs
would include, for example, fixed overheads that would already be incurred by the business before the further
process decision was taken. The shortage of labour means that its ‘true’ cost will be higher and need to be included.
– Impact on sales volumes. Sniff is selling a ‘highly branded’ product. Existing customers may well be happy with
the existing product. If the further processing changes the existing product too much there could be an impact on
sales and loyalty.
– Impact on reputation. As is mentioned in the question, adding hormones to a product is not universally popular.
Many groups exist around the world that protest against the use of hormones in products. Sniff could be damaged by
this association.
– Potential legal cases being brought regarding allergic reactions to hormones.
(b) Production costs for 1,000 litres of the standard perfume

$
Aromatic oils 10 ltrs x $18,000/ltr 180,000
Diluted alcohol 990 ltrs x $20/ltr 19,800
––––––––
Material cost 199,800
Labour 2,000 hrs x $15/hr 30,000
––––––––
Total 229,800
––––––––
Cost per litre 229·80
Sales price per litre 399·80
Lost contribution per hour of labour used on new products
($399,800 – $199,800) ÷ 2,000 hrs = $100/hr
Incremental costs
Male version Female version
$ $
Hormone 2 ltr x $7,750/ltr 15,500 8 ltr x $12,000/ltr 96,000
Supervisor Sunk cost 0 Sunk cost 0
Labour 500 hrs x $100/hr 50,000 700 hrs x $100/hr 70,000
Fixed cost Sunk cost 0 Sunk cost 0
Market research Sunk cost 0 Sunk cost 0
––––––– ––––––
Total 65,500 166,000
––––––– ––––––
Incremental revenues
Male version Female version
$ $
Standard 200 ltr x $399·80/ltr 79,960 800 ltr x $399·80
319,840
Hormone added 202 ltr x $750/ltr 151,500 808 ltr x $595/ltr 480,760
––––––– ––––––
Incremental revenue 71,540 160,920
––––––– ––––––
Net benefit/(cost) 6,040 (5,080)
––––––– ––––––
The Male version of the product is worth further processing in that the extra revenue exceeds the extra cost by
$6,040.
The Female version of the product is not worth further processing in that the extra cost exceeds the extra revenue by
$5,080.
In both cases the numbers appear small. Indeed, the benefit of $6,040 may not be enough to persuade management
to take the risk of damaging the brand and the reputation of the business. To put this figure into context: the normal
output generates a contribution of $170 per litre and on normal output of about 10,000 litres this represents a
monthly contribution of around $1·7m (after allowing for labour costs).
Future production decisions are a different matter. If the product proves popular, however, Sniff might expect a
significant increase in overall volumes. If Sniff could exploit this and resolve its current shortage of labour then

more contribution could be created. It is worth noting that resolving its labour shortage would substantially reduce
the labour cost allocated to the hormone added project. Equally, the prices charged for a one off experimental
promotion might be different to the prices that can be secured in the long run.
(c) The selling price charged would have to cover the incremental costs of $166,000. For 808 litres that would mean
the price would have to be
($166,000 + $319,840)
–––––––––––––––––––––– = $601·29/ltr
808 ltrs
or about $60·13 per 100 ml.

This represents an increase of only 1·05% on the price given and so clearly there may be scope for further
consideration of this proposal.
(d) Outsourcing involves consideration of many factors, the main ones being:
– Cost. Outsourcing often involves a reduction in the costs of a business. Cost savings can be made if the outsourcer
has a lower cost base than, in this case, Sniff. Labour savings are common when outsourcing takes place.
– Quality. Sniff would need to be sure that the quality of the perfume would not reduce. The fragrance must not
change at all given the product is branded. Equally Sniff should be concerned about the health and safety of its
customers since its perfume is ‘worn’ by its customers
– Confidentiality. We are told that the blend of aromatic oils used in the production process is ‘secret. This may not
remain so if an outsourcer is employed. Strict confidentiality should be maintained and be made a contractual
obligation.
– Reliability of supply. Sniff should consider the implications of late delivery on its customers.
– Primary Function. Sniff is apparently considering outsourcing its primary function. This is not always advisable as
it removes Sniff’s reason for existence. It is more common to outsource a secondary function, like payroll
processing for example.
– Access to expertise. Sniff may find the outsourcer has considerable skills in fragrance manufacturing and hence
could benefit from that.
December 2008
16. Henry Company (HC) provides skilled labour to the building trade. They have recently been asked by a builder to
bid for a kitchen fitting contract for a new development of 600 identical apartments. HC has not worked for this
builder before. Cost information for the new contract is as follows:
Labour for the contract is available. HC expects that the first kitchen will take 24 man-hours to fit but thereafter the
time taken will be subject to a 95% learning rate. After 200 kitchens are fitted the learning rate will stop and the time
taken for the 200th kitchen will be the time taken for all the remaining kitchens. Labour costs $15 per hour.
Overheads are absorbed on a labour hour basis. HC has collected overhead information for the last four months and
this is shown below:
Hours worked Overhead cost $
Month 1 9,300 115,000
Month 2 9,200 113,600
Month 3 9,400 116,000
Month 4 9,600 116,800
HC normally works around 120,000 labour hours in a year.
HC uses the high low method to analyse overheads.
The learning curve equation is y = axb, where b = Log R/Log 2 = - 0.074
Required:
(a) Describe FIVE factors, other than the cost of labour and overheads mentioned above, that HC should take
into consideration in calculating its bid. (10 marks)
(b) Calculate the total cost including all overheads for HC that it can use as a basis of the bid for the new
apartment contract. (13 marks)
(c) If the second kitchen alone is expected to take 21·6 man-hours to fit demonstrate how the learning rate of
95% has been calculated. (2 marks) (25 marks)
Answers:
(a) There are various issues that HC should consider in making the bid. (Only five are required for two marks each.)

Contingency allowance. HC should consider the extent to which its estimates are accurate and hence the degree of
uncertainty it is subjected to. It may be sensible to allow for these uncertainties by adding a contingency to the bid.
Competition. HC must consider which other businesses are likely to bid and recognise that the builder may be able
to choose between suppliers. Moreover, HC has not worked for this builder before, and so they will probably find
the competition stiff and the lack of reputation a problem.
Inclusion of fixed overhead. In the long run fixed overhead must be covered by sales revenue in order to make a
profit. In the short run it is often correctly argued that the level of fixed cost in a business may not be affected by a
new contract and therefore could be ignored in bid calculation. HC needs to consider to what extent the fixed costs
of its business will change if it wins this new contract. It is these incremental fixed costs that are relevant to a bid
calculation.
Materials and loose tools. No allowance has been made for the use of tools and the various fixings (screws etc) that
will be needed to assemble and fit the kitchens. It is possible that most fixings would be provided with the kitchen
units, but HC should at least consider this.
Supervision of labour. The time given in the question is 24 hours to ‘fit’ the first kitchen. There seems no
allowance for supervision of the labour force. It could, of course, be included within the overhead figures but no
detail is shown.
Idle time. It is common for building works to be delayed by lack of materials for example. The labour time figure
needs to reflect this.
Likelihood of repeat business. Some businesses consider it worthwhile to accept a low price for a new contract if it
establishes a reputation with a new buyer. HC could offer to do this work cheaper in the hope of more profitable
work later on.
The risk of non-payment. HC may decide not to bid at all if it feels that the builder may struggle to pay.
Opportunity costs of alternate work.
Possibility of working in overtime.
(b) Bid calculations for HC to use as a basis for the apartment contract.
Cost Hours Rate per hour Total
$
Labour 9,247 (W1) $15 138,705
Variable Overhead 9,247 $ 8 (W2) 73,976
Fixed Overhead 9,247 $ 4 (W2) 36,988
––––––––
Total Cost 249,669
––––––––
(W1)
Need to calculate the time for the 200th kitchen by taking the total time for the 199 kitchens from the total time for
200 kitchens.
For the 199 Kitchens
Using
y = axb OR y = axb
–0.074
y = 24x199 y = (24 x 15) x 199–0.074
y = 16·22169061hours y = 243·32536
Totaltime = 16·22169061x199 Total cost = $48,421·75
Totaltime = 3,228·12hours
For the 200 Kitchens
y = axb OR y = axb
–0.074
y = 24x200 y = (24 x 15) x 200–0.074
y = 16·21567465hours y = 243·2351198
Totaltime = 16·21567465x200 Total cost = $48,647·02
Totaltime = 3,243·13hours 200th cost = $225·27
The 200th Kitchen took 3,243·13 – 3,228·12 = 15·01 hours
Total time is therefore:
For first 200 3,243·13 hours
For next 400 (15·01 hours x 400) 6,004·00 hours
Total 9,247·13 hours (9,247 hours)
(W2)

The overheads need to be analysed between variable and fixed cost elements.
Taking the highest and lowest figures from the information given:
Hours Cost $
Highest 9,600 116,800
Lowest 9,200 113,600
Difference 400 3,200
Variable cost per hours is $3,200/400hours = $8 per hour
Total cost = variable cost + fixed cost
116,800 = 9,600 x 8 + fixed cost
Fixed cost = $40,000 per month
Annual fixed cost = $40,000 x 12 = $480,000
Fixed absorption rate is $480,000/120,000 hours = $4 per hour
(c) A table is useful to show how the learning rate has been calculated.
Number of Time for Kitchen Cumulative time Average time
Kitchens (hours) (hours) (hours)
1 24·00 24·00 24·00
2 21·60 45·60 22·80
The learning rate is calculated by measuring the reduction in the average time per kitchen as cumulative production
doubles (in this case from 1 to 2).
The learning rate is therefore 22·80/24·00 or 95%
December 2009
17. Stay Clean manufactures and sells a small range of kitchen equipment. Specifically the product range contains a
dishwasher (DW), a washing machine (WM) and a tumble dryer (TD). The TD is of a rather old design and has for
some time generated negative contribution. It is widely expected that in one year’s time the market for this design of
TD will cease, as people switch to a washing machine that can also dry clothes after the washing cycle has
completed.
Stay Clean is trying to decide whether or not to cease the production of TD now or in 12 months’ time when the new
combined washing machine/drier will be ready. To help with this decision the following information has been
provided:
1. The normal selling prices, annual sales volumes and total variable costs for the three products are as follows:
DW WM TD
Selling price per unit $200 $350 $80
Material cost per unit $70 $100 $50
Labour cost per unit $50 $80 $40
Contribution per unit $80 $170 –$10
Annual sales 5,000 units 6,000 units 1,200 units
2. It is thought that some of the customers that buy a TD also buy a DW and a WM. It is estimated that 5% of the
sales of WM and DW will be lost if the TD ceases to be produced.
3. All the direct labour force currently working on the TD will be made redundant immediately if TD is ceased now.
This would cost $6,000 in redundancy payments. If Stay Clean waited for 12 months the existing labour force would
be retained and retrained at a cost of $3,500 to enable them to produce the new washing/drying product. Recruitment
and training costs of labour in 12 months’ time would be $1,200 in the event that redundancy takes place now.
4. Stay Clean operates a just in time (JIT) policy and so all material cost would be saved on the TD for 12 months if
TD production ceased now. Equally, the material costs relating to the lost sales on the WM and the DW would also
be saved. However, the material supplier has a volume based discount scheme in place as follows:
Total annual expenditure ($) Discount
0–600,000 0%
600,001–800,000 1%
800,001–900,000 2%
900,001–960,000 3%
960,001 and above 5%
Stay Clean uses this supplier for all its materials for all the products it manufactures. The figures given above in the
cost per unit table for material cost per unit are net of any discount Stay Clean already qualifies for.

5. The space in the factory currently used for the TD will be sublet for 12 months on a short-term lease contract if
production of TD stops now. The income from that contract will be $12,000.
6. The supervisor (currently classed as an overhead) supervises the production of all three products spending
approximately 20% of his time on the TD production. He would continue to be fully employed if the TD ceases to
be produced now.
Required:
(a) Calculate whether or not it is worthwhile ceasing to produce the TD now rather than waiting 12 months
(ignore any adjustment to allow for the time value of money). (13 marks)
(b) Explain two pricing strategies that could be used to improve the financial position of the business in the
next 12 months assuming that the TD continues to be made in that period. (4 marks)
(c) Briefly describe three issues that Stay Clean should consider if it decides to outsource the manufacture of
one of its future products. (3 marks) (20 marks)
Answers:
(a) The relevant costs of the decision to cease the manufacture of the TD are needed:
Cost or Revenue Working reference Amount ($)
Lost revenue Note 1 (96,000)
Saved labour cost Note 2 48,000
Lost contribution from other products Note 3 (118,500)
Redundancy and recruitment costs Note 4 (3,700)
Supplier payments saved Note 5 88,500
Sublet income 12,000
Supervisor Note 6 0
––––––––
Net cash flow (69,700)
––––––––
Conclusion: It is not worthwhile ceasing to produce the TD now.
Note 1: All sales of the TD will be lost for the next 12 months, this will lose revenue of 1,200 units x $80 = $96,000
Note 2: All normal labour costs will be saved at 1,200 units x $40 = $48,000
Note 3: Related product sales will be lost.
This will cost the business 5% x ((5,000u x $150) + (6,000u x $270)) = $118,500 in contribution (material
costs are dealt with separately below)
Note 4: If TD is ceased now, then:
Redundancy cost ($6,000)
Retraining saved $3,500
Recruitment cost ($1,200)
––––––––
Total cost ($3,700)
Note 5. Supplier payments:
DW ($) WM ($) TD ($) Net cost Discount Gross cost
($) level ($)
Current buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158
Loss of TD (60,000) (60,000) 5% (63,158)
Loss of related sales at cost (17,500) (30,000) (47,500) 5% (50,000)
New buying cost 921,500 3% 950,000
Difference in net cost 88,500
Note 6: There will be no saving or cost here as the supervisor will continue to be fully employed.
An alternative approach is possible to the above problem:
Cash flow Ref Amount ($)
Lost contribution – TD Note 7 12,000
Lost contribution – other products Note 8 (71,000)
Redundancy and recruitment Note 4 above (3,700)
Lost discount Note 9 (19,000)
Sublet income 12,000
Supervisor Note 6 above 0
––––––––
Net cash flow (69,700)

––––––––
Note 7: There will be a saving on the contribution lost on the TD of 1,200 units x $10 per unit = –$12,000
Note 8: The loss of sales of other products will cost a lost contribution of 5% ((5,000 x $80) + (6,000 x $170)) =
$71,000
Note 9
DW ($) WM ($) TD ($) Net cost Discount Gross cost
($) level ($)
Current buying cost 350,000 600,000 60,000 1,010,000 5% 1,063,158
Saved cost (17,500) (30,000) (60,000)
New buying cost 332,500 (570,000) 0 902,500 5% 950,000
921,500 3% 950,000
Lost discount (19,000)
(b) Complementary pricing

Since the washing machine and the tumble dryer are products that tend to be used together, Stay Clean could link
their sales with a complementary price. For example they could offer customers a discount on the second product
bought, so if they buy (say) a TD for $80 then they can get a WM for (say) $320. Overall then Stay Clean make a
positive contribution of $130 (320 + 80 – 180 – 90).
Product line pricing
All the products tend to be related to each other and used in the utility room or kitchen. Some sales will involve all
three products if customers are upgrading their utility room or kitchen for example. A package price could be
offered and as long as Stay Clean make a contribution on the overall deal then they will be better off.
(c) Outsourcing requires consideration of a number of issues (only 3 required):
– The cost of manufacture should be compared to cost of buying in from the outsourcer. If the outsourcer can
provide the same products cheaper than it is perhaps preferable
– The reliability of the outsourcer should be assessed. If products are delivered late then the ultimate customer could
be disappointed. This could damage the goodwill or brand of the business.
– The quality of work that the outsourcer produces needs to be considered. Cheaper products can often be at the
expense of poor quality of materials or assembly.
– The loss of control over the manufacturing process can reduce the flexibility that Stay Clean has over current
production. If Stay Clean wanted, say, to change the color of a product then at present it should be able to do that.
Having contracted with an outsourcer this may be more difficult or involve penalties.
June 2009
18. Bits and Pieces (B&P) operates a retail store selling spares and accessories for the car market. The store has
previously only opened for six days per week for the 50 working weeks in the year, but B&P is now considering
also opening on Sundays.
The sales of the business on Monday through to Saturday averages at $10,000 per day with average gross profit of
70% earned.
B&P expects that the gross profit % earned on a Sunday will be 20 percentage points lower than the average earned
on the other days in the week. This is because they plan to offer substantial discounts and promotions on a Sunday to
attract customers. Given the price reduction, Sunday sales revenues are expected to be 60% more than the average
daily sales revenues for the other days. These Sunday sales estimates are for new customers only, with no allowance
being made for those customers that may transfer from other days.
B&P buys all its goods from one supplier. This supplier gives a 5% discount on all purchases if annual spend
exceeds $1,000,000.
It has been agreed to pay time and a half to sales assistants that work on Sundays. The normal hourly rate is $20 per
hour. In total five sales assistants will be needed for the six hours that the store will be open on a Sunday. They will
also be able to take a half-day off (four hours) during the week. Staffing levels will be allowed to reduce slightly
during the week to avoid extra costs being incurred.
The staff will have to be supervised by a manager, currently employed by the company and paid an annual salary of
$80,000. If he works on a Sunday he will take the equivalent time off during the week when the assistant manager is
available to cover for him at no extra cost to B&P. He will also be paid a bonus of 1% of the extra sales generated
on the Sunday project.

The store will have to be lit at a cost of $30 per hour and heated at a cost of $45 per hour. The heating will come on
two hours before the store opens in the 25 ‘winter’ weeks to make sure it is warm enough for customers to come in
at opening time. The store is not heated in the other weeks.
The rent of the store amounts to $420,000 per annum.
Required:
(a) Calculate whether the Sunday opening incremental revenue exceeds the incremental costs over a year
(ignore inventory movements) and on this basis reach a conclusion as to whether Sunday opening is
financially justifiable. (12 marks)
(b) Discuss whether the manager’s pay deal (time off and bonus) is likely to motivate him. (4 marks)
(c) Briefly discuss whether offering substantial price discounts and promotions on Sunday is a good
suggestion. (4 marks) (20 marks)
Answers:
(a) The decision to open on Sundays is to be based on incremental revenue and incremental costs:
Ref $ $
Incremental revenue W1 800,000
Incremental costs
– Cost of sales W2 335,000
– Staff W3 45,000
– Lighting W4 9,000
– Heating W5 9,000
– Manager’s bonus W6 8,000
– Total 406,000
––––––––
Net incremental revenue 394,000
––––––––
Conclusion
On the basis of the above it is clear that the incremental revenue exceeds the incremental costs and therefore it is
financially justifiable.
(W1) Incremental revenue
Day Sales Gross profit Gross profit Cost of Sales
$ % $ $
Average 10,000 70%
Sunday (+60% of average) 16,000 50% 8,000 8,000
Annually (50 days) 800,000 400,000 400,000
Current results (300 days) 3,000,000 70·0% 2,100,000
New results 3,800,000 65·8% 2,500,000
(W2) Purchasing and discount on purchasing
Extra purchasing from Sunday trading is $800,000 – $400,000 = $400,000
Current annual purchasing is $18,000 x 50 =$900,000
New annual purchasing is ($900,000 + $400,000) x 0·95 = $1,235,000
Incremental cost is $1,235,000 – $900,000 = $335,000 (a $65,000 discount)
(W3) Staff costs
Staff costs on a Sunday are 5 staff x 6 hours x $20 per hour x 1·5 = $900 per day
Annual cost is $900 x 50 days = $45,000
(W4) Lighting costs
Lighting costs are 6 hours x $30 per hour x 50 days = $9,000
(W5) Heating costs
Heating cost in winter is 8 hours x $45 per hour x 25 days = $9,000
(W6) Manager’s bonus
This is based on the incremental revenue $800,000 x 1% = $8,000 (or $160 per day)
(b) The manager’s rewards can be summarised as follows:

Time off
This appears far from generous. The other staff are being paid time and a half and yet the manager does not appear
to have this option and also is only being given time off in lieu (TOIL) at normal rates. Some managers may want

their time back as TOIL so as to spend time with family or social friends; others may want the cash to spend. One
would have thought some flexibility would have been sensible if the manager is to be motivated properly.
Bonus
The bonus can be calculated at $8,000 per annum (W6); on a day worked basis, this is $160 per day. This is less
than that being paid to normal staff; at time and a half they earn 6 hours x $20 x 1·5 = $180 per day. It is very
unlikely to be enough to keep the presumably better qualified manager happy. Indeed the bonus is dependent on the
level of new sales and so there is an element of risk involved for the manager. Generally speaking higher risk for
lower returns is far from motivating.
The level of sales could of course be much bigger than is currently predicted. However, given the uplift on normal
average daily sales is already +60%, this is unlikely to be significant.
(c) Discounts and promotion

When new products or in this case opening times are launched then some form of market stimulant is often
necessary. B&P has chosen to offer substantial discounts and promotions. There are various issues here:
Changing buying patterns: It is possible that customers might delay a purchase a day or two in order to buy on a
Sunday.
This would cost the business since the margin earned on Sunday is predicted to be 20% points lower than on other
days.
Complaints: Customers that have already bought an item on another day might complain when they see the same
product on sale for much less when they come back in for something else on a Sunday. Businesses need to be strong
in this regard in that they have to retain control over their pricing policy. Studies have shown that only a small
proportion of people will actually complain in this situation. More might not, though, be caught out twice and hence
will change the timing of purchases (as above).
Quality: The price of an item can say something about its quality. Low prices tend to suggest poor quality and vice
versa. B&P should be careful so as not to suggest that lower prices do not damage the reputation of the business as
regards quality.
Risk & Uncertainty

June 2014
19. Gam Co sells electronic equipment and is about to launch a new product onto the market. It needs to
prepare its budget for the coming year and is trying to decide whether to launch the product at a price of
$30 or $35 per unit.
The following information has been obtained from market research:
Price per unit $30 Price per unit $35
Probability Sales volume Probability Sales volume
0·4 120,000 0·3 108,000
0·5 110,000 0·3 100,000
0·1 140,000 0·4 94,000
Notes
1 Variable production costs would be $12 per unit for production volumes up to and including 100,000
units each year. However, if production exceeds 100,000 units each year, the variable production cost per
unit would fall to $11 for all units produced.
2 Advertising costs would be $900,000 per annum at a selling price of $30 and $970,000 per annum at a
price of $35.
3 Fixed production costs would be $450,000 per annum.
Required:
(a) Calculate each of the six possible profit outcomes which could arise for Gam Co in the coming
year. (8 marks)
(b) Calculate the expected value of profit for each of the two price options and recommend, on this
basis, which option Gam Co would choose. (3 marks)
(c) Briefly explain the maximin decision rule and identify which price should be chosen by
management if they use this rule to decide which price should be charged. (3 marks)
(d) Discuss the factors which may give rise to uncertainty when setting budgets. (6 marks)
Hints:

(a) Profit outcomes
Unit contribution Sales price per unit
$30 $35
Up to 100,000 units $18 $23
Above 100,000 units $19 $24
Sales price $30
Sales Unit Total Fixed Advertising Profit
volume contribution contribution costs costs
$ $’000 $’000 $’000 $’000
120,000 19 2,280 450 900 930
110,000 19 2,090 450 900 740
140,000 19 2,660 450 900 1,310
Sales price $35
Sales Unit Total Fixed Advertising Profit

volume contribution contribution costs costs
$ $’000 $’000 $’000 $’000
108,000 24 2,592 450 970 1,172
100,000 23 2,300 450 970 880
94,000 23 2,162 450 970 742
(b) Expected values

Sales price $30
Sales Profit Probability EV of profit
Volume
$’000 $’000
120,000 930 0·4 372
110,000 740 0·5 370
140,000 1,310 0·1 131
––––
873
––––
Sales price $35
Sales Profit Probability EV of profit
Volume
$’000 $’000
108,000 1,172 0·3 351·6
100,000 880 0·3 264
94,000 742 0·4 296·8
––––––
912·4
––––––
If the criterion of expected value is used to make a decision as to which price to charge, then the price charged
should be $35 per unit since the expected value of this option is the greatest.
(c) Maximin decision rule
Under this rule, the decision-maker selects the alternative which offers the most attractive worst outcome, i.e. the
alternative which maximises the minimum profit. In the case of Gam Co, this would be the price of $35 as the lowest
profit here is $742,000 as compared to a lowest profit of $740,000 at a price of $30.
(d) Reasons for uncertainty arising in the budgeting process
Uncertainty arises largely because of changes in the external environment over which a company will sometimes
have little control. Reasons include:
– Customers may decide to buy more or less goods or services than originally forecast. For example, if a major
customer goes into liquidation, this has a huge effect on a company and could also cause them to go into
liquidation.
– Competitors may strengthen or emerge and take some business away from a company. On the other hand, a
competitor’s position may weaken leading to increased business for a particular company.

– Technological advances may take place which lead a company’s products or services to become out-dated and
therefore less desirable.
– The workforce may not perform as well as expected, perhaps because of time off due to illness or maybe simply
because of lack of motivation.
– Materials may increase in price because of global changes in commodity prices.
– Inflation can cause the price of all inputs to increase or decrease.
– If a company imports or exports goods or services, changes in exchange rates can cause prices to change.
– Machines may fail to meet production schedules because of breakdown.
– Social/political unrest could affect productivity, e.g. the workforce goes on strike.
Note: This list is not exhaustive, nor would candidates be expected to make all the points raised in order to score
full marks.
December 2014
20. Tree Co is considering employing a sales manager. Market research has shown that a good sales manager
can increase profit by 30%, an average one by 20% and a poor one by 10%. Experience has shown that
the company has attracted a good sales manager 35% of the time, an average one 45% of the time and a
poor one 20% of the time.
The company’s normal profits are $180,000 per annum and the sales manager’s salary would be $40,000
per annum.
Based on the expected value criterion, which of the following represents the correct advice which Tree Co
should be given?
A. Do not employ a sales manager as profits would be expected to fall by $1,300
B. Employ a sales manager as profits will increase by $38,700
C. Employ a sales manager as profits are expected to increase by $100
D. Do not employ a sales manager as profits are expected to fall by $39,900
Hints: A.
New profit figures before salary paid:
Good manager: $180,000 x 1·3 = $234,000
Average manager: $180,000 x 1·2 = $216,000
Poor: $180,000 x 1·1 = $198,000
EV of profits = (0·35 x $234,000) + (0·45 x $216,000) + (0·2 x $198,000) = $81,900 + $97,200 + $39,600 =
$218,700
Deduct salary cost and EV with manager = $178,700
Therefore do not employ manager as profits will fall by $1,300.
September 2016
21. The following scenario relates to questions I–V.
Mylo runs a cafeteria situated on the ground floor of a large corporate office block. Each of the five floors
of the building are occupied and there are in total 1,240 employees.
Mylo sells lunches and snacks in the cafeteria. The lunch menu is freshly prepared each morning and
Mylo has to decide how many meals to make each day. As the office block is located in the city centre,
there are several other places situated around the building where staff can buy their lunch, so the level of
demand for lunches in the cafeteria is uncertain.
Mylo has analysed daily sales over the previous six months and established four possible demand levels
and their associated probabilities. He has produced the following payoff table to show the daily profits
which could be earned from the lunch sales in the cafeteria:
Demand level Probability Supply level
450 620 775 960
$ $ $ $
450 0·15 1,170 980 810 740
620 0·30 1,170 1,612 1,395 1,290
775 0·40 1,170 1,612 2,015 1,785
960 0·15 1,170 1,612 2,015 2,496

I. If Mylo adopts a maximin approach to decision-making, which daily supply level will he choose?
A. 450 lunches
B. 620 lunches
C. 775 lunches
D. 960 lunches
II. If Mylo adopts a minimax regret approach to decision-making, which daily supply level will he
choose?
A. 450 lunches
B. 620 lunches
C. 775 lunches
D. 960 lunches
III. Which of the following statements is/are true if Mylo chooses to use expected values to assist in
his decision-making regarding the number of lunches to be provided?
(1) Mylo would be considered to be taking a defensive and conservative approach to his decision
(2) Expected values will ignore any variability which could occur across the range of possible outcomes
(3) Expected values will not take into account the likelihood of the different outcomes occurring
(4) Expected values can be applied by Mylo as he is evaluating a decision which occurs many times over
A. 1, 2 and 3
B. 2 and 4
C. 1 and 3 only
D. 4 only
IV. The human resources department has offered to undertake some research to help Mylo to
predict the number of employees who will require lunch in the cafeteria each day. This information will
allow Mylo to prepare an accurate number of lunches each day.
What is the maximum amount which Mylo would be willing to pay for this information (to the nearest
whole $)?
A $191
B $359
C $478
D $175
V. Mylo is now considering investing in a speciality coffee machine. He has estimated the following
daily results for the new machine:
$
Sales (650 units) 1,300
Variable costs (845)
––––––
Contribution 455
Incremental fixed costs (70)
––––––
Profit 385
––––––
Which of the following statements are true regarding the sensitivity of this investment?
(1) The investment is more sensitive to a change in sales volume than sales price
(2) If variable costs increase by 44% the investment will make a loss
(3) The investment’s sensitivity to incremental fixed costs is 550%
(4) The margin of safety is 84·6%
A. 1, 2 and 3
B. 2 and 4
C. 1, 3 and 4
D. 3 and 4 only
Hints: I - A; II – D; III – B; IV – A; V- D
I. The maximin rule selects the maximum of the minimum outcomes for each supply level.
For Mylo the minimum outcomes are:
450 lunches – $1,170
620 lunches – $980
775 lunches – $810
960 lunches – $740
The maximum of these is at a supply level of 450 lunches.
II. The minimax regret rule selects the minimum of the maximum regrets.
Demand level Supply level
450 620 775 960
$ $ $ $
450 – 190 360 430
620 442 – 217 322
775 845 403 – 230
960 1,326 884 481 –
Max regret 1,326 884 481 430
The minimum of the maximum regrets is $430, so suggests a supply level of 960 lunches.
III. Expected values do not take into account the variability which could occur across a range of outcomes; a
standard deviation would need to be calculated to assess that, so Statement 2 is correct.
Expected values are particularly useful for repeated decisions where the expected value will be the long-run
average, so Statement 4 is correct.
Expected values are associated with risk-neutral decision-makers. A defensive or conservative decision-maker is
risk averse, so Statement 1 is incorrect.
Expected values will take into account the likelihood of different outcomes occurring as this is part of the
calculation, so Statement 3 is incorrect.
IV. This requires the calculation of the value of perfect information (VOPI).
Expected value with perfect information = (0·15 x $1,170) + (0·30 x $1,612) + (0·40 x $2,015) + (0·15 x $2,496) =
$1,839·50
Expected value without perfect information would be the highest of the expected values for the supply levels =
$1,648·25 (at a supply level of 775 lunches).
The value of perfect information is the difference between the expected value with perfect information and the
expected value without perfect information = $1,839·50 – $1,648·25 = $191·25, therefore $191 to nearest whole $.
V. The investment’s sensitivity to fixed costs is 550% ((385/70) x 100), so Statement 3 is correct.
The margin of safety is 84·6%. Budgeted sales are 650 units and BEP sales are 100 units (70/0·7), therefore the
margin of safety is 550 units which equates to 84·6% of the budgeted sales, so Statement 4 is therefore correct.
The investment is more sensitive to a change in sales price of 29·6%, so Statement 1 is incorrect.
If variable costs increased by 44%, it would still make a very small profit, so Statement 2 is incorrect.
December 2008
22. Shifters Haulage (SH) is considering changing some of the vans it uses to transport crates for customers. The new
vans come in three sizes; small, medium and large. SH is unsure about which type to buy. The capacity is 100 crates
for the small van, 150 for the medium van and 200 for the large van.
Demand for crates varies and can be either 120 or 190 crates per period, with the probability of the higher demand
figure being 0·6.
The sale price per crate is $10 and the variable cost $4 per crate for all van sizes subject to the fact that if the
capacity of the van is greater than the demand for crates in a period then the variable cost will be lower by 10% to
allow for the fact that the vans will be partly empty when transporting crates.
SH is concerned that if the demand for crates exceeds the capacity of the vans then customers will have to be turned
away. SH estimates that in this case goodwill of $100 would be charged against profits per period to allow for lost
future sales regardless of the number of customers that are turned away.
Depreciation charged would be $200 per period for the small, $300 for the medium and $400 for the large van. SH
has in the past been very aggressive in its decision-making, pressing ahead with rapid growth strategies. However,
its managers have recently grown more cautious as the business has become more competitive.
Required:
(a) Explain the principles behind the maximax, maximin and expected value criteria that are sometimes used
to make decisions in uncertain situations. (4 marks)
(b) Prepare a profits table showing the SIX possible profit figures per period. (9 marks)

(c) Using your profit table from (b) above discuss which type of van SH should buy taking into consideration
the possible risk attitudes of the managers. (6 marks)
(d) Describe THREE methods other than those mentioned in (a) above, which businesses can use to analyse
and assess the risk that exists in its decision-making. (6 marks) (25 marks)
Answers:
(a) Maximax stands for maximising the maximum return an investor might expect. An investor that subscribes to the
maximax philosophy would generally select the strategy that could give him the best possible return. He will ignore
all other possible returns and only focus on the biggest, hence this type of investor is often accused of being an
optimist or a risk-taker.
Maximin stands for maximising the minimum return an investor might expect. This type of investor will focus only
on the potential minimum returns and seek to select the strategy that will give the best worst case result. This type of
investor could be said to be being cautious or pessimistic in his outlook and a risk-avoider.
Expected value averages all possible returns in a weighted average calculation.
For example if an investor could expect $100 with a 0·3 probability and $300 with a 0·7 probability then on average
the return would be:
(0·3 x $100) + (0·7 x $300) = $240
This figure would then be used as a basis of the investment decision. The principle here is that if this decision was
repeated again and again, then the investor would get the EV as a return. Its use is more questionable for use on one-
off decisions.
(Note: you were not asked for a critique of this method.)
(b) Profit calculations
Small Van Medium Van Large Van
Capacity 100 150 200
Low Demand (120) 300 w1 468 w3 368 w5
w2 w4
High Demand (190) 300 500 816 w6
Workings
W1 W2 W3 W4 W5 W6
Sales 1,000 1,000 1,200 1,500 1,200 1,900
VC (400) (400) (480) (600) (480) (760)
Goodwill (100) (100) (100)
VC adjustment 48 48 76
Depreciation (200) (200) (300) (300) (400) (400)
Profit 300 300 468 500 368 816
(c) Which type of van to buy?

This depends on the risk attitude of the investor. If they are optimistic about the future then the maximax criteria
would suggest that they choose the large van as this has the potentially greatest profit.
If they are more pessimistic, then they would focus on the minimum expected returns and choose the medium van as
the worst possible result is $468, which is better than the other options. We are also told that the business managers
are becoming more cautious and so a maximin criterion may be preferred by them.
Expected values could be calculated thus:
Small van $300
Medium van ($468 x 0·4) + ($500 x 0·6) = $487
Large van ($368 x 0·4) + ($816 x 0·6) = $637
Given SH is considering replacing a number of vans you could argue that an EV approach has merit (not being a
one-off decision – assuming individual booking sizes are independent of each other).
The final decision lies with the managers, but, given what we know about their cautiousness, a medium sized van
would seem the logical choice. The small van could never be the correct choice.
(d) Methods of uncertainty reduction:

– Market research. This can be desk-based (secondary) or field-based (primary). Desk-based is cheap but can lack
focus. Field-based research is better in that you can target your customers and your product area, but can be time
consuming and expensive. The internet is bringing down the cost and speeding up this type of research, email is
being used to gather information quickly on the promise of free gifts etc.
– Simulation. Computer models can be built to simulate real life scenarios. The model will predict what range of
returns an investor could expect from a given decision without having risked any actual cash. The models use

random number tables to generate possible values for the uncertainty the business is subject to. Again, computer
technology is assisting in bringing down the cost of such risk analysis.
– Sensitivity analysis. This can be used to assess the range of values that would still give the investor a positive
return. The uncertainty may still be there, but the affect that it has on the investor’s returns will be better understood.
Sensitivity calculates the % change required in individual values before a change of decision results. If only a (say)
2% change is required in selling price before losses result an investor may think twice before proceeding. Risk is
therefore better understood.
– Calculation of worst and best case figures. An investor will often be interested in range. It enables a better
understanding of risk. An accountant could calculate the worst case scenario, including poor demand and high costs
whilst being sensible about it. He could also calculate best case scenarios including good sales and minimum
running costs. This analysis can often reassure an investor. The production of a probability distribution to show an
investor the range of possible results is also useful to explain risks involved. A calculation of standard deviation is
also possible.
June 2013
23. Gym Bunnies (GB) is a health club. It currently has 6,000 members, with each member paying a
subscription fee of $720 per annum. The club is comprised of a gym, a swimming pool and a small
exercise studio.
A competitor company is opening a new gym in GB’s local area, and this is expected to cause a fall in
GB’s membership numbers, unless GB can improve its own facilities. Consequently, GB is considering
whether or not to expand its exercise studio in a hope to improve its membership numbers. Any
improvements are expected to last for three years.
Option 1
No expansion. In this case, membership numbers would be expected to fall to 5,250 per annum for the
next three years. Operational costs would stay at their current level of $80 per member per annum.
Option 2
Expand the exercise studio. The capital cost of this would be $360,000.The expected effect on
membership numbers for the next three years is as follows:
Probability Effect on membership numbers
0·4 Remain at their current level of 6,000 members per annum
0·6 Increase to 6,500 members per annum
The effect on operational costs for the next three years is expected to be:
Probability Effect on operational costs
0·5 Increase to $120 per member per annum
0·5 Increase to $180 per member per annum
Required:
(a) Using the criterion of expected value, prepare and fully label a decision tree that shows the two
options available to GB. Recommend the decision that GB should make.
Note: Ignore time value of money. (12 marks)
(b) Calculate the maximum price that GB should pay for perfect information about the expansion’s exact
effect on MEMBERSHIP NUMBERS. (6 marks)
(c) Briefly discuss the problems of using expected values for decisions of this nature. (2 marks) (20
marks)
Hints: (a)

Workings
Option 1
Net income = $720 – $80 = $640 per annum.
Option 2
If costs $120 per annum, net income = $720 – $120 = $600 per annum.
If costs $180 per annum, net income = $720 – $180 = $540 per annum.
Expected value and decision:
EV at A = (0·5 x $3·6m) + (0·5 x $3·24m) = $3·42m
EV at B = (0·5 x $(3·9m) + (0·5 x $3·51m) = $3·705m
EV at C = (0·4 x $3·42m) + (0·6 x $3·705m) = $3·591m per annum
At D, compare EV of:
Option 1: (3 x $3·36m) = $10·08m
Option 2: ($3 x $3·591m) – $360k = $10·413m
Therefore choose option 2 – expand exercise studio.
(b) With perfect information:
If membership numbers were 6,000:
EV = $3·42m x 3 = $10·26m
Less costs of $360k = $9.9m
Therefore, with these membership numbers, GB would choose option 1 instead.
If membership numbers were 6,500:
EV = $3·705 x 3 = $11·115m
Less costs of $360k = $10·755m
In this instance, GB would choose option 2.
So, if membership numbers are 6,000, of which there is a 0·4 probability, EV will be $10·08m (option 1) and if
membership numbers are 6,500, of which there is a 0·6 probability, then EV will be $10·755m (option 2).
Therefore EV with perfect information = (0·4 x $10·08m) + (0·6 x $10·755) = $10·485m.
Without perfect information the EV is $10·413m, therefore the value of it is $72k ($10·485m – $10·413m). This
represents the maximum price that GB should be prepared to pay for the information.
(c) The expansion decision is a one-off decision, rather than a decision that will be repeated many times. Expected
values, on the other hand, give us a long run average of the outcome that would be expected if a decision was to be
repeated many times. The actual outcome may not be very close to the expected value calculated and the technique
is therefore not really very useful here.
Also, estimating accurate probabilities is difficult because this exact situation has not arisen before. The expected
value criterion for decision-making is useful where the attitude of the investor is risk neutral. We do not know what
the management of Gym Bunnies’ attitude to risk is, which makes it difficult to say whether this criterion is a good

one to use. In a decision such as this one, it would be useful to see what the worst case scenario and best case
scenario results would be too, in order to assist decision-making.

Section B. Decision Making Techniques - Tutor

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Section B. Decision Making Techniques - Tutor

Uploaded by

Copyright:

Available Formats

Compiled by CA.

nirmal shrestha Decision Making Techniques

CVP Analysis (Breakeven Analysis)

What is CVP (break-even) analysis?

How is the break-even point calculated?

Contribution target = Fixed costs + Target profit

FC + Desired Profit /(1−t)

Margin of Safety ($) = Sales – BEP level sales

Sales−BEP level Sales MOS sales

Fixed Cost = BEP sales * CS Ratio

Profit = MOS Sales * CS Ratio

Cost and Total cost

performance management- acca f5 B.2

Limitations of break-even analysis

performance management- acca f5 B.3

performance management- acca f5 B.4

LIMITING FACTOR ANALYSIS

Calculate the maximum profit that may be earned.

LINEAR PROGRAMMING – MULTI LIMITING FACTORS

1. Define the problem

2. Objective Function – maximise contribution = Z

4. Plotting the graph

Identifying the optimal solution

performance management- acca f5 B.8

Slack and surplus

SENSITIVITY ANALYSIS – SHADOW PRICE

Department X – shadow price of one hour

Department Y – shadow price of one hour

performance management- acca f5 B.9

Department Z – shadow price of one hour

Assumptions and limitations of linear programming

FACTORS AFFECTING PRICING DECISIONS

Ways of calculating the price

Cost-plus pricing may be based on:

1. Full cost-plus pricing

performance management- acca f5 B.11

2. Marginal cost-plus pricing

Product life cycle

performance management- acca f5 B.12

Phase Introduction Growth Maturity Decline

performance management- acca f5 B.13

Penetration pricing strategy is appropriate when:

Existing market – no monopoly position

Going rate pricing or average pricing

Discount pricing (loss leaders)

Supermarket economy range, 99p shops.

Complementary product pricing

Captive product pricing

Product line pricing

Relevant cost pricing

DEMAND BASED PRICING

Deriving the demand curve

Current Qty at Current Price

Factors influencing demand

Price elasticity of demand

performance management- acca f5 B.16

Other factors affecting elasticity

Advantages of demand based pricing

Limitations of demand based pricing

PROFIT MAXIMISING PRICE AND QUANTITY

performance management- acca f5 B.17

Marginal revenue (MR) = marginal cost (MC)

SHORT TERM DECISIONS