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AMAB333
Advanced Management Accounting
Semester 1 2014/2015

TOPIC 3: Decision Making Techniques

Learning Outcomes:
At the end of this lecture students should be able to:
1. Justify the use of linear cost and revenue functions
2. Describe the situation when it may be appropriate to use linear programming.
3. Use graphical linear programming to find optimal output levels
4. Formulate the initial linear programming model and interpret the final solution using simplex
method.
5. Explain the meaning of the term shadow prices.
6. Explain different pricing strategies
7. Calculate a price from using Marginal Cost = Marginal Revenue theory

Cost-volume profit (CVP)
1. The DM process involves selecting a range if possible course of action where managers
need to compare the likely effects of the options they are considering.
2. It provides answers to questions, such as:
o How many units must be sold to break-even?
o What would be the effect on profits if we reduce our selling price and sell
more?
o What sales volume is required to meet the additional fixed charged arising
from and advertising campaign?
3. These questions can be answer using cost-volume-profit (CVP analysis).
4. It is a model examining the relationship between changes in activity (output) and
changes between total sales revenue, expenses and net profit.
5. A numerical approach to CVP analysis shall use contribution margins (CM); CM =
sales revenue minus variable cost (assuming SP per unit, VC per unit to be constant,
CM is also assumed to be constant)
6. Formula
BEP in units = Fixed cost x
SP per unit - VC per unit (CM per unit)

Unit to sold to obtain targeted profit = ___Fixed cost + desired profit x
SP unit - VC per unit (CM per unit)

BEP in units if FC and revenue are not given = Total Fixed cost x Total Sales
Total contribution

Profit volume ratio (CM Ratio) = ____Total CM x 100
Total Sales revenue

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7. Example:

Answer:
1. BEP in units




2. Units to be sold to obtain a RM30,000 profit





3. Profit from the sales of 8,000 tickets





4. Selling price to be changed to show profit of RM30,000 on sales of 8,000 tickets





5. Additional sales volume to meet RM8,000 additional fixed advertisement charges.

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Linear Programming

1) Linear programming deals with a class of optimization problems, where both the
objective function to be optimized and all the constraints, are linear in terms of the
decision variables. Linear programming has proven to be an extremely powerful tool,
both in modeling real-world problems and as a widely applicable mathematical
theory.
2) Today, this theory is being successfully applied to problems of capital budgeting,
design of diets, conservation of resources, games of strategy, economic growth
prediction, and transportation systems.
3) Any LP problem consists of an objective function and a set of constraints. In most
cases, constraints come from the environment in which you work to achieve your
objective. When you want to achieve the desirable objective, you will realize that the
environment is setting some constraints (i.e., the difficulties, restrictions) in fulfilling
your desire or objective.

You need to understanding the problem (i.e., formulating a mental model) by carefully
reading and asking yourself the following general questions:
1. What are the decision variables? That is, what are controllable inputs? Define the
decision variables precisely, using descriptive names. Remember that the controllable
inputs are also known as controllable activities, decision variables, and decision
activities.
2. What are the parameters? That is, what are the uncontrollable inputs? These are
usually the given constant numerical values. Define the parameters precisely, using
descriptive names.
3. What is the objective? What is the objective function? Also, what does the owner of
the problem want? How the objective is related to his decision variables? Is it a
maximization or minimization problem? The objective represents the goal of the
decision-maker.
4. What are the constraints? That is, what requirements must be met? Should I use
inequality or equality type of constraint? What are the connections among variables?
Write them out in words before putting them in mathematical form.
Learn that the feasible region has nothing or little to do with the objective function (min
or max). These two parts in any LP formulation come mostly from two distinct and
different sources. The objective function is set up to fulfill the decision-maker's desire
(objective), whereas the constraints which shape the feasible region usually comes from
the decision-maker's environment putting some restrictions/conditions on achieving
his/her objective.


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Example 1: (refer to Example 25.1, pg 642)

LP is a manufacturing company that currently makes two products. The standards per unit
of product are as follows:
Product Y RM RM Product Z RM RM
Standard selling price 110 Standard selling price 118
Less Standard cost: Less Standard cost:
Materials (8 units at RM4) 32 Materials (4 units at RM4) 16
Labour (6 hours at RM10) 60 Labour (8 hours at RM10) 80
Variable oh (4 mh at RM1) 4 96 Variable oh (6 mh at RM1) 6 102
Contribution 14 Contribution 16

During the next accounting period, the availability of resources are expected to be subject
to the following limitations:
Labour 2,880 hours
Materials 3,440 units
Machine capacity 2,760 hours

The marketing manager estimates that the maximum sales potential for product Y is
limited to 420 units. There is no sales limitation for product Z. You are asked to advise
how these limited facilities and resources can best be used so as to gain the optimum
benefit from them.

Solution
Formulate the linear programming model
Maximise C = ________________subject to





Graphical Method
Identify the respective point on the X & Y-axis and plot each constraint equation.
8Y + 4Z 3,440 (material constraint) 6Y + 8Z 2,880 (labour constraint)

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4Y+ 6Z 2,760 (machine capacity constraint) 0 Y 420 (maximum & minimum sales
limitation)













All of the above constraint equations should be plotted on the same graph as the figure below:

















Optimum solution via LP (Example 1)

1. The optimum output can be determined by solving the simultaneous equations that intersect
at point C:

8Y + 4Z = 3,440
6Y + 8Z = 2,880
:. Y = 400 and Z = 60; and Contribution = RM6,560

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2. The materials and labour constraints are binding and therefore have opportunity costs. The
marginal contribution from obtaining one extra unit of materials can be calculated by solving
the following equations:

8Y + 4Z = 3,441 (revised materials constraint)
6Y + 8Z = 2,880 (unchanged labour constraint)
:.Y = 400.2 units, Z = 59.85 units
Marginal contribution = RM0.40

Therefore the planned output of Y would be increased by 0.2 units (Y= 400.2-400) and Z
reduced by 0.15 units (Z=59.85-60) and contribution will increase by RM0.40 (C=6,560.4-
6,560) (the opportunity cost).

3. The marginal contribution from obtaining one extra labour hour can be found in a similar
way:

8Y + 4Z = 3,440 (unchanged materials constraint)
6Y + 8Z = 2,881 (revised labour constraint)
:. Y = 399.9 and Z = 60.2
Marginal contribution = RM1.80

Therefore the planned output of Y would be reduced by 0.1 units (Y= 399.9-400) and Z
increased by 0.2 units (Z=60.2-60) and contribution will increase by RM1.80 (C=6,561.8-
6,560) (the opportunity cost or shadow price).

4. Shadow price - a shadow price is the maximum price that management is willing to pay for
an extra unit of a given limited resource. For example, if a production line is already
operating at its maximum 40 hour limit, the shadow price would be the maximum price the
manager would be willing to pay for operating it for an additional hour, based on the
benefits he would get from this change.
The value of the shadow price can provide decision makers powerful insight into
problems.
For instance if you have a constraint that limits the amount of labor available to 40 hours
per week, the shadow price will tell you how much you would be willing to pay for an
additional hour of labor.
If your shadow price is RM10 for the labor constraint, for instance, you should pay no
more than RM10 an hour for additional labor. Labor costs of less than RM10/hour will
increase the objective value (ie profit); labor costs of more than RM10/hour will decrease
the objective value. Labor costs of exactly RM10 will cause the objective function value
to remain the same.




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SIMPLEX METHOD

1. The Simplex Method is another algorithm for solving LP problems. The Simplex Method is a
modification of the Algebraic Method, which overcomes this deficiency.
2. However, the Simplex Method has its own deficiencies. For example, it requires that all
variables be non-negative ( 0); also, all other constraints must be in dollar form with non-
negative right-hand-side (RHS) values.
3. Like the Algebraic Method, the simplex method is also a tabular solution algorithm. However,
each tableau in the simplex method corresponds to a movement from one basic variable set
(BVS) (extreme or corner point) to another, making sure that the objective function improves
at each iteration until the optimal solution is reached.






Example 2: based on LP in example 1

Step 1 & 2: The first stage is to introduce slack variables:

Maximize C = 14Y + 16Z (subject to);
8Y + 4Z + S1 = 3,440 (materials constraint)
6Y + 8Z + S2 = 2,880 (labour constraint)
4Y + 6Z + S3 = 2,760 (machine capacity constraint)
1Y + S4 = 420 (sales constraint for product Y)

First matrix:
Quantity Y Z
Materials
Labour

Machine
hours
Sales
Contribution

Step 3: NOTES 1-4 ARE OPTIONAL THESE ARE THE METHOD OF SOLVING THE SIMPLEX
MANUALLY WHICH WILL NOT BE TESTED.
1. Based on the first matrix --> Choose product Z (because C=+16>+14); but output restricted
by:
S1 (Materials) = 860 units (3,440/ 4)
S2 (Labour) = 360 units (2,880/ 8)
S3 (Machine hours) = 460 units (2,760/ 6)
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2. From the first matrix, since Labour (S2) is the least production to target for, we rearrange
the equation that results in the constraint (S2) in terms of the product chosen. Therefore S2
becomes:
S2= 2,880 6Y 8Z
8Z = 2,880 6Y S2
Z = 360 Y 1/8 S2

3. We now substitute this value for Z into each of the above equations. The revised equations
are listed in the second matrix.
Second matrix:
Quantity Y S2
S1 = 2,000 5 +1/2 Materials
Z = 360 3/4 1/8
S3 = 600 +1/2 +3/4
Machine
hours
S4 = 420 1 0 Sales
C = 5,760 +2 -2 Contribution

4. Based on the second matrix --> Choose product Y (because C=+2>-2); i.e. substitute 1 unit of
Y for units of Z) but substitute is restricted by:
S1 (materials) = 400 units (2,000/ 5)
Z (substitution of Z) = 480 units (360/ )
S4 (max. sales of Y) = 420 units (420/ 1)
Step 4 Determine whether the matrix is optimal ensuring that the C row is NEGATIVE.
Rearrange the equation, which results in the constraint (S1) in terms of the chosen product (Y)
and substitute the revised values of Y in each of the equations shown in the second matrix. The
revised values are listed in the third matrix.


Third matrix: (final)
Quantity S1 S2
Y = 400 -1/5 +1/10
Z = 60 +3/20 1/5
S3 = 800 -1/10 +4/5
Machine
hours
S4 = 20 +1/5 -1/10 Sales
C = 6,560 -2/5
-1
4/5 Contribution




Effect of
REDUCE 1 unit scare resource (S1 & S2)
OR
PRODUCE 1 unit product (the product
that supposedly not to produce)
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Step 5 - Interpretation of final matrix:
1. The contribution row contains only negative items, which signifies that the optimum solution
has been reached.

2. Interpretation of final matrix
Produce 400 units of Y and 60 units of Z.
Unused resources = 800 machine hours and 20 units unused sales potential of Y.
Materials and labour hours are fully utilized.
Maximum contribution = RM6,560
Opportunity costs = RM0.40 for materials and RM1.80 for labour hours.

3. To RELEASE 1 unit of materials from the optimum production programme we should increase
the output of Z by 3/20 of a unit and decrease Y by 1/5 of a unit.



4. If additional scarce resources are obtained, all of the signs in the final matrix and the table in
(4) above should be reversed (e.g. increase Y by 1/5 of a unit and decrease Z by 3/20 of a unit
and contribution will increase by RM0.40).

5. Relevant costs = Acquisition cost + Opportunity costs
6. Potential uses:
Costing alternative uses of scarce resources by different products.
Determining the minimum payment for additional resources.
Variance analysis for bottleneck operations.
Transfer pricing.

8. The marginal rates of substitution and opportunity costs only apply within a certain range for
each scarce resource:
Materials: 1,440 (3,440 2,000) to 3,540 units (3,440 + 100)
Labour hours: 2,680 to 3,880 hours




Refer
textbook
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Lecture Illustration

The electronic department of Cempaka Electronic Bhd produces two products CP205 and QT312.
The standard revenues and costs per unit for these products are shown below;

CP205 (RM) QT312 (RM)
Selling price 200 180
Variable costs:
Materials (RM10 per kg) 40 40
Direct labour (RM8 per hour) 32 16
Plating (RM12 per hour) 12 24
Other variable costs 76 70
Total variable costs 160 150
Contribution 40 30

In any week the maximum availability of input resources is limited to the following:
Material 1200 kg
Direct labour 1000 hours
Plating time 500 hours

The accountant has used simplex method to determine the optimal production plan to maximise
profit. He uses X for CP205, Y for QT312, slack variables S1 for unused materials, S2 for unused
direct labour and S3 for unused plating time. The final matrix for the optimal solution is as follows:
S1 S2
X = 200 0.25 -0.5
Y = 100 -0.5 0.5
S3 = 100 0.75 -0.5
C = 11,000 -5 -5

Required:
(a) Formulate the above data into a linear programming model so that the company may
maximise contribution.
(b) Interpret the final matrix.
(c) Use the final matrix to calculate:
i. The effect of an increase of 50kg of materials;
ii. The effect of a reduction of 10 hours of direct labour.

Assumptions underlying LP
1. Linearity
2. Divisibility of products
3. Divisibility of resources
4. All of the available opportunities can be included in the model
5. Assumed fixed costs are constant for the period
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PRICING DECISIONS



Introduction
1. Selling price depend on:
a) Cost selling price must cover variable cost and should be high enough to cover fixed
costs at the sales volume achieved.
b) Customers what will customers be prepared to pay? How will they react to price
changes (elasticity of demand)
c) Competition what do competitors offer and at what price? How competitive is the
market? Are there substitute products?
2. Some industries are subject to price controls. Eg many utility companies must have prices
agreed by government regulators.
3. Pricing which is part of the overall marketing strategy plays a very critical role in the success
of a company as it is able to increase the profitability and or increase the market share.
4. Normally, the higher the prices means higher profit being attained but might means lower
market share.
5. Pricing ties very closely with the various stages of a product life cycle.
6. A critical part of a company's overall strategic planning includes the establishment of pricing
objectives for the products it sells. A company has several pricing objectives from which to
choose, and the objective chosen will depend on the goals and type of product sold by a
company. The four most commonly adopted pricing objectives are (a) competitive, (b)
prestige, (c) profitability, and (d) volume pricing.
7. Factors that influence the pricing of a product or service are:
a) Taking pricing decision is one of the critical factors of a business. To decide on a price, a
proper research needs to be carried out such as on the product availability, competitor's
pricing strategy, customer's perceived pricing, customers willingness to pay the price of
the product, demand factor etc.
b) The pricing decision influences the demand of the product in the market, the pricing
strategy of the competitors, the profitability of the company and the most important is
the customer decision on purchasing the product such as which brand product to buy and
which not, which will give the major satisfaction to the customer by rendering the higher
value at the lesser price then the competitors.
c) Before a decision on the pricing is made, certain factors need to be considered:
Costs
Customers Competition
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- What are the objectives of the company e.g. to maximize profit, to gain market share,
to penetrate the new market, etc?
- What is the existing economic conditions
- Any government regulations
- Cost structure of the organization
- Demand for the product which should includes a study of the price elasticity of
demand
- Inflation
- Surplus production capacity
- Level of competition
- Political scenario

Generic strategies and pricing
Pricing strategies have to be seen in the light of generic competitive strategies:
1. Cost leadership
Success depend on keeping costs very low
Competitive environment prices determined by market, good margins earned at
ordinary market price.
Large co. enjoy economies of scale and substantial production experience will achive
cost leadership more easily compare to small firms.
2. Differentiation
Products are made distinct (differentiated) from competitors
Do not compete head on in the market and may allow co. to raise prices.
Co. must judge what costomers are prepared to for these differentiated products and
what price will maximize profit
3. Focus
Company specializes in a small section of the market and gains a very good reputation
there.
Although a co. could focus and be a cost leader, it would be more natural to focus and
be a differentiator.
Specializing in a small market segment should allow better products and services to
be devised for the segment, and these should command premium prices.

Different price strategies
1. Cost-plus pricing is a pricing method used by companies. It is used primarily because it is easy
to calculate and requires little information. There are several varieties, but the common
thread in all of them is that one first calculates the cost of the product, and then includes an
additional amount to represent profit. Cost-plus pricing is often used on government
contracts, and has been criticized as promoting wasteful expenditures.
The method determines the price of a product or service that uses direct costs, indirect
costs, and fixed costs whether related to the production and sale of the product or service
or not. These costs are converted to per unit costs for the product and then a
predetermined percentage of these costs are added to provide a profit margin.
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Different cost bases and mark-ups can be used to determine the cost-plus selling price
(refer pg. 256)
Target mark-ups seek to provide a contribution to non assigned costs and profit.
Target mark-ups are also adjusted to reflect demand, types of products, industry
norms, competitive position, etc.
Criticisms of cost-plus pricing:
1. Ignores demand
2. Does not necessarily ensure that total sales revenue will exceed total cost.
3. Can lead to wrong decisions if budgeted activity is used to unitize costs.
4. Circular reasoning Volume estimates are required to estimate unit fixed costs and
ultimately price.
Reasons for using cost-plus pricing:
1. May encourage price stability
2. Demand can be taken into account by adjusting the target mark-ups.
3. Simplicity
4. Difficulty in applying sophisticated procedures where a firm markets hundreds of
products/services.
5. Used as guidance to setting the price but other factors are also taken into account.
6. Applied to only the relatively minor revenue items.

2. Target pricing
The required profit for the organisation is estimated and, working back from there, selling
prices that should generate that profit are calculated.
No guarantee that the product will sell at the price arrived at.
A useful initial approach when investigating possible selling prices for a new product.

3. MR = MC
Economic arguments state that profits are maximized when marginal revenue = marginal
cost.
This is a theoretical approach that can be used only if the organisation has detailed
knowledge about demand and cost curves.
In practice a target profit is often used instead of maximizing profit.

4. Skimming is selling a product at a high price, sacrificing high sales to gain a high profit.
Usually employed to reimburse the cost of investment of the original research into the
product - commonly used in electronic markets when a new range, such as DVD players,
are firstly dispatched into the market at a high price.
This strategy is often used to target "early adopters" of a product/service. These early
adopters are relatively less price sensitive because either their need for the product is
more than others or they understand the value of the product better than others.
This strategy is employed only for a limited duration to recover most of investment made
to build the product. To gain further market share, a seller must use other pricing tactics
such as economy or penetration.

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5. Penetration pricing is the pricing technique of setting a relatively low initial entry price, often
lower than the eventual market price, to attract new customers.
The strategy works on the expectation that customers will switch to the new brand
because of the lower price.
Penetration pricing is most commonly associated with a marketing objective of increasing
market share or sales volume, rather than to make profit in the short term.
Price Penetration is most appropriate where:
- Product demand is highly price elastic.
- Substantial economies of scale are available.
- The product is suitable for a mass market (ie. enough demand).
- The product will face stiff competition soon after introduction.
- There is not enough demand among consumers to make price skimming work.
- In industries where standardization is important. The product that achieves high
market penetration often becomes the industry standard (eg Microsoft Windows)
and other products, whatever their merits, become marginalized. Standards carry
heavy momentum.

6. Complementary product is material or product whose use is interrelated with the use of an
associated or paired good such that a demand for one (tires, for example) generates demand
for the other (gasoline, for example). If the price of one good falls and people buy more of it,
they will usually buy more of the complementary good also whether or not its price also falls.
Similarly, if the price of one good rises and reduces its demand, it may reduce the demand
for the paired good as well.
Complimentary product pricing is the method in which one of the complementary
products (shaving razor, for example) is priced to achieve maximum sales volume,
(without cost or profit considerations) to stimulate the demand for the other product
(razor blades).
The objective is to generate a level of profit that adequately covers losses sustained by
the first product.

7. Volume discounting is a method used by sellers and manufacturers to reward those who are
able to purchase in bulk amounts or in mass quantities.
For manufacturers, businesses that buy more of an item usually get it at a lower price
because the manufacturer is not only interested in making a sale, but also getting rid of
manufactured goods.
The businesses that buy in bulk may have large warehouses in which to store such goods
and can offer a lower price to consumers. A volume discount for merchants may inspire
merchant loyalty. If a merchant buys X amount of an item, they may be offered incentives
to purchase more or receive a lower purchasing price in the future.

8. Perceived value pricing - What is the customer willing to pay.
Based on perceived value. This is not necessarily anything to do with the cost of
production.
A high price can also be set increase perceived value.
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9. Product-line pricing strategy can only be used if you have a whole product line or if you are
in the process of building a whole product line (more than one product, and usually more
than several products). This is because products are not usually brought out in a full line; they
are introduced one at a time.
To use a product line pricing strategy you will need to keep track of each product's life
cycle stage, how inter-dependent the products are, when you estimate a product will
leave the line, when a new product is scheduled to enter the line, and how the products
in the line complement each other. All of these product line elements will affect your
product line pricing strategy.
One way of looking at pricing for a product line is to consider pricing and profitability of
the whole line, not only individual products of the line. In this type of price analysis, you
might have some products that lose money but they help pull in buyers for those products
that make money (preferably that make a lot of money). Other products in the line might
just break-even but they contribute to the fullness of the line and help support the
money-making products.
The other way to look at product line pricing is to analyze the importance of one or more
products to the whole line. For example, for a car dealership, the car model is the product,
and the accessories, extended warranties, service package, color, sunroof and other
options are the rest of the line items. Those line items would be rather meaningless, for
the most part, without the car as the primary product.
Product line pricing strategies can be further complicated by competitive activity by
product, not exclusively by line. If you have five competitors for one of your products in
the line, and then only two competitors for the other products in the line, you might use
a different price strategy for the product with lots of competition, than the other line
products.

10. Competitive pricing
What do competitors charge?
If our product is essentially the same, the selling price will have to be substantially the
same.

11. Price discrimination exists when sales of identical goods or services are transacted at
different prices from the same provider.
In a theoretical market with perfect information, no transaction costs or prohibition on
secondary exchange (or re-selling) to prevent arbitrage, price discrimination can only be
a feature of monopoly and oligopoly markets, where market power can be exercised.
Otherwise, the moment the seller tries to sell the same good at different prices, the buyer
at the lower price can arbitrage by selling to the consumer buying at the higher price but
with a tiny discount.
However, market frictions in oligopolies such as the airlines and even in fully competitive
retail or industrial markets allow for a limited degree of differential pricing to different
consumers. Price discrimination also occurs when it costs more to supply one customer
than it does another, and yet the supplier charges both the same price.
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The effects of price discrimination on social efficiency are unclear; typically such behavior
leads to lower prices for some consumers and higher prices for others. Output can be
expanded when price discrimination is very efficient, but output can also decline when
discrimination is more effective at extracting surplus from high-valued users than
expanding sales to low valued users. Even if output remains constant, price discrimination
can reduce efficiency by misallocating output among consumers.
Price discrimination requires market segmentation and some means to discourage
discount customers from becoming resellers and, by extension, competitors. This usually
entails using one or more means of preventing any resale, keeping the different price
groups separate, making price comparisons difficult, or restricting pricing information.
The boundaries set up by the marketer to keep segments separate are referred to as a
rate fence. Price discrimination is thus very common in services, where resale is not
possible; an example is student discounts at museums.
Price discrimination can also be seen where the requirement that goods be identical is
relaxed. For example, so-called "premium products" (including relatively simple products,
such as cappuccino compared to regular coffee) have a price differential that is not
explained by the cost of production. Some economists have argued that this is a form of
price discrimination exercised by providing a means for consumers to reveal their
willingness to pay.

The theoretical approach to pricing

MC = MR
Marginal cost = the increase in total cost from making one more unit.
Marginal revenue = the increase in total revenue from selling one more unit.
MC is an increasing function.
MR is a decreasing function.
So if :
MC > MR profit must be falling
MC < MR profit must be rising.
MC = MR profit must be maximized.
Steps to calculating the optimal price:
1. Establish price equation (P = a bQ).
2. Establish MR equation (MR = a 2bQ)
3. Find MC (usually just the variable cost per unit)
4. Make MC = MR to get optimal quantity to sell.
5. Insert this quantity back into the price equation to get the optimal price.







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Illustration

At a price of RM20 per unit, 10,000 units were sold. A price drop to RM18 resulted in sales
reaching 12,000 units.
Fixed costs = RM30,000
Variable cost per unit = RM5.

a) What are the equations for:
i. The demand curve
ii. MR.
b) Calculate :
i. Output level that will maximized profits.
ii. Total revenue.
iii. Total costs
iv. Total profit at this output level.