Exam Flashcards
What is meant by a “shadow price”?
Limiting Factor Analysis
The shadow price represents the maximum premium above the normal rate that a company will be willing to pay for more of the scarce resource
Shadow price should be considered carefully as the price could be negotiated at a lower amount
What are the non-financial considerations for a company when deciding to sub-contract from a third party?
- Reliability of the supplier - delivery, price, quality? Likelihood of future price increase
- Loss of control - possibility of becoming dependent on the supplier
- Effect on the existing workforce morale (demotivated, may be worried about losing their job)
- Quality of the bought in product - low quality could damage the company reputation
- How is the company going to use the spare capacity?
What is a make or buy decision?
A decision about whether a company should make a product/ carry out activity with its own internal resources
Or whether it should pay another organisation to make the product/ carry out the activity
If there is no scarce resource, what is the relevant cost of the make or buy decision?
The differential costs between making and buying
Differential cost - the difference in total costs between alternatives
What is the make or buy decision if the company has scarce resources?
If an organisation is forced to subcontract because they have insufficient in-house resources, the decision is what items to make and what items to buy
Total costs are minimised if the units made in-house have the highest saving per unit of scarce resource
What can spare labour capacity be used for?
Additional work can be undertaken
- There is no relevant cost
What should a company do if they have full labour capacity?
Additional work cannot be undertaken
They should hire more staff
- The relevant cost is the current rate of pay or cost of hiring
If they can’t hire any more staff
- The relevant cost is the variable cost and lost contribution from not taking on the additional work
What is the relevant cost of labour?
Direct labour cost plus contribution lost by diverting labour to make another product
What is the relevant cost of materials?
If they are not owned - current replacement cost
If they are owned but will be replaced (in continual use) - current replacement cost
If they are owned but will not be replaced (no other use) - higher of current resale value and value if put to an alternative use
If the resource is scarce (if used it can’t be replaced) - opportunity cost
Define a “sunk cost”
Non-relevant costs
A past (historical) cost which is not directly relevant in decision making
Define a “committed cost”
Non-relevant costs
A future cost which cannot be recouped e.g. a service contract for machinery
Are fixed costs and variable costs relevant costs?
Unless indication of the contrary, assume:
Fixed costs - irrelevant
Variable costs - relevant
What costs should be used when making business decisions?
Relevant or non-relevant
Relevant costs
What are relevant costs?
- Future costs
- Incremental costs
- Cash flows
(They are avoidable costs, as the cost will not be incurred if they activity to which they relate to do not exist)
What are irrelevant costs?
Those that cannot be changed by making decisions
i.e. fixed costs
What is an opportunity cost?
The benefit which would have been earned, but has been given up, by choosing one option instead of another
What is the formula for return on investment?
ROI
Profit from division/ capital employed (x100%)
How is residual income calculated?
Divisional profit
Less notional interest (cost of capital)
= Residual income
What are the problems with ROI?
- Can encourage dysfunctional behaviour: especially if managers bonus relies on ROI being met (i.e rejecting profitable investments that will bring down the average)
- The ratio will be distorted by the age of assets, this is not considered
- Profit can be manipulated
What is residual income?
The operating profit that an investment centre earns above the minimum required return on its operating assets
What are the problem with residual income?
- The calculation gives an absolute number
- The ratio will be distorted by the age of assets
- Profit can be manipulated
Compare RI and ROI
RI is more flexible as different costs of capital can be used to reflect risk
What are the advantages of divisionalisation?
- Decentralises the decision making process (improves speed and quality of decision making)
- Authority to make decisions to improve performance should motivate division managers
- Senior management are freed up from day to day operations, they can devote more time to strategic planning
- Valuable training for future senior management
What is divisionalisation?
Dividing organisations into divisions
Each divisional manager is responsible for the performance of the division
E.g. Profit centres, cost centres, investment centres
What is the problem with producing a surplus amount?
Surplus occurs when more than a minimum requirement is made
Do you have enough demand for the additional units?
If not then an alternative “optimal” point may be chosen
What is a slack?
Limiting factor analysis
The maximum availability of a resource has not been used
Slack is more important than surplus because unused resources can be put to other uses
What is a binding constraint?
Limiting factor analysis
If all resources are fully utilised at the optimal point then they are referred to as critical (binding) constraints
When there are 3 constraints
The remaining one has either slack or surplus amount
When are shadow prices applicable?
When extra resources improves the optimal solution
i.e. the constraint line concerned moves out increasing the size of the feasible region and moving the optimal point
The shadow price is valid for a small range before the constraint becomes non-binding or different resources become critical
What are the main assumptions of limiting factor analysis?
- A single quantifiable object (e.g. maximise contribution)
- Each product always uses the same amount of the scarce resource per unit
- The contribution per unit is constant
- The variable cost per unit is constant
- Estimates of demand and resource requirements are known with certainty
What are the 5 stages of limiting factor analysis?
- Identify the scarce resource
- Calculate the contribution per unit
- Calculate the contribution per scarce resource
- Rank in order of the contribution per scarce resource
- Allocate the resources - make first up to maximum demand
Then calculate the profit/contribution as question requests
What method of limiting factor analysis if there is only one constraint?
Using the contribution per limiting factor method
What method of limiting factor analysis if there is more than one constraint?
Use linear programming (simultaneous equations)
What is an incremental cost?
A marginal cost
The cost incurred by producing one additional unit of a product
What is outsourcing?
The use of external suppliers for finished products, components or services
Decision making from ROI and residual income
- Which one will generate more sales?
- Which one generates the most profits?
- Which one has the highest residual income
- Which one has the highest ROI
- ROI compared to the company’s target rate of return
- Residual income that is positive
Break even analysis - additional expenditure (e.g. advertising)
Calculate the new contribution of the product per unit
Multiply by number of units produced to get total contribution
Previous contribution - new contribution
If new total contribution is less than the original, don’t accept the additional expenditure project as it will make a loss for the company
What is the breakeven point calculation?
single product (units) = FC/ unit contribution (x selling price for £revenue)
multi-product (revenue) = FC/ WACS ratio
How is number of units for a target profit calculated?
(FC + Target Profit)/ unit contribution
When should overtime be accepted?
When labour is the scarce resource
And the premium paid for overtime is less than the shadow price
Since the shadow price is the maximum the company should pay for the overtime premium
When is transfer pricing used?
Within a decentralised business, when goods are transferred between divisions
What basis can transfer prices be set?
- Market price based
- Cost-based
- Opportunity cost
What is dual pricing and why is it used?
The range between the minimum acceptable to the buyer and the maximum the buyer would pay
Used to motivate managers and achieve goal congruence (maximising corporate profits)
Which basis of transfer prices is most likely to lead to dysfunctional behaviour?
Cost-based
If a division has spare capacity to transfer to another, how should the transfer price be set?
Dual pricing (sensible pricing) - to achieve goal congruence
Between:
- The minimum price that the seller would sell for (the variable costs)
- The maximum price that the buyer would buy from them for (the price they can get it for externally)
If the transfer price is set above the price charged from the external supplier, the division will buy from the external supplier, which will decrease group profit (by buying price from external - variable costs of internal production)
If a division is working at full capacity and all production can be sold on the external market, how should the transfer price be set?
Add the loss of contribution (from selling internally) to the variable cost of making the product
The division may want to purchase from an external supplier at a lower price
The contribution is the market price less the variable costs
What are the objectives of setting a transfer price?
- Goal congruence (maximise company’s overall profits, generally cheaper to buy internally)
- Performance evaluation
- Promote divisional autonomy (decision making freedom/ independence)
- Motivate divisional managers (profits)
- Optimise resource allocation
How can the transfer price affect the profits of the divisions of a company?
High transfer price set by selling division: higher profits for selling division, lower profits for the buying division (higher cost)
Since divisional managers are responsible for the profits of that division, the selling division will want the transfer price as high as possible. The buying division will want the transfer price as low as possible.
Transfer prices do not affect the profits of the company as a whole
