Module 1: Strategy, management accounting, and decision-making

Transcription

1 file:///f /Courses/ /CGA/MA2/06course/m01intro.htm Module 1: Strategy, management accounting, and decision-making Overview This introductory module provides an overview of the role of management accounting in creating and evaluating corporate strategy. It outlines the strategic management process and describes a framework for how managers make decisions. This module provides opportunities for you to review cost behaviour, linear programming, and uncertainty models, and concludes with a discussion of professional ethics in management accounting. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Assignment reminder Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). It is a good idea to review the assignment now so that you are familiar with the requirements as you work through Modules 1-5. Topic outline and learning objectives 1.1 What is strategy? Define the term strategy, and explain how managers determine corporate strategy. (Level 2) 1.2 PEST and SWOT analysis Identify and describe the role of PEST and SWOT analysis in corporate strategy. (Level 1) 1.3 Implementing strategy Summarize the management accountant's role in implementing strategy. (Level 2) 1.4 Planning and control Describe how management accounting facilitates planning and control processes. (Level 2) 1.5 Different kinds of costs Analyze costs to determine whether they are actual or budgeted, direct or indirect, variable or fixed. (Level 1) 1.6 Decision framing Outline the basic process in decision framing. (Level 1) 1.7 Decision models and uncertainty Explain the impact of uncertainty in decision models. (Level 1) 1.8 Linear programming Describe how linear programming can be used to solve management accounting problems. (Level 2) 1.9 Make-or-buy and add-or-drop decisions Evaluate relevant cost decisions using linear programming. (Level 1) 1.10 Management accounting and professional ethics Outline the role of professional ethics in management accounting. (Level 1) Module summary Print this module file:///f /Courses/ /CGA/MA2/06course/m01intro.htm [09/09/2010 1:45:07 PM]

2 file:///f /Courses/ /CGA/MA2/06course/m01t01.htm 1.1 What is strategy? Learning objective Define the term strategy, and explain how managers determine corporate strategy. (Level 2) Required reading Chapter 1, pages 1-5 (to The Value Chain of Business Functions Leads to the Customer) Chapter 13, pages (to Implementing the Balanced Scorecard ) LEVEL 2 Strategic management is the process a company uses to match its organizational capabilities with opportunities in the marketplace in order to accomplish its overall objectives. The organization first evaluates the external environment (also called environmental scanning) and the market or industry in which it operates by analyzing the following factors: Current competitors Market structure and the company's cost structure Potential of new entrants to enter the market Market attractiveness and barriers to entry Substitutes for the product or service offered Bargaining power of customers Bargaining power of suppliers (Adapted from Porter's Five Forces, which you learn more about in Module 7.) After evaluating the market a company plans its overall strategy to help it compete in the marketplace. To do this, managers develop strategies at various levels within the organization. The two levels this course focuses on are the corporate and business unit levels of strategy (see Exhibit 1.1-1). Corporate level strategy is about being in the right mix of businesses. Corporate strategy is concerned more with the question of where to compete than with how to compete in a particular industry; the latter is a business unit strategy. At the corporate level, the issues are (1) the definition of businesses in which the firm will participate and (2) the deployment of resources among those businesses. Corporate wide strategic analysis for a diversified company results in decisions about what businesses to add, retain, emphasize, deemphasize, and/or divest. Competition between diversified companies does not take place at the corporate level. Rather, a business unit in one firm (such as Procter & Gamble s Pampers unit) competes with a business unit in another firm (such as Kimberly Clark s Huggies unit). The corporate office of a diversified company does not produce profit by itself; revenues are generated and costs are incurred in the business units. Business unit strategies deal with how to create and maintain competitive advantage in each of the industries in which the company participates. Exhibit 1.1-1: Corporate and business unit levels of strategy 1 file:///f /Courses/ /CGA/MA2/06course/m01t01.htm (1 of 2) [09/09/2010 1:45:08 PM]

3 file:///f /Courses/ /CGA/MA2/06course/m01t01.htm When developing strategy at the business level, a company also develops a competitive advantage or strategy to compete in a given market. The following generic competitive advantages drive the development and implementation of the corporate level strategy at the business unit level: Cost leadership Offering products or services at low cost relative to competitors requires focus on increased efficiency, productivity, and cost control, and eliminating waste. Wal-Mart is an example of a cost leadership strategy in which the focus is on operational excellence. Product differentiation Offering products or services that are perceived by customers as superior or unique, relative to the competition, allows companies to charge a premium price. Porsche and Tommy Hilfiger are examples of companies that focus on product differentiation. In other words, a business organization first makes decisions about which business areas to compete within (corporate level strategy) and then decides within these markets how to compete (business level strategies). In terms of key success factors, when implementing business level strategies that is, when putting the corporate level strategy into action by determining the specifics of how to deliver the product or service to the market cost leadership requires a focus on cost, efficiency, and time, while product differentiation requires a focus on quality and innovation. Within each of these primary strategies, companies can also focus on a small portion or niche of the market. These are referred to as focused cost-leadership or focused differentiation strategies. An example is Porter Airlines, a Toronto based regional airline that offers flight services to a unique portion of the differentiated market. (Corporate and business unit level strategies are addressed in greater detail in Module 7.) 1 Source: Reading 7.4-1, page 6 file:///f /Courses/ /CGA/MA2/06course/m01t01.htm (2 of 2) [09/09/2010 1:45:08 PM]

4 file:///f /Courses/ /CGA/MA2/06course/m01t02.htm 1.2 PEST and SWOT analysis Learning objective Identify and describe the role of PEST and SWOT analysis in corporate strategy. (Level 1) LEVEL 1 The environmental scan must incorporate both quantitative and qualitative information from a variety of sources. In making decisions about which industries or businesses to compete within, the company must consider consumer demand and business capabilities, as well as future demand requiring political, economic, social, and technological (PEST) analyses of the market. The political analysis looks at the current political landscape and legal issues that the business unit might face. For example, new political leadership in the U.S. can have large implications for the future direction of the U.S. economy and its impact on Canada. Also, upheavals in Canadian politics could mean that there is no clear economic policy direction that the government can take, which might hinder the ability of companies to project future demand. The economic analysis must look at the potential impact that changes in interest rates, inflation, and unemployment could have on future demand. Other factors to consider include foreign direct investment, transparency of accounting and legal practices, market functions, GDP, GNP and other macro and micro economic implications to demand and supply flows. The social aspect looks at changes in future demand by customers based on changes in social demographics and consumer desires. For example, the movement of people from the city to the country (suburbs) caused a new demand for infrastructure and small and medium enterprises, as well as schools, hospitals, and so on. With recent increasing gas prices, this trend is reversing as the cost of transportation increases. The population of the baby boom generation will continue to age over the next 20 years, offering new business opportunities and advances in healthcare also mean that this older generation is healthier, creating changes in demand for travel and recreation. The technological boom of the past 30 years continues to accelerate, which means that certain product lifecycles continue to shrink. Where technology firms had 5-7 years to recover research costs in the 1970s, this has been reduced to 1-3 years in this decade, requiring a much greater emphasis on pricing and cost recovery determinations. SWOT analysis When determining corporate strategy, management scans the external environment for opportunities (O) and threats (T) that can affect the corporation in relation to the Five Forces introduced in Topic 1.1, and also analyze its internal environment for strengths (S) and weaknesses (W). SWOT analysis is critical to determining which strategy will best fit the organization in light of its external operating environment. SWOT analysis can be useful in identifying and matching the company's core capabilities (those things that the company does better than the competition), with the external environment, and determining how these can be used for competitive advantage in the market. Strengths can include strong research and development, cash flows, and market presence or branding held patents weak customer or supplier power, and good reputation Weaknesses can include weak research and development programs, cash flows, and product branding ending of patent protection strong customer or supplier power, and file:///f /Courses/ /CGA/MA2/06course/m01t02.htm (1 of 2) [09/09/2010 1:45:09 PM]

5 file:///f /Courses/ /CGA/MA2/06course/m01t02.htm high cost structure. Opportunities arise from competition, the market, or the economy, and can include any chance the organization has to increase market share and gain new sales (for example, following the collapse of a competitor). Other factors to consider are lowering of interest rates, reduction in trade barriers for foreign expansion, and favourable news releases (for example, articles indicating red wine is good for the heart can stimulate wine sales). Threats arise from competition, political changes, or the economy, and can include reduction in domestic trade barriers change in government policy that increases the cost of production (for example, meeting international environmental standards) increase in interest rates, or new competitors. A shift in consumer demand can also lead to decline in sales, (for example, raising awareness of healthier diets can have a negative impact on junk food sales). file:///f /Courses/ /CGA/MA2/06course/m01t02.htm (2 of 2) [09/09/2010 1:45:09 PM]

6 file:///f /Courses/ /CGA/MA2/06course/m01t03.htm 1.3 Implementing strategy Learning objective Summarize the management accountant's role in implementing strategy. (Level 2) Required reading Chapter 1, pages 5-9 LEVEL 2 Once the corporate-level strategy (what business do we want to be in?) has been decided, managers must implement the strategy at the business level. This is accomplished by managing the sequence of business functions in which value to the customer is added to the product or service throughout the organization (the value chain). The management accountant provides information that managers use to make decisions within the value chain, specifically: research and development, product and process design, production, marketing, distribution, and customer service. Management accountants also provide information on the flow of goods and services from raw supplies to final customer (the supply chain) and help management improve productivity, efficiency, and value creation. Management accountants help managers track the performance of the key financial and nonfinancial success factors of cost, efficiency, effectiveness, quality, time, and innovation. This tracking and analysis can lead to continuous improvement, and allows managers to benchmark to the competition. Measuring the success of strategy the Balanced Scorecard Management accountants also aid in the company's planning and control functions by providing information on the effectiveness of the strategy implementation. This is done by assessing feedback and taking controlling action as necessary, which may result in adjustments to strategies that a company has implemented. Managers have traditionally relied on financial feedback such as return on investment, a lag indicator that can be manipulated through accounting policy choices, as a basis for control. This limited view of the corporation did not take into consideration the other factors that contribute to a corporation s successful implementation of strategy. The Balanced Scorecard (BSC) is a tool that allows management to view key perspectives that contribute to corporate profitability utilizing both financial and non-financial performance indicators. (Module 9 builds on the BSC concepts introduced in MA1 Management Accounting Fundamentals.) file:///f /Courses/ /CGA/MA2/06course/m01t03.htm [09/09/2010 1:45:09 PM]

7 file:///f /Courses/ /CGA/MA2/06course/m01t04.htm 1.4 Planning and control Learning objective Describe how management accounting facilitates planning and control processes. (Level 2) Required reading Chapter 1, pages 9-13 LEVEL 2 Planning and control are critical to determining whether management's strategy is implemented effectively. Planning is the role of choosing goals, predicting results under various ways of achieving those goals, then deciding how to attain them. Planning is done prior to strategy implementation, to help managers decide how to best utilize available financial and nonfinancial resources The budget is the quantitative expression of the proposed strategy, including both historical and expected financial and nonfinancial information. It expresses the strategy by describing the goals, production, distribution, and customer service necessary to achieve stated sales goals, anticipated cash flows, and potential financing needs. Control is a feedback system that covers both the action that implements the planning decision and the performance evaluation of personnel and operations. Exhibit 1-4 on page 10 illustrates how the planning and control functions are interrelated. Using methods such as management-by-exception (identifying areas of the business that are not operating within accepted norms) and variance analysis (difference between actual and budgeted amounts), managers compare actual results of the implementation to the budgeted amount. This analysis helps management determine the effectiveness and efficiency of implementing the corporate and business-level strategies and to decide whether changes in strategy or implementation are necessary. Example 1.4-1: Meatpacking plants Planning and control You manage a food-processing firm with two meatpacking plants, one in Calgary and one in Swift Current. A simplified manufacturing overhead budget for the Calgary plant for the fiscal year 20X1 is shown in Exhibit Manufacturing overhead consists of costs related to production but is difficult to trace to cost objects. In this situation, the cost objects are "Steaks" (individual units of product) and "Products sold to the consumer either frozen or fresh" (segments of production). The costs included in this budget are therefore common to "Steaks" and "Products sold to consumers" produced at the Calgary plant. Exhibit 1.4-1: Calgary plant 20X1 processing overhead budget ($000s) Depreciation, equipment $ 10,000 Indirect labour 2,000 Indirect materials 1,200 Insurance, property and liability 150 Lease, plant 1,000 Maintenance 500 Utilities 200 Total $15,050 This budget assumes a certain level of sales and a given sales mix (for example, the proportion of fresh to frozen meat sold). If the actual level of sales were to be different in 20X1 (say, the sales of fresh meats were 20% greater than expected), then file:///f /Courses/ /CGA/MA2/06course/m01t04.htm (1 of 3) [09/09/2010 1:45:10 PM]

8 file:///f /Courses/ /CGA/MA2/06course/m01t04.htm the following would occur: Some of these actual numbers would be different than budgeted. The cost of utilities would be higher because more power would be required to operate meat-cutting equipment. Maintenance of the equipment, such as replacement of blades, would likely change. Other costs would remain the same, regardless of moderate changes in sales level and mix. Depreciation of equipment, for instance, would not change in response to increases in sales levels on the order of 10% or 20%. As manager of the Calgary plant, you can use this overhead budget as a planning tool because it reflects your expectations regarding resource needs for 20X1, given a certain sales forecast. The cost of equipment that needs to be replaced or upgraded represents part of the depreciation budget of $10 million; the number of required production supervisors is reflected in the indirect labour cost of $2 million; and so on. Care must be taken though when reading a budget to remember that depreciation is not a cash expense and to replace equipment, cash will be required. The budget can also be used as a control tool by the firm's president, to whom you report. You are paid a bonus each year depending on your ability to meet the total overhead budget, although some of the budget may have to be adjusted up or down if sales volume or mix is different than expected. The president will leave it up to you to trade off some costs against others (for example, investing in new equipment while reducing maintenance expenditures on aging equipment), but will expect you to limit total overhead costs to approximately $15 million. From the president's point of view, the only incremental cost of this control is the cost of your bonus, should you maintain adequate control. There has been no other investment in control, such as hiring an internal auditor to monitor overhead spending at the Calgary plant. Unexpected changes Suppose that the following two events occur in the first quarter of 20X1: First, due to deregulation of utilities in Alberta and substantial decreases in the price of natural gas, the cost of utilities is projected to be 30% less than expected for the remaining three- quarters of the year. Second, you are able to negotiate insurance contracts, effective in the second quarter, for 25% less than your expected annual cost of $150,000. In total, the expected cost reduction for the remaining three-quarters amounts to $73,125 as follows. Utilities: 30% 3/4 $200,000 $45,000 Insurance: 25% 3/4 $150,000 28,125 Total expected reduction in expense $73,125 From a planning perspective, does it make sense for you to revise your overhead budget? Yes, it does make sense since you are using the budget as a planning tool. Moreover, you intend to use the adjusted budget as a starting point in setting next year's budget. From a control standpoint, does it also make sense for the president to revise the budget for the purpose of calculating your bonus, in response to the changes in utilities and insurance costs? One way to answer this question is to ask: "How would I feel if the president reduced my overhead budget by $73,125?" Even though the reduction is small compared to the total budget of $15 million, you would be discouraged, at least with respect to the effort you spent in reducing insurance costs. You managed to reduce costs, yet your only reward will be a more difficult budget target to meet for 20X1. Furthermore, suppose that costs of indirect materials increase suddenly through next year. Will you expect the president to increase your budget by that amount for the year after that? Eventually, you may come to expect adjustments from the president whenever prices of overhead items change, whether you have little control over them (as in the case of utilities rates) or substantial control (insurance). In order to motivate you to control spending on overhead, or at least to avoid discouraging you from controlling it, the president must commit to the original budget target of $15 million. This means ignoring the changes in utilities and insurance costs. The bonus paid may turn out to be larger than it would have been if the budget had been changed but in the long run file:///f /Courses/ /CGA/MA2/06course/m01t04.htm (2 of 3) [09/09/2010 1:45:10 PM]

9 file:///f /Courses/ /CGA/MA2/06course/m01t04.htm it would be costly, in terms of the president's time, to frequently renegotiate the overhead budget. As well, you as manager would have less motivation to meet budget expectations if the budget is frequently changed. In Example 1.4-1, there are good reasons to use different numbers for planning and control purposes the adjusted budget for planning and the original budget for control. In other situations, however, it is feasible to use the same numbers for both purposes. For instance, standard absorption inventory costs can sometimes be used both to control production costs and set prices that are expected to be maintained over a relatively long time period. You should always orient yourself along the planning control continuum when providing or using managerial accounting information. Is one role more important than the other, or are they equally important in the given decision-making context? By asking yourself this question, you stand a better chance of using numbers that enable you or your management audience to make better decisions. file:///f /Courses/ /CGA/MA2/06course/m01t04.htm (3 of 3) [09/09/2010 1:45:10 PM]

10 file:///f /Courses/ /CGA/MA2/06course/m01t05.htm 1.5 Different kinds of costs Learning objective Analyze costs to determine whether they are actual or budgeted, direct or indirect, variable or fixed. (Level 1) Required reading Chapter 1, pages (to Organization Structure Line and Staff Relationships) Chapter 2, pages LEVEL 1 Actual costs are incurred in the course of business, while budgeted costs are the amounts that are expected to be incurred. Direct costs can be easily traced directly to a cost object. Indirect costs are related to the cost object but cannot be easily traced directly. With variable and fixed costs, the distinction is evident in the behaviour of the cost. Variable costs change the total cost based on the number of units, and the cost per unit does not change. Fixed costs stay the same over a given range of units, so the unit cost will vary based on the number of units produced. An understanding of the fundamental differentiations in cost is paramount to understanding advanced management accounting and in making effective business decisions. See how well you understand these concepts by working through the following activity. Activity 1.5-1: Cost behaviour This activity reinforces the concept of different kinds of costs, using the scenario of a company that makes movie DVDs and music CDs. It is also important to remember that the management accountant takes into consideration that costs are appropriately interpreted and presented. The cost of resources should be weighed against the benefits to ensure that the final decision regarding resource allocation assists the organization in achieving its goals. Costs should also be presented in a way that assists management in making prudent decisions and provides attainable goals for both management and employees. file:///f /Courses/ /CGA/MA2/06course/m01t05.htm [09/09/2010 1:45:10 PM]

11 file:///f /Courses/ /CGA/MA2/06course/m01t06.htm 1.6 Decision framing Learning objective Outline the basic process in decision framing. (Level 1) Required reading Chapter 11, pages Note on the required reading On page 538 in the text, the third paragraph calculates the increase in operating income based on accepting the special order from the luxury hotel chain. It states that Surf Gear would gain an additional $17,500 in operating income per month. However, page 537, third paragraph, states that there will be no subsequent sales to this hotel chain. LEVEL 1 Management accountants help managers in problem-solving, scorekeeping, and attention-directing by analyzing situations that require management attention, gathering information, reducing the scope of the alternatives, and identifying the best alternative to achieve corporate goals. Throughout your CGA program of studies you will be introduced to a number of decision processes. One methodology that is used throughout the textbook is presented on page 530 (Exhibit 11-1). When making decisions, managers need to define the problem or issue within the context of the situation facing them; that is, they need to operationalize the problem. This is the context of decision framing. Decision framing places a given problem into a framework of variables to create boundaries on the nature of the problem. Framing leads to optimal decisions when managers follow the three principles of consistent framing: the irrelevance of increasing transformations, the importance of local searches, and the need for component searches. Irrelevance of increasing transformations In the context of maximizing profit, adding or subtracting a constant dollar amount is irrelevant, since doing so will not change profit-maximizing quantities. For example, a make-or-buy decision (a short-run profit-maximization problem) can be framed either in terms of incremental profit frame or in terms of total profit frame. In the incremental profit frame, the alternative of outsourcing the product is preferred if incremental revenue exceeds the incremental costs. The incremental frame ignores fixed costs because they do not change in either make or buy decisions. In the total profit frame, the total profit is calculated for each of the alternatives, and the difference should equal the profit figure obtained under the incremental profit frame. In this total profit frame, because the fixed costs are added to both make and buy options, the total profit frame is an increasing transformation of the incremental frame. To test whether your framing is consistent, first solve the problem with the incremental profit frame. Second, solve the same problem using the total profit frame. Third, compare the final results. The result must be the same under both frames; otherwise, your framing was not consistent. Now you can look for the reasons for the inconsistency. For example, you may have forgotten to include in your incremental profit frame revenues that could be earned from leasing a space freed by the alternative of discontinuing production if the product or service is outsourced. Importance of local searches Managers must pre-screen decision alternatives. In framing decisions, managers reduce the number of alternatives to be considered to a limited set of perhaps three or four options. This pre-screening leads to optimal decisions as long as the benefits associated with the excluded options opportunity costs are not greater than benefits of the option chosen for solution. For example, managers choosing to outsource can initially look globally for possible sources. However, they will limit their choices based on such factors as accessibility to the market, cost, quality of production, and subsequently narrow the choice to the best three or four countries. file:///f /Courses/ /CGA/MA2/06course/m01t06.htm (1 of 3) [09/09/2010 1:45:11 PM]

12 file:///f /Courses/ /CGA/MA2/06course/m01t06.htm Pre-screening requires judgment, and a manager can never be certain that a better option was not missed. However, some framing in the form of restricting options for detailed study is unavoidable. Need for component searches To solve profit-maximization problems, it must be possible to break a profit function into cost and revenue components. Assume that you are given a profit function as graphed in Exhibit An example would be where a product demand increases to a given point (maximum profit). To increase sales beyond this point, discounts would be necessary to increase revenues but this would diminish profitability. Exhibit 1.6-1: Profit function Maximum profit is reached when the vertical line between the curve and the x-axis is greatest. It is possible to search components because the profit function can be broken down into two components: a nonlinear revenue function and a nonlinear cost function. This results in functions as described in Exhibit Exhibit 1.6-2: Economic functions of revenue and cost file:///f /Courses/ /CGA/MA2/06course/m01t06.htm (2 of 3) [09/09/2010 1:45:11 PM]

13 file:///f /Courses/ /CGA/MA2/06course/m01t06.htm Maximum profit occurs where the vertical distance between the two curves is the greatest (that is, at point T, the revenue curve being above the cost curve). Then, these functions of total revenue and total cost can be approximated linearly (using LLAs local linear approximations). Activity 1.6-1: The decision-making process Activity defines the qualitative considerations that go into decision making at the management accounting level, and outlines the steps in quantitative analysis for decision making. Work through the activity for a synthesis of the decisionmaking process. file:///f /Courses/ /CGA/MA2/06course/m01t06.htm (3 of 3) [09/09/2010 1:45:11 PM]

14 file:///f /Courses/ /CGA/MA2/06course/m01t07.htm 1.7 Decision models and uncertainty Learning objective Explain the impact of uncertainty in decision models. (Level 1) Required reading: Chapter 3, pages LEVEL 1 Decision models are designed to provide managers with tools to make decisions among different alternatives, using decision criteria. The problem with most models is that they generally consider only one set of variables at a time, and compute one output. To be accepted or rejected, the output must then be compared to some predetermined barrier or criteria. This does not echo how decisions are made in reality. Because of the uncertainties that exist in business, this process is much more complex in the real world. Situational factors also differ between theoretical models and real-world applications. Factors such as industry and market structure, ownership structure, size, demand-and-supply variables, interest rates, political changes, inflation, management compensation, regulation changes, and globalization (to name just a few), create uncertainty when managers undertake to make decisions. The timeframe from decisions to actual implementation can also hinder the success of a proposal under consideration, as these factors also change over time. To make effective decisions, management should run multiple scenarios that consider a wide range of possibilities. This is referred to as sensitivity analysis, which indicates how sensitive the results of the modeling are to changes in economic and other variables. For example, when running a make-or-buy decision model, sensitivity analysis can be included by changing conditions to include opportunity costs, which can change the outcome substantially; or adding the opportunity cost of the next-best alternative use of resources may change the make decision to a buy decision. However, consideration of the impact of any decision on company image and fit with its strategic goals should all be taken into account. Topic 1.8 also uses sensitivity analysis when attempting to maximize profits with constrained resources. The topic of sensitivity analysis will recur throughout the course as managers are always interested in what effect a change in certain factors will have on profitability. You may have observed in your workplace that sometimes changes meant to help improve process decisions end up actually adding to uncertainty. For example, additional problems are caused when just-in-time (JIT) purchasing (covered in your introductory management accounting course) leads to stockout situations. To justify any change, a thorough and rational decision model based on cost-benefit analysis needs to be evaluated in each case. Ethical decision making Management accountants are responsible for creating decision models and are often also responsible for data gathering and assessment of the output of the decision model. All decision models are predicated on the premise that ethically responsible professionalism has gone into the creation of and completion of the model and therefore into the final output. The code of ethics from the Institute of Management Accountants (IMA) requires that all management accountants behave with competence, confidentiality, integrity, and objectivity. Management accountants are responsible, as auditors are, to protect the public interest. To behave responsibly and ethically and in a way that protects the public interest, they must ensure that their information has been provided competently, with integrity and objectivity, and in a way that protects the confidentiality of the organization. (Topic 1.10, provides more detail on this subject and about the IMA). file:///f /Courses/ /CGA/MA2/06course/m01t07.htm [09/09/2010 1:45:11 PM]

15 file:///f /Courses/ /CGA/MA2/06course/m01t08.htm 1.8 Linear programming Learning objective Describe how linear programming can be used to solve management accounting problems. (Level 2) Required reading Chapter 11, pages LEVEL 2 A number of tools have been developed to assist managers in making optimal decisions to solve management accounting problems. One such tool is linear programming. Knowing how to formulate and interpret a linear program will help you determine the optimum production plan, analyze various overhead costing schemes, decide whether to make or buy a product, and solve special-order problems (which factor in capacity cost). Linear programming (LP) is so called because it requires solving sets of simultaneous linear equations. LP has applications in many diverse areas. For example, a manufacturer might be interested in designing a production schedule that minimizes total production, inventory holding, and labour change-over costs; or a marketing manager might need to know the best way to allocate a fixed advertising budget among different advertising media. The common theme to each problem is the need to minimize or maximize some quantity, usually cost or profit (the objective), within certain resource restrictions (the constraints). In general, there are three types of constraints: Resource constraints determine the available resources such as labour-hours, machine-hours, and raw materials. Structural constraints describe the production and use of products. Marketing constraints indicate the maximum or minimum sales levels of products. Steps in linear programming Step 1: Determine the objective. What is the goal? Write the goal in terms of an equation. This equation is called the objective function. Step 2: Specify the constraints. Like the objective, each constraint needs to be written in the form of an equation, which will be either an equality or an inequality. These equations are mathematical models of the relationships in the problem. Step 3: Compute the optimal solution. There are three approaches to compute the optimal solution: trial-and-error, graphic, and computer modeling. Trial-and-error approach Refer to Exhibit on page 555. Graphing the possible options results in 5 "corners represented by dots on the graph: (0,0), (75,90), and so on. Page 554 provides a series of steps that can be taken to arrive at the answer. The following steps provide a similar method that can be used to arrive at the same solution. Try each of the 5 coordinates in the formula, and solve the following equations for each. 2S + 5B = 600 (1) 1S + 0.5B = 120 (2) To equate the 2 lines, eliminate the S or B by multiplying one line so that either the S or B is equal. file:///f /Courses/ /CGA/MA2/06course/m01t08.htm (1 of 3) [09/09/2010 1:45:12 PM]

16 file:///f /Courses/ /CGA/MA2/06course/m01t08.htm Multiply (2) by 2 2S + 1B = 240 (3) but 2S + 5B = 600, or 2S = 600 5B Substituting 2S = 600 5B into 2S + 1B = 240 gives you: 600 5B + 1B = 240 Thus, 4B = 360 Therefore B = = 90 Substituting for B in (2) 1S + 0.5(90) = 120 Solving for S S = = 75 Given S = 75 and B = 90, TCM = $240(75) + $375(90) = $51,750 Now you have the total contribution margin (TCM) equation, apply this to each of the other corner points. Point (0,0) TCM = $240(0) + $375(0) = $0 Point (0,110) TCM = $240(0) + $375(110) = $41,250 Point (25,110) TCM = $240(25) + $375(110) = $47,250 Point (75,90) TCM = $240(75) + $375(90) = $51,750* Point (120,0) TCM = $240(120) + $375(0) = $28,800 * Indicates the optimal solution Graphic approach Choose an artificial contribution margin, for example $12,000. Solve the equation $240S + $375B = $12,000 (using a 0 point for each of S and B to identify two points that you can use to draw a line). Choosing S=0, you get $240(0) + $375B = $12,000, B = 32. Thus, the point (0,32) solves the equation. Choosing B=0, you get $240S + $375(0) = $12,000, S = 50. Thus, the point (50,0) solves the equation. Refer again to Exhibit on page 555. Graphing the two points, you get the dotted line represented. You can choose additional contribution-margin points, which are represented by additional dotted lines in Exhibit (Each dotted line is parallel to the first line computed). To find the optimal data point, use a ruler to identify the furthest parallel dotted line contained in the feasible solution area. Point (75,90) represents the optimal point. Sensitivity analysis and linear programming Sensitivity analysis can also be performed when dealing with future projections or uncertainties. Any change in the variable, fixed, or nonfinancial information can have dramatic impacts on the equations, and would alter the optimal situations. For example, assume that a learning curve will reduce the number of machine-hours and thus reduce the variable cost of boat engines, which will increase the contribution margin for the engines. This would alter the optimal decision. Changes in inflation, supplier costs, mix of employees in a production shift, or new technologies can affect the optimal situation because each has the potential to affect the contribution margin and changes in efficiencies can alter the constraints. In the previous example, if a learning curve was to increase the contribution margin of the boat engine to $400 from $375, and reduce the number of hours to manufacture a boat engine from 5 to 4 hours per engine, increasing the daily maximum to 150 boat engines, you would have the following: 2S + 4B = 600 (1) 1S + 0.5B = 120 (2) To equate the two lines, eliminate the S or B by multiplying one line so that either the S or B is equal: Multiply (2) by 2 2S + 1B = 240 (3) equating the S Subtracting (3) from (1) 3B = 360 file:///f /Courses/ /CGA/MA2/06course/m01t08.htm (2 of 3) [09/09/2010 1:45:12 PM]

17 file:///f /Courses/ /CGA/MA2/06course/m01t08.htm Therefore B = = 120 Substituting for B in (2) 1S + 0.5(120) = 120 Therefore S = = 60 Given S = 60 and B = 120, TCM = $240(60) + $400(120) = $62,400 Sensitivity analysis can be used to determine the impact of a change in parameters. The effect of changes can be determined by calculating the shadow price, which is covered in detail in the next topic. This scenario is calculated as follows: Incremental change in the contribution margin one-unit change in the constraint associated with this variable Note: Solver can be used for sensitivity analysis. Before continuing to the next topic, work through the Foundation Reviews 1, 2, and 3. file:///f /Courses/ /CGA/MA2/06course/m01t08.htm (3 of 3) [09/09/2010 1:45:12 PM]

18 file:///f /Courses/ /CGA/MA2/06course/m01t09.htm 1.9 Make-or-buy and add-or-drop decisions Learning objective Evaluate relevant cost decisions using linear programming. (Level 1) Required reading Chapter 11, pages LEVEL 1 Note: For a refresher on interpreting the results of Solver, refer to Foundation Review 3 and Mathematics for Business: The CGA Reference Handbook, pages Linear programming applies to various types of relevant costing decisions, including product-mix decisions using the Solver program. Under certain circumstances, make-or-buy and add-or-drop product decisions can also be incorporated into linear programming situations. For make-or-buy decisions, costs of producing a product must be cost of purchasing, taking into account production constraints, to justify making the product. Similarly, where the making of a product uses resources that are also used in the production of other products, buying the product externally may change the optimal mix of existing products, which could affect their segment margins. Sensitivity analysis can be included in the decision-making process by changing conditions to include opportunity costs for next best alternative use of resources. For add-or-drop decisions, when the contribution margin is less than the relevant costs (that is, those revenue and expenses that change depending on whether the decision to drop the product line is made), the product should be dropped. In this case, data on partial savings must be built into the equation. When the product contribution margin exceeds the relevant costs, the product should be kept. Remember, that in certain situations, there may be partial cost savings (for example, electricity on machines or insurance costs). Expansions of the use of linear programming for add-or-drop decisions could include the impact of changes in production scheduling (optimum output). The most common use of linear programming, however, is when there are constraints in the production of products. This is demonstrated in the following computer illustration. Computer illustration 1.9-1: Shallow Inc. file:///f /Courses/ /CGA/MA2/06course/m01t09.htm [09/09/2010 1:45:12 PM]

19 file:///f /Courses/ /CGA/MA2/06course/m01t09.ci.htm Computer illustration 1.9-1: Shallow Inc. Updated September 7, 2010, MA2-10-TU04 Read Example FR2-1 in the linear programming section of the Foundation review for the background information on the Shallow Inc. case. Shallow Inc. produces two types of goldfish bowls (round and square), which require glass bases and metal bases (for square bowls only), as well as shaping in the furnace. Formulating the problem as a linear programming model, the problem is as follows: Maximize 6x 1 + 8x 2 Subject to 2x 1 + 2x 2 1,600 2x 1 + 4x 2 2,000 x x 1 0, x 2 0 Material provided File MA2M1P1 containing a partially completed worksheet, M1P1 and the solution worksheet M1P1S Answer Report 1 and Sensitivity Report 1 (output from Solver) Procedure 1. Before you begin working on the data files in this course, you must first download them and save them to your hard drive. Click the Data files link in the course introduction, then follow the instructions for downloading and saving the files. 2. Open the file MA2M1P1 from the data folder. 3. Review the layout of the spreadsheet. The data table contains the basic information for the problem. Make sure you understand the formulas in cells B23 to B25. The formula in cell B23 is SUMPRODUCT($D17:$E17,C11:D11). This formula takes the value in cell D17 and multiples it by the value in cell C11, then adds it to the product of the values in cell E17 times D11. This formula calculates the total furnace hours used in producing both products based on the number of units produced of each. Cells D17 and E17 are the variables. 4. Note that initial values have been entered in cells D17 and E Select Solver from the Tools menu on the toolbar. The Solver parameters dialogue box will appear. If you have Office 2007, then choose Data and click on Solver. If Solver is not available on your Tools menu, instructions are available from Microsoft by pressing F1 and searching for Solver. 6. Click the Options button and select Assume Linear Model and Assume Non-Negative to ensure that a linear model is used (that is, with no exponents) and that solutions including negative values for choice variables (that is production numbers) are not used. Click OK to return to the Solver Parameters dialogue box. 7. Set the target cell to B20. To select $B$20, drag the Solver Parameters dialogue box to reveal cell B20, then click the cell once. The cell reference of $B$20 will appear in the Set Target Cell box. Click Max for Equal to. This tells Excel that you want the cell containing the total net profit to be maximized in solving the linear problem. 8. Click the By Changing Cells box and select cell D17: E Click the Subject to the Constraints box and then click Add. This brings you to the Add Constraints dialogue box. The first constraint is that the furnace hours can not exceed Enter cell B23 in Cell Reference. Using the drop-down box choose <= then set D23 in the Constraint box. Then click the OK button to return to the Solver Parameters dialogue box. If you made an error entering the constraint, you can change it by selecting the constraint and clicking the Change button. file:///f /Courses/ /CGA/MA2/06course/m01t09.ci.htm (1 of 2) [09/09/2010 1:45:13 PM]

20 file:///f /Courses/ /CGA/MA2/06course/m01t09.ci.htm 10. Add the remaining constraints for the problem as follows: Cell reference Constraint B24 D24 B25 D You are now ready to solve the linear program. In the Solver Parameters dialogue box, click Solve. The Solver Results dialogue box will appear. Ensure that the Keep Solver Solution is selected. In the Reports box, click both Answer and Sensitivity Reports to select them and then click OK. Note: A bug has been discovered when trying to execute these instructions in Excel If you are following the instructions in the assignment and running Excel 2007, you will get the following error message: "An unexpected internal error occurred or available memory was exhausted." Here are alternative instructions that will allow you to complete the computer illustration using Excel 2007: You are now ready to solve the linear program. In the Solver Parameters dialogue box, click Solve. The Solver Results dialogue box will appear. Ensure that Keep Solver Solution is selected. Click OK. Then click Solver again. All the parameters will already be entered, so click Solve. In the Reports box, click both Answer and Sensitivity Reports to select them. Ensure that Keep Solver Solution is selected, and then click OK. 12. At the bottom of your worksheet, you will see six tabs listing the various worksheets. You can scroll from left to right using arrows in the bottom left-hand corner of the screen to access tabs of hidden reports and worksheets. Click the Answer Report 2 tab, which is the report you created with Solver. Compare it with the worksheet on the Answer Report 1 tab, which is the correct solution for this problem. The Answer Report reminds you what your original values were (column D) and states that the first two constraints were binding (see cells F19 and F20). The optimum amount to produce is 600 Round and 200 Square goldfish bowls. 13. Now click the Sensitivity Report 2 tab to display the results of the sensitivity analysis. Compare it to the results in the Sensitivity Report 1 worksheet, which is the solution. If you wish to return to the original worksheet, select the tab labeled M1P1. If you create several reports from the same worksheet, more tabs will be created at the bottom; for example, Answer Report 3. Notice that the shadow prices are 1 for furnace hours and 2 for glass used (cells E15 and E16). Procedure to calculate the shadow price 14. Now let's have some fun! To demonstrate the meaning of a shadow price, try to change the first constraint to 1999, then to 2001, and solve the problem each time. When the Solver Results dialog box comes up, you do not need to keep the Answer, Sensitivity or Limits Reports, just click OK to see the solution found. The shadow price for the furnace hours binding constraint is the decrease in net profit when compared to the solution of the original program: Net profit in the original linear program $ 5,200 Less: Net profit with the tightened constraint _ (5,199) Equals: Shadow price of furnace hours constraint $ Now, relax the glass constraint and change the value in cell D24 to 1601 and The shadow price for the glass constraint is: Net profit in the original linear program $ 5,200 Less: Net profit with the relaxed constraint (5,202) Equals: Shadow price of glass constraint $ (2) To conclude, the shadow price represents the increase (decrease) in net profit by relaxing or tightening a binding constraint. Note that the same solution calculated in the linear programming is found using Solver in a fraction of the time. Foundation Review example FR3-1 shows the use of Solver with sensitivity analysis. file:///f /Courses/ /CGA/MA2/06course/m01t09.ci.htm (2 of 2) [09/09/2010 1:45:13 PM]

21 file:///f /Courses/ /CGA/MA2/06course/m01t10.htm 1.10 Management accounting and professional ethics Learning objective Outline the role of professional ethics in management accounting. (Level 1) Required readings: Chapter 1, pages ERH (available under Resources), C2: Ethical issues in accounting ERH, C3: CGA-Canada s ethical principles and rules of conduct ERH, C6: The ethics of managerial and financial accounting ERH, C6: Corporate Greed vs. IMA s Ethics Code LEVEL 1 Corporate social responsibility (CSR) and corporate governance are gaining increased awareness globally. While there is no universal definition, Industry Canada characterizes CSR as the private sector s way of integrating the economic, social, and environmental imperatives of their activities. On the other hand, corporate governance requires the company to comply with existing laws. Accountants are called upon to provide professional judgment in many situations where the CICA Accounting Handbook does not identify what should be done, or where alternatives are allowed. In each case, professional ethics must be considered, as accountants are responsible for the integrity of the financial information provided to internal and external stakeholders. Each professional organization has its own ethical guidelines, which must be adhered to by each member of the organization. Self-governance includes monitoring members of the organization and disciplining those who violate the ethical guidelines. The text uses the Ethical Guidelines of the Society of Management Accountants of Canada, but you should review the CGA- Canada Code of Ethical Principles and Rules of Conduct (CEPROC), which can be found in the Reference library under Resources. The balance of the ERH readings should provide you with a good sense of the issues faced by accountants in general and management accountants in particular. Now read Problem 1-32 on page 32 of the text. Take some time to think through the answers you would come up with before moving on to the suggested solution. Suggested solution file:///f /Courses/ /CGA/MA2/06course/m01t10.htm [09/09/2010 1:45:13 PM]