Performance Management: In the First of Two Articles, Ian Janes Analyses the Principles Underpinning the Types of Decision-Making Scenarios to Be Found in the New P2 Paper

Article excerpt

Decision-making is a big part of most accountants' jobs. They regularly have to take, or provide the information for, key business decisions, both on a day-to-day basis and for the longer term. This is also true of candidates studying paper P2, which requires many fundamental choices to be made.


Probably the most crucial element in decision-making is the cost-benefit analysis, where we take into account the cost and revenue implications of the options open to us. It's important to recognise that making decisions on a financial accounting (absorption) costing basis is likely to be inappropriate, because the fixed cost element may not be affected by a particular course of action. Instead, many decisions are based on contribution. The measurement of this (contribution per unit equals the selling price per unit minus the variable cost per unit) is really a form of marginal or cost-benefit analysis that's used when you're faced with choices such as selecting which products to make if there's a shortage of resources, or deciding whether to accept or reject a sales order.

More generally, if the benefits of doing something will exceed the costs, the decision should be to go ahead and do it, but many benefits and costs are difficult to quantify. For example, we can all appreciate that working a few hours' overtime costs us some leisure time in order to earn some extra money. Harder to measure is the less tangible benefit of getting the job done balanced against the cost of, say, feeling more tired. Fortunately, the decision-making problems you will encounter in the P2 exam will focus on the variables that we can measure and analyse more easily.

Let's consider how we can use contribution analysis to solve a problem concerning scarce resources, which is a scenario that's regularly examined. Obviously, for most companies in most situations, market demand will be the limiting factor on operations--businesses will do their utmost to ensure that they have the resources to make a sale. But what if there's an unavoidable short-term lack of, say, skilled labour or a particular component? The key concept here is that the most beneficial production plan will be made when we prioritise production in such a way that the contribution per unit of the scarce resource is maximised.

Consider company X, which provides three different services, denominated as units of service for ease of analysis (see table 1, previous page). If labour hours are a limiting factor, then the provision of services needs to be prioritised. Note that any fixed costs are not relevant to the decision, providing that all three services use the same central facilities.

The incorrect response would be to state that BL501 is the best service to provide at 60 [pounds sterling] contribution per unit; then SJ301 at 48 [pounds sterling] per unit if resources allow; and, lastly, GS365 at 40 [pounds sterling] per unit if there are any hours left. This is the answer of a weak candidate. In a multiple-choice objective test question it would undoubtedly be included as one of the incorrect options.

The correct response is to consider the contribution per labour hour. That makes GS365 the service to prioritise, because it gives the best return (cost-benefit trade-off) of 33.33 [pounds sterling] per unit per labour hour. Next in line is S J301 (12 [pounds sterling]) and only then, if resources allow, BL501 (10 [pounds sterling]).

If you're still unconvinced that GS365 is the top-priority service, suppose that there are only 60 labour hours available. In this time company X could provide: 20 units of GS365, giving a contribution of 20 x 40 [pounds sterling] = 800 [pounds sterling]; or 15 units of SJ301, giving a smaller contribution of 720 [pounds sterling]; or only ten units of BL501, giving a contribution of a mere 600 [pounds sterling].

Of course, there may not be demand for 20 units of GS365. …