Types of decisions

CASE STUDY4

Dateposted

12/12/14

Due date

12/15/14 by 12:00 PMEST

Name

Charlotte Agyemang

Types ofdecisions

Please read the case study carefully and answer the questionsbelow

A business continually makes decisions at all levels. Think of a retailer such asNext.Tokeepthebrand’shighprofileposition, itsmanagershavetomakemanydecisions. Each major strategic decision leads to tactical decisions, which break downinto operationaldecisions.

Decisions are broadly taken at threelevels:

· Strategic decisions are big choices of identity anddirection.

Whoarewe?Whereareweheading? Thesedecisionsareoftencomplex andmulti- dimensional. They may involve large sums of money, have a long-term impact andare usually taken by seniormanagement.

· Tactical decisions are about how to manage performance to achieve the strategy.

What resources are needed? What is the timescale? These decisions are distinctivebut within clearer boundaries. They may involve significant resources, havemedium-term implications and may be taken by senior or middlemanagers.

· Operational decisions are more routine and follow knownrules.

Howmany?Towhatspecification?These decisionsinvolvemorelimitedresources, have a shorter-term application and can be taken by middle or first linemanagers.

StrategicDecisions

Should it open dedicatedsportswear stores?

Should range includesurf wear?

TacticalDecisions

Which surf wear products should itstock? How will the new range bepromoted?

OperationalDecisions

Where in the stores would the surf wearbe displayed?

Are extra Saturday staffneeded?

Alldecisionsdependoninformation.Thekeyistogettherightinformationtothe right people at the right time. For example, management accountants at Shell,the global oil and gas company, have been improving the way the company deals withthe strategicandoperationaldataaboutitsglobalenergy projectstoimprove strategic planning.

The company brought together data from 1,200 projects and opportunities across40 countriesintoasinglesystem. Bringingtheinformationtogetherwasacomplextask due to the size of thecompany’s operations. However, the system has helped to definestrategies and provide greater insight and detail to the Executive Committee andBoard.

Thishasgiven greaterclarityonthebusiness’currentandpotentialperformanceandhighlightedwherethecompany shouldallocateresources.Todate,thesystemhas helped Shell to increase net present value by over15%.

Howare decisionsmade?

Management accountants use their skills alongside hard information tosupport decision making. Through intelligent analysis of information, they cangenerate alternativesolutions andmatchthesetothelargerstrategy.Eachalternativecanthen be evaluated for its contribution towards objectives, taking intoaccount:

· the timescale: money received in the future being worth less thanmoney receivedtoday

· therisk:factoringintheprobabilityofunder-oroverperformance(alsocalled negative or positivevariance).

Onceadecisionismadeandimplementeditneedscareful monitoringtoensure it keepsontrackandanyproblemsaredetectedearly.TheElectricitySupplyBoard (ESB)inIrelandfacedthechallenge ofreducing itscostsfrom€250mto€200mover fiveyears.

Ateamincludingmanagementaccountantswasformed tobreakdowncostsand identify waste. The team discovered that ESB was carrying the costs of electrical faults caused by external building and construction companies. Meanwhile theESB technicians were over-burdened with paperwork. The team simplified andcentralized thiswithinadesignatedadministrationteam.Thismeantthetechnical staffhadmore timetogiveafaster,flexible responsetofaults andtodiagnosetheircauses. Major savings followed as faults plummeted by 75% and cost efficiencyat the company’scallCentre significantlyimproved.

Some operational decisions can be made mainly from experience and based onan assessment of circumstances. More complex decisions need a systematicand structured approach. This is where decision-making modelshelp.

Decisiontrees

Most business problems may potentially have more than one solution. Each choice can lead to varying outcomes, some more likely than others. To illustrate this,consider thedecision facedbyProspect plc,a(fictitious)propertydevelopmentbusiness.The companyownsatownCentrebuildingsite.Thiscouldbesoldnowforanestimated

£1.6m. Alternatively the site could be developed with shops and a restaurant at a costof

£1.5m.Theproperty couldthenbesoldfor£4m-providedthatabypass proposalis rejected by the local council. The odds of the bypass being rejected are judged atabout 75:25duetoenvironmentalobjections.If,however, thebypassweretobebuilt,much tourist trade would be lost and the value of the development would only be £2m. Which choice should Prospect plc make? A decision tree is a useful tool whenanalyzing choices of this kind. A decision tree is an outcome and probability map of thescenario.

Decision Point

Build shopsand Restaurant(£1.5m)

Chancenode

Bypass rejected£4.0m

Bypass approved£2.0m

Sell siteundeveloped

£1.6m

.0/msohtmlclip1/01/clip_image002.gif”>There arethreepossible outcomestothisscenario,eachofwhichcanbegivena financialvalue.

Outcome

Probability

EstimatedValue

Outcome 1 – the site is

The development value is

A 75% chance of receiving

developed and thebypass

£4m. However, there isonly

£4m is ‘worth’ £4m X 0.75=

isrejected

a

75%

chance

of

this

£3m

occurring.

Outcome 2 – the siteis developed and thebypass goesahead

There is a 25% chanceof receiving only£2m

If the bypass goes aheadit is ‘worth’ £2m X 0.25=

£0.5m

Outcome 3 – the site is sold undeveloped

Undeveloped, worth£1.6m

the

site

is

To calculate the possible yield of developing the site, the values of outcomes 1 and2 are combined. The cost of development is then subtracted: £3m + £0.5m – £1.5m =£2m

Thiscomparestothevalueofsellingtheundevelopedsiteatonly£1.6m.Onthis basis, depending on its attitude to risk and the likely timescales, the company is likelyto build the shops andrestaurant.

Decision trees encourage managers to look at a range of options rather thanrelyingon‘gutfeeling’. However,theyareonlyasaccurateasthedataonwhichtheyare based.Thisdataisusually basedonestimates.Theydoalsoruntheriskofover- simplifyingaproblemparticularlywhere humanorotherexternalfactors areinvolved. Other analysis tools can supplement the decision makingprocess.

Ratioanalysis

Businessesgenerate ahugeamountofdata.Managementaccountantscanuseanumberofthecompany’skeyaccountingstatementstoextract greatermeaningfrom this information.

Theincomestatementsetsoutthetotalsalesrevenueandsubtractsthecostsof generatingthatrevenuetogiveoperatingprofit.Thisisthesurplus earnedbythe normal operations of the company and tells us most about underlyingbusiness performance.

To continue to use the earlier illustrative example, Prospect plc is expandingrapidly as it builds a commercial property portfolio consisting mainly of shops and offices.The companyreceives rentsandalsobenefitsfromanyprofits whenitsellspropertyand sites.

Prospectplc-Summarizedincomestatementforyearending31March2012(against previousyearfor comparison)

£m2012

£m2011

SalesRevenue

120

80

From products/servicessold

(less)Expenses

105

60

E.g. costs,

overheads

(equals) OperatingProfit

15

20

The balance sheet (or statement of financial position) shows the wealth ofa company at a particular date. It lists the company’s assets (what it owns) followed byits liabilities(what itowes)–thedifferencebeingthenetassets.Assets maybecurrent, such as cash, or fixed, such as property or equipment. This value representsthe shareholders’ equity–the value in the company that the shareholders actuallyown.

Prospect plc – Balance sheet/statement of financial position as at 31 March2012

£m2012

£m2011

Fixed (non- current)assets

135

80

Currentassets

75

45

Currentliabilities

60

25

E.g. short termloan, suppliers’bills

Net currentassets (orworking capital)

15

20

Current assetsless currentliabilities

Totalassets

150

100

(current plusfixed)

lesscurrent

liabilities

Non-current liabilities

70

30

E.g.mortgages, pensionfund

Netassets

80

70

(Total assets –

currentliabilities)

lessnon-current

liabilities

Total shareholders’ equity

80

70

ThislooksasifProspectplchasexpanded veryfastindeed–buthowstrongisits performance? Accounting ratios allow different pieces of financial data to becompared. Analyzing some key ratios helps to explore behind the figures and offer strong cluesfor the business to steer towards its objectives (previous year data inbrackets):

Return on Capital Employed(ROCE)

Thisisameasure ofprofitability.ROCEcomparesthelevelofprofitmadetothe value of the capital invested in thebusiness.

= operating profit/(equity + non-currentliabilities)

= 15/(80 + 70) = 10%(20%)

Profit margin

Anotherprofitabilityratio,profit margin,identifieswhatpercentageoftherevenue remains as profits after all costs have beenpaid.

= operatingprofit/sales

= 15/120 = 12.5%(25%)

Current ratio

This is a measure of liquidity i.e. the ability of a firm to pay its short termdebts.

= current assets/current liabilities

= 75/60 = 1.25(1.8)

Gearing

The gearing ratio shows how much of a firm’s capital is fromlong-term loans,which must be paid back regularly withinterest.

The more highly geared a firm is, the greater the risk itfaces.

= non-current liabilities/(equity + non-currentliabilities)

= 70/(80 + 70) x 100 = 46.6%(30.0%)

The chart shows every sign of a firm that has expanded tooquickly:

• sales have increased by an impressive 50% in oneyear

• however, profitability hashalved

• Liquidity has weakened while gearing is more risky at nearly50%.

The result is a danger signal! Management accountants investigate this sort ofdata in order to alert managers to worrying trends, as well as to possibleopportunities.

Questions:

1. Give examples of decisions made at every level of equipment leasingcompany.

2. Explain the factors that need to be taken into account when makingdecisions.

3. Analyze the arguments for and against the use of decisiontrees.

4. Evaluate the use of accounting ratios when making strategicdecisions.

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