Types of decisions

| September 28, 2018

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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