congruence and fit the organization’s strengths to market opportunities more exactly than can be achieved by strategic planning alone. Above
all, benchmarking is an effective risk management tool that is indispensable in the performance management process.
33. Difficulties in maximising the benefits of benchmarking stem from the need of organizations to protect business sensitive information that
gives them competitive advantage over their rivals. The cost structures and pricing strategies of cost leaders would hardly be available to the
strategic management accountant who may have to settle for data generated from cost models that simulate competitor cost volume profit
relationships. Production processes, customer care methods employee relationship management schemes, strategic buying and selling plans,
quality management methods and other best practices that give competitive edge may not be fully accessible. Benchmarking teams would
need to work hard to gain ideas and information by all legal means possible to continue to improve best practices of the organization.
Evaluate how risk and uncertainty play an especially important role in long term strategic planning and decision
making that relies upon forecasts of exogenous variables. [3] Focus notes:
- look ahead to survive: avoid threats, maximise opps, overcome weaknesses; competitor and industry analysis: relative levels and trends in cost and price levels,
technology, processes, globalisation, etc.
- clarify CSF: maximise competitive edge;
- strategic choice: risk is key determinant of objectives, strategies (e.g. lifecycle: prospector or builder, harvester or defender; uncertainty and risk preference) projects
Designing - Strategic orientation e.g. towards innovation
- Growth orientation e.g. organic growth
- Staff capabilities (e.g. see Balanced Scorecard Learning and
growth perspective)
- Porters Diamond e.g. Government incentives such as grants
- Proximity of rivalry e.g. Silicon Valley
- Economic outlook
Reflect on P3 strategic lenses: Which of the following is most relevant to uncertainty and risk management? Explain your answer.
a) The ideas lens
b) The design lens
c) Discourse lens
d) Experience lens
The method for dealing with uncertainty using expected values is to assign probabilities to each possible outcome (e.g. optimistic, pessimistic or
realistic). The probability weighted outcomes are then added together to obtain the expected values. See the tables below under Case Study Solutions.
The variables are said to be random meaning that the organisation cannot predetermine the outcome e.g. cannot determine the volume of sales and
other factors in advance. This implies that sales (a discreet variable) can take on any value within the scope of the strategic planning horizon.
Discreet variable simply means that an exact (rather than a range) of sales volumes are estimated and assigned probabilities.
CASE STUDY QUESTION (expected values)
Smart inc manufactures metal pipes for utilities in the water, electricity and similar industries. As part of the strategic management of profitability
against a tough competitive environment Smart inc. is considering the redesign of its pipes to make them more competitive. Specifically the redesign
of a major component W is under consideration. It is expected that the redesign of W will result in changes in quantity and number of cuts in the
fitting process and this has implications for the unit cost of W.
To help evaluate the potential impact of this cost for strategic planning in an uncertain environment random values have been assigned to the discreet
variable of unit cost in Table 1. In addition, the outcomes predicted in Table 1 have been weighted by assigning subjective probabilities to the
various outcomes (Table 2).
Table 3 gives the weighted expected values. This gives an expected value of $43.82 a 3.3% decrease from the current cost levels of $45.33.
Required
Evaluate the redesign implications for the unit cost of W. In your evaluation you should address the risk attitudes indicated by the following:
i) 30% of the management team set a 12% reduction in unit cost as the minimum that would make the effort worthwhile.
Percentage change in costs (45.33-43.82)/45.33 3.32%
Evaluation and analysis The redesign would result in a reduction in unit cost of W to $43.82 from current levels of $45.33, a reduction of 3.32 %. Only a limited evaluation
can be done as we do not know what it would cost to bring about the redesign. For example, what is the opportunity cost (the best alternative
foregone) of the redesign. If the design department have to forego other productive work then the benefit forgone would form part of the evaluation.
i) 12 % Reduction in unit cost would be acceptance criterion for 30% of the management
% reduction
Reduced to
Probability of
attainment Risk
attitude Interpretation
5% 43.06 50.00% Neutral Indifferent
10% 40.80 30.00%
12% 39.89 18.00% Seeking Less likely, more risky,
6% 42.61 50.00%
1% 44.88 60.00% Averse More likely to succeed, safe
13% 39.44 10.00%
According to the table a 12% reduction in the unit cost of W has only an 18% chance of success. Given that only 30% of the management require this
criterion it is unlikely to be adopted as a decision criterion for the redesign because it is highly risky. The risk attitude of the management is
characterised as risk seeking. This could be an example of gaming where management adopts a position which they know is not going to work in
order that they may achieve their own hidden agenda.
A reduction of 5% or less is more likely to succeed as an acceptable decision criterion because it would have a more than 50% probability of
attainment. However, some in the management team would argue that what counts is not the likelihood of occurrence but the magnitude of the
reduction itself!
ii) If redesign would lead to an increase in unit cost 40% of the management team would not be in favour of it
According to Table 1 and Table 2 there is a 66% chance that the redesign process will result in a reduction in unit cost ranging from $37.77 to $44.89
(Table 1: before probability waiting). This is a risk averse decision criterion that ought to find favour with 40% of the management. However, there is,
according to the same tables, a 32% chance that the redesign would lead to an increase in costs above the current level of $45.33. It seems that to the
risk averse management this chance is too high to risk redesign. Therefore on balance 40% of the management team would not favour a change.
iii) If it would lead to a reduction in unit cost then 30% would be in favour
The expected value is the weighted average of all the possible outcomes of unit costs from the redesign process. According to Table 3 this is $43.82,
a 3.32% reduction in current unit cost directly attributable to the redesign process. Therefore the management team would accept this.
NB: expected value probability is 1 because it is the weighted average of all the possible outcomes.
Exam Insight!
This area was last examined in December 2011. The examiners comments:
“There was a general unfamiliarity with the application of methods for decision-making under uncertainty (Q1).
“Requirement (ii) asked candidates to evaluate the new vehicle project using methods for decision-making under risk and uncertainty. As this is the
final level of the ACCA qualification, candidates were expected to apply their knowledge of these methods. Most candidates knew that they were
being required to apply expected value, maximax, maximin and minimax regret but unfortunately, they were not well practised in the application of
these techniques.” Based on this the examiner is likely to revisit this area again very soon as this is a crucial area in any sort of planning.
Practise and pass
Attempt Workbook questions:
The strategy for exam practice questions is i) analyse all relevant aspects of the problem within the scope of the syllabus; ii) design questions
within the intellectual levels that address all the different aspects; iii) ensure the examiners review comments are addressed; iv) ensure latest
developments are addressed where appropriate.
Attempt question 1 ACCA December 2011
Metacognitive discernment The issues raised by Q1 ACCA December 2011
- A variety of methods exist to deal with risk and uncertainty. You are required to appraise their suitability, acceptability and feasibility. This question and answer provides
fertile learning and practise opportunity. It repays careful study.
- Package 1 is consistently attractive to risk seeker and pessimist, producing maximum profits while minimizing (maximum) regrets. This is not surprising given it incurs the
least amount of fixed costs while allowing scalability across the range of estimated demand levels. This highlights the importance of cost structure in performance evaluation
using profit measures.
- Highlights the importance of risk attitude in evaluating and selecting projects (in strategic planning). We learn about the differing priorities of managers based on their risk
attitude and profit objectives
- The importance of a methodical approach. There are two features that evidence the methodical approach. i) Analysis of the problem and solution options making it easy to
apply the selection criteria; ii) Logical presentation and reasoning to justify the selection (rational and coherent). This is worth paying careful attention to and emulating.
- Clarifies where probabilities are used to estimate demand and expected values are calculated as a result. Weighting refers to assigning probabilities to all possible outcomes.
Average refers to adding up all the probability weighted outcomes to obtain the expected values.
- Clarifies where it is not feasible to use probabilities to estimate the various demand outcomes: the method of selection is maximax, maximin and minimax regret.
- Attention to detail. This is abundantly evidenced as exemplified by the commentary on Expected values: the expected profit for package 2 is higher than that of package 1
and 3 due to the increased likelihood of increased demand.
- The importance of clarity: the language used adds to the clarity of the methodical approach. The language is crisp and clear and the sentences are short and sharp. This is
worth paying careful attention to. You are advised to practise writing out your answers and notes in this succinct style. The language is not simply cosmetic: it has a
functional purpose which is why professional marks are awarded. From an examination point of view the economical use of language allows the candidate to maximize
points in the time allowed.
- Risk looms large in the mind of the decision-maker. The recommendation needs to be an evaluative synthesis of the preceding analysis and evaluation. The
Recommendation is a model of a sophisticated approach that reflects the syllabus requirements: “…candidates are then expected to synthesise this knowledge in the role of
advisor to senior management or independent clients on how to assess and control the performance of an entity…”
Maximax, Maximin and minimax regret Example
Maximax stands for maximize the maximum outcome of a range of outcomes. This is an optimistic scenario wherein the optimist seeks to optimise
the chances of the best outcome. In the example below Pass Driving School maximax strategy produces a total contribution of $1,336,500 when it sets
prices at $180 to achieve 90% occupancy at a variable cost of $70.
Maximin means select the option that maximises the minimum outcome that can be achieved given the related variables. In the example below Pass
Driving School maximin strategy is to set the price at $200 to achieve 75% occupancy at a variable cost of $95. This would be the pessimistic
scenario.
Minimax regret stands for minimize the maximum outcome of a range of options (why would anyone want to do that?). If the range of expected
outcomes is bad then minimax would mean limiting the adverse effects. This would be the case where the wrong decision is taken and the opportunity
loss calculated as the difference between the right and wrong decisions is known as the regret. In the example below Pass Driving School’s minimax
regret is a price of $200 that minimises the maximum regrets ($20,250) from the pricing options.
CASE STUDY QUESTION
Pass Driving School organises residential driving lessons for high net worth individuals who can book and stay in residential accommodation to take
their driving lessons. The fee is all inclusive. For the year to 31 December 2012 the forecast is as follows
i) The maximum capacity for the facility is 45 clients per day for 300 days.
ii) Clients will be charged on a daily rate basis and invoiced when they leave.
iii) It is expected that the occupancy rate will vary with the client fee chargeable and estimates of the occupancy rates corresponding to various fee
This reasoning and analysis is repeated for the other possible variable costs and a table of the results is produced below.
Opportunity loss (regret)
Level of Given pricing options
Variable cost $180 $200 $220
High ($95) 30,375 0 50,625
Medium ($85) 10,125 0 70,875
Low ($70) 0 20,250 121,500
Maximum regret 30,375 20,250 121,500
Evaluation of the results:
- The minimax-regret strategy is the price ($200) that minimises the maximum regrets from the pricing options ($20,250 in the above table)
SENSITIVITY ANALYSIS EXAMPLE
The estimated expenditure and income streams used to inform the financial appraisal will invariably involve assumptions about the future.
Changing assumptions, particularly those relating to less robust assumptions, may significantly alter the ranking of options. It is therefore
important that the effects of variability are assessed.
This can be undertaken using sensitivity analysis, which involves repeating the appraisal calculations with the value of the less robust estimates set
at the upper or lower end of likely outcomes as appropriate. For example, if an option depends on additional research contract income a scenario
should be examined where the anticipated income levels are not attained. Similarly if the building/ refurbishment costs associated with a particular
option are estimated the NPV computation should be recalculated for the construction being over budget. The number of scenarios tested using
sensitivity analysis will depend on the robustness of the assumptions used in the initial appraisal, with 2-4 being sufficient in the majority of cases.
There will often also be other areas of risk associated with individual options which cannot be readily expressed in financial terms e.g. planning
permission being delayed, site location not being available. All areas of risk associated with each option, particularly the preferred one, should be
considered and listed in a risk index where applicable.
Extract from Finance Directorate, Queen’s University Belfast.
The Learning Curve effect
The learning curve is a function that measures how labour hours per unit decline as units of production increase because workers learn and
improve in repetitive labour intensive tasks. The learning curve is therefore a planning tool used by operational managers to predict how labour
