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Back to basics the use of algebra in management accounting

Back to basics the use of algebra in management accounting

June 2012
Bob Scarlett explains how algebra can be useful in day to day management accounting; a vital subject for C03, C04, P1 and P2 students. The use of algebraic methods is an element of many management accounting practices and techniques. Such methods may involve expressing the relationship between variables in the form of equations and carrying out calculations involving powers and roots. This general technique is relevant to the whole CIMA suite of subjects including papers C03 (fundamentals of business mathematics), C04 (fundamentals of business economics), P1 (performance operations) and P2 (performance management). Mathematical models One key element that runs through many areas of management accounting is the identification of relationships between variables and the expression of those relationships in the form of simple mathematical models. Those models can be used as a guide to both decision making (if we take action A, what will the consequences be?) and control (how does outcome B compare with what should have happened?) Algebraic equations (and the graphical representation of such equations) lie at the core of these models. The following graphs provide simple examples of the kind of algebra that is involved:

In these graphs, the two variables whose relationship we seek to model are shown as x on the horizontal axis and y on the vertical axis. In the case of figure 1, an increase in x by 1 is associated with an increase in y by 2. The slope (or gradient) of the line along its whole length has a value of 2. In the case of figure 2, an increase in x by 1 is associated with a decrease in y by 2 and the line has a slope of -2 along its whole length. In the case of figure 3 the relationship between x and y is non-linear and the slope of the curve rises as x and y increase. Let us consider a simple case study in order to illustrate the manner in which such models can be used as decision support tools in business. Note: this case study provides a real life example of the sorts of techniques you will come across in your studies but it is not intended as a sample exam question. Case study A bar is open for one hour and sells beer to customers. At a selling price of GBP4 per pint no beer is sold, but consumption increases by 100 pints with every GBP0.40 reduction per pint in the selling price below GBP4. Beer costs the bar GBP0.75 per pint and the rental cost of the bar is GBP200 per hour. What is the profit-maximising selling price per pint and sales volume in pints? What are the bars break even points in terms of pints sold per hour and selling price per pint? Sales revenues, costs and profit at different selling prices per pint may be tabulated as follows:

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Back to basics the use of algebra in management accounting

The table indicates a profit maximising selling price in the region of GBP2.40, but we need to be more rigorous. To do this we can express the relevant factors that determine the profit maximising selling price and sales volume in the form of algebraic equations, as in figure 4 below.

Figure 4 The price line represents the relationship between price and sales volume. It runs from GBP4.00 on the vertical axis to 1000 on the horizontal axis. If we give beer away free (price = GBP0) then customers will drink 1000 pints. The mc (marginal cost) line is the cost of 1 pint of beer which is GBP0.75 at all levels of consumption. The mr (marginal revenue) line represents the change in total sales revenue associated with each 1 pint change in consumption. The marginal revenue associated with the first pint consumed is the same as its price therefore the mr line intersects the vertical axis at 4.00. T Total revenue is maximised at 500 pints (see tabulation) therefore the mr line crosses the horizontal axis at 500. Marginal revenue must become negative as consumption is increased beyond 500 pints since total sales revenue is seen to fall. The three lines may be represented by the equations shown below. They are constructed using the standard equation of the line y = mx +c, where in the case of the price line, the intercept (c) is equal to 4, and the slope (gradient) is equal to (4/1,000). The equations for the other lines are determined in a similar way: Price: p = 4 (4/1,000)q ; mc: p = 0.75; mr: p = 4 (4/500)q Profit will be maximised at a level of consumption in pints where mc = mr (where the mc and mr lines cross on the chart): 0.75 = 4 (4/500)q; therefore profit maximising consumption is 406 pints. The selling price per pint which gives 406 pints consumption can be determined from the price line where: P = 4 (4/1,000)406; therefore profit maximising selling price per pint is GBP2.38. Profit curve Further insights can be gained from a chart showing the profit structure of the operation.

Figure 5 The profit curve may be represented by the following quadratic equation: Profit: p = q(4 (4/1000)q) 0.75q 200, or p = 0.004q2 + 3.25q 200 The equation states that profit is equal to sales revenue (price x quantity - as taken from the price line stated earlier) minus variable costs, minus fixed costs. Note that the profit curve rises and then falls as consumption is increased. Profit is maximised at the peak of the curve where the slope of the line is equal to zero. We have already determined this point occurs at a consumption of 406 pints and a price of GBP2.38. There are two break even points where the profit curve crosses the horizontal axis. The equation for profit is a quadratic equation. Therefore the values for q where p is equal to zero may be determined from the following standard formula: q = (-b(b^2-4ac))/2a; where in this case a = 0.004, b = + 3.25 and c = 200
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Back to basics the use of algebra in management accounting

Hence q = ( 3.25 2.713393) / 0.008 Therefore break even points for the operation are at 67 pints (selling price GBP3.73 per pint) and 745 pints (selling price GBP1.02 per pint). The model used to solve the case study requirements is that of short term profit maximisation assuming constant marginal cost per unit, constant fixed costs at all levels of output and a downward sloping demand function. The main limitations of this model are: in many practical situations the cost structure is more complex. Economies of scale often result in marginal cost per unit declining as output increases and fixed costs rarely remain constant over the full range of possible output levels the concept of the downward sloping demand function may be less widely applicable in the era of globalisation, the internet and high personal mobility. The whole market may establish the going price for a product and no one supplier can escape this the assumption that output should be established at a level where short term marginal cost equals marginal revenue ignores modern pricing practices such as price discrimination (charging different prices to different customers) and strategic pricing.

In some cases the above issues can be accommodated by the use of more complex mathematical models, such as the idea that marginal cost per unit declines as output increases, which can be incorporated within a learning curve model. The management accounting student should be comfortable in the use of basic algebra and graphics. The practical application of such method will involve undertaking power and root calculations using a scientific calculator.

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