CIMA STUDY 29/8/12 10:25 Page 2
Decision making techniques
FINANCE
Introduction
A business aims to generate value for its owners, customers and
other stakeholders. It must decide how to combine valuable
resources – typically buildings and equipment, materials, people
and knowledge – in such a way that the value of the output
exceeds the costs of the input.
As resources flow into or out of a business, information flows too.
Much of this information leaves a footprint in the form of financial
data as the activities along a business’ value chain result in financial
outcomes. These are reported in financial statements including the
cash flow and income statements as well as the formal balance
sheet. Traditional accounting is concerned with reporting on a
business in financial terms about its past performance.
Management accountants go beyond this to prepare both financial
and non-financial information to support the business. They
combine the relevant expertise of a traditional professionally
qualified accountant with an understanding of the drivers of cost,
risk and value in a business. This enables them to provide analysis
and insights which are used to improve future performance.
16 Curriculum topics covered: • Types of decisions • Decision making
• Decision trees • Ratio analysis
CIMA, the Chartered Institute of Management Accountants, is the
world’s leading professional body of management accountants.
CIMA-trained management accountants help to lead the process
of strategy formation in a business. Strategy is the plan for
achieving objectives. However, strategy only points the way. Many
decisions – large and small – must be made. Management is all
about decision making and management accountants play a vital
role in providing the crucial evidence that helps managers to make
the right decisions.
Detecting, monitoring and evaluating risk is a very important
element of this process. Management accountants use their
accounting know-how to factor risk into decisions to help senior
managers make realistic plans. The effectiveness of this depends
on good communication. Even the best information has little value
if not received by the right staff in the right format at the right time.
Types of decisions
A business continually makes decisions at all levels. Think of a
retailer such as Next. To keep the brand’s high profile position, its
managers have to make many decisions. Each major strategic
decision leads to tactical decisions, which break down into
operational decisions.
Decisions are broadly taken at three levels:
• Strategic decisions are big choices of identity and direction.
Who are we? Where are we heading? These decisions are
often complex and multi-dimensional. They may involve large
sums of money, have a long-term impact and are usually taken
by senior management.
• Tactical decisions are about how to manage performance to
achieve the strategy. What resources are needed? What is the
timescale? These decisions are distinctive but within clearer
boundaries. They may involve significant resources, have
medium-term implications and may be taken by senior or
middle managers.
CIMA STUDY 29/8/12 10:25 Page 3
• Operational decisions are more routine and follow known rules.
How many? To what specification? These decisions involve
more limited resources, have a shorter-term application and
can be taken by middle or first line managers.
Imagine Next is planning to expand its product range. Its decisions
would involve all three levels.
Strategic
decisions
Tactical
decisions
Operational
decisions
All decisions depend on information. The key is to get the right
information to the 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 with
the strategic and operational data about its global energy projects
to improve strategic planning.
The company brought together data from 1,200 projects and
opportunities across 40 countries into a single system. Bringing the
information together was a complex task due to the size of the
company’s operations. However, the system has helped to define
strategies and provide greater insight and detail to the Executive
Committee and Board. This has given greater clarity on the
business’ current and potential performance and highlighted where
the company should allocate resources. To date, the system has
helped Shell to increase net present value by over 15%.
How are decisions made?
Management accountants use their skills alongside hard
information to support decision making. Through intelligent analysis
of information, they can generate alternative solutions and match
these to the larger strategy. Each alternative can then be evaluated
for its contribution towards objectives, taking into account:
• the timescale: money received in the future being worth less
than money received today
• the risk: factoring in the probability of under- or over-
performance (also called negative or positive variance).
www.thetimes100.co.uk
Once a decision is made and implemented it needs careful monitoring
to ensure it keeps on track and any problems are detected early.
The Electricity Supply Board (ESB) in Ireland faced the challenge
of reducing its costs from €250m to €200m over five years.
A team including management accountants was formed to break
down costs and identify waste. The team discovered that ESB
was carrying the costs of electrical faults caused by external
building and construction companies. Meanwhile the ESB
technicians were over-burdened with paperwork. The team
simplified and centralised this within a designated administration
team. This meant the technical staff had more time to give a
faster, flexible response to faults and to diagnose their causes.
Major savings followed as faults plummeted by 75% and cost-
efficiency at the company’s call centre significantly improved.
Some operational decisions can be made mainly from experience
and based on an assessment of circumstances. More complex
decisions need a systematic and structured approach. This is
where decision-making models help.
Decision trees
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 the decision faced by
Prospect plc, a (fictitious) property development business.
The company owns a town centre building site. This could be sold
now for an estimated £1.6m. Alternatively the site could be
developed with shops and a restaurant at a cost of £1.5m.
The property could then be sold for £4m - provided that a bypass
proposal is rejected by the local council. The odds of the bypass
being rejected are judged at about 75:25 due to environmental
objections. If, however, the bypass were to be built, 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 when analysing choices of this kind.
17
CIMA STUDY 29/8/12 10:25 Page 4

A decision tree is an outcome and probability map of the scenario.
Decision tree
Ratio analysis
Businesses generate a huge amount of data. Management
accountants can use a number of the company’s key accounting
statements to extract greater meaning from this information.

The income statement sets out the total sales revenue and
subtracts the costs of generating that revenue to give operating
profit. This is the surplus earned by the normal operations of the
company and tells us most about underlying business performance.

To continue to use the earlier illustrative example, Prospect plc is

expanding rapidly as it builds a commercial property portfolio
£1.6m
consisting mainly of shops and offices. The company receives rents
and also benefits from any profits when it sells property and sites.

Prospect plc - Summarised income statement for year ending

There are three possible outcomes to this scenario, each of which 31 March 2012 (against previous year for comparison)
can be given a financial value.
£m 2012 £m 2011
Sales revenue 120 80 From products/
Outcome Probability Estimated value
services sold
Outcome 1 – the site The development A 75% chance of
(less) Expenses 105 60 E.g. costs, overheads
is developed and the value is £4m. receiving £4m is
bypass is rejected. However, there is 'worth' £4m X 0.75 = (equals) Operating
profit 15 20
only a 75% chance £3m
of this occurring.
The balance sheet (or statement of financial position) shows the
Outcome 2 – the site There is a 25% If the bypass goes
wealth of a company at a particular date. It lists the company's
is developed and the chance of receiving ahead it is ‘worth’
assets (what it owns) followed by its liabilities (what it owes) – the
bypass goes ahead. only £2m £2m x 0.25 = £0.5m
difference being the net assets. Assets may be current, such as
Outcome 3 – the site Undeveloped, the cash, or fixed, such as property or equipment. This value
is sold undeveloped. site is worth £1.6m represents the shareholders' equity – the value in the company
that the shareholders actually own.

To calculate the possible yield of developing the site, the values of

outcomes 1 and 2 are combined. The cost of development is then
subtracted: £3m + £0.5m - £1.5m = £2m

This compares to the value of selling the undeveloped site at only

£1.6m. On this basis, depending on its attitude to risk and the likely
timescales, the company is likely to build the shops and restaurant.

Decision trees encourage managers to look at a range of options

rather than relying on ‘gut feeling’. However, they are only as
accurate as the data on which they are based. This data is usually
based on estimates. They do also run the risk of over-simplifying a
problem particularly where human or other external factors are
involved. Other analysis tools can supplement the decision-
making process.

18 www.thetimes100.co.uk
CIMA STUDY 29/8/12 10:25 Page 5

www.cimaglobal.com

Prospect plc - Balance sheet/statement of financial position as at 31 March 2012

£m 2012 £m 2011

Fixed (non-current) assets 135 80

Current assets 75 45

Current liabilities 60 25 E.g. short term loan, suppliers’ bills

Net current assets (or working capital) 15 20 Current assets less current liabilities

Total assets (current plus fixed) less current liabilities 150 100

Non-current liabilities 70 30 E.g. mortgages, pension fund

Net assets 80 70 (Total assets - current liabilities) less non-current liabilities

Total shareholders' equity 80 70

This looks as if Prospect plc has expanded very fast indeed – but how
strong is its performance? Accounting ratios allow different pieces of
financial data to be compared. Analysing some key ratios helps to
explore behind the figures and offer strong clues for the business to
steer towards its objectives (previous year data in brackets):
The chart shows every sign of a firm that has expanded too quickly:
• sales have increased by an impressive 50% in one year
• however, profitability has halved
• liquidity has weakened while gearing is more risky at
nearly 50%.

The result is a danger signal! Management accountants investigate

Return on Capital Employed (ROCE)
This is a measure of profitability. ROCE compares the level of profit this sort of data in order to alert managers to worrying trends, as
made to the value of the capital invested in the business. well as to possible opportunities.

= operating profit/(equity + non-current liabilities) Conclusion

= 15/(80 + 70) = 10% (20%)
Profit margin
Another profitability ratio, profit margin, identifies what percentage
of the revenue remains as profits after all costs have been paid.
Management accountants use complex business data to help
businesses identify critical points and isolate weak and under-
performing systems. It can also uncover opportunities that lie
hidden under routines and processes.

= operating profit/sales
CIMA-trained management accountants work at all levels in a
= 15/120 = 12.5% (25%)
business and partner with managers across various business
Current ratio functions. This can become a real source of competitive
This is a measure of liquidity i.e. the ability of a firm to pay its short advantage that is resistant to copying by competitors.
term debts.

= current assets/current liabilities 1. List two of the types of decisions that are made by
= 75/60 = 1.25 (1.8)
managers. (2 points)
Exam-style questions

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

Gearing
The gearing ratio shows how much of a firm’s capital is from when making decisions. (4 points)
long-term loans, which must be paid back regularly with interest. 3. Analyse the arguments for and against the use of
The more highly geared a firm is, the greater the risk it faces. decision trees. (6 points)
4. Evaluate the use of accounting ratios when making
= non-current liabilities/(equity + non-current liabilities)
strategic decisions. (8 points)
= 70/(80 + 70) x 100 = 46.6% (30.0%)

CIMA | Decision making techniques 19