Strategic Cost Management

Accounting 044
 APPLICATION OF QUANTITATIVE
TECHNIQUES IN PLANNING,
CONTROL AND DECISION MAKING
Learning Objectives
Explain the rationale in using quantitative models for
planning, control and decision making.
Apply probabilities in decision making.
Use payoff tables in decision making.
Determine the expected value of perfect information.
Describe and prepare a decision tree.
Discuss the benefits and limitations of decision tree
analysis.
Describe techniques quantitative such as simulation
technique, Monte Carlo technique, sensitivity analysis and
queuing.
Learning Objectives
State the nature and application of linear programming.
Apply linear programming techniques using the graphic
and simplex methods.
Define Program Evaluation and Review Technique (PERT)
Discuss and properly apply the basic underlying concept
of PERT.
Enumerates the benefits and limitation of PERT.
Describe and prepare a Gantt Chart.
Apply ECQ model for inventory.
Compute re-order point and safety stock.
Quantitative Models for Planning,
Control and Decision Making
1. Probability
2. Payoff (decision) Tables
3. Value of Perfect Information
4. Decision Tree
5. Learning Curve
6. Simulation Technique
7. Monte Carlo Technique
8. Sensitivity Analysis
Quantitative Models for Planning,
Control and Decision Making
9. Queuing
10. Linear Programming
11. Program Evaluation and Review Technique – Critical
Path Method (PERT-CPM)
12. Gantt Chart
13. Inventory Modeling
14. Regression Analysis
15. Present value Concept
1. Probability
Probability is the branch of mathematics concerning
numerical descriptions of how likely an event is to
occur or how likely it is that a proposition is true.

The probability of an events varies from 0 to 1.

a) A probability of 0 means the event cannot occur,
whereas a probability of 1 means the event is certain
to occur.
b) A probability between 0 to 1 indicates the likelihood of
the event’s occurrence.
Types of Probabilities
A) Objective probabilities – are calculated from either
logic or actual experience. Example, in rolling a dice
one would logically expect each face on a single die
to be equally likely to turn up at a probability of 1/6.

B) Subjective probabilities – are estimates, based on

judgment and past experience, of the likelihood of
future events. Weather forecast often include the
subjective probability of rain.
Basic Term Used with Probabilities
1) Two events are mutually exclusive if they cannot
occur simultaneously .
2) The joint probability for two events is the
probability that both will occur.
3) The conditional probability of two events is the
probability that one will occur given that the other
has already occurred.
4) Two events are independent if the occurrence of
one has no effect on the probability of the other.
Basic Term Used with Probabilities
a) If one event has effect on the other event, they are
dependent.

b) Two events are independent if their joint

probability equals the product of their individual
probabilities.

c) Two events are independent if the conditional

probability of each event equals its unconditional
probability.
Illustration
The probabilities shown in the table represents the estimate
of sales for a new product.

Sales (Units) Probability

0-200 15%
201-400 45%
401-600 25%
601-800 15%

1. What is the probability of selling between 201 and 600

units of the product?
2. What is the best estimates of the expected sales of the new
product?
Solution
1) 201-400 units 45%
401-600 units 25%
Total 70%

2) 380 units (200 + (400 * 45%))

2. Payoff (Decision) Table
Decision analysis tool that summarizes pros and cons
of a decision in a tabular form.

 It lists payoffs (negative or positive returns)

associated with all possible combinations of
alternative actions (under the decision maker's
control) and external conditions (not under decision
maker's control).
Illustration - Payoff
A beverage stand can sell either soft drinks or coffee on
any given day. If the stands sells soft drinks and the
weather is hot, it will make P5,000; if the weather is
cold, the profit will be P2,000. If the stands sells coffee
and the weather is hot, it will make P3,800; if the
weather is cold, the profit will be P4,000. The
probability of cold weather on a given day at this time is
60%.
1. The expected payoff for selling coffee is?
2. The expected payoff if the vendor has perfect
information is?
Solution
1) Coffee hot weather P3,800 x 40% = 1,520
Coffee cold weather P4,000 x 60% = 2,400
P3,920

2) Soft drinks hot weather P 2,000 (P5,000 * 40%)

Coffee cold weather P 2,400 (P4,000 * 60%)
P2,200
3. Value of Perfect Information
In decision theory, the expected value of perfect
information (EVPI) is the price that one would be
willing to pay in order to gain access to perfect
information.

 EVPI - is the difference between the expected value

without perfect information and return if the best
action is taken given perfect information.

Perfect information - is the knowledge that a future

state of nature will occur with certainty.
Expected Value of Perfect Information
The formula for EVPI is defined as follows:

It is the difference between predicted payoff under certainty and

predicted monetary value.

EVPI = EPC - EMV

Illustration
A group of students raise money each year by selling souvenirs outside the
stadium of a cricket match between teams A and B.
They can buy any of three different types of souvenirs from a supplier. Their
sales are mostly dependent on which team wins the match.

A conditional payoff (Pesos) table is as under:

Type of Souvenir I II III

Team A wins 1200 800 300
Team B Wins 250 700 1100

(i) Construct the opportunity loss table.

(ii) Which type of souvenir should the students buy if the probability of
team A's winning is 0.6?
(iii) Compute the cost of uncertainty.
Since the Expected Opportunity Loss (EOL) of buying Type I Souvenir is minimum,
the optimal decision is to buy Type I Souvenir.
Cost of uncertainty = EOL of optimal action = P340
4. Decision Tree
A Decision Tree Analysis is a graphic representation
of various alternative solutions that are available to
solve a problem.

The manner of illustrating often proves to be decisive

when making a choice.
Using a simple decision tree example, we can see
the basic elements used when visualizing a choice.

 The drawing will generally have the following

elements:
a) Rectangles represent the decision or choice.
b) Circles correspond to uncertain outcomes, with
each following branch describing an outcome with
a specified probability.
c) Triangles signify the end of a path through the
decision tree.
ABC Ltd. is a company manufacturing skincare products. It was
found that the business is at the maturity stage, demanding some
change. After rigorous research, management came up with the
following decision tree:
5. Learning Curve
A learning curve is a concept that graphically depicts
the relationship between the cost and output over a
defined period of time, normally to represent the
repetitive task of an employee or worker.
Illustration
Given an 80% learning curve model based on the first
assumption stated above, the following performance is
expected during the early stages of the manufacture of a
new product:

Cumulative No. of Task Cumulative Ave. Time/Unit

100 3.0
200 2.4 (3.0*80%)
400 1.92 (2.4*80%)
800 1.536 (1.92*80%)
1,600 1.228 (1.536*80%)
6. Simulation Technique
Simulation is a techniques for experimenting with
logical and mathematical model using a computer.

 A simulation technique uses a probability

experiment to mimic a real-life situation. Instead of
studying the actual situation, which might be too
costly, too dangerous, or too time-consuming,
scientists and researchers create a similar situation but
one that is less expensive, less dangerous, or less time-
consuming.
5 Steps in Simulation Procedures
1. Define the objective. Objectives serve as guidelines for all that follows.

2. Formulate the model. The variables to be included, their individual

behavior, and their interrelationship must be defined in precise-
logical mathematical terms.

3. Validate the model. Some assurance is needed that the result of the
experiment will be realistic.

4. Design the experiment. Experimentation is sampling the operation of

a system.

5. Conduct the simulation. Simulation should be conducted with care.

Advantages of Simulation
a) Time can be compressed. A corporate planning model can show
the result of policy for 5 years into the future, using only
minutes of computer time.

b) Alternative policies can be explored. With simulation,

managers can ask what if question to explore possible policies,
providing management with a powerful new planning tool.

c) Complex system can be analyzed. In many cases, simulation is

the only quantitative method for analyzing a complex system
such as a production or inventory system, or the entire firm.
Limitation of Simulation
a) Cost. Simulation models can be costly to develop.
They can be justified only if the information to be
obtained is worth more than the cost to develop the
model and carry out the experiment.

b) Risk of error. A simulation results in a prediction of

how an actual system would behave. As in
forecasting, the prediction may be in error.
7. Monte Carlo Technique
Monte Carlo (MC) methods are a subset of
computational algorithms that use the process of
repeated random sampling to make numerical
estimations of unknown parameters.

They allow for the modeling of complex situations

where many random variables are involved, and
assessing the impact of risk.
How Does Monte Carlo Works
Monte Carlo simulation performs risk analysis by
building models of possible results by substituting a
range of values—a probability distribution—for any
factor that has inherent uncertainty.

It then calculates results over and over, each time

using a different set of random values from the
probability functions.
8. Sensitivity Analysis
Sensitivity analysis is a financial model that
determines how target variables are affected based on
changes in other variables known as input variables.

 This model is also referred to as what-if or

simulation analysis. It is a way to predict the outcome
of a decision given a certain range of variables.
Steps to Conduct Sensitivity Analysis
1) Firstly the base case output is defined; say the NPV at a particular
base case input value (V1) for which the sensitivity is to be
measured. All the other inputs of the model are kept constant.

2) Then the value of the output at a new value of the input (V2)
while keeping other inputs constant is calculated.

3) Find the percentage change in the output and the percentage

change in the input.

4) The sensitivity is calculated by dividing the percentage change in

output by the percentage change in input.
Illustration- Sensitivity
9. Queuing
Queuing theory is the mathematical study of the
delays of waiting in line, covering all aspects, from
arrival time to the number of servers.

Basic issues in every queuing:

a) Input mechanism
b) Line or queue discipline
c) Service facilities
d) Output
How Queuing Theory Works
Queues happen when resources are limited.

In fact, queues make economic sense; no queues would

equate to costly over capacity.

Queuing theory helps in the design of balanced systems

that serve customers quickly and efficiently but do not cost
too much to be sustainable.

All queuing systems are broken down into the entities

queuing for an activity.
Illustration
10. Linear Programming
Linear programming (LP, also called linear
optimization) is a method to achieve the best
outcome (such as maximum profit or lowest cost) in a
mathematical model whose requirements are
represented by linear relationships.
Illustration
In real life, we are subject to constraints or conditions.

We only have so much money for expenses; there is only so

much space available; there is only so much time.

So this means we need to find a way of using these

limitations to our advantage, like finding the optimum
amount of money, space, time, etc., to accomplish our
goals.

And this is what linear programming is all about!

How do we do this?
First, we must identify all constraints, by creating a system of
inequalities.

Then we must identify the Objective Function, which is the

equation we want to maximize or minimize.

Next, we will graph the system of inequalities and find the

feasible solution, which is the shaded or overlapping region
common to all conditions.

Then we will locate all vertices and corners of this feasible

solution, as Purple Math accurately states.
Because the Fundamental Theorem of Linear Programming says
that the optimum value always occurs at the corners or vertices of
the enclosed shaded region!
11. Program Evaluation and Review
Technique (PERT-CPM)
Program evaluation and review technique or
PERT is a technique adopted by organizations to
analyze and represent the activity in a project, and to
illustrate the flow of events in a project.

Critical Path Method or CPM is a well known

project modeling technique in project management.
CPM is mainly used in projects to determine critical
as well as non-critical tasks that will help in
preventing conflicts and reduce bottlenecks.
12. Gantt Chart
A Gantt chart is a type of bar chart that illustrates a
project schedule, named after its inventor,
Henry Gantt (1861–1919), who designed such
a chart around the years 1910–1915.

Modern Gantt charts also show the dependency

relationships between activities and current schedule
status.
13. Inventory Modeling
Inventory model is a mathematical model that helps
business in determining the optimum level of
inventories that should be:
 maintained in a production process,
 managing frequency of ordering,
 deciding on quantity of goods or raw materials to be
stored, and
 tracking flow of supply of raw materials and goods to
provide uninterrupted service to customers without any
delay in delivery.
Inventory Model Simulation
Economic Order Quantity
Annual Ordering Cost = Annual Usages x Cost per Order
EOQ

Annual Carrying Cost = Order Size x Carrying Cost/unit

2

Reorder Point = Average lead time usage + safety stock

Average lead time usage = Lead time x Average Usage/unit of time

14. Regression Analysis
Regression is a statistical method used in finance,
investing, and other disciplines that attempts to
determine the strength and character of the
relationship between one dependent variable (usually
denoted by Y) and a series of other variables (known as
independent variables).
Illustration - Regression
15. Present Value Concept
Present value is the concept that states an amount
of money today is worth more than that same amount
in the future.

In other words, money received in the future is not

worth as much as an equal amount received today.
Illustration
NPV of Cash Flow
Time Period (T) Cash (Out Flow) Discount Rate DR + 1 (DR + 1) ^ T {Cash Flow /
Inflow (DR)
(DR +1)^T}

0 (500,000) 0.00% 0.0% 0.0% (500,000)

1 120,000 5.00% 105.0% 105.0% 114,286

2 120,000 5.00% 105.0% 110.3% 108,844

3 120,000 5.00% 105.0% 115.8% 103,661

4 120,000 5.00% 105.0% 121.6% 98,724

5 120,000 5.00% 105.0% 127.6% 94,023

NPV 19,537
The End