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# ADVANCED MANAGEMENT ACCOUNTING

Lecture (6)

Linear Programming

Dr Owolabi Bakre

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**Cost Behaviour Summary
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The use of Least-Squares Regression Method to analyse mixed costs and estimate cost functions. It is objective and incorporate all of the available observations into the cost estimate.

Simple linear regression (manual and computer solutions ± Excel & SPSS) Multiple linear regression Non-linear regression (the learningcurve-effect)

Dr Owolabi Bakre 2

**Briefly Reviewing Cost Classifications for Decision Making For decision-making classified into:
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Differential Cost, Opportunity Cost, Sunk Cost.

Dr Owolabi Bakre

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**Differential Costs and Revenues
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Costs and revenues that differ among alternatives.

Example: You have a job paying £1,500 per month in your hometown. You have a job offer in a neighbouring city that pays £2,000 per month. The commuting cost to the city is £300 per month. Differential revenue is: £2,000 ± £1,500 = £500 Differential cost is: £300

Dr Owolabi Bakre

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Opportunity Costs

The potential benefit that is given up when one alternative is selected over another.

Example: If you were not attending university, you could be earning £15,000 per year. Your opportunity cost of attending university for one year is £15,000.

Dr Owolabi Bakre

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you cannot change the £10. Example: Example: You bought a car that cost £10. The £10.000 cost is sunk because whether you drive it. or sell it.Sunk Costs Sunk costs cannot be changed by any decision.000 two years ago. They are not differential costs and should be ignored when making decisions.000 cost. Dr Owolabi Bakre 6 . park it. trade it.

limited direct labour hours available. For example. Dr Owolabi Bakre 7 . a firm may have: limited raw materials.What is Linear Programming? Managers are routinely faced with the problem of deciding how constrained resources are going to be utilised. There is an opportunity cost for scare resources that should be included in the relevant cost calculation for decision making. and limited floor space. How should the firm proceed to find the right combination of products to produce? The proper combination or µmix¶ can be found by use of a quantitative method known as linear programming.

What is Linear Programming? (cont«) Linear Programming (LP) is a powerful mathematical technique that can be applied to the problem of allocating constrained (scare) resources among many alternative uses in such a way that the optimum benefits (total contribution margin) can be derived from their utilisation in the short run. (Notice: fixed costs are usually unaffected by such choices). Dr Owolabi Bakre 8 .

which specify for each decision variable xj either (1) variable xj must be nonnegative ± xj >= 0. 2) a set of constraints (each of which must be a linear equality or linear inequality) that restrict the values that may be assumed by the decision variables. zero. «. or (2) variable xj may be positive. or negative ± xj is unrestricted in sign Dr Owolabi Bakre 9 . 3) the sign restrictions. x1.What is meant by a linear programming problem? A linear programming problem consists of three parts: 1) a linear function (the objective function) of decision variables (say. xn) that is to be maximized or minimized. x2.

The available capacity for this resource is then allocated to the alternative uses on the basis of contribution per scare resource. the contribution per unit should be calculated for each of these uses. Dr Owolabi Bakre 10 .A single-resource constraint problem Where a scare resource exists. that has alternative uses.

pp. and A mountain model Cost and revenue data for the two models are given below: Dr Owolabi Bakre 11 .Example from Seal et al. Chapter (9). There are two models of panniers: A touring model. 366-367 Mountain Goat Cycles makes a line of panniers (saddlebags for bicycles). (2006).

Dr Owolabi Bakre 12 . the mountain pannier appears to be much more profitable than the touring pannier.Mountain Goat Cycles Example (cont«) Model Mountain Pannier Touring Pannier Selling price per unit Variable cost per unit Contribution margin per unit Contribution margin (CM) ratio £25 10 15 60% £30 18 12 40% According to this information.

In this situation. The bottleneck (the constraint) is a particular stitching machine. and each unit of the touring pannier requires one minute of the stitching time. The mountain pannier requires 2 minutes of stitching time.Mountain Goat Cycles Example (cont«) Now let us add one more piece of information the plant that makes panniers is operating at capacity. which product is more profitable? Dr Owolabi Bakre 13 .

the touring model provides the larger contribution margin in relation to the constrained resource.Mountain Goat Cycles Example (cont«) Model Mountai n Pannier Touring Pannier Contribution margin per unit (from above) (a) Time on stitching machine required to produce one unit (b) Contribution margin per unit of the constrained resource (c)= (a) ÷ (b) £15 2 7. Dr Owolabi Bakre 14 .50 £12 1 12 According to this information.

The additional hour could be used to make either 30 mountain panniers or 60 touring panniers. suppose an additional hour of stitching time is available and there are unfilled orders for both products.Mountain Goat Cycles Example (cont«) To verify that the touring model is indeed the more profitable. Dr Owolabi Bakre 15 .

Mountain Goat Cycles Example (cont«) Model Mountain Pannier Contribution margin per unit (from above) (a) Additional units that can be processed in one hour Additional contribution margin Touring Pannier £15 X 30 450 £12 X 60 720 This example clearly shows that the touring model provides the larger contribution margin in relation to the constrained resource. Dr Owolabi Bakre 16 .

Total contribution margin will be maximised by promoting products or accepting orders that provide the highest unit contribution margin in relation to the constrained resource.Then. Dr Owolabi Bakre 17 . the rule in the case of a single resource constraint problem Should not necessarily promote those products that have the highest UNIT contribution margins.

000 2.000 6 1 18 Capacity for the period is restricted to 12 000 machine hours. Dr Owolabi Bakre . PP.000 12. Chapter (9).000 2 3 Y £10 2 2.200 5 2 Z £6 1 2.000 4.321-322 Components Contribution per unit Machine hours per unit Estimated sales demand (units) Required machine hours Contribution per machine hour Ranking per machine hr X £12 6 2.Another Example from Drury (2004).

000 4.cont« Profits are maximized by allocating scarce capacity according to ranking per machine hour as follows: Production Machine hours Balance of machine used hours available 2.000 6.000 - The production programme will result in the following: 2 000 units of Z at £6 per unit contribution £12 000 2 000 units of Y at £10 per unit contribution £20 000 1 000 units of X at £12 per unit contribution £12 000 Total contribution £44 000 Dr Owolabi Bakre 19 .000 6.000 units of Y 1.000 units of Z 2.000 units of X 2.Another Example from Drury (2004). Chapter (9).000 10.

More than one scare resource problem Graphical Method (two products + many constraints) Simplex Method (More than two products + many constraints) Manual (tables/ matrices) Computer programs: Lindo MS Excel Dr Owolabi Bakre 20 .

We may graphically solve an LP (max problem) with two decision variables as follows: Step (1): Graph the feasible region. Dr Owolabi Bakre 21 . Step (3) Move parallel to the iso-contribution in the direction of increasing the objective function. Step (2): Draw an iso-contribution line.e.Graphical Method Any linear programming problem with only two variables (i. two products) can be solved graphically. The last point in the feasible region that contactsan iso-profit line is an optimal solution to the LP.

50 per hour During the coming period the company will have the following resources available to it: 4. Dr Owolabi Bakre 22 . pumps and fans that use similar raw materials and labour skills. The market price of a pump is £152 and that of a fan is £118.Example from Seal et al (2006). using graphical solution.000 kg of materials and 6. P.000 labour hours Required: Determine the mix of products (pumps and fans) that will maximise Colnebank¶s profit for the coming period.893 Colnebank Ltd is a medium-sized engineering company and is one of the large number of producers in a very competitive market. The company produces two products. The resource requirements of producing one unit of each of the two products are: Material (kg) Labour hours Pump 10 22 Fan 15 8 Material costs are £4 per kg and labour costs are £3.

then the problem may be set up as follows: 1. If P= units of pumps produced and F= units of fans produced.50) 28 (8 hrs at 3. 3.50) 117 88 Selling price 152 118 Contribution 35 30 The linear programming problem is to maximise the total contribution subject to the constraints.Solution: formulating a mathematical model of the above problem Pumps (£) Fans (£) 60 40 (10kg at £4) 77 (22hrs at £3. 2. Maximise: £35P + £30F Subject to: 10P + 15F < 4000 (materials) 22P + 8F < 6000 (labour hours) Materials (15kg at £4) Labour Dr Owolabi Bakre 23 .

Graphing the feasible region Dr Owolabi Bakre 24 .

Steps (2) & (3): Drawing an iso-contribution line and moving parallel to the iso-contribution in the direction of increasing the objective function Dr Owolabi Bakre 25 .

³Which is the best combination of products?´ Dr Owolabi Bakre 26 .

For example. What happens if the market price of pumps falls to £145? What will be the loss of contribution and will the revised contribution change the optimal combination? Dr Owolabi Bakre 27 .Sensitivity Analysis Sensitivity Analysis involves asking µwhat-if¶ questions.

Sensitivity Analysis (cont«) Dr Owolabi Bakre 28 .

opportunity costs are known as shadow prices. which is the profit foregone by not having an additional unit of the resource.Shadow Prices Each constraint will have an opportunity cost. Shadow prices are defined as the increase in value that would be created by having one additional unit of a scare resource. In linear programming. For example: ³What is the additional contribution if one extra labour hour is available?´ Dr Owolabi Bakre 29 .

90 (the shadow price of labour hours) Dr Owolabi Bakre 30 . the constraints 10 P + 15 F <= 4000 and 22 P + 8F <= 6000 will still be binding.06 units of P.96 units of F and 232.Shadow Prices (cont«) If one extra labour hour is obtained. and the new optimum solution can be determined by solving the following simultaneous equations: 10 P + 15 F <= 4000 (unchanged labour constraint) 22 P + 8 F <= 6001 (revised labour constraint) The revised optimal output when the above equations are solved is 111. This will increase contribution by 0.

1110 Dr Owolabi Bakre 31 . P.Another Example from Drury (2004).

cont« Dr Owolabi Bakre 32 .Another Example from Drury (2004).

440 (When Y= 0. Z = 860. Y = 430 Dr Owolabi Bakre 33 . when Z= 0.Materials constraint (8Y + 4Z 3.

Labour constraint 6Y + 8Z 2. Z =360) Dr Owolabi Bakre 34 .880 (When Z = 0. When Y = 0. Y = 480.

when y = 0. Z = 460) Dr Owolabi Bakre 35 .Machine capacity constraint 4Y + 6Z 2.760 (When Z = 0. Y = 690.

Sales limitation Y 420 Dr Owolabi Bakre 36 .

Optimum solution Dr Owolabi Bakre 37 .

Optimum solution Dr Owolabi Bakre 38 .

if possible.Simplex Method: Manual Solution In 1947. Step (5): Find the new bfs with the better objective function value. Step (2): Obtain a basic feasible solution (bfs). then determine which non-basic variable should become a basic variable and which basic variable should become a non-basic variable to find a new bfs with a better objective function value. Go back to step (3). from the standard form. The simplex algorithm proceeds as follows: Step (1): Convert the linear programming problem to standard form. Step (3): Determine whether the current bfs is optimal. Dr Owolabi Bakre 39 . George Dantzig developed the simplex algorithm for solving linear programming problems. Step (4): If the current bfs is not optimal.

p.Applying the simplex algorithm See the Drury¶s example.1110 Dr Owolabi Bakre 40 .

Simplex method: Drury¶s example Dr Owolabi Bakre 41 .

Dr Owolabi Bakre 42 .Simplex method contd.

Simplex method contd. Second Matrix Dr Owolabi Bakre 43 .

Dr Owolabi Bakre 44 .Simplex method contd.

Dr Owolabi Bakre 45 .Simplex method contd.

Dr Owolabi Bakre 46 .Simplex method contd.

Computer Programs The use of the LINDO Computer Package to solve linear programming problems The use of Microsoft Excel to solve linear programming problems« Dr Owolabi Bakre 47 .

5. Objective of the firm (maximise short term contribution). 3. 6. 2. All of the available opportunities can be included in the model. Divisibility of resources.Assumptions underlying linear programming 1. Linearity. Dr Owolabi Bakre 48 . 4. Fixed costs are constant for the period. Divisibility of products.

The theory of constraints helps in managing constraints in the short term. The alternative to optimizing against given constraints is to concentrate on managing constraints. It has an extensive focus on the short term. Furthermore. Dr Owolabi Bakre 49 . It is the topic of the next lecture. most production resources can be varied even in the short term through overtime and buying-in.The Limitations of Linear Programming LP ignores marketing considerations.

2006) Dr Owolabi Bakre 50 ..Workshop (3) See Exercises P21-4 & C21-8 (Seal et al.