ADVANCED MANAGEMENT ACCOUNTING

Lecture (6)

Linear Programming

Dr Owolabi Bakre

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

Dr Owolabi Bakre

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Differential Costs and Revenues
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

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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.

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

For example. Dr Owolabi Bakre 7 . There is an opportunity cost for scare resources that should be included in the relevant cost calculation for decision making. 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? Managers are routinely faced with the problem of deciding how constrained resources are going to be utilised.  limited direct labour hours available. and  limited floor space. a firm may have:  limited raw materials.

Dr Owolabi Bakre 8 .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).

zero. or (2) variable xj may be positive. xn) that is to be maximized or minimized. x1. x2.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. «.  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.  3) the sign restrictions. or negative ± xj is unrestricted in sign Dr Owolabi Bakre 9 . which specify for each decision variable xj either (1) variable xj must be nonnegative ± xj >= 0.

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

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

the mountain pannier appears to be much more profitable than the touring pannier. Dr Owolabi Bakre 12 .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.

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

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 . the touring model provides the larger contribution margin in relation to the constrained resource.50 £12 1 12 According to this information.

Dr Owolabi Bakre 15 .Mountain Goat Cycles Example (cont«) To verify that the touring model is indeed the more profitable. 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«) 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. Dr Owolabi Bakre 17 .Then. 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 6 1 18 Capacity for the period is restricted to 12 000 machine hours.000 2 3 Y £10 2 2.000 12.321-322 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. PP.200 5 2 Z £6 1 2. Dr Owolabi Bakre .000 2.000 4. Chapter (9).Another Example from Drury (2004).

000 6.000 units of X 2.Another Example from Drury (2004).000 10.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 units of Z 2.000 - 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 4.000 units of Y 1. Chapter (9).000 6.

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 .

Dr Owolabi Bakre 21 .e. We may graphically solve an LP (max problem) with two decision variables as follows: Step (1): Graph the feasible region.Graphical Method Any linear programming problem with only two variables (i. Step (3) Move parallel to the iso-contribution in the direction of increasing the objective function. two products) can be solved graphically. Step (2): Draw an iso-contribution line. 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. The company produces two products.000 kg of materials and 6. pumps and fans that use similar raw materials and labour skills. using graphical solution.000 labour hours Required: Determine the mix of products (pumps and fans) that will maximise Colnebank¶s profit for the coming period. The market price of a pump is £152 and that of a fan is £118.893 Colnebank Ltd is a medium-sized engineering company and is one of the large number of producers in a very competitive market.Example from Seal et al (2006). 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. P. Dr Owolabi Bakre 22 .

If P= units of pumps produced and F= units of fans produced. 3. Maximise: £35P + £30F Subject to: 10P + 15F < 4000 (materials) 22P + 8F < 6000 (labour hours) Materials (15kg at £4) Labour Dr Owolabi Bakre 23 .50) 28 (8 hrs at 3.Solution: formulating a mathematical model of the above problem Pumps (£) Fans (£) 60 40 (10kg at £4) 77 (22hrs at £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. 2. then the problem may be set up as follows: 1.

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 .

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. For example.

Sensitivity Analysis (cont«) Dr Owolabi Bakre 28 .

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

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 111.96 units of F and 232.90 (the shadow price of labour hours) Dr Owolabi Bakre 30 .Shadow Prices (cont«) If one extra labour hour is obtained.06 units of P. This will increase contribution by 0. the constraints 10 P + 15 F <= 4000 and 22 P + 8F <= 6000 will still be binding.

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

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

when Z= 0.440 (When Y= 0. Z = 860. Y = 430 Dr Owolabi Bakre 33 .Materials constraint (8Y + 4Z ” 3.

Y = 480.Labour constraint 6Y + 8Z ” 2.880 (When Z = 0. When Y = 0. Z =360) Dr Owolabi Bakre 34 .

Machine capacity constraint 4Y + 6Z ” 2. Y = 690. Z = 460) Dr Owolabi Bakre 35 . when y = 0.760 (When Z = 0.

Sales limitation Y ” 420 Dr Owolabi Bakre 36 .

Optimum solution Dr Owolabi Bakre 37 .

Optimum solution Dr Owolabi Bakre 38 .

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

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

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

Simplex method contd. Dr Owolabi Bakre 42 .

Second Matrix Dr Owolabi Bakre 43 .Simplex method contd.

Simplex method contd. Dr Owolabi Bakre 44 .

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 .

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

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

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

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