Performance management: in the first of two articles, Ian Janes analyses the principles underpinning the types of decision-making scenarios to be found in the new P2 paper.

AuthorJanes, Ian
PositionStudy notes: PAPER P2

Decision-making is a big part of most accountants' jobs. They regularly have to take, or provide the information for, key business decisions, both on a day-to-day basis and for the longer term. This is also true of candidates studying paper P2, which requires many fundamental choices to be made.


Probably the most crucial element in decision-making is the cost-benefit analysis, where we take into account the cost and revenue implications of the options open to us. It's important to recognise that making decisions on a financial accounting (absorption) costing basis is likely to be inappropriate, because the fixed cost element may not be affected by a particular course of action. Instead, many decisions are based on contribution. The measurement of this (contribution per unit equals the selling price per unit minus the variable cost per unit) is really a form of marginal or cost-benefit analysis that's used when you're faced with choices such as selecting which products to make if there's a shortage of resources, or deciding whether to accept or reject a sales order.

More generally, if the benefits of doing something will exceed the costs, the decision should be to go ahead and do it, but many benefits and costs are difficult to quantify. For example, we can all appreciate that working a few hours' overtime costs us some leisure time in order to earn some extra money. Harder to measure is the less tangible benefit of getting the job done balanced against the cost of, say, feeling more tired. Fortunately, the decision-making problems you will encounter in the P2 exam will focus on the variables that we can measure and analyse more easily.

Let's consider how we can use contribution analysis to solve a problem concerning scarce resources, which is a scenario that's regularly examined. Obviously, for most companies in most situations, market demand will be the limiting factor on operations--businesses will do their utmost to ensure that they have the resources to make a sale. But what if there's an unavoidable short-term lack of, say, skilled labour or a particular component? The key concept here is that the most beneficial production plan will be made when we prioritise production in such a way that the contribution per unit of the scarce resource is maximised.

Consider company X, which provides three different services, denominated as units of service for ease of analysis (see table 1, previous page). If labour hours are...

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