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.

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.

Decision making techniques

FIN

AN

CE

Curriculum topics covered: • Types of decisions • Decision making• Decision trees • Ratio analysis

CIMA STUDY 29/8/12 11:07 Page 2

• 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.

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).

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.

Strategicdecisions

Tacticaldecisions

Operationaldecisions

CIMA STUDY 29/8/12 11:07 Page 3

A decision tree is an outcome and probability map of the scenario.

There are three possible outcomes to this scenario, each of which

can be given a financial value.

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.

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

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

31 March 2012 (against previous year for comparison)

The balance sheet (or statement of financial position) shows the

wealth of a company at a particular date. It lists the company's

assets (what it owns) followed by its liabilities (what it owes) – the

difference being the net assets. Assets may be current, such as

cash, or fixed, such as property or equipment. This value

represents the shareholders' equity – the value in the company

that the shareholders actually own.

Decision tree

£1.6m

Outcome

Outcome 1 – the site

is developed and the

bypass is rejected.

Outcome 2 – the site

is developed and the

bypass goes ahead.

Outcome 3 – the site

is sold undeveloped.

Probability

The development

value is £4m.

However, there is

only a 75% chance

of this occurring.

There is a 25%

chance of receiving

only £2m

Estimated value

A 75% chance of

receiving £4m is

'worth' £4m X 0.75 =

£3m

If the bypass goes

ahead it is ‘worth’

£2m x 0.25 = £0.5m

Undeveloped, the

site is worth £1.6m

Sales revenue

(less) Expenses

(equals) Operatingprofit

From products/services sold

E.g. costs, overheads

£m 2012

120

105

15

£m 2011

80

60

20

CIMA STUDY 29/8/12 11:07 Page 4

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

this sort of data in order to alert managers to worrying trends, as

well as to possible opportunities.

Conclusion

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.

CIMA-trained management accountants work at all levels in a

business and partner with managers across various business

functions. This can become a real source of competitive

advantage that is resistant to copying by competitors.

CIMA | Decision making techniques

Exam

-style qu

estion

s

www.cimaglobal.com

1. List two of the types of decisions that are made by

managers. (2 points)

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

when making decisions. (4 points)

3. Analyse the arguments for and against the use of

decision trees. (6 points)

4. Evaluate the use of accounting ratios when making

strategic decisions. (8 points)

Return on Capital Employed (ROCE)

This is a measure of profitability. ROCE compares the level of profit

made to the value of the capital invested in the business.

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

= 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.

= operating profit/sales

= 15/120 = 12.5% (25%)

Current ratio

This is a measure of liquidity i.e. the ability of a firm to pay its short

term debts.

= current assets/current liabilities

= 75/60 = 1.25 (1.8)

Gearing

The gearing ratio shows how much of a firm’s capital is from

long-term loans, which must be paid back regularly with interest.

The more highly geared a firm is, the greater the risk it faces.

= non-current liabilities/(equity + non-current liabilities)

= 70/(80 + 70) x 100 = 46.6% (30.0%)

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

Fixed (non-current) assets

Current assets

Current liabilities

Net current assets (or working capital)

Total assets (current plus fixed) less current liabilities

Non-current liabilities

Net assets

Total shareholders' equity

E.g. short term loan, suppliers’ bills

Current assets less current liabilities

E.g. mortgages, pension fund

(Total assets - current liabilities) less non-current liabilities

£m 2012

135

75

60

15

150

70

80

80

£m 2011

80

45

25

20

100

30

70

70

CIMA STUDY 29/8/12 11:07 Page 5