ACC3023W – Management Accounting II – Risk and Uncertainty
UNIVERSITY OF CAPE TOWN - COLLEGE OF ACCOUNTING
MANAGEMENT ACCOUNTING II (ACC3023W)
RISK AND UNCERTAINTY
Contents
1.
Learning approach .............................................................................................................................
2.
Pre-reading details.............................................................................................................................
3.
Supplementary lecture notes ............................................................................................................
4.
Annotated lecture examples .............................................................................................................
5.
Tutorials..............................................................................................................................................
6.
Tutorial Solutions................................................................................................................................
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ACC3023W – Management Accounting II – Risk and Uncertainty
1.
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Learning objectives for this module:
Differentiate between risk and uncertainty;
Debate ways to deal with risk and uncertainty;
Explain the role and limitation of standard deviation and coefficient of variation as a
measure of risk;
Calculate and explain the meaning of expected values and how these impact on decision
making;
Describe and calculate the value of perfect and imperfect information;
Explain the impact of perfect and imperfect information on the decision-making process;
Construct a decision tree when there is a range of alternatives and possible outcomes;
Use a decision tree to determine the expected value of a decision.
Describe the strategic considerations that would influence the decision-making process
and explain the impact these would have on decisions made.
Secondary learning objective for this module:

Understand when it is appropriate to use Maximin, Maximax and regret criteria and how it is
applied.
SAICA COMPETENCY FRAMEWORK:
C1.4 Uncertainty, volatility or inaccuracy, and consideration of qualitative factors in decision-making
Level Learning Outcomes
Minimum content
2
a) Perform sensitivity and scenario analyses on key  Cost Volume Profit Analysis
variables affecting the financial outcome of the  Sensitivity and Scenario analyses
decision, and interpret the result of the calculation
 Risk and Uncertainty
b) Incorporate the possibility of various outcomes into  Probabilities and distributions
the decision-making process, including the use of  Qualitative considerations under CVP, Relevant
probabilities and expected values
costing and Capital Budgeting
c) Assess alternatives and recommend a course of
action, considering both quantitative and qualitative
factors, and whether the proposed decision is
consistent with the organisation’s strategic objectives
and plans
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ACC3023W – Management Accounting II – Risk and Uncertainty
2. Pre-reading details
Before attempting this module it is important to ensure your academic comfort in explaining the
following concepts:
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The decision-making function of management accounting.
This module builds on the decision-making framework of management accounting.
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Relevant costing principles.
The decision-making principles also build on the backbone of the relevant costing principles
covered in the previous module.
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ACC3023W – Management Accounting II – Risk and Uncertainty
Key Terms:
Expected value: A figure calculated by weighting each of the possible outcomes by its associated
probability.
Risk: A term applied to a situation where there are several possible outcomes and there is relevant
past experience to enable statistical evidence to be produced for predicting possible outcomes.
Uncertainty: A term applied to a situation where there are several possible outcomes and there is
little previous statistical evidence to enable probabilities to be attached to possible outcomes.
Standard deviation: The square root of the mean of the squared deviations from the expected value.
Coefficient of variation: A ratio measure of dispersion derived by dividing the standard deviation by
the expected value.
Decision tree: A diagram showing several possible courses of action and possible events and the
potential outcomes for each of them.
Diversification strategy: A strategy of investing in a range of different projects in order to minimise
risk.
Risk seeker: given the choice between more or less risky alternatives with identical expected values,
prefers the riskier alternative.
Risk averter: chooses to avoid risk and prefers the less risky alternative.
Risk neutral: is indifferent between alternatives with the same expected value. Always chooses the
course of action with the highest expected value.
Perfect information: refers to information not previously available or available at a cost, which will
influence your behaviour and decision- ultimately resulting in a revised expected value based on this
enhanced decision-making ability.
Source: Drury 1st Edition.
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ACC3023W – Management Accounting II – Risk and Uncertainty
3.
Supplementary lecture notes
In the previous module (Relevant Costing), you learnt of the importance of using only costs (and
revenues) that are relevant to making a decision. In this module, we build on relevant costing
principles by considering the impact of risk and uncertainty on the decision-making process.
The firm’s value is maximised by consistently choosing courses of action that result in positive
increases in the value of the firm. Where there is a choice of more than one alternative, this
means choosing the alternative that increases the firm’s value the most. You must remember
that firms have different strategies to maximise value, and that the strategic considerations you
learnt of in the previous module will therefore also impact on the decision made. The value of
the firm is the present value of future cash flows.
Because we are attempting to maximise the value of future cash flows, it should be very obvious
that these cannot be known with absolute certainty. The only thing we know for certain about
the future is that it is uncertain. All decisions we make are therefore going to result in uncertain
outcomes. This does not mean that we should not make decisions. On the contrary, we need to
constantly make good decisions to maximise the value of the firm.
This raises the question of how to make good decisions?
Good decisions are made taking into account all information that is cost-effectively available. In
addition, the business should be positioned in such a way that action can be taken when new
information becomes available. For example, when the future realises and a brilliant investment
opportunity is available, then the business needs to have cash in hand to invest.
Good decisions will also take into account the firm’s strategic goals, resource constraints and
appetite for risk.
In this module, we are going to use relevant costs and revenues to make decisions. However, we
are going to include the impact of outcomes that are uncertain and show the impact of these
on the decision-making process.
The work in this module relies on work done in statistics, such as Probability distributions,
Expected Values, Standard deviation and Coefficient of variation. Furthermore, the concept of
risk, as discussed in Corporate Financial Management, will also be used. Please revise these
topics.
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ACC3023W – Management Accounting II – Risk and Uncertainty
Key Concepts:

Risk vs. uncertainty
When given several possible outcomes for a scenario, there is a difference if you have
information or evidence to substantiate your decision or not.
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You are taking a risk if your decision is based on past experience i.e. there is statistical
evidence to support your predicted outcomes.
You are uncertain if your decision is based on little or no past experience i.e. there is
little or no statistical evidence to support your predicted outcomes.
It is far better to be taking a ‘calculated’ risk as compared to a completely unsubstantiated and
uncertain decision. In order to deal with uncertainty it may be necessary to take out insurance or
diversify. Tools like scenario analysis, Monte Carlo simulation or sensitivity analysis may also
assist.
Thus, in this module, where you are provided with an expected probability of an outcome, it
implies that the outcome involves risk rather than uncertainty.
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Probabilities and probability distributions
Probabilities are used to measure the likelihood that an event or state of nature will occur. A
probability distribution lists all possible outcomes for an event and the probability that each will
occur.
It is essential to consider the probability distribution rather than simply the most likely outcome
in any decision (the expected value). This may significantly impact your decision concerning the
scenario.
For example, two students may have a likely outcome of passing i.e. it is likely that both students
pass. HOWEVER, the first student may have a 90% probability of passing and the second only a
60% probability. Which student would you prefer to be? It shows that knowing the probability
distribution (1 = 90% chance, 2 = 60% chance) provides important information and context to
make more sense of the most likely outcome (of them both passing).
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Expected values, standard deviation and coefficient of variation
When dealing with risk, both the expected value and standard deviation for a scenario are
important.
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The expected value gives the most likely outcome (based on the probability distribution)
of the scenario and
the standard deviation gives some indication of the underlying probability distribution
(as it gives a measure of deviation from the expected value/ most likely outcome).
Remember that the standard deviation is an absolute and not a relative measure and therefore,
if comparing different scenarios the coefficient of variation (a standardized risk index or
standardized standard deviation) can also be very helpful.
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ACC3023W – Management Accounting II – Risk and Uncertainty

Joint probability and Decision trees
A "decision tree" is used as a visual and analytical decision support tool, where the expected
values (or expected utility) of competing alternatives are calculated.
A decision tree consists of 3 types of nodes:
1. Decision nodes - commonly represented by squares
2. Chance nodes - represented by circles
3. End nodes - represented by triangles
Illustration:
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ACC3023W – Management Accounting II – Risk and Uncertainty
4. Annotated lecture examples
With Expected Value, the word
“expected” indicates an Estimation.
The formula you should be thinking
about is:
Lecture Example 1: Basic Expected value
Outcome1 x Probability1 +
Outcome2 x Probability2 +...
= Expected Value
Product A profit probability distribution
Lecture example 2: Intermediate Expected value
(Source: past test paper)
Dan’s Dairy Delites (DDD) operates a chain of ice-cream and frozen yoghurt stores in Gauteng. The
owner of the firm, Dan Daring, plans to expand his operations to Cape Town in October. However, he
will only do this if he can be assured that his Net Income (EBIT) from the Cape Town business will at
least be positive during the first six months of trading. A break-even or negative net income projection
would cause Dan to cancel his Cape expansion plans.
Dan expects that selling prices and sales volumes for the first six months will be affected by the
notoriously unpredictable Cape weather. Consequently, he obtains the following long-range weather
forecast from the Cape Meteorological Office:
Weather Conditions
Probability
Fine and Hot
0.2
Moderate and Warm
Chilly to Cold
0.5
0.3
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ACC3023W – Management Accounting II – Risk and Uncertainty
Dan has found that his products are more price-sensitive in cooler weather. Also, if weather conditions
tend towards the cooler side, he will initially open fewer stores. This will have an effect on his fixed
costs. Based on this thinking, his business projections for the first six months of the new Cape Town
business are as follows:
Expected Weather
Sales Volumes
Fine and Hot
Moderate and Warm
Chilly to Cold
1 000 000 units
600 000 units
350 000 units
Selling Price per
Unit
R 5.00
R 4.50
R 4.00
Fixed Costs
R 1 440 000
R 1 200 000
R 960 000
Throughout the above forecast period, Dan expects his variable unit cost to be R 2.00 per unit sold,
but only if the weather is Fine and Hot or Moderate and Warm. If conditions are Chilly to Cold, Dan
will need to spend an extra R 1.00 per unit on advertising and promotion costs so as to achieve his
forecast sales volumes.
Required:
(a) On the basis of Expected Values of Net Income, and based on Dan’s stated condition for opening
the Cape Town business, advise Dan whether he should go ahead with his expansion plans, or
not. (Work in R 000’s, and show your workings clearly)
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ACC3023W – Management Accounting II – Risk and Uncertainty
Lecture example 2: Suggested solution
Expected
weather
Fine and hot
Moderate and
warm
Chilly and
cold
Sales volume
CM/Unit
Total CM
1 000 000
R3.00
3 000 000
LESS
Fixed costs
(1 440 000)
600 000
R2.50
1 500 000
(1 200 000)
300 000
350 000
R1.00
350 000
(960 000)
-610 000
Net income
1 560 000
Lecture example 3 – Drury Example
12.2 page 292 (10th Edition)
Drury Example 12.2 page 339 (1st
edition)
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ACC3023W – Management Accounting II – Risk and Uncertainty
Remember what the definition of perfect information is:
• Information that sheds more light on
probable outcomes.
• Having it will change our
behaviour and decision making.
Lecture Example 4: Valuing perfect information
• Consequently, changes expected value.
• Comes at a cost.
Fresh Market Supplies buys a product, which easily spoils, at R3 per box, and re-sells the product at
R5 per box. If the product is not sold within one day, it has to be destroyed at R0,25 per box. The
purchasing manager has to decide how many boxes to buy to meet demand of the next day. Sales
records have indicated that sales over the past 150 days have been as follows:
Boxes sold
per day
100
200
300
400
# of days that this
quantity of boxes were
sold
15
45
60
30
10% probability
30% probability
40% probability
20% probability
It is possible to hire a market research specialist who will confirm exactly how many boxes will be
sold the following day.
A) Calculate the (normal) expected value of each alternative
B) Calculate the expected value with perfect information (if told the exact number of boxes to
be sold the next day and the amount you would pay for this info).
This is the scenario’s way of triggering the availability of
‘perfect information’.
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ACC3023W – Management Accounting II – Risk and Uncertainty
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ACC3023W – Management Accounting II – Risk and Uncertainty
Comment:
Looking back over 150 days we’ve been able to associate some probabilities to four different
outcomes. Either 100, 200, or 300 or 400 boxes will be sold per day and those are associated with
different probability levels.
The decision is, how much should we order? Well, we are only going to order to match a certain
level of demand.
What’s important in this case is to figure out the only thing we can decide on, is how much to order.
The demand level out there for the following day is not clear. It’s going to either be 100 200 300 or
400. And as a result of us needing to decide on our quantity level, we need to realise that in all of those
decisions, there’s a multitude of different outcomes that can exist here. Outcome wise, we have 16
different outcomes.
Because within each decision of whether to buy 100 units, when we decide to buy 100, four
different things could possibly happen. The demand could either be 100 200 300 or 400 based on
our decision to buy 100 units. And that exists for every different level that we would decide to order.
So, there are 16 different outcomes that could exist here.
Optimal decision without perfect information is to buy 200 boxes.
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ACC3023W – Management Accounting II – Risk and Uncertainty
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ACC3023W – Management Accounting II – Risk and Uncertainty
Lecture Example 5: Perfect info for Lecture Example 2
Use the information from lecture example 2:
(a) Professor Stormy, an eccentric UCT academic, has developed a fool-proof weather forecasting
model. He offers to predict the overall weather during Dan’s forecast period. Although
eccentric, Professor Stormy is no fool; he will charge R 100 000 for his perfect weather forecast.
You are required to advise Dan whether this is a reasonable fee to pay for perfect
information. (Again, show your workings clearly)
RECALL:
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ACC3023W – Management Accounting II – Risk and Uncertainty
Lecture example 6-8 : Simple Maximax, Maximin, and Regret criteria
Required:
Which Machine should you choose if you use the maximin, maximax, and regret criteria tools
for the following information?
Machine A
Machine B
Low
demand
R100 000
R10 000
Suggested solution
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High
demand
R160 000
R200 000
ACC3023W – Management Accounting II – Risk and Uncertainty
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ACC3023W – Management Accounting II – Risk and Uncertainty
7. Tutorials
The tutorials for this week should all be attempted blind prior to looking at any solutions. This should
be the way that all your tutorials should be attempted as the learning in management accounting is
not through being able to do the calculations, but rather being able to articulate the thought process
and come up with a way of solving the question in the most efficient manner. Students should
therefore feel comfortable when practicing questions to spend time thinking of ways to solve problems
instead of just making themselves comfortable with the calculations of the final answer.
MANAGEMENT ACCOUNTING II
ACC3023W
RISK AND UNCERTAINTY FOR DECISION MAKING
Tutorial Questions
Tutorials
WEEK 4
RU01: The Chick Farm
RU02: Nuvo Electronics (Pty) Ltd
RU03: Ruby Ltd
RU04: Golf Haven Property Developers (GH)
RU05: Totem Ltd*
*Unseen tutorial
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ACC3023W – Management Accounting II – Risk and Uncertainty
RU01: The Chick Farm
John Khumalo is seriously considering the purchase of The Chick Farm, a poultry-rearing company
situated 30 kilometers north of Cape Town. The company has been poorly managed and has incurred
large losses over the past few years. After investigating the industry thoroughly, John believes that he
can make a success of The Chick Farm.
The company purchases day-old broiler chicks, and rears them in a free-range environment inside
large, barn-like structures. After 32 weeks, the poultry is at the correct age and weight for slaughter.
At this stage, they are sold to an independent company, which culls, cleans and packages them, for
sale to supermarkets across the Western Cape.
After each 32-week cycle, the barns must be cleaned, fumigated and then left empty for 20 weeks.
Failure to do this leads to the spread of highly infectious poultry diseases. This has been a large part of
The Chick Farm’s problems in recent times, and John has decided to adhere strictly to the 32-week full,
20-week empty cycle for his barns. (32 + 20 weeks = One full production year.)
The barn space available to John allows him to introduce 50 000 chicks into his barns at the beginning
of each production year.
The poultry industry is not without its risks, and John has identified the main risks as being:
(1) Infectious diseases. Chicks can be inoculated against the most common diseases, but the
threat of unknown diseases remains;
(2) Crushing. Chickens are very nervous creatures, and sudden loud noises (such as very loud
thunder, or the sound of an air-force jet flying low overhead) can cause the chickens to rush
towards the sides of the barns, where many of them will be crushed to death against the walls
of the barns.
Given the situation at The Chick Farm, John has come up with three possible scenarios for the next
production year:
Possible: No infectious disease outbreaks or crushing incidents. 5% of chickens will die of other causes,
at an average age of 16 weeks;
Probable: No infectious disease outbreak. 5% of chickens will die of other causes, and 10% in crushing
incidents, both at an average age of 16 weeks;
Worst-case: Infectious disease outbreak and crushing incidents. 5% of chickens will die of other causes,
10% from crushing incidents and 20% from infectious disease outbreaks, all at an average age of 16
weeks.
The probability of these scenarios occurring has been determined as follows:
Possible
25%
Probable
45%
Worst-case
30%
Costs:
Day-old chicks are purchased at a cost of R1.00 each. Variable costs incurred in the rearing of the chicks
(e.g. medicines, food, vitamin supplements, lighting and heating etc.) amount to R0.28 per chick, per
week.
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ACC3023W – Management Accounting II – Risk and Uncertainty
Fixed costs for The Chick Farm for the full production year amount to R90 000.00
Full-grown (32-week-old) chickens are sold at R15.00 each.
Crushed chickens are sold to pet food companies. The selling price exactly covers the cost of
transporting the dead chickens to the pet food companies. Infected chickens are not sold. The disposal
costs of these chickens are already included in the fixed cost figure of R90 000 per year.
Required:
(a) John will buy The Chick Farm if the expected value of the annual net income is positive. He
asks you to calculate this figure, using the information provided above;
(b) Professor Rooster, from the Onderstepoort Veterinary Institute, has developed a method for
forecasting the types of infectious poultry diseases which will affect South Africa in any given
year. This would allow John to medicate his chickens and thereby prevent all deaths from
disease (At no extra cost, other than the charge from Prof. Rooster)
What is the maximum price that John should pay for the perfect information from Prof.
Rooster regarding the expected diseases?
(c) If the price is acceptable and John buys the perfect information, will he definitely be better off
than if he had not bought the information?
(d) In your opinion, what is the personality profile of an investor who always buys perfect
information if the price is right?
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ACC3023W – Management Accounting II – Risk and Uncertainty
RU02- Nuvo Electronics
(42 Marks: 50 Minutes)
Nuvo Electronics (Pty) Ltd (‘Nuvo’) manufactures electrical appliances (e.g. kettles, irons, blenders,
heaters etc.) suitable for both domestic use, and use in the hospitality industry. The company’s
products are sold to large retailers, who on-sell the products to the general public.
Nuvo has noticed a slight decline in demand for its products in recent months, which the company
attributes to consumers purchasing gas appliances, in preference to electronic appliances, given the
uncertainty regarding power outages and increasing electricity tariffs. Many consumers have
purchased generators and inverter operated battery systems that cannot power standard heating
appliances, opting to use gas for cooking and boiling water instead. The company believes it can
increase sales, and win back it’s market, by introducing appliances with low kilowatt consumption that
are not only extremely energy-efficient but can be run from the domestic size generator or battery
bank. Consequently, the company is considering launching a low-watt kettle, as kettles are considered
to be one of the most popular kitchen appliances.
If Nuvo were to launch the low-watt kettle, they believe that there is a 30% probability that market
acceptance would be low and that only 10,000 kettles would be sold to consumers, a 40% probability
that market acceptance would be moderate and 20,000 kettles sold to consumers, and a 30%
probability that acceptance would be strong and 30,000 kettles would be sold to consumers. Due to
the nature of the distribution channel, long lead times between production and eventual sale to
consumers exist. This is necessary for Nuvo and the retailers to contractually agree to the number of
units of product that Nuvo will supply the retailer with several months in advance, in order for the
retailer to plan usage of shelf space. Consequently, if Nuvo was to go ahead with this order they would
produce the maximum quantity (30,000 units) in order to test consumers’ response to the product, as
the low-watt kettles would have to be produced within the next 2 month period in order to time the
sale of low-watt kettles appropriately. Nuvo’s marketing team believes that the opportunity to
successfully launch a new product far outweighs the downside risk of not selling the full quantity
produced. Future production and sales would depend on consumer’s response to the launch of the
low-watt kettle.
It has been suggested that the low-watt kettle be sold to the retailers at R240, which represents cost
plus a mark up of 20% as per the costing below:
Material costs
- 1 heating element 1
- Plastic and other 2
Consumables and variable overheads 3 & 5
Labour 4 & 5
Other fixed manufacturing overheads3 & 5
Total Cost
20% mark up
Selling Price (to retailers) 6
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R’s
35
35
48
12
70
200
40
240
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ACC3023W – Management Accounting II – Risk and Uncertainty
1 Nuvo purchases elements from the sole national distributor in South Africa of an international
appliance component supplier, as these are regarded as being arguably the best quality elements on
the market. The heating element cost above of R35 represents the purchase price of an element from
the South African distributor. In terms of the licensing agreement which exists between Nuvo, the
international company and South African distributor, Nuvo cannot purchase elements from any other
supplier. The manufacturer already supplies 70,000 elements per month to Nuvo, and as a result of
their own procurement constraints and existing commitments to other parties, is only able to supply
Nuvo with an additional 17,000 elements over the next two month period.
Nuvo has 2,000 of these elements in stock after normal production and sales. These elements are
used in the standard kettles that the company produces (refer to the next page). One element is used
per kettle. In addition to using the element in the production of kettles, the company sells the
element to customers at R50 per element. Approximately 2,900 elements are sold to customers per
month. Customers would purchase these elements from competitors if Nuvo was out of stock of
these items.
2 The plastic and other materials to be used on the order are the same as those used in many other
products that Nuvo produces. The cost included in the calculation above reflects the last invoice price
at which these materials were purchased. Nuvo expects prices of these materials to be 10% higher
when they are next purchased due to inflation in the industry. Nuvo has sufficient quantities of plastic
and other materials on hand to produce 30,000 low-watt kettles.
3 The company allocates consumables and overhead costs to its products on the basis of machine hours.
The company estimates that it will require 10 minutes of machine time per low-watt kettle, and that
production of the low-watt kettle will consume an equal amount of labour and machine time. The
average machine time per kettle was determined by dividing the total number of units of kettles to be
produced by the total amount of machine time required, including the time required to set up and
clean the machinery (also refer note 5).
4 This labour cost applies to the permanent workforce (and is consequently regarded as a fixed cost),
and has been allocated based on labour hours per kettle (as per note 3 above).
5 Nuvo has determined that the company will have 4,000 spare machine hours over the next 2 month
period, as well as 3,500 spare labour hours. Any shortfall in hours required to make the minimum of
30,000 kettles can be sourced by reducing sales and production levels of standard kettles. The
company manufactures the standard kettle that sells at R275 (to retailers, which represents a 30%
mark up on cost) and earns a contribution margin of R120.46 per unit. The standard kettle uses 7.5
minutes of machine time per kettle, and requires only 1 hour of labour time for every 2 hours of
machine time. Alternatively, additional labour could be hired at R60 per hour.
6 The marketing manager has argued that his division should be allowed to carry out a market survey
in order to ascertain what level of market demand would be at the suggested price level, in order to
inform production levels. Nuvo has not carried out market surveys for the last two years in order to
save costs, as market surveys only produce reliable results where extensive work is done, which is a
very costly exercise. Nuvo had consequently taken the policy decision that in the current economic
environment where electronic appliances have become more of a luxury product, than a necessity, for
many consumers, and their profit margin was under pressure due to decline in demand, that the
company could not afford to undertake market surveys, as they did not add sufficient value.
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ACC3023W – Management Accounting II – Risk and Uncertainty
REQUIRED:
1. Calculate the financial impact of launching the low-watt kettle.
(22 marks)
2. Calculate the maximum amount that Nuvo would be prepared to pay for a market survey to be
conducted, as suggested by the marketing manager.
(10 marks)
3. Identify and discuss the considerations that should be taken into account in the decision to launch
the low-watt kettle.
(10 marks)
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ACC3023W – Management Accounting II – Risk and Uncertainty
RU03 Ruby technology
Ruby Ltd, a company in the technology sector, is famous for its innovative, well-designed and high- level
performance products such as cameras, phones, laptops and tablets. These products have in many ways
revolutionised the markets in which it was introduced and Ruby is considered to be a very successful
company.
Since the departure of Ruby’s famous and charismatic CEO, Ruby has been struggling to develop and release
its next generation innovative product. As a result, the market is concerned that Ruby is not the same
company without its CEO. Ruby is in the process of deciding whether to launch its latest product offering, a
smart watch. The company is hoping that the smart watch will be the product which will show the market
that the company can still produce marvellous, revolutionary products. The watch will be able to tell the
time, monitor health and physical activity, as well as display notices from social networks. Ruby expects to
sell the watches for R2,000 each and make a contribution margin of 50% on this price. Ruby will use a
production facility that can produce a total of 450,000 watches. Fixed costs to support this capacity amount
to R200 million per annum.
The company has already spent R1 million on research and development of the smart watch. The
development process was successful, but the company is not sure whether it will be appropriate to produce
and release the product into the market as it is not clear how the market will react and the resultant market
size.
Ruby knows that its biggest competitor, Legis Ltd, is in the process of manufacturing a product similar to
Ruby’s smart watch. The success of Ruby’s smart watch largely depends on which one of the two companies
releases its product first, and whether the market considers the value/price ratio to be fair. Ruby considers
that there is a 75% probability that it will be able to introduce its smart watch before Legis. If Legis
introduces its smart watch first, Ruby will have to drop its selling price by R200 per unit to get a reasonable
market share. There are also other products in the market which have similar functionality to Ruby’s smart
watch. Ruby also knows that the first year of the project will determine the success of the smart watch. If
the product is a failure, it will be discontinued immediately.
Based on Ruby’s past experience of introducing new products into an existing market, as well as additional
market research that has been done (which cost R250,000), the following information is available:
The total market size and probability:
800,000 watches for the first year
30%
600,000 watches for the first year
60%
200,000 watches for the first year
10%
Ruby is expected to capture the following market share depending on which company introduces its smart
watch first:
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24
ACC3023W – Management Accounting II – Risk and Uncertainty
Ruby smart watch
Legis smart watch
Other offerings
Ruby introduces
first
60%
20%
20%
Legis introduces first
40%
40%
20%
Ruby has been approached by an employee from Legis who will be able to give Ruby inside information
regarding the exact date that Legis plans to launch its smart watch. The Legis employee wants R100,000
compensation for the provision of this information.
REQUIRED [Please round all number to the nearest R’000]
(a)
Evaluate the decision of whether Ruby should go ahead with the project or not based
on the first year of operations.
Communication skills – structure and layout
(b)
Determine the amount Ruby should be willing to pay to receive the additional
information from the employee of Legis and discuss whether the company should
accept this offer of information.
(c)
Identify 3 different ways in which Ruby can mitigate the risks associated with the
launch of the new smart watch product.
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25
ACC3023W – Management Accounting II – Risk and Uncertainty
RU04 Golf Haven Property Developers
(35 Marks: 53 MINUTES)
Golf Haven Property Developers (GH) have recently begun the development of a West Coast Golf Estate.
The foundations have been cast for the first luxury free-standing house, and the brickwork has been built
up to slab height, and the structure has been backfilled, compacted and is now ready for the slab to be cast.
GH is currently trying to decide how much steel mesh should be put into the concrete slab. The purpose of
the mesh is to limit cracking. Cracking occurs over an 18 month period and as a result the worst of the
cracking will not be evident until after the house is completed and sold. If the slab cracks, then repairs will
be required, the cost of which is dependent on the severity of the crack. If only minor cracking occurs, the
repair costs are unlikely to exceed R500. If the cracking is moderate, the costs of repair will amount to R4
000. However, if major cracks develop, repair costs will probably amount to R15 000, as a substantial portion
of the travertine flooring would have to be replaced.
The degree to which the slab is likely to crack is dependent on two factors – the quality of the sub- grade,
and shrinkage.
The quality of the sub-grade refers to how well the sand has been compacted – i.e. the degree and
consistency of compaction. There is a 40% probability that the compaction is of a mediocre quality, which will
increase the extent to which the slab will crack, but a 60% probability that the compaction will be of a high
quality.
All concrete slabs exceeding 5.5m in length will crack due to shrinkage. Steel mesh is cast into the slab in
order to control this cracking and encourage a large number of minor cracks to develop, rather than a few
major cracks. The idea is to achieve a high probability of minor cracks and a low probability of moderate and
major cracks. Two different grades of mesh could be used:


Ref A193 mesh – this is a relatively light weight mesh built from steel bars that are 5.6mm in
diameter. The quantity of mesh required for this house will cost R3 600.
Ref A245 mesh – this is a heavier mesh constructed from steel bars that are 6.3mm in
diameter. The quantity of mesh required for this house will cost R9 200.
The probability of minor, moderate and major cracks developing (dependent on steel mesh and sub-grade
compaction), is as follows:
Cracking type
Minor
Moderate
Major
Compaction of High Quality
Ref A193 mesh
Ref 245 mesh
50%
65%
30%
25%
20%
10%
Compaction of Mediocre Quality
Ref A193 mesh
Ref 245 mesh
5%
55%
10%
30%
85%
15%
GH needs to decide which reference mesh to put into the slab. It is possible to carry out a compaction test
on the sub-grade in order to establish the quality of the compaction – but this will cost R1 000.
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ACC3023W – Management Accounting II – Risk and Uncertainty
Required:
1. Which reference mesh should be included in the slab?
(20 marks)
2. Is carrying out the compaction test worthwhile?
(8 marks)
3. GH is aware that it is possible to put a sufficient quantity of steel (roughly 0.5% of the cross-sectional
area of the slab should be steel) into the slab in order to prevent major cracks occurring (with
almost 100% certainty). If this thicker mesh was used, there is a 5% probability of moderate cracks
occurring given a high quality of compaction, and a 20% probability of moderate cracks occurring if
the sub-grade quality is mediocre. What is the maximum amount that GH should be willing to pay
for this higher reference mesh?(7 marks)
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27
ACC3023W – Management Accounting II – Risk and Uncertainty
RU05 Totem (Source ACC3023H June 2019)
(43 MARKS: 64 MINUTES)
Totem Ltd. (“the Group”) is a multi-national oil and gas company founded in 1925. Totem South Africa
(Pty) Ltd (“Totem SA” or “the Company”) is a wholly owned subsidiary of Totem Ltd. Totem SA began
its operations in South Africa in 1955. The Company prides itself on being globally aligned to the Group
and benefiting from internationally acclaimed best practices shared within Totem Ltd.
Totem SA’s operations consist of the production and sale of numerous oil & gas products. The Company
relies heavily on imports of crude oil3 to manufacture the final refined oil and gas by-products which
are sold to consumers.
Totem SA announced last month, that they have discovered a large natural gas4 field, known as the
Bullfrog Block, off the coast of Mossell Bay. The Company predicts that the area could yield a total of
1 billion barrels5 (barrel-oil-equivalents) of natural gas for the project. If the predictions are correct it
will make the Bullfrog Block the largest natural gas discovery globally in the past year. The Totem SA CEO
is confident that the recent announcement may decrease the Company’s current reliance on crude oil
imports.
Totem SA attempted to drill the Bullfrog block in 2014, but was unsuccessful in discovering natural gas.
The failure to discover natural gas was attributed to the fast-flowing Agulhas ocean current that passes
through the Block, causing significant large waves the height of multi-story buildings. Further, adverse
weather conditions impacted the ability of the Company to drill during the period.
Despite this initial failure, the Totem SA CEO decided to drill again, she believes that with high risk comes
high reward. Totem SA’s recent second attempt to discover gas in the Bullfrog Block proved to be
fruitful (as previously detailed in the announcement), due to the use of improved technology. The
Company used a sophisticated weather forecasting system as well as an onshore high-frequency radar
to stay ahead of adverse weather and ocean conditions to optimise drilling.
Natural Gas:
Natural gas is a hydrocarbon energy source similar to crude oil. There are several uses for natural gas;
such as heating, cooking, electricity generation, as well as producing fuel for vehicles. Natural gas is a
fossil fuel6, however, it is considered a viable option to meet global energy needs due to it being the
most environmentally friendly fossil fuel.
The use of fossil fuels as an energy source has been found to have a significant carbon footprint causing
damage to the environment. There has been a global push for environmental awareness and
developing more sustainable methods of energy creation. Asa result, Totem SA has made sustainable,
economically friendly energy creation an objective of the Company.
3
Unrefined liquid, which is processed in to petroleum to be used as fuel.
Flammable gas consisting mostly of Methane, which is formed underground.
5
Even though natural gas is not sold in physical barrels, the prices are quoted globally in barrel-oil-equivalents
6
A non-renewable source of energy formed naturally over thousands of years.
4
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ACC3023W – Management Accounting II – Risk and Uncertainty
The discovery of natural gas, a first for South Africa, could have tremendous positive effects on the
local economy and has been met with great enthusiasm. However, Professor Khumo Mo’ledies is more
alarmed than enthusiastic by Totem SA’s discovery, as he believes it will have adverse effects on the
environment through possible gas leakages to the ocean. The process of drilling for natural gas is
complex - often gas may leak out of the sea-bed causing devastating effects to the ocean’s ecosystem.
Further, Mossel Bay is predominantly a fishing town, and the community depends on the ocean for its
livelihood.
Natural Gas Extraction Process:
The first stage of the natural gas extraction process (initial drilling) involves performing seismic tests
to identify hydrocarbons on the rock formations of the seabed, and thereafter setting up one initial
drill well to gauge whether natural gas exists. Totem SA have just completed this stage and were
successful in the identification of natural gas, as detailed in the announcement.
Thereafter, the second phase, appraisal drilling occurs after the successful completion of the initial
drilling. Appraisal drilling involves sinking wells in order to find sufficient quantities of natural gas
deposits. Only if sufficient quantities of natural gas for large scale production are found, will Totem SA
set up a mining rig.
The final stage relates to production. The existing wells will be developed further to extract natural gas
from each of the appraisal wells to the mining rig. The mining rig will require tremendous effort to set
up, as the rig will be in the sea. Sea-water natural gas extraction is an inherently risky operation. The
ocean represents a significant danger to its operations, as several employees of Totem SA will be
working on the rig once it is set up. Once the mining rig is set up successfully, Totem SA can begin its
natural gas extraction process.
Totem SA Bullfrog Block Project:
The Bullfrog Block project of Totem SA is currently considering entering the second phase, appraisal
drilling. The Company is unsure of whether to use four or six wells to drill for natural gas. These are the
only two drilling options available to the Company during appraisal in evaluating whether sufficient
quantities of natural gas exist for large scale production. The oil and gas industry precedent is that 65%
of the time, four wells have found sufficient quantities of natural gas to continue mining. Six wells have
a 90% chance of discovering sufficient quantities of natural gas, due to the greater surface area covered
by the wells. Each well will cost R100 million to sink and setup during the appraisal drilling phase.
If sufficient quantities of natural gas are discovered, the mining rig will be set up and extraction can
begin. If sufficient quantities of natural gas are not discovered, Totem SA will stop their mining
operations as it will not be profitable to extract small quantities of natural gas. The cost of sinking and
setting up the well will not be recovered once appraisal drilling has begun.
If sufficient quantities of natural gas are discovered, there is a 60% chance that the natural gas deposits
are as expected and 100 million barrel-oil-equivalents are extracted per annum over the life of the
project, and a 40% chance that the yield of gas is low and only 55 million
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ACC3023W – Management Accounting II – Risk and Uncertainty
barrel-oil-equivalents are extracted per annum over the life of the project – irrespective of the number
of wells. The project is estimated to last for 10 years in either case.
The estimated financial information for one year of operations is as follows:
Revenue per barrel
Selling Price (N1)
$9 per barrel-oil-equivalent
Total Production Costs per Annum
Amount (R’000)
Labour (N2) *
25 000
Transport (N3) **
600 000
Processing costs (N4)
???
Royalty expense (N5)
???
Depreciation
1 400 000
Decommissioning costs (N6) *
1 500 000
* The amount is based off an estimated extraction of 100 million barrel-oil-equivalents.
** The amount is based off four wells being used.
N1: As with all commodities, the price of natural gas is determined by global supply and demand forces
and quoted in US Dollars. The price detailed is the most recent selling price of a barrel-oil-equivalent
of natural gas. The price of natural gas has been extremely volatile in recent years. During the past ten
years prices have dropped significantly due to increased supply. Totem SA will enter in to forward
exchange contracts to lock in the current exchange rate for its sale of natural gas throughout the ten
years of operations.
N2: A large labour force is required for the success of this project, specifically artisanal workers such
as electricians and welders are required. These artisanal workers will be employed on a pay as you
work model. There is a direct relationship between the number of barrel-oil-equivalents extracted and
the number of artisanal workers required. The artisanal workers will mostly be sourced from Mossel
Bay and its surrounding areas.
Further, the engineers required for the project will be recruited from America due to the skills not being
available in South Africa. The engineers will each be paid a fixed salary of $100 000per annum. The
project requires ten engineers for the duration of the operations irrespective of the quantity of natural
gas discovered.
These are the only two categories of employees required, all employee’s costs are included as part of
the labour cost detailed above.
N3: The raw natural gas will be transported via underwater piping from the ocean mining rig to the
processing facilities, in Mossel Bay. The cost of the piping will vary based on the number of wells. Each
well will require its own piping at a cost of R150 000 000 per annum.
N4: After the raw natural gas is extracted and transported to the processing facilities in Mossel Bay,
the raw natural gas is refined. Refinery involves the removal of all other elements and compounds such
as water, ethane, butane, propane, and carbon dioxide.
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ACC3023W – Management Accounting II – Risk and Uncertainty
The estimated processing costs for the first three months of operations are:
Month
Barrel-Oil-Equivalents (Thousands)
Cost (R’000)
July
7 000
R250 000
August
10 000
R400 000
September 12 000
R350 000
N5: Totem SA will be required to pay a royalty tax on natural gas sold. The royalty tax expense is 5% of
revenue. There is a risk that this royalty tax may increase in the future due to uncertainty regarding
regulation governing oil and gas mining in South Africa.
N6: Decommissioning costs are a legal requirement for any extraction of oil and gas, and will be
required if appraisal drilling occurs. The decommissioning of the mine relates to the removal of all
mining infrastructure and restoration of land/sea to its original state. The full decommissioning costs
will only be incurred at the end of the project. The cost detailed in the table is the annualized
decommissioning costs – i.e. the total cost allocated across ten years. The decommissioning costs
above relates to four wells used. If six wells are used, decommissioning costs will be greater, and is
estimated to be R2 600 million per annum.
The process of removing all mining infrastructure built will be as difficult as setting up the natural gas
mining rig initially. Due to the risks and difficulties of offshore mining decommissioning, there are very
few companies that are offering decommissioning services. Further, the number of companies offering
these services has been on a steady decline, which may lead to a supply shortage in the future. The
industry best practice is to outsource the decommissioning to a qualified company. If the
decommissioning process is incorrectly completed, it may cause more harm to the environment and
result in significant fines being levied on Totem SA.
This will be the first time Totem SA’s management embark on mining natural gas. The Board of
Directors of Totem SA are worried that by committing to this project, significant fixed costs will be
incurred making Totem SA very dependent on good yields of natural gas. Since the Company’s
discovery, the price of mining rights7 to the Bullfrog block has increased exponentially. Totem SA could
decide to forego the entire mining process and sell their rights to its competitors Shelly Ltd or Ingin Ltd
for R18 billion. The rights sale, should Totem SA consider that to be a viable option, will occur
immediately prior to appraisal drilling. Totem SA’s rights to mine in this region will expire after twenty
years, thereafter it will be open to competitors to bid for the rights.
Additional information:
- The prevailing exchange rate currently is R14.7 for US$ 1. This exchange rate is hedged with the
forward exchange contract and applies to ALL US Dollar incomes and expenses in the scenario.
- Ignore time value of money in the scenario.
- Depreciation can be used as a proxy for future capital expenditure
7
This gives you permission to mine for natural gas in a specified block of the ocean.
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ACC3023W – Management Accounting II – Risk and Uncertainty
REQUIRED
1.
MARKS
Determine which course of action Totem SA should follow relating to the 23
Bullfrog Block over the life of the project. Calculate the Expected Values
for all possible decisions available to Totem SA.
Detail and provide workings for all decisions considered.
Answers are to be presented in R’000s.
2.
The CEO of Totem SA has asked you for your insights and additional factors 18
she should consider relating to the Bullfrog Block project.
You are required to draft a memorandum to the Totem SA CEO in which
you discuss all factors that should be considered in arriving at a decision
regarding the Bullfrog Block project, and finally conclude as to what the
optimal course of action should be for Totem SA.
- Include as part of the memorandum, one insightful and relevant
Cost Volume Profit (CVP) calculation with appropriate
interpretation – the CVP calculation is limited to 1 calculation. (4
Marks)
Assume that the Totem SA CEO wants to go forth with the natural gas
mining project using four exploration wells and an extraction of 100 million
barrel-oil-equivalents per annum. The CVP (cost volume profit)
calculations are to be considered in light of this decision.
Presentation and Communication: Effective Communication and
2
Layout of the communication
TOTAL
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43
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ACC3023W – Management Accounting II – Risk and Uncertainty
9. Tutorial Solutions
MANAGEMENT ACCOUNTING II
ACC3023W
RISK AND UNCERTAINTY FOR DECISION MAKING
Tutorial Solutions
Tutorials
Week 4: Beginning
RU01: The Chick Farm
RU02: Nuvo Electronics
RU03: Ruby Ltd
RU04: Golf Haven Property Developers (GH)
* Unseen tutorial – solution will be done in your tutorial session
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33
ACC3023W – Management Accounting II – Risk and Uncertainty
RU01: SUGGESTED SOLUTION
(a) Calculation of Net Income under each scenario:
Possible
Deaths: 5% of 50 000 = 2 500 chickens
Sales: 47 500 X R15
Less: Cost of Sales: 47 500 X (R1 + [32 X R0.28]) = 47 500 X R9.96
Less: Cost of dead chickens: 2 500 X (R1 + [16 X R0.28]) = 2 500 X R5.48
Less: Fixed Costs
Net Income
Probable
Deaths: (5% + 10%) of 50 000 = 7 500 chickens
Sales: 42 500 X R15
Less: Cost of Sales: 42 500 X (R1 + [32 X R0.28]) = 42 500 X R9.96
Less: Cost of dead chickens: 7 500 X (R1 + [16 X R0.28]) = 7 500 X R5.48
Less: Fixed Costs
Net Income
Worst-Case
Deaths: (5% + 10% + 20%) of 50 000 = 17 500 chickens
Sales: 32 500 X R15
Less: Cost of Sales: 32 500 X (R1 + [32 X R0.28]) = 32 500 X R9.96
Less: Cost of dead chickens: 17 500 X (R1 + [16 X R0.28]) = 17 500 X R5.48
Less: Fixed Costs
Net Income
Expected Value of Net Income:
Possible:
R 135 700 X 0.25
Probable:
R 83 100 X 0.45
Worst-Case:
-R 22 100 X 0.30
Expected Value
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=
R 33 925
=
R 37 395
=-R 6 630
R 64 690
34
R’s
712 500
(473 100)
(13 700)
(90 000)
135 700
R’s
637 500
(423 300)
(41 100)
(90 000)
83 100
R’s
487 500
(323 700)
(95 900)
(90 000)
(22 100)
ACC3023W – Management Accounting II – Risk and Uncertainty
(b) Maximum price of perfect information:
New net income under Worst-Case scenario = Deaths of (5% + 10%) X 50 000 = 7 500 chickens
This is the same as the Probable scenario, therefore Net Income = R83 100
Revised EV:
Possible
R 33 925
Probable
R 37 395
Worst-Case: R83 100 X 0.30 =
R 24 930
EV with perfect information
R 96 250
EV without perfect information R 64 690
Maximum value of perfect info. R 31 560
(c) John will not always be better off with perfect information. For example, he may be prepared to
gamble that the Probable scenario will occur in the next year, with no unknown infectious diseases. If
he does not pay for perfect information, and the Probable scenario occurs, he makes a net income of
R 135 700 as shown under (a) above. If he had paid for perfect information, his profit of R 135 700
would have been reduced by the amount paid for perfect information, and he would have been worse
off.
(d Perfect information, which is a risk management strategy, should reduce risk. Because it comes at a
cost it also reduces the return. Therefore an investor who always pays for perfect information is likely
to have a risk-averse personality.
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ACC3023W – Management Accounting II – Risk and Uncertainty
RU02 Solution
1.
Suggested Solution to Question 2
1.
Marks
Expected Revenue
R's
4,800,000
Material costs
- Elements
- Plastics and other
1,050,000
1,155,000
35 x 1.05 x 30,000
2
2
Consumables and variable overheads
1,440,000
48 x 30,000
1
8,000 x 120.46 ( W2 ) or
1
Workings
2
35 x 30,000
Opportunity costs:
963,692
Standard kettle sales
Lost element sales
W1
45,000 W1
Hire additional labour
60,000
Other fixed manufacturing overheads & existing labour
force
Relevant cost
500 x 1,927.38
3,000 x (50-35)
1.5
1,000 x 60
1
Not incremental
1
1
-
86,308
Lack of internal consistency= -2.
W1 Constraints
Spare
Required
Short
From:
Std kettle sales
Element sales
Hire labour
Elements
19,000
-30,000
-11,000
8,000
-3,000
3,000
Machine
Hours
4,000
-5,000
-1,000
Labour hours
3,500
-5,000
-1,500
1,000
0
500
-1,000
1
2
2.5
0.5
1
1
1,000
W2 Cm/ std kettle
Contribution margin
per labour hour
120.46
1927.36 (120.46 x 60/3.75)
Cheaper to forego elements sales and hire labour (i.e. R15 + R60/6 = R25 per element obtained this way, than
reduce kettle sales further (R120.46 per element obtained in this way).
1.5
3
Total available
25
Additional marks availab le for justification and explanation.
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ACC3023W – Management Accounting II – Risk and Uncertainty
2.
Relevant benefit at each possible demand level:
10,000 20,000
Revenue (R240 x demand level)
Costs at each demand level
Variable costs (35 + 35x1.1 + 48) x10,000; x 20,000
Lost element sales at 20,000 units
2,400,000 4,800,000
Finacial impact of each option
Probability
Expected value of launch before paying for market surve
-
30,000 Expected value
7,200,000
1,215,000 - 2,430,000 - 15,000
1,185,000 2,355,000
30%
40%
355,500 942,000
1
1
4,886,308 (4,800,000 - 86,308)
2,313,692
30%
694,108
3
1
1,991,608
1
1
86,308
1,905,300
2
The opportunity costs (lost kettle sales and element sales) and additional hired labour will only be incurred if the final 10,000
units are produced, as spare capacity exceeds 2/3rds of the total machine and labour to produce 30,000 units of the low-watt
kettle. This is except for 1000 element sales that would be forgone if 20,000 kettles were produced - spare capacity was for
19,000 elements, 20,000 would be required.
Total available
3
13
Expected value without the launch
Value of certainty as to the demand level
Additional marks available for justification and explanation.
3.
Marks

Without the survey, the expected outcome is only marginally positive, but this is
not an actual outcome.
1

There is a 70 % probability that the launch of the kettle will have a positive
financial impact, if either 20,000 (Financial impact: R86,308) or 30,000 (Financial
impact: R694,108) kettles are sold.
1
2

If only 10,000 kettles are sold the company will incur a loss of –R2,313,692 (i.e.
86,308 – 4,800,000 + 2,400,000).
2

However, Nuvo should not consider either changing the price as a result:
 The price suggested is based on a long term costing of the product – i.e. it
covers the fixed costs relating to the resources used, ignores opportunity
costs and provides a profit margin. This is appropriate in order to provide
an indication of product acceptance. A lower or higher price would not be
reflective of the price that the company would charge in the long term,
and consumers responses to a different price would not provide a
reasonable input into the decision to continue with the product in the
future, or not. Further, the price that is set now will set a precedent for
future sales.
 Alternatively, there may be an argument to set the price slightly below the
optimal long term price, in order to make it unattractive to competitors to
introduce competing low-watt kettles. Once Nuvo is satisfied that they
have sufficiently established their brand in the low-watt market niche
1
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37
1
1
1
1
1
1
ACC3023W – Management Accounting II – Risk and Uncertainty
(and buying behaviour/brand loyalty is established), they could slowly
increase prices. The entry of competitors at this point (now that better
profit margins can be achieved) will serve to reinforce the increased prices
Nuvo now charges.



Nuvo should also not consider aborting the launch of the kettle as a result of a
30% probability of incurring a loss, unless of course the company’s cash flow
situation is not sufficiently strong to sustain the loss. Even though there is a 30%
probability of a loss, all new products have a possibility of failing, and the benefit
of success over time, outweighs the cost of products that fail. (The expected value,
while not the actual outcome for a once off decision, becomes the average
outcome overtime, as similar projects are repeated, in this case, launching new
products).
While the company should not consider aborting the launch of the kettle, they
should consider ways to improve the anticipated profitability of the decision, and
reduce cost and potential losses where possible.
It is clear from part 2 that the launch has the possibility of contributing generously
to the company’s profit under any demand level, provided that production is
matched to demand. The cost of having to produce the maximum quantity in full
upfront, is high (R1,911,300 – part 2). Unless the cost of undertaking a market
survey exceeds this (unlike, surely?), the effect of the company’s decision to not
carry out market surveys would have been to decrease the company’s profitability
over the long term (unless other new products did not carry similar probability
profiles, and did not require the maximum quantity to be manufactured in
advance.)

The market survey should be carried out, at a cost below R1,905,300.

Is the cost allocation accurate for variable overheads and consumables? The
current financial benefit is marginal, and variable overheads account for 30% of
the expected revenue figure. Further consideration should be given as to whether
allocating all overheads, including consumables, on a proportional, volume based
system (relative use of machine time) is correct, and whether all costs behave in
this manner. This would be unlikely. For instance, consumables may be a batch
level cost, if these relate to cleaning of the machinery.

The labour requirement per kettle may be able to be reduced in the future (there
is quite a significant discrepancy between the amount of labour time required for
a standard (16 kettles per hour) and low-watt (6 kettles per hour) kettle. Why such
a difference? Would the amount of labour time reduce if larger quantities of the
kettle were produced in the future? Does the large amount of labour time
currently estimated include an allowance for the fact that staff are unfamiliar with
the new product, and initial set up and production might be unusually slow as a
result?
Total available
Maximum available
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38
1
1
1
2
1
1
1
2
1
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1
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ACC3023W – Management Accounting II – Risk and Uncertainty
Marker's comments on Q2
Part 1
 Read the question! 2900 element sales per month may be dropped. Only the level of
sales is variable based on probabilities (expected sales of 20,000 units), 30,000
kettles will be produced regardless.
 Treatment of the kettle elements is similar to that of the 'Saline solution' used for
'Chicken pops' (relevant costing tutorial). You either needed to include purchase of all
30,000 elements as a cost and then use the contribution margin after the kettle
element for sales foregone (elements and standard kettle's) or you needed to follow
the incremental approach where 19,000 kettle's were reflected at replacement cost
(R35), 3,000 at CM forgone + the sunk element cost (R15 + R35) and 8,000 at the CM
forgone + the sunk element cost (R120.46 + R35)
 Consumables and variable overheads are incremental and therefore relevant.
 Do not double count! Standard kettles cut back must be reflected either under
elements or opportunity costs (to obtain machine and labour hours).
 Format of workings for constraints is very important for clarity of logic. Format
marks were included in this working (W1)
 State your assumptions and clearly indicate your thought pattern for decisions.
Outsourced labour was cheaper than further standard kettle cut-backs but you
needed to state that you had thought about this issue, calculated this and proven it
as fact.
Part 2
 The value of perfect information is the difference between the expected value of
a project without the information vs. the expected value of a project with perfect
information.
 The crux of this question was that, with perfect information, production will be variable
based on demand levels per the market survey. Associated production and opportunity
costs will thus vary accordingly.
Part 3
 Marks were awarded for application and insight. For example:
Sighting product cannibalisation as a potential problem is insufficient (generic) but
referring to the relatively cheaper sales price of the new low-watt kettle and the
impact this may have on standard kettle sales is both insightful and highly
applicable.
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C3023W – Management Accounting II – Risk and Uncertainty
RU03 Ruby Ltd
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C3023W – Management Accounting II – Risk and Uncertainty
3
Profit
(R'000)
250 000
160 000
-80 000
PROB
0.225
0.45
0.075
WAV
(R'000)
56 250
72 000
-6 000
0.25
EV with information
EV without information
Value of information
122 250
121 850
400
The employee is acting unethical and Ruby should not accept the offer
even though the cost of the information is less than the additional value it will add. The source of this information is also questionable.
4 Increase advertising and marketing of the smart watch.
Do more research and find out exactly what the market size will be. Reduce fixed costs buy reducing capacity.
Consider outsourcing production and turn fixed costs into variable costs.
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C3023W – Management Accounting II – Risk and Uncertainty
Solution to RU04 Golf Haven Property Developer
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C3023W – Management Accounting II – Risk and Uncertainty
Conclusion
Based on expected values, it would be cheaper to put the Ref A193 mesh in the slab.
However - expected values are limited in term of information content, and consideration should be given to the various scenarios themselves.
(A project could have a high EV due to a small probability of a very large positive outcome, despite a very large probability of a smaller negative
outcome.)
Consideration should be given to the worst case scenario - major cracking.
There is a 46% (34% + 12%, i.e. (40% x 85%) + (60% x 20%)) probability of the worst case scenario happening if the A193 mesh is used. This is pretty
high.
There is only a 12% ((10% x 60%) + (40% x 15%)) possibility of major cracking occurring if the A245 mesh is used - a significant improvement.
Expected values do not represent an actual outcome if a project is once off. However, the EV does approximate the average actual outcome if the
project is repeated several times.
In this case the project is going to be repeated many times as GH is a property developer and is intending to build a number of houses.
This means that if the A193 is included, 46% of houses built will have major cracking.
The reputational damage from major cracking on a repeated basis (almost 50% of the house built develop major cracks!) could be severe.
But from a cost perspective it would be cheaper to use the A193 mesh in all houses built - the actual average cost per house would work out to be
R11,540, as opposed to R12,385.
C3023W – Management Accounting II – Risk and Uncertainty
2.
Expected valuewiithoutcompaction test
less:Expected Vallu:ewithcompaction test(before paying for thetest-see below}
Maximum amount whi:chcould bepaid forthe compactiontest
11540
10 000 w1
1540
w1
Thereiisa60%probabilitythat hecompaction testwou'ldcomeback witha high quallityratiing,and a40%probability itwouldcome badk witha medioue rating.
11
11
11
11
Ifahigh ratingw,agsivet\ tlhenwe wouldchoose toput the A193,mesh intheslab{the expected valueachievedif he A11'93mesh is used ANDahighratiing is achieved
is smallllerthan heexpected cost of usingthe A245 mesh ifahighrating wasachiieved).
4830 <
7 215
Ifamedliocreratiingwas achieved]GH wouldratherput the A245 intotheslab..
51170 <
6710
CalculationofExpected value
High rating(60% probable)
Mediocre rating(40%prnbab le)
1
EVof
project
overall
4830
5170
10 000
Co11cllusion:Thecompaction testshould be carried out as thecost of the test(R1,000)is lessthan theamount by whichGH would expect tobenefitfrom theresults of the test {R1540}.
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ACC3023W – Management Accounting II – Risk and Uncertainty
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