How financial modelling can assist decision making process


Financial modelling is a way that could help the management on decision making for future plan (Investopedia ULC, 2011) as it provides long-range planning framework. Financial modelling is an important activity which can provide Thompson Audio Limited varying degrees of automatic linkage among key variables and output format (Erich A. Helfert, 2001, pg.188). It simply not a predictor but an estimator where it estimate the company profile will be in the future and to test what would need to do in the future in order to achieve company goals. Financial modelling also allows management in Thompson Audio Limited to see the difference between current performance and future performance (John S. Tjia, 2009). If a model is well designed and well organized, it would benefits to both the developer and users to get the information easily. Moreover, financial model can help decision making in analysis, choice and implementation (John Tennent, Graham Friend, 2005). Besides that, changes and modifications also can be made easily due to the well-arranged structure of the model. Some companies create a model not only to calculate the specific assumption, but also to consider selecting the best alternative investment or financing patterns according to management's criteria stipulation (Erich A. Helfert, 2001, pg.185).

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Although financial modelling could help Thompson Audio Limited to improve their decision making for the future plan. However, financial modelling is not perfect. It is important to learn the computer knowledge in order to create a financial model, but due to the rapid technological change and various choice of software available, this can cause to over focus on the software system rather than the model (V.K, Bhalla, 2006). In addition, use of spreadsheet to construct a model would cause error and lies to be made easily because it is difficult to be detected (John Tennent, Graham Friend, 2005). Furthermore, using of spreadsheet is considerable duplication effort because spreadsheets are usually started from a blank sheet (John Tennent, Graham Friend, 2005). Besides that, the sophisticated financial model might not be easily understood by the decision maker in Thompson Audio Limited who is outside the accounting profession because financial model is usually computed upon the logic of accounting system (V.K, Bhalla, , 2006).

2.0 Sensitivity Analysis

One of the advantages of financial model is the ability to do sensitivity analysis with no difficulty (Erich A. Helfert, 2001, pg.186). Sensitivity analysis, also known as what-if analysis is crucial to help improving decision making. Sensitivity analysis refers to changing the assumption of the given financial model in order to determine the sensitivity result of the changes (F. L. Harrison, Dennis Lock, 2004, pg. 25). Besides that, additional cross-check or benchmark with which to view the result can be provided by considering different modelling and valuation approaches. (Michael Rees, 2008, pg.129). Take the case study as an example, if the cost per unit of the product increases after the sensitivity analysis, Thompson Audio Limited could take action earlier to avoid losses. Sensitivity analysis is the solution for careful planning with current financial state for one's requirement and projection that involves future events. The effect of the final results varies from each hypothesis of every single variable that are also considered the key driver must be tested in order to aid the judgement of possible outcome of one's financial state in the future. Sharpen analytical and decision making process tend to come from drivers that are often focusing on most impact depending on the financial models (Erich A. Helfert, 2001, pg.188).

Although there are some advantages of sensitivity analysis, but there are also disadvantages. Usually only one variable will change at a time using sensitivity analysis, however, the variable tends to move together in the real world. Besides that, this analysis is essentially a subjective analysis where given the same sensitivity analysis; one decision maker would accept the project and another one might reject it (Prasanna Chandra, 2008).

3.0 Activity Based Costing (ABC)

ABC is a powerful tool for decision maker. According to Innes and Mitchell (1990), activity-based costing (ABC) approach is different from traditional costing approach because the ABC is non-volume related overhead costs (Amrik S. Sohal and Walter W.C. Chung, 1998, pg.137). ABC has two main objectives which are providing information to Thompson Audio Limited about range, cost and consumption of activity, and providing accurate information for manager to improve decisions (Chwen Sheu, Ming-Hsiang Chen, and Stacy Kovar, 2003). ABC recognizes that unit-level activity in producing a product would cause the cost to arise (John C. Lere, 2000). In Thompson Audio Limited, there are few activities in manufacturing a product such as purchase order, set up, inspection and delivery. When comparing ABC with traditional costing system, ABC has two major advantages; ABC able to allocates indirect cost to cost objects when using variety of cost drivers and it also recognizes the consumption of cost object of different activity types at different rates (Chwen Sheu, Ming-Hsiang Chen, and Stacy Kovar, 2003).

4.0 Data Analysis

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As mentioned in the case study, Thompson Audio Limited is a sub-contracting company that manufacturing audio speaker to Volkswagen car models, which are the Beetle, Golf and Polo variants. The overhead absorption rate is based on machine hour basis. As show in the spreadsheet, the calculation of the total cost per unit based on traditional approach is £218.10, £277.35 and £321.32 for each of the model. If compared to ABC approach, the total cost per unit is lesser for every model, the cost has drop to £221.84 for Beetle, £273.78 for Golf, and £322.56 for Polo as shown in the spreadsheet. This shows that by using ABC approach, it's able to reduce the cost per unit and hence it would help Thompson Audio Limited to increase the profit.

4.1 Scenario 1

In scenario 1, Thompson Audio Limited is assumed to bring in some new machines. These new machines are more advances that could help to reduce the machine hour per unit by 0.1 for every product. In this situation, total machine hour drop from 24,800 to 21,000. Due to using machine hour basis as the overhead absorption, hence the overhead absorption rate will be affected. Although the overhead absorption rate has increased, but due to decrease in machine hour per unit, as a result the total cost per unit has drop. The total cost per unit in ABC approach maintain the same as in Sheet 1 because ABC approach does not compute the overhead cost regarding machine hour but it is based on production activity.

4.2 Scenario 2

In scenario 2, it mentioned that Thompson Audio Limited face with economic downturn and it is assumed that the material cost will increase 30%. The calculation of 30% increment for material is shown in Sheet 3. In this change, the prime cost and total cost per unit in traditional approach also increase. This situation shows that there is a positive relationship between material cost and cost per unit. Same situation with ABC approach, the total cost per unit has also increase due to increasing in material cost although it doesn't affect the cost driver rate and overhead cost per unit.

4.3 Scenario 3

In scenario 3, assuming there is an increment of number of the set ups in manufacturing the audio speaker for every product which is increased to 4,200 for Beetle, 5,200 for Golf and 4,700 for Polo. Total number of set up increased from 10,500 to 14,100 as shown in Sheet 4. Due to this, it causes on the set up related cost rate to drop from £8.57 per set up to £6.38 per set up. Although the cost driver rate drop, but it does not decrease the set up related cost to drop due to increasing of number of set up for every product. Therefore, the overhead cost per unit and total cost per unit also increase if compared to the original value in Sheet 1. In this situation, the traditional costing doesn't have any effect caused from the increasing number of set up. This is because number of set up is the cost driver and ABC causing it calculate cost per unit based on the production activity whereas traditional costing approach is calculate the cost per unit based on unit production.

5.0 Conclusion

Financial modelling can be use by Thompson Audio Limited as a method to do planning but depending on how well-organized is the planning function and accepted by the decision maker. Thompson Audio Limited can use financial modelling to improve planning but shouldn't use it as a substitute for planning. Models should be well structured and organized for the purpose of letting users to understand easily. It also should be protected properly to ensure robustness of use. Since the future of Thompson Audio Limited is uncertain, sensitivity analysis (also known as what-if analysis) should be created to help foreseen what will happen to the project when there are some variables such as cost material and overhead changed from the expected value. In manufacturing the audio speaker for three types of models of Volkswagen, Thompson uses both of the traditional costing approach and ABC approach to calculate the total cost per unit. ABC approach is different with traditional costing approach because it computes total cost per unit based on manufacturing activities. ABC provides information about range, cost and consumption of activity as well as provides information for manager to improve in decision making. With the given data in case study, Thompson Audio Limited able to see the difference by calculating total cost per unit using two different approaches. It shows that ABC approach is able to reduce the total cost per unit if compared to traditional approach. A scenario saying that Thompson Audio Limited bringing new machines will be able to reduce the machine hour per unit, as a result it also helps to reduce the total cost per unit based on the traditional costing approach. Next scenario saying that Thompson Audio Limited facing economic downturn and that the cost of material is assumed to be increased 30% from the original value. As a result, it affects the total cost per unit in both of the traditional costing and ABC approach. Last scenario about increment of number of set up and it obviously it don't affect on the traditional costing approach result. With the result in sensitivity analysis, Thompson Audio Limited is able to do consideration on the future planning with the purpose of maintaining the company performance.

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