Chapter 13: Questions & Answers
Question 1 - KPIs and beyond budgeting
The RRR Group (RRR) provides roof repair, refurbishment and renewalservices to individual customers on a nationwide basis. RRR operates alarge number of regional divisions, each of which offers a similar rangeof services.
RRR expects divisional management to prepare its own annual budgetby focusing on the achievement of a net profit figure set at grouplevel. This budget is currently used for planning and reporting.
Table A shows actual results for Alpha division for the yearsending 30 November 20X7 and 30 November 20X8, together with datarepresenting an average of a number of similar competitor companydivisions.
RRR has given Alpha division a budgeted profit requirement of $20mfor the year to 30 November 20X9. The management of Alpha division hasprepared the strategy shown in Table B as the framework for theachievement of the budget profit requirement for the year to 30 November20X9.
RRR plc has, however, decided that in line with current 'beyondbudgeting' philosophy, each division should follow a number of adaptiveprocesses including the following:
(1)Setting 'stretch goals' aimed at relative improvement and avoiding dysfunctional decision-making.
(2)Evaluation and rewards at each division based on relative improvement contracts (with hindsight).
(3)Action planning that focuses on a strategy to achieve continuous value creation for the group.
As an incentive to the overall achievement of goals and thecreation of 'value', a set of KPI's (key performance indicators) will beintroduced in 20X9 and used on the basis of the data in Table C.
Divisional staff will be paid a bonus as a percentage of salarybased on the overall weighted percentage score deduced from the analysisas per table C.
(a)Evaluate the extent to which the budget ofAlpha division for the year ending 30 November 20X9 is achievable andconsistent with the 'beyond budgeting' philosophy detailed above.
Note: Your answer should include specific examples from the data contained in the question to illustrate your discussion.
(b)Apply the KPI performance appraisal processshown and explained in Table C, using actual data for 20X7 and 20X8 inorder to show the bonus (as a % of salary) that would have been achievedby Alpha division for the year ending 30 November 20X8;
(c)Discuss potential benefits that may bederived from the application of the KPI appraisal and bonus approach,both for Alpha division and throughout the RRR Group.
(Total: 30 marks)
Table A - Summary of financial and other operating information
Note 1: includes materials, wages/salaries, vehicle and machine costs, etc
Note 2: following inspection by surveyors after work implemented
Note 3: initial survey and site analysis
Note 4: investigation & action on complaints.
Proposed strategy for Alpha division for year to 30 November 20X9
It is estimated that the budgeted profit requirement of $20m will be achieved as a consequence of the following:
- The number of orders received and processed will be 11,000 (with average price levels remaining as per 20X8 actual price levels) from an initial total of 15,500 customer enquiries
- The marketing cost allowance would be reduced to $7.2m
- The training cost allowance would be reduced to $3m
- Cost of sales ($) will rise by 10% from the 20X8 actual total to allow for the combined effect of volume and price changes
- Remedial work on orders will total $1m for material, labour and overhead costs
- Initial survey and analysis costs on customer enquiries will remain at the 20X8 average cost per enquiry
- Customer complaint related costs are expected to rise to $0.25m.
Staff bonus calculation for the year ended 30 November 20X8 using KeyPerformance Indicators (KPI's) based on relative contract factors
(B)* â€“ each KPI score value is positive (+) where the 20X8 valueshows an improvement over the previous year OR negative (â€“) where the20X8 value shows poorer performance than in the previous year.
Each KPI score value is the % increase (+) or decrease (â€“) in 20X8 as appropriate
Question 2 - Environmental influences
Hawk Leathers Ltd ("Hawk") is a company based in the UK thatemploys around 60 people in the manufacture and sale of leather jackets,jeans, one and two piece suits, and gloves. These are aimed primarilyat motorcyclists, although a few items are sold as fashion garments.
Hawk sells 65% of its output to large retail chains such asMotorcycle City and Carnells, exports 25% to the USA and Japan, andsells the remaining 10% to individuals who contact the company directly.The latter group of customers specify their requirements for a made tomeasure suit (they are often professional racers whose suits must beapproved by the authorities such as the Auto Cycle Union). The largeretailers insist on low margins and are very slow to settle their debts.
There are around a dozen companies in the UK who make similarproducts to Hawk, plus very many other companies who compete with muchlower prices and inferior quality. Hawk's typical selling price for aoneÂpiece suit is Â£1,000, whereas the low quality rivals' suits retailat around Â£400. As Hawk say in their literature "if you hit thetarmac,there's no substitute for a second skin from Hawk". Syntheticmaterials are waterproof, unlike leather, but do not currently offersufficient protection in an accident.
Sales of leathers in the UK are growing rapidly, mainly due to aresurgence of biking from more mature riders of large, powerfulmachines. Such riders are often wealthy and have family and financialcommitments. Currently Hawk, and its rivals for quality leathers arefinding it hard to keep up with demand. However, Government policy andEU emissions controls are likely to limit motorcycle performance, andsome experts predict that these regulations will cause sales of largemotorcycles to level off.
Whilst supplies of leather from Asia, Scandinavia and the UK areplentiful, a key problem is recruiting and training machinists to stitchand line the garments. Hawk has been able to invest in modern machineryto help production but the process is still labour intensive. Hawk hasfound that the expertise, reputation and skilled labour needed tosucceed in the industry takes years to build up.
Although the industry is fairly traditional, there are some newdevelopments such as a website for individual customers to browse andspecify requirements, and new colours such as metallics for leathers,and a small but growing demand from non bikers who are interested in'recreational' and 'club wear' items.
(a)Analyse the issues facing Hawk's industry using PEST analysis.
(b)Using Porter's 5 forces, evaluate the strength of each competitive pressure facing Hawk.
(Total: 20 marks)
Question 3 - Budgetary information
You have been asked to provide budgetary information to the boardof Directors for a meeting where they will decide the pricing of animportant product for the next period.
The following information is available from the records:
You find that between the previous and current periods there was a4% general inflation rate and it is forecast that costs will furtherincrease by 6% in the next period.
The firm did not increase the selling price in the current periodalthough competitors raised their prices by 4% to allow for theincreased costs.
A survey by economic consultants was commissioned and has foundthat the demand for the product is elastic with an estimated priceelasticity of demand of 1.5. This means that volume will fall by one anda half times the rate of real price increase.
(a)Show the budgeted position if the firmmaintains a $13 selling price for the next period (when it is expectedthat competitors will increase their prices by 6%)
(b)Show the budgeted position if the firm increases its prices by 6%
(c)Write a short report to the Board, withappropriate figures, recommending whether the firm should maintain the$13 selling price or raise it by 6%
(Total: 20 marks)
Question 4 - ZBB
NN Ltd manufactures and markets a range of electronic officeequipment. The company currently has a turnover of $40 million perannum. The company has a functional structure and currently operates anincremental budgeting system. The company has a budget committee that iscomprised entirely of members of the senior management team.
No other personnel are involved in the budget-setting process.
Each member of the senior management team has enjoyed an annualbonus of between 10% and 20% of their annual salary for each of the pastfive years. The annual bonuses are calculated by comparing the actualcosts attributed to a particular function with budgeted costs for thatfunction during the twelve month period ended 31 December in each year.
A new Finance Director, who previously held a senior managementposition in a 'not for profit' health organisation, has recently beenappointed. Whilst employed by the health service organisation, the newFinance Director had been the manager responsible for the implementationof a zero-based budgeting system which proved highly successful.
(a)As the new Finance Director, prepare a memorandum to the senior management team of NN Ltd which identifies and discusses:
(i)factors to be considered when implementing a system of zero-based budgeting within NN Ltd;
(ii) the behavioural problems that themanagement of NN Ltd might encounter in implementing a system ofzero-based budgeting, recommending.
(b)Explain how the implementation of azero-based budgeting system in NN Ltd may differ from the implementationof such a system in a 'not for profit' health organisation.
(Total: 20 marks)
Question 5 - ABB and benchmarking
The activity matrix below shows the budget for the sales orderdepartment of Cognet Inc. Relevant information with regard to theoperation of the sales order department is as follows:
iA team of staff deals with existingcustomers in respect of problems with orders or with prospectivecustomers enquiring about potential orders.
ii The processing of orders requires communication with the production and despatch functions of the company.
iiiThe nature of the business is suchthat there is some despatching of part-orders to customers which helpsreduce stock holding costs and helps customers in their work flowmanagement.
ivSales literature is sent out to existing and prospective customers by means of a monthly mail shot.
Cognet Inc has decided to acquire additional computer software withinternet links in order to improve the effectiveness of the sales orderdepartment. The cost to the company of this initiative is estimated at$230,000 pa.
It is estimated that there will be the following cost and volume changes to activities in the sales order department:
(1)Reduction in overall salaries by 10% per annum, applied to the existing salary apportionments.
(2)Reduction of 60% in the stores/supplies cost in the sales literature activity only.
(3)$20,000 of the computer software cost willbe allocated to the sales literature activity. The balance will beshared by the other activities in proportion to their existing share ofIT costs.
(4)Sundry costs for customer negotiation,processing of orders and implementing despatches will vary in proportionto the number of units of each activity. Sundry costs for salesliterature and general administration will be unchanged.
(5)Amended volume of activity will be: totalcustomers 2,600; customer negotiations 6,000; home orders 5,500; exportorders 2,000; despatches to customers 18,750.
Recent industry average statistics for sales order departmentactivities in businesses of similar size, customer mix and product mixare as follows:
Activity cost matrix â€“ Sales order department
(a)Prepare a summary of the amended activitycost matrix (per matrix above) for the sales order department afterimplementing the proposed changes.
(b)Prepare an analysis (both discursive andquantitative/monetary as appropriate) which examines the implications ofthe IT initiative. The analysis should include the following.
A benchmarking exercise on the effectiveness of the sales orderdepartment against both its current position and the industry standardsprovided.
You should incorporate comment on additional information likely to improve the relevance of the exercise.
(Total: 20 marks)
Question 6 - Value chain
Woodsy is a garden furniture manufacturing company, which employs30 people. It buys its timber in uncut form from a local timbermerchant, and stores the timber in a covered area to dry out and seasonbefore use. Often this takes up to two years, and the wood yard takes upso much space that the production area is restricted.
The product range offered by the company is limited to themanufacture of garden seats and tables because the owner-manager, BillThompson, has expanded the business by concentrating on the sale ofthese items and has given little thought to alternative products. Billis more of a craftsman than a manager, and the manufacturing area isanything but streamlined. Employees work on individual units at theirown pace, using little more than a circular saw and a mallet and woodenpegs to assemble the finished product. The quality of the finished itemsis generally good but relatively expensive because of the productionmethods employed.
Marketing has, to date, been felt to be unnecessary because thepremises stand on a busy road intersection and the company's productsare on permanent display to passing traffic. Also, satisfied customershave passed on their recommendations to new customers. But things havechanged. New competitors have entered the marketplace and Bill has foundthat orders are falling off. Competitors offer a much wider range ofgarden furniture and Bill is aware that he may need to increase hisproduct range, in order to compete. As the owner-manager, Bill is alwaysvery busy and, despite working long hours, finds that there is neverenough time in the day to attend to everything. His foreman is a worthyindividual but, like Bill, is a craftsman and not very good atman-management. The overall effect is that the workmen are left verymuch to their own devices. As they are paid by the hour rather than bythe piece, they have little incentive to drive themselves very hard.
(a)Explain what is meant by the terms 'value chain' and 'value chain analysis'?
(b)Use a diagram to give a brief explanation of the two different categories of activities that Porter describes.
(c)Analyse the activities in the value chain to identify the key problems facing Woodsy.
(d)Based on your analysis, prepare a set ofrecommendations for Bill Thompson to assist in a more efficient andeffective operation of his business.
(Total: 20 marks)
Question 7 - BPR
Explain the term 'Business process re-engineering' and how itsapplication might enable overall business performance to be improved.Briefly discuss potential problems which may be encountered in theimplementation of a business re-engineering programme.
Question 8 - Reward schemes
You are the Senior Management Accountant of Better Gardens Ltd(BGL), a well-established manufacturer of a range of conservatories,summerhouses and large garden ornaments. The company's revenue andafter-tax profits for the year ending 31 May 20X7 are forecast to be$100 million and $20 million respectively. The company has 350 employeesin total who are comprised as follows:
BGL's products are sold to specialist 'Garden Centres' by its salesstaff, each of whom is home-based. The forty sales staff work from homeand are supported by administrative and support staff who alsoundertake telephone-based selling activities.
The manufacture of conservatories and summer-houses is undertakenby 210 assembly staff, some of whom work in teams and others who work onan individual basis.
The large garden ornaments, each of which is hand-finished, areproduced by 40 assembly staff who are responsible for their individualoutput.
The directors of BGL are considering whether to implement a rewardscheme for all employees within the organisation. They have approachedyou for advice with regard to this matter. The production directorrecently stated 'if we implement a reward scheme then it is bound to bebeneficial for BGL'.
(a)Explain the potential benefits to be gained from the implementation of a reward scheme.
(b)Explain the factors that should be considered in the design of a reward scheme for BGL.
(c)Explain whether you agree or not with the statement made by the production director.
(d)Briefly discuss how stakeholder groups (other than management and employees) may be rewarded for 'good' performance.
(Total: 20 marks)
Question 9 - Planning and MIS
You have recently been appointed the finance manager for asmall/medium engineering company that makes components for the shippingindustry. The company experienced rapid growth in turnover and profitsfrom 1990 â€“ 1998, but since then its profits and turnover haveslumped. It has relied on a loyal but slowly contracting client base andhas never concerned itself with exploring new markets of products. Thecompany's management spends most of its time on day to day operationalissues with limited consideration given to the analysis of strategicissues.
Prepare a memo to the Managing Director covering the following issues:
(a)A discussion of the concentration on operational matters to the exclusion of strategic planning and management.
(b)An explanation of the potential benefits of aManagement Information System encompassing both operational andstrategic information.
(c)The changes in attitude and approach that will be required if strategic management is to be implemented.
(Total: 20 marks)
Question 10 - MIS
During 1990 a printing company designed and installed a ManagementInformation System that met the business needs of a commercialenvironment which was characterised at that time by:
- a unitary structure with one profit centre
- central direction from senior managers
- 100% internal resourcing of ancillary services
- the employment exclusively of permanent full-time employees
- customers holding large inventories who accepted long delivery times
- most of the work concerned with long print runs for established large publishing houses.
A radical change in the business environment has resulted in the following outcomes:
- the development of a divisionalised structure with four profit centres that utilise each others services
- empowerment of team leaders and devolved decision making
- considerable outsourcing of activities
- a significant proportion of the employees work part-time and/or on temporary contracts
- customers now commonly operate JIT systems requiring immediate replenishment of inventories
- the typical customer requires specialist low volume but complex high value printing.
Recommend the significant changes in the Management InformationSystems that would probably be required to meet the needs of this newsituation. Explain the reasons for your recommendations.
Note: your answer does not require a consideration of technical matters.
Question 11 - NPV/IRR
SC Co is evaluating the purchase of a new machine to produceproduct P, which has a short product life-cycle due to rapidly changingtechnology. The machine is expected to cost $1 million. Production andsales of product P are forecast to be as follows:
The selling price of product P (in current price terms) will be $20per unit, while the variable cost of the product (in current priceterms) will be $12 per unit. Selling price inflation is expected to be4% per year and variable cost inflation is expected to be 5% per year.No increase in existing fixed costs is expected since SC Co has sparecapacity in both space and labour terms.
Producing and selling product P will call for increased investmentin working capital. Analysis of historical levels of working capitalwithin SC Co indicates that at the start of each year, investment inworking capital for product P will need to be 7% of sales revenue forthat year.
SC Co pays tax of 30% per year in the year in which the taxableprofit occurs. Liability to tax is reduced by capital allowances onmachinery (tax-allowable depreciation), which SC Co can claim on astraight-line basis over the four-year life of the proposed investment.The new machine is expected to have no scrap value at the end of thefour-year period.
SC Co uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
(a)Calculate the net present value of the proposed investment in product P.
(b)Calculate the internal rate of return of the proposed investment in product P.
(c)Advise on the acceptability of the proposedinvestment in product P and discuss the limitations of the evaluationsyou have carried out.
(d)Discuss how the net present value method ofinvestment appraisal contributes towards the objective of maximising thewealth of shareholders.
(Total: 25 marks)
Question 12 - Financial performance
UKCOM is a large US owned company that was formed in 20X0 andoperates only within the UK. The company has grown rapidly viaacquisition and concentrates its activities in the rapidly growing andhighly competitive mobile phone market. The acquired companies havesubstantial infrastructure assets with only 10% of the available networkcapacity being utilised in the provision of services to customers. 35%of the assets are categorised as intangible and are composed of goodwilland license acquisition expenditures. The Board has announced that itwill not acquire any further companies and will maintain the same levelof debt for the next decade. The Board of Directors based in the US takeall the strategic decisions concerned with financing and acquisitionpolicy but leave the operating activities to the UK based ChiefOperating Executive.
Financial highlights ($millions)
Management have provided the following estimates of projected cash flows*:
These cash flows are based on the current level of competition and the current state of governmental legislation.
- Received and paid at the end of each year.
The cash outflows can be estimated with a high degree of certaintyowing to the fixed nature of the costs. On the other hand, the cashinflow estimates are subject to considerable uncertainty because of thealternative outcomes that may arise. There are three possible marketscenarios that are likely to impact on the inflows:
(1)Intensified competition â€“ there is a 40%probability of this occurring and the consequences will be a reductionof 10% on the estimate of cash inflows.
(2)Government price regulation â€“ there is a 20% probability of this occurring and it will reduce the estimated inflows by 20%.
(3)Less competition â€“ this would result in cash inflows increasing by 5%. There is a 40% probability of this scenario developing.
The company's cost of capital is set at 4% above the averageweighted cost of debt interest in the year prior to the first year ofthe forecast period (rounded up to the nearest percentage point).
(a)Provide a report on the financial performance of UKCOM from 20X1 to 20X4 from the perspective of the parent company.
(b)The UK based Chief OperatingExecutive maintains that his/her team's financial performance hascontinued to improve throughout the period. Explain how this claim mightbe substantiated. Your answer should include a relevant indicator ofeach of the year 20X1-20X4 which the COE could use.
(i)Calculate the NPV of the future cash flows for the period 20X5-20X9
Your answer should show all relevant working notes and explainthe basis of your calculation (a decision tree type analysis is notrequired).
(ii) Comment on the relevance of your answer in the evaluation of future performance.
(Total: 20 marks)
Question 13 - Divisional performance 1
Tannadens Division is considering an investment in a qualityimprovement programme for a specific product group which has anestimated life of four years. It is estimated that the qualityimprovement programme will increase saleable output capacity and providean improved level of customer demand due to the enhanced reliability ofthe product group.
Forecast information about the programme in order that it may beevaluated at each of best, most likely and worst scenario levels is asfollows:
- There will be an initial investment of $4,000,000 on 1 January, year 1, with a programme life of four years and nil residual value. Depreciation will be calculated on a straight line basis.
- Additional costs of staff training, consultancy fees and the salary of the programme manager are estimated at a most likely level of $100,000 per annum for each year of the proposal. This may vary by Â±2.5%. This is the only relevant fixed cost of the proposal.
- The most likely additional output capacity which will be sold is 1,000 standard hours in year 1 with further increases in years 2, 3 and 4 of 300, 400 and 300 standard hours respectively. These values may vary by 5%.
- The most likely contribution per standard hour of extra capacity is $1,200. This may vary by Â±10%.
- The most likely cost of capital is 10%. This may vary from 8% to 12%.
Assume that all cash flows other than the initial investment take place at the end of each year. Ignore taxation.
(a)Present a table (including details ofrelevant workings) showing the net profit, residual income and return oninvestment for each of years 1 to 4 and also the net present value(NPV) for the BEST OUTCOME situation of the programme.
Using the information provided above, the net profit, residual income(RI), and return on investment (ROI) for each year of the programmehave been calculated for the most likely outcome and the worst outcomeas follows:
In addition, the net present value (NPV) of the programme has beencalculated as most likely outcome: $1,233,700 and worst outcome:$214,804.
It has been decided that the programme manager will be paid a bonusin addition to the annual salary of $40,000 (assume that this salaryapplies to the best, most likely and worst scenarios). The bonus will bepaid on ONE of the following bases:
A Calculated and paid each year at 1.5% of any profit in excess of $250,000 for the year.
B Calculated and paid each year at 5% of annual salary for each $100,000 of residual income in excess of $250,000.
C Calculated and paid at 15% of annual salary in each year in which a positive ROI(%) is reported.
D Calculated and paid at the end of year 4 as 2.5% of the NPV of the programme.
(b)Prepare a table showing the bonus to be paidin each of years 1 to 4 and in total for each of methods (A) to (D)above, where the MOST LIKELY outcome situation applies.
(c)Discuss which of the bonus methods is likelyto be favoured by the programme manager at Tannadens Division. Youshould refer to your calculations in (b) above as appropriate. Youshould also consider the total bonus figures for the best outcome andworst outcome situations which are as follows:
(d)'The achievement of the quality improvement programme will be influenced by the programme manager's:
- level of effort
- attitude to risk, and
- personal expectations from the programme'.
Discuss this statement.
(Total: 35 marks)
Question 14 - Divisional performance 2
E&F use a range of metrics to assess the performance of the company.
The following information has been extracted from the accounts for the last two years
Income Statement ($000)
Balance Sheet ($000)
Additional information is as follows :
(i)Capital employed at the end of 20X7 was $2,480k. This included $2,100k of Non-Current Assets.
(ii) The pre-tax cost of debt for 20X8 and 20X9 was 5%.
(iii)E&F had non-capitalised leases of $100k in both years. The leases were not subject to amortisation.
(iv)Amortised goodwill was $120k in 20X8 and $130k on 20X9. The annual amortisation charge was $10k.
(v) The cost of equity was estimated at 8% for both years.
(vi)The economic depreciation for bothyears was the same as the depreciation used for accounting and taxpurposes. However, the replacement cost of Non-Current Assets is 10%higher than stated in the accounts.
(vii)The target capital structure was 40% debt and 60% equity for both years.
(viii)The company uses a cost of capital of 8% to assess the viability of any new projects being considered.
(a)Calculate the following performance metrics for both years and comment on the company's performance.
- Return on Investment.
- Residual Income.
- Economic Value Added.
All calculations should use a capital employed figure at the beginning of the year.
(b)Discuss the similarities and differences between the three metrics used in part (a).
(Total: 20 marks)
Question 15 - Transfer pricing
FP sells and repairs photocopiers. The company has operated formany years with two departments, the Sales Department and the ServiceDepartment, but the departments had no autonomy. The company is nowthinking of restructuring so that the two departments will become profitcentres.
The Sales Department
This department sells new photocopiers. The department sells 2,000copiers per year. Included in the selling price is $60 for a one yearguarantee. All customers pay this fee. This means that during the firstyear of ownership if the photocopier needs to be repaired then therepair costs are not charged to the customer. On average 500photocopiers per year need to be repaired under the guarantee. Therepair work is carried out by the Service Department who, under theproposed changes, would charge the Sales Department for doing therepairs. It is estimated that on average the repairs will take 3 hourseach and that the charge by the Service Department will be $136,500 forthe 500 repairs.
The Service Department
This department has two sources of work: the work needed to satisfythe guarantees for the Sales Department and repair work for externalcustomers. Customers are charged at full cost plus 40%. The details ofthe budget for the next year for the Service Department revealedstandard costs of:
Parts - at cost
Labour - $15 per hour
Variable overheads - $10 per labour hour
Fixed overheads - $22 per labour hour
The calculation of these standards is based on the estimated maximummarket demand and includes the expected 500 repairs for the SalesDepartment. The average cost of the parts needed for a repair is $54.This means that the charge to the Sales Department for the repair work,including the 40% mark-up, will be $136,500.
It has now been suggested that FP should be structured so that thetwo departments become profit centres and that the managers of theDepartments are given autonomy. The individual salaries of the managerswould be linked to the profits of their respective departments.
Budgets have been produced for each department on the assumptionthat the Service Department will repair 500 photocopiers for the SalesDepartment and that the transfer price for this work will be calculatedin the same way as the price charged to external customers.
However the manager of the Sales Department has now stated that heintends to have the repairs done by another company, RS, because theyhave offered to carry out the work for a fixed fee of $180 per repairand this is less than the price that the Sales Department would charge.
(a)Calculate the individual profits of theSales Department and the Service Department, and of FP as a whole fromthe guarantee scheme if:
(i)The repairs are carried out by the Service Department and are charged at full cost plus 40%
(ii) The repairs are carried out by the Service department and are charged at marginal cost
(iii)The repairs are carried out by RS.
(b)Expalin, with reasons, why a 'full costplus' transfer pricing model may not be appropriate for FP and commenton other issues that the managers of FP should consider if they decideto allow RS to carry out the repairs.
(c)Briefly explain how the problems encountered above can be overcome using
- Profit Maximisation Rules
- Dual Pricing
- Two part tariff
(Total: 20 marks)
Question 16 - International transfer pricing
A multinational computer manufacturer has a number of autonomoussubsidiaries throughout the world. Two of the group's subsidiaries arein America and Europe.
The American subsidiary assembles computers using chips that itpurchases from local companies. The European subsidiary manufacturesexactly the same chips that are used by the American subsidiary butcurrently only sells them to numerous external companies throughoutEurope. Details of the two subsidiaries are given below.
The American subsidiary buys the chips that it needs from a localsupplier. It has negotiated a price of $90 per chip. The productionbudget shows that 300,000 chips will be needed next year.
The chip production subsidiary in Europe has a capacity of 800,000chips per year. Details of the budget for the forthcoming year are asfollows:
Sales 600,000 chip
Selling price $105 per chip
Variable costs $60 per chip
The fixed costs of the subsidiary at the budgeted output of 600,000chips are $20 million per year but they would rise to $26 million ifoutput exceeds 625,000 chips.
Note: The maximum external demand is 600,000 chips per year and the subsidiary has no other uses for the current spare capacity.
The Managing Director of the group has reviewed the budgets of thesubsidiaries and has decided that in order to improve the profitabilityof the group the European subsidiary should supply chips to the Americansubsidiary.
She is also thinking of linking the salaries of the subsidiarymanagers to the performance of their subsidiaries but is unsure whichperformance measure to use.
The Manager of the European subsidiary has offered to supply thechips at a price of $95 each. He has offered this price because it wouldearn the same contribution per chip that would be earned on externalsales (this is after adjusting for increased distribution costs andreduced customer servicing costs).
(a)Assume that the 300,000 chips are suppliedby the European subsidiary at a transfer price of $95 per chip.Calculate the impact of the profits on each of the subsidiaries and thegroup.
(b)Demonstrate how application of the profitmaximisation rules would enable the Group to increase the profitdeclared in part (a). You should explain the price that should becharged by the European Division, and the likely sourcing decisionstaken by the American Division.
(c)Using the Two Part Tariff approachdemonstrate how any arising conflict from the application of profitmaximisation rules, can be resolved.
(d)Briefly explain and illustrate howmulti-national companies can use transfer pricing to reduce theiroverall tax charge and the steps that national tax authorities havetaken to discourage the manipulation of transfer prices.
(Total: 20 marks)
Question 17 - Not for profit organisations
AV is a charitable organisation, the primary objective of which isto meet the accommodation needs of persons within its locality.
BW is a profit-seeking organisation which provides rentedaccommodation to the public. Income and Expenditure accounts for theyear ended 31 May 20X4 were as follows:
Operating information in respect of the year ended 31 May 20X4 was as follows:
(1)Property and rental information:
(2)Staff salaries were payable as follows:
(3)Planned maintenance and major repairs undertaken:
All expenditure on planned maintenance and major repairs may be regarded as revenue expenditure.
(4)Day-to-day repairs information:
Each repair undertaken by BW costs the same irrespective of the classification of repair.
(a)Critically evaluate how the management of AVcould measure the 'value for money' of its service provision during theyear ended 31 May 20X4.
(i)Identify TWO performance measures inrelation to EACH of the following dimensions of performance measurementthat could be used by the management of AV when comparing its operatingperformance for the year ended 31 May 20X4 with that of the previousyear:
- Service quality.
(ii) Calculate and comment on THREEperformance measures relating to 'cost and efficiency' that could beutilised by the management of AV when comparing its operatingperformance against that achieved by BW.
(c)Explain why differing objectives make itdifficult for the management of AV to compare its operating andfinancial performance with that of BW, and comment briefly on additionalinformation that would assist in the appraisal of the operating andfinancial performance of BW for the year ended 31 May 20X4.
(Total: 20 marks)
Question 18 - Financial/non-financial performance
The following information relates to Preston Financial Services, anaccounting practice. The business specialises in providing accountingand taxation work for dentists and doctors. In the main the clients arewealthy, self-employed and have an average age of 52.
The business was founded by and is wholly owned by Richard Preston,a dominant and aggressive sole practitioner. He feels that promotion ofnew products to his clients would be likely to upset the conservativenature of his dentists and doctors and, as a result, the business hasbeen managed with similar products year on year.
You have been provided with financial information relating to thepractice in appendix 1. In appendix 2, you have been provided withnon-financial information which is based on the balanced scorecardformat.
Appendix 1: Financial information
Appendix 2: Balanced scorecard (extract)
Learning and growth
(1)Error rates measure the number of jobs with mistakes made by staff as a proportion of the number of clients serviced.
(2)Core work is defined as being accountancyand taxation. Non-core work is defined primarily as pension advice andbusiness consultancy. Non core work is traditionally high margin work.
(a)Using the information in appendix 1 only,comment on the financial performance of the business (briefly considergrowth, profitability, liquidity and credit management).
(b)Using the data given in appendix 2 commenton the performance of the business. Include comments on internalbusiness processes, customer using the data given in appendix 2 commenton the performance of the business. Include comments on internalbusiness processes, customer knowledge and learning/ growth, separately,and provide a concluding comment on the overall performance of thebusiness.
(c)Explain why non financial information, suchas the type shown in appendix 2, is likely to give a better indicationof the likely future success of the business than the financialinformation given in appendix 1.
(Total: 25 marks)
Question 19 - Corporate failure
Assume that 'now' is June 20X6.
Ears'n'eyes Inc is a well-known and respected chain of stores selling books, CDs and DVDs.
Following a number of very successful years, the company decided toembark on a programme of expansion by opening new stores in differentgeographical markets. This has been ongoing for the last few years.Current plans are to continue this expansion. There are now 50superstores across the world, 40 in Ears'n'eyes Inc's home country, 10overseas and a number of smaller stores at stations and airports. Thereare plans to open five more superstores in the next year.
The company's revenue comes from the sales of books, CDs, and DVDsthrough its stores, with a small proportion from internet sales via athird party internet-based retailer.
The company has recently developed a card-based loyalty programmebased on rewards collected through an EPOS system in the stores.Managers have been pleased with the number of customers signing up forthe card.
The board of the company are now concerned as poor profits areforecast for the current financial year to date. In addition the companyis receiving increasingly negative reports from analysts and the shareprice has dropped more than the market as a whole.
The latest summarised accounts of are shown below:
Balance sheets as at
Income statement for the years ending
The share price of Ears'n'eyes Inc on 1 April 20X6 was 108 cents. The price on 1 April 20X5 was 133 cents.
The modified version of Altman's Z score model for corporate failure prediction for non-manufacturing companies is given by:
Zâ€ = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4 where:
X1 = working capital / total assets.
X2 = accumulated retained earnings / total assets.
X3 = earnings before interest and tax / total assets.
X4 = market value of equity / book value of total liabilities.
It has been found that that:
- Companies with a Z'' score of below 1.81 are in danger and possibly heading towards bankruptcy.
- Companies with a score of 3 or above are financially sound.
- Companies with scores between 1.81 and 2.99 need further investigation.
You have been requested by the managing director of Ears'n'eyes Inc to prepare a briefing document that includes:
(a)An assessment of the financial health of Ears'n'eyes Inc based on the accounts above.
(b)A brief discussion of any furtherinvestigations required to ascertain whether or not Ears'n'eyes Inc islikely to experience financial distress and/or corporate failure.
(c)Recommendations for any actions which thecompany should take to improve its future prospects, based on yourfindings in (a) and (b) above and any other considerations.
(d)Suggested performance indicators to be usedto monitor the future performance of the business and the impact ofactions suggested in (c) above.
(Total: 25 marks)
Question 20 - Six sigma
The There 4 U Company (T4UC) commenced trading on 1 January 20X6.It was founded by Ken Matthews, who is the managing director of T4UC.
The initial aim of T4UC was to provide 'good quality' repairs andservicing to customers with domestic central heating systems anddomestic 'white goods' (white goods are items such as washing machines,tumble dryers, dishwashers, refrigerators and freezers).
T4UC provides contract services on an annual basis to individualcustomers who require insurance covering the repair and servicing oftheir central heating systems and domestic white goods. T4UC charge anannual contract fee and undertake all client repair and servicingrequirements without further charge.
Ken, who has a very strong background in sales and marketing,recruited engineers who came from a variety of engineering backgrounds.
Initial growth was prolific with Ken being very successful inestablishing a good sized customer base within the first two years ofthe business. Ken believes that staff utilisation is the key driver ofprofitability within T4UC.
T4UC set up a website where clients could access product manualsand other diagnostic data as well as being able to book an appointmentwith a service engineer.
The following data is available:
At the end of 20X8 Ken became anxious regarding the fact that thegrowth in the customer base had stopped and that a number of clients hadchosen not to renew their contracts with T4UC. In view of these facts,Ken undertook an extensive survey of the customers who had entered intocontracts with T4UC since it commenced trading.
Ken received the following comments which were representative ofall other comments that he received. 'T4UC ought to adopt a 'right firsttime' mentality.'
'I booked an engineer for last Monday who never arrived but two engineers turned up on Tuesday!'
'You send me a different engineer each time to inspect my centralheating system. Some are here for an hour and yet others are here forthe whole day and some of those even have to come back the next day.'
'Your people never seem to have the required parts with them and have to come back the next day!'
'An engineer arrived at my home to repair my washing machine butthe required parts which were shipped to my home direct from themanufacturer arrived three days later! I've heard that 'Appliances R Us'is the best organisation in your service sector and that they provide amuch more efficient service than T4UC and unlike T4UC is alwayscontactable on a twenty-four hours basis during every day of the year!When I have tried to contact you on Saturdays and Sundays I have oftengiven up out of sheer frustration!'
Ken also obtained the following data from the 'Centre for Inter-Firm Comparison'.
Ken undertook further investigations which revealed remedial visitswere frequently due to staff servicing appliances with which they werenot completely familiar.
(a)Describe the Six-Sigma methodology for the improvement of an existing process.
(b)Explain how the above-mentioned problems atT4UC could be analysed and addressed using the Six Sigma methodology.Your answer should include suggestions regarding additional activitiesthat should be undertaken in order to improve the performance of T4UC.
(Total: 20 marks)
Test your understanding answers
Question 1 - KPIs and beyond budgeting
(a)Signiï¬cant items in the budget prepared for the year ending 30 November 20X9 are as follows:
- Sales revenue is budgeted to increase by 10% from the 20X8 actual level. It is questionable whether this is likely to be achievable given cost changes that are planned as discussed below.
- Cost of sales has the same percentage relationship to sales (66.7%) as in 20X8. Note that the corresponding ï¬gure for 20X7 was 62.5%. The percentage differences may be inï¬‚uenced by the change in mix of work â€“ repairs, refurbishment, renewals that are planned for 20X9.
- Marketing expenditure has been reduced by $1.3m. which is a 15% reduction from the 20X8 actual ï¬gure. It must be asked whether demand is sufï¬ciently buoyant to achieve the planned 10% sales increase with this marketing reduction.
- Staff training has been reduced to $1.0m which is a 25% reduction from 20X8. Will the quality of work be reduced through this reduction and lead to increased costs, remedial work and customer complaints in 20X9 and future years?
- Uptake of orders from customer enquiries is planned at 71% compared with 66.7% in 20X8 and 55% in 20X7. Is this forecast improvement realistic or achievable? This requires very careful consideration especially given the planned decrease in marketing expenditure in the 20X9 budget.
Problems relating to the likely achievement of the 20X9 budgetand its inconsistency with the 'beyond budgeting' points 1 to 3 raisedin the question may be viewed as follows:
- 'Stretch goals' are intended as moving away from ï¬xed targets (as in the budget) that may lead to 'gaming' and irrational behaviour. Relative improvements should be the outcome of strategic changes agreed, whereas the budget focus seems to be a continuation of the 'status quo' linked to arbitrary value changes. The budgeting system is also seen to be meeting the planned target through arbitrary costs, particularly in discretionary areas such as training and marketing (see Table A in the question).
- Evaluation and rewards should be based on relative improvement contracts (with hindsight). Until 20X8, no such evaluation and reward processes seem to have been in place. The question indicates that a bonus system will be implemented in 20X9 using a set of Key Performance Indicators as an incentive to the overall achievement of goals and the creation of value.
- The existing budget process does not focus on a strategy to achieve continuous value creation for RRR. The budget planned for 20X9 has a target proï¬t of $20m which is a 33% increase on the actual proï¬t achieved in 20X8, linked to a 10% increase in sales volume. It would appear that (as discussed in answer (a) (ii) above) this expresses an arbitrary set of data that is NOT the outcome of a new charge strategy.
(b)Staff bonus calculation: Year ended 30November 20X8 using Key Performance Indicators (KPI's) based on relativeimprovement contract factors
(B)* â€“ each KPI score value is positive (+) where 20X8 value isgreater than the previous year or negative (â€“) where 20X8 value isless than previous year. Each KPI score value is the % increase (+) ordecrease (â€“) in 20X8 as appropriate
W1 (1 â€“ (300/440)) Ã— 100 = 31.8
W2 (1 â€“ (100/132)) Ã—100 = 24.2
W3 20X8 = (10,000/15,000) = 66.7%; 20X7 = (8,800/16,000) = 55%
improvement in 20X8 = (66.7 â€“ 55)/55 = 21.3%
(c)The KPI appraisal and bonus process providesa broad range of indicators that may be monitored, both individuallyand collectively over time in respect of the relative improvement inAlpha Division. The analysis may also be used in order to give aspectrum of measures against which to compare the Alpha divisionrelative improvement against that of other divisions in RRR plc.
In addition, the factors which improve or detract from the sizeof the bonus earned are clearly shown. This should act as an additionalincentive for staff, particularly where an improvement in the weightedscore for any particular element is required. For example, in proï¬tversus that of competitor, which shows a negative score in the 20X8comparison in (b) above.
Question 2 - Environmental influences
(a) PEST analysis
Approval from the ACU is vital for Hawk's racing suits. Whilstthis will require regular inspections, it is important for credibilityamongst customers. It may be seen as an endorsement of quality for theentire range (the soÂcalled "halo effect").
Government/EU regulation that could damage motorcycle sales is anissue for the whole industry. If there is a clamp down it mightseriously threaten sales. Hawk might consider setting up a lobby groupwith other manufacturers.
The recession in the UK economy (and foreign markets) is likelyto result in lower disposable incomes for what is often a luxurypurchase. Hawk may well find a major dip in sales as the recessioncontinues.
The weakening Â£ is making exports to the USA and Europe easier,but increases the import costs of leather. There is little Hawk can doabout that, so it is likely to seek new global markets such as the BRICeconomies [Brazil, Russia, India and China].
There has been a growth in demand from mature riders("born--again bikers"). Have companies such as Hawk done any research toassess the life of this trend? How effective is Hawk's marketing atreaching this potentially important market segment?
More emphasis on safety of riders who often have family; this is aboost for the industry and Hawk's customers are likely to beresponsible bikers.
Relevant issues include website ordering and metallic paints butneither of these is especially important. However, Hawk and othersshould be aware of new ideas that could help with their processes.
(b) Porter's 5 forces
Threat of new entrants
The threat of new entrants is reasonably high from overseasrivals but is limited by existing entry barriers. These includerecruiting skilled staff, close associations with racing teams,established relationships with major retailers and brand reputation.
Bargaining power of customers
The power of customers depends on which customers are beingconsidered. For those individual customers it is low because they willbe loyal to the brand and are not buying in bulk.
However for the large retailers there is higher power that arisesfrom the volumes purchased. Retail chains will exercise this power interms of designs, lead times, prices paid and credit period taken. Hawkneed to meet these needs or risk losing major customers to existing/newcompetition.
It will also be high for the professional racing teams. HavingHawk's products associated with top class racing teams is imperative tomaintain the quality of its brand in the market place. Suits must bemade to a high quality and exactly to customer specification/compliancewith the Auto Cycle Union's requirements.
Bargaining power of suppliers
The power of suppliers is generally low, because leather andmachinery are readily available (note: it may be that supply of leatherof the required quality for professional suits is limited, in which casethe power would be higher).
However, supplies of skilled labour are limited and Hawk may find it has to pay high wages.
Threat of substitutes
Hawk believes that the threat from substitutes is low and statesthat only leather can offer the required degree of abrasion resistance.Clearly this must be kept under review as newer fabrics and technologiesmay change this perception.
The threat of substitute products/fabrics may be higher in thefashion lines, although this does not yet constitute a major proportionof Hawk's turnover.
Question 3 - Budgetary information
(a)In the next period the firm's prices will become 6% cheaper in real terms, so demand will increase by 1.5 * 6% = 9%
Sales will therefore be 106,000 * 1.09 = 115,540 units
To determine the next period's costs we can use the high lowmethod to identify fixed and variable elements from the data in thequestion.
So the variable cost per unit is $36,000 / 6000 = $6
The fixed costs in the previous period are ($1,000 â€“ (100 * $6)) = $400,000
We are now in a position to restate the numbers into the nextperiod and show the budgeted position if the firm maintains the $13selling price.
(b)If the firm raises its prices by 6% it willbe selling goods to the market in the next period at a price unchangedin real terms, so it will continue to sell 106,000 units. The budgetedposition will be as follows:
You have asked me to provide you with advice on pricing our product for the next period.
A survey has been commissioned from economic consultants to determine the effects on sales volumes of varying the sales price.
Following the receipt of this survey's results I have now calculated the budgeted effects of:
(1)Maintaining the sales price at $13; or
(2)Raising the sales price by 6%
Maintaining the sales price means that our product becomesrelatively more attractive in the market, and sales volumes willincrease. A budgeted profit of $296,832 is expected for the period.
Raising the sales price by 6% in line with our competitors meansthat sales volume are unchanged, but sales revenues rise due to theincreased price charged per item. A budgeted profit of $318,594 isexpected for the period.
I therefore recommend that the selling price should be raised by 6% in order to obtain the larger budgeted profit figure.
Question 4 - ZBB
To: Board of Directors
From: Finance Director
Date: 11 June 20x4
Re: The adoption of Zero-based budgeting within NN Ltd.
During recent years the management of NN Ltd has used thetraditional approach of incremental budgeting. This approach entails theuse of the previous year's budget as a baseline and adds or subtractsamounts to/ from that budget in order to reflect assumptions for theforthcoming budget year. The typical justification for increasedexpenditures, other than those related to volume changes, has been dueto the increased cost of inputs to our business. This approach can leadto inefficiencies in the previous year's budget being rolled forwardinto the next year's budget purely by virtue of the fact that lastyear's budget is the base starting point for the construction of the newbudget.
The implementation of a system of zero-based budgeting will require a consideration of the following:
- The need for major input by management;
- The fact that it will prove extremely time consuming;
- The need for a very high level of data capture and processing;
- The subjective judgement inherent in its application;
- The fact that it might be perceived as a threat by staff;
- Whether its adoption may encourage a greater focus upon the short-term to the detriment of longer-term planning.
Zero-based budgeting was developed to overcome the shortcomingsof the technique of incremental budgeting. The implementation of azero-based budgeting would require each manager within NN Ltd toeffectively start with a blank sheet of paper and a budget allowance ofzero. The managers would be required to defend their budget levels atthe beginning of each and every year. Thus, past budget decisions wouldas part of the process of zero-based budgeting need to be re-evaluatedeach year.
The comprehensive resource cost-analysis process is a stronginternal planning characteristic of zero-based budgeting. It followsthat resource requirements are more likely to be adjusted to changingbusiness conditions.
The development and implementation of the zero-based budgetingmodel will require managers and others in the organisation to engage inseveral major planning, analytical and decision-making processes. Ourcompany has already established mission and goal statements. However, weas a management team ought to give consideration as to whether it isnecessary to redefine the statements that are already in existenceand/or create new ones. This redefinition of mission and goal statementswill be of much value if we as a management team consider that majorchanges have occurred in the internal and external environment of ourbusiness.
A zero-based budgeting decision unit is an operating division forwhich decision packages are to be developed and analysed. It can alsobe described as a cost or a budget centre. Thus the manager responsiblefor each cost centre within NN Ltd would be responsible for developing adescription of each program to be operated in the next budget year. Inthe context of zero-based budgeting such programs are referred to asdecision packages, and each decision package usually will have three ormore alternative ways of achieving the decision package's objectives.Briefly, each decision package alternative must contain, as a minimum,goals and/or objectives, activities, resources and their associatedcosts.
Each decision package should contain a description of how it willcontribute to the attainment of the mission and goals of theorganisation.
Each manager within NN Ltd will be required to review eachdecision package and its alternatives in order to be able to assess andjustify its operation and in doing so, several questions must beanswered. In particular, each manager will need to answer the followingquestions:
- Does this decision package support and contribute to the goals of the organisation?
- What would be the result to the organisation if the decision package were to be eliminated?
- Can this decision package's objectives be accomplished more effectively and/or efficiently?
The ranking process, based upon cost/benefit analysis is used toestablish a prioritised ranking of decision packages within theorganisation. During the ranking process managers and their staff willanalyse each of the several decision package alternatives. The analysisallows the manager to select the one alternative that has the greatestpotential for achieving the objective(s) of the decision package.Ranking is a way of evaluating all decision packages in relation to eachother. Since, there are any number of ways to rank decision packagesmanagers will no doubt employ various methods of ranking. The rankingprocess could prove to be problematic insofar as it will require ourmanagers to make value judgements and thus subjectivity is an inherentfactor in the application of zero-based budgeting. Although difficult,the ranking of decision packages is fundamental to the process ofzero-based budgeting.
Following a review and analysis of all decision packages,managers will determine the level of resources to be allocated to eachdecision package. Managers at different levels of responsibility in theorganisation usually perform the review and analysis. Sometimes, theexecutive levels of management may require the managers of the decisionpackages to revise and resubmit their decision packages for additionalreview and analysis.
Our budget will be prepared following the acceptance and approvalof the decision packages. Once the company's budget has been approved,managers of the decision units will put into operation all approveddecision packages during the budget year.
The last major process of zero-based budgeting is monitoring andevaluation. The processes of planning, analysis, selection and budgetingof decision packages will prepare our company for operation during thenext year. However, what managers plan to happen during the next yearmay or may not occur. Adjustments may be essential during the year inorder to achieve the decision package objectives. Also, there is a needto know whether or not the organisation did accomplish what it set outto achieve and what level of achievement was obtained. The monitoringand evaluation process of zero-based budgeting requires a number offeatures are incorporated in the overall design and implementation ofdecision packages.
- It is essential that all decision packages include measurable performance objectives and identifies the appropriate activities as means for achieving the performance objectives.
- The required resources for conducting the activities, together with the planned methods for carrying out the activities should also be included.
- The decision package should also include a mechanism to evaluate whether an objective is being achieved both during and after the conclusion of the program of activities for subsequent reporting to management.
(ii) Implementation of zero-basedbudgeting will require a major planning effort by our personnel. It isthrough the planning process that important guidelines and directionsare provided for the development and ranking of the decision packages.Also, the planning process will enable managers to prepare for theuncertainty of the future. Long-range planning allows managers toconsider the potential consequences of current decisions over anextended timeframe.
Zero-based budgeting addresses and supports comprehensiveplanning, shared decision-making, the development and application ofstrategies and allocation of resources as a way of achieving establishedgoals and objectives. In addition, zero-based budgeting supports theadded processes of monitoring and evaluation.
Zero-based budgeting, when properly implemented, has thepotential to assist the personnel of an organisation to plan and makedecisions about the most efficient and effective ways to use theiravailable resources to achieve their defined mission, goals andobjectives.
There is no doubt that the process of zero-based budgeting willconsume a great deal more management time than the current system ofbudgeting does. This will certainly be the case in implementation of thesystem because managers will need to learn what is required of them.Managers may object that it is too time-consuming to introducezero-based budgeting, however, it could be introduced on a piece-mealbasis. As regards the imposition upon management time, managers mayobject that they simply do not have the necessary time in order toundertake an in-depth examination of every activity each year. However,if this proves to be the case then we could consider the establishmentof a review cycle aimed at ensuring that each activity is reviewed on atleast one occasion during every two or three years.
I propose that we hold a series of training seminars for ourmanagement to help in the transition to a system of zero-basedbudgeting. We must also ensure that we 'sell the benefits' that wouldarise from a successful implementation.
A zero-based budgeting system would assist our managers to:
- Develop and/or modify the organisation's mission and goals.
- Establish broad policies based on the mission and goals.
- Efficiently identify the most desirable programs to be placed in operation.
- Allocate the appropriate level of resources to each program.
- Monitor and evaluate each program during and at the end of its operation and report the effectiveness of each program.
Thus, as a consequence of the adoption of zero-based budgetingour managers should be able to make decisions on the basis of animproved reporting system.
It is quite possible that zero-based budgeting would helpidentify and eliminate any budget bias or 'budget slack' that may bepresent. Budgetary slack is 'a universal behavioural problem' whichinvolves deliberately overstating cost budgets and/or understatingrevenue budgets to allow some leeway in actual performance. We mustacknowledge that in organisations such as ours where reward structuresare based on comparisons of actual with budget results, bias can help toinfluence the amount paid to managers under incentive schemes. However,we should emphasise that if managers are to earn incentives as aconsequence of incentive schemes that are based upon a comparison ofactual outcomes with budgeted outcomes, then a zero-based budget wouldprovide a fair yardstick for comparison.
It is important to provide reassurance to our managers that we donot intend to operate a system of zero-based budgeting against thebackdrop of a blame-culture. This will help to gain their most positiveacceptance of the change from a long established work practice that theymay perceive afforded them a degree of 'insurance'.
Signed: Finance Director
(b)The finance director is probably aware thatthe application of zero-based budgeting within NN Ltd might prove mostfruitful in the management of discretionary costs where it is difficultto establish standards of efficiency and where such costs can increaserapidly due to the absence of such standards.
A large proportion of the total costs incurred by NN Ltd willcomprise direct production and service costs where the existence ofinput: output relationships that can be measured render them moreappropriate to traditional budgeting methods utilising standard costs.
Since the predominant costs incurred by a not for profit healthorganisation will be of a discretionary nature, one might conclude thatthe application of zero-based budgeting techniques is more appropriatefor service organisations such as the not for profit health organisationthan for a profit-seeking manufacturer of electronic office equipment.
A further difference lies in the fact that the ranking ofdecision packages is likely to prove less problematic within anorganisation such as NN Ltd which is only involved in the manufactureand marketing of electronic office equipment. By way of contrast, thereis likely to be a much greater number of decision packages of adisparate nature, competing for an allocation of available resourceswithin a not for profit health organisation.
Question 5 - ABB and benchmarking
(a)Revised activity cost matrix â€“ sales order department
(W1) Total cost/Customers = $740,000/2,000 = $370
(W2) Orders/Customers = 5,000 + 1,200/2,000 = 3.1 units
(W3) Number of despatches/Number of orders = 11,500/5,000 + 1,200 = 1.85
The IT initiative will reduce the average cost per customer by$20, i.e. by 5.4%, bringing it closer to the industry average of 300,although still 16.7% above this figure (at 350).
Customer numbers will increase by 600, i.e. 30%.
Orders will increase overall by 1,300, i.e. 21%, with UK orders increasing by 500, i.e. 10% and export orders by 800, i.e. 67%.
Cognet Inc's cost per UK order increases under the post IT schemeto a level above the industry average, a rise of 22.5%. Costs perexport order reduce post IT by 15.5% but remain significantly above theaverage (by 55%).
Cost per despatch falls post IT to a level close to the industryaverage (reducing from 11.13 to 8.64). The sales literature per customerfalls by 38% to a new level below the industry average. When linked tothe 30% customer increase this could be viewed as part of theeffectiveness of the new system.
Question 6 - Value chain
(a) 'Value chain' describes the full range of activitieswhich are required to bring a product or service from conception,through the intermediary of production, delivery to final consumers, andfinal disposal after use. It is a way of looking at a business as achain of activities that transform inputs into outputs that customersvalue. Customer value derives from three basic sources:
- activities that differentiate the product
- activities that lower its cost
- activities that meet the customer's need quickly.
The value chain includes a profit margin since a markup above thecost of providing a firm's value-adding activities is normally part ofthe price paid by the buyer â€“ creating value that exceeds cost so asto generate a return for the effort.
'Value chain analysis' views the organisation as asequential process of value-creating activities, and attempts tounderstand how a business creates customer value by examining thecontributions of different activities within the business to that value.Value activities are the physically and technologically distinctactivities that an organisation performs. Value analysis recognises thatan organisation is much more than a random collection of machinery,money and people. These resources are of no value unless they areorganised into structures, routines and systems, which ensure that theproducts or services that are valued by the final consumer are the onesthat are produced.
(b) Porter describes two different categories of activities.
The primary activities, in the lower half of the value chain are grouped into five main areas:
- Inbound logistics are the activities concerned with receiving, storing and handling raw material inputs.
- Operations are concerned with the transformation of the raw material inputs into finished goods or services. The activities include assembly, testing, packing and equipment maintenance.
- Outbound logistics are concerned with the storing, distributing and delivering the finished goods to the customers.
- Marketing and sales are responsible for communication with the customers e.g. advertising, pricing and promotion.
- Service covers all of the activities that occur after the point of sale e.g. installation, repair and maintenance.
Alongside all of these primary activities are the secondary, orsupport, activities of procurement, technology development, humanresource management and firm infrastructure. Each of these cuts acrossall of the primary activities, as in the case of procurement where ateach stage items are acquired to aid the primary functions.
(c)The key problem areas are as follows:
- Inbound logistics â€“ Woodsy has problems with the procurement of the raw materials, labour and machinery. The company is buying its raw materials two years in advance of using it. This must be tying up capital that could be used to purchase new machinery and tools. Storing the timber entails large amounts of money being tied up in stocks, which are prone to damage, restrict the production area and is very slow moving. The workmen are being paid by the hour rather than by the piece and this means that they have little incentive to work harder.
- Operations are concerned with the transformation of the raw material inputs into finished goods or services. At Woodsy, employees work at their own pace on the assembly of the garden seats and tables, using very basic tools. The production methods used make the finished product relatively expensive. The linkages between the support activities are also causing some problems. Both the owner and the foreman have no man-management skills. Technological development is non-existent and the company needs re-structuring.
- Outbound logistics are concerned with storing, distributing and delivering the finished goods to the customers. Woodsy does not seem to have a system for distributing and delivering its goods.
- Marketing and sales are responsible for communication with the customers e.g. advertising, pricing and promotion. This seems to be non-existent at Woodsy as, in the past, satisfied customers have passed on their recommendations to new customers. The company relies on its position on a busy road intersection to displays its products, for customers to carry away themselves.
(d) For Bill Thompson, the main task is todecide how individual activities might be changed to reduce costs ofoperation or to improve the value of the organisation's offerings. Therecommendations would include the following:
- The business needs managing full-time. A new manager, or assistant manager, could encourage Bill to streamline the manufacturing process, introduce new technologies and new production and administrative systems. He or she could also negotiate new payment methods to give the workforce an incentive to work harder.
- To increase the production area the alternative strategies that the company could explore include storing the timber elsewhere, or purchasing it after it has dried out and seasoned.
- Holding high levels of finished goods might give a faster customer response time but will probably add to the total cost of operations.
- The purchase of more expensive power tools and equipment may lead to cost savings and quality improvements in the manufacturing process.
- The company needs a marketing and sales department to research the market, inform the customers about the product, persuade them to buy it and enable them to do so. The product range may need to be extended and alternative outlets for the products sought.
Question 7 - BPR
Business process re-engineering involves examining businessprocesses and making substantial changes to the way in which anorganisation operates. It requires the redesign of how work is donethrough activities. A business process is a series of activities thatare linked together in order to achieve the desired objective. Forexample material handling might be viewed as a business process whichinvolves the separate activities of production scheduling, storingmaterials, processing purchase orders, inspecting materials and payingsuppliers.
The aim of Business process re-engineering is to enhanceorganisational performance by achieving improvements in the key businessprocesses by focusing on simplification, improved quality, enhancedcustomer satisfaction and cost reduction. Business processre-engineering can be applied not only to manufacturing processes butalso to an extensive range of administrative activities. In the case ofmaterial handling an organisation might re-engineer the activity ofprocessing purchase orders by collaboration with suppliers of componentsfor their products by integration of their production planning systemwith that of their suppliers. This would enable purchase orders to besent directly to their suppliers thereby obviating the need for anyintermediate administrative activity. By the same token scheduled ordersmight be agreed with the supplier which would reduce the need to holdstocks of components. In circumstances where suppliers are working inclose collaboration with an organisation, it may be possible to roll thequality back down the supply chain and agree quality control procedureswith the supplier which would reduce the need to inspect incomingdeliveries of components.
Thus savings in material handling costs could be achieved viareduced storage, processing and inspection costs. Such costs do not addvalue to the final product and thus are of no benefit to the customer.The focus of elimination of non-value added costs and cost reductionlinks Business process re-engineering to Total quality management andJust-in-time philosophies.
Business process re-engineering is sometimes regarded as a'one-off' cost-cutting exercise even though its primary focus is not thereduction of costs. The above example shows that cost reductions canresult from such activities. However it should not be regarded as'one-off' but as a continuous activity. If the aims of Business processre-engineering are not clearly understood across the entire organisationthen staff may be suspicious of managerial motives for undertaking aprogramme of Business process re-engineering. This may be partlyattributable to the fact that Business process re-engineering was seenas being connected with the downsizing and shedding of large numbers ofjobs during the early part of the last decade.
A distinguishing feature of Business process re-engineering is thatit involves the radical overhaul and dramatic changes in processesentailing the abandonment of existing practices and the re-design of newones.
However, Business process re-engineering is still sometimes viewedas a way of making small improvements by 'tinkering' with existingpractices.
In much the same way as a Total quality programme with its focus oncontinuous improvement, business process re-engineering requires thelong-term commitment of management and staff within an organisationwhich is not always easily achievable.
Question 8 - Reward schemes
(a)The potential benefits to be gained from the implementation of a reward scheme
Assists in achieving strategy - rewards and incentives canmake a positive contribution to strategy implementation by shaping thebehaviour of individuals and groups. A well designed reward scheme willbe consistent with organisational objectives and structure.
Improves performance - there is evidence which suggeststhat the existence of a reward scheme provides an incentive to achieve agood level of performance. Moreover, the existence of effective schemesalso helps not only to attract but to retain employees who makepositive contributions to the running of an organisation.
Improves understanding of factors required for success -key values can be emphasised by incorporating key performance indicatorsin the performance-rewards mechanisms which underpin the scheme. Thishelps to create an 'understood environment' in which it is clear to allemployees what performance aspects precipitate organisational success.
Continuous improvement - an effective reward scheme will create an environment in which all employees are focused upon 'continuous improvement'.
Long-term benefit - schemes which incorporate equity shareownership for managers and employees alike can encourage behaviourwhich is in the longer-term interests of the organisation by focusing onactions aimed at increasing the market value of the organisation.
(b)Factors that should be considered in the design of a reward scheme for BGL
Choice of performance target - should performance targetsshould be set with regard to results or effort? It is more difficult toset targets for administrative and support staff since in many instancesthe results of their efforts are not easily quantifiable. For example,sales administrators will improve levels of customer satisfaction butquantifying this is extremely difficult.
Type of reward - should rewards should be monetary ornon-monetary? Money means different things to different people. In manyinstances people will prefer increased job security which results fromimproved organisational performance and adopt a longer term-perspective.Thus the attractiveness of employee share option schemes will appeal tosuch individuals. Well designed schemes will correlate the prosperityof the organisation with that of the individuals it employs.
Implicit or explicit reward - should the reward promiseshould be implicit or explicit? Explicit reward promises are easy tounderstand but in many respects management will have their hands tied.Implicit reward promises such as the 'promise' of promotion for goodperformance is also problematic since not all organisations are largeenough to offer a structured career progression. Thus in situationswhere not everyone can be promoted there needs to be a range ofalternative reward systems in place to acknowledge good performance andencourage commitment from the workforce.
The size and time span of the reward - this can bedifficult to determine especially in businesses such as BGL which aresubject to seasonal variations. i.e. summerhouses will invariably bepurchased prior to the summer season! Hence activity levels may vary andthere remains the potential problem of assessing performance when anorganisation operates with surplus capacity.
Whether the reward should be individual or group based -this is potentially problematic for BGL since the assembly operativescomprise some individuals who are responsible for their own output andothers who work in groups. Similarly with regard to the sales force thenthe setting of individual performance targets is problematic sincesales territories will vary in terms of geographical spread and customerconcentration.
Whether the reward scheme should involve equity participation- such schemes invariable appeal to directors and senior managers butshould arguably be open to all individuals if 'perceptions of inequity'are to be avoided.
Tax - tax considerations need to be taken into account when designing a reward scheme.
(c)'If we implement a reward scheme then it is bound to be beneficial for BGL'.
The statement of the manufacturing director is not necessarilycorrect. Indeed there is much evidence to support the proposition thatthe existence of performance-related reward schemes can encouragedysfunctional behaviour. This often manifests itself in the form of'budgetary slack' which is incorporated into budgets in anticipation ofsubsequent cuts by higher levels of management or to make subsequentperformance look better.
There is also a risk that employees may prioritise the achievement of their reward which could impact their risk appetite.
Employee morale (and hence productivity) may fall if employeesfeel that they are being penalised for circumstances outside of theircontrol.
(d)Good performance should result in improvedprofitability and therefore other stakeholder groups may be rewarded for'good performance' as follows:
- Shareholders may receive increased returns on equity in the form of increased dividends and /or capital growth
- Customers may benefit from improved quality of products and/service and possibly lower prices.
- Suppliers may benefit from increased volumes of purchases
- Government will benefit from increased amounts of taxation.
Question 9 - Planning and MIS
Subject: The role and contribution of strategic planning within the company
(a)The management of our company have historically concentrated on operational issues that are characterised by:
- a predominantly internal focus
- short-term concerns
- frequently of a routine nature
- limiting decision-making and utilising the use of existing resources
- plans and control systems are precise and detailed
- control and feedback can be immediate.
In contrast, strategic planning and management tends to be:
- concerned with external considerations, the role of the organisation in the wider environment, anticipating environmental shifts and responding appropriately
- concerned with long-term issues, perhaps up to 20/30 years, and not merely with this month's or this year's budget
- the management have extensive freedom in their planning and decision-making, less variables are taken as given
- looking at broad issues, with detailed plans and activities deferred until nearer the time, when greater precision is required
- concerned with the acquisition of new/additional resources e.g. capex, and not merely the use of current resources
- concerned with achieving a vision, where the organisation is going.
(b)Organisations need to focus on both of thesegroups of issues if they are to be successful in the long term. Thisbusiness appears to have given limited recognition to the strategicissues, for example, it has not explored new markets and products, whichrequires consideration of external long term matters that may involvethe acquisition of new resources. The company appears to be reactive andnot proactive. The business needs to develop the MIS so that itincorporates information from the external environment, especiallymarket intelligence and data.
The traditional client base is contracting with no apparent plansin place to meet the 'planning gap'. An organisation that fails toconsider the long term business environment is not likely to survive. Wehave to think about the future now, or else, there will not be one.
The business needs to ask questions such as:
- where do we want to be in ten years?
- what do we need to do to get there?
- what is happening in the outside world?
- what should we do to meet the needs of the market in a changing environment?
- what are the risks of alternative strategies?
The highlighting of these issues does not now mean that themanagers should only be concerned with strategy. They also need to planand control the operational day-to-day matters that are necessary tokeep the business running. A balanced comprehensive management shouldincorporate consideration of both strategic and operational issues,although not necessarily by the same person(s). As long as the twoaspects are co-ordinated and integrated, they can be undertaken bydifferent groups of people within the organisation. The MIS whichsupports this is key.
(c)The successful implementation of strategic management will require the following conditions to prevail:
- Communicate and explain the need for the change in approach.
- Emphasise that strategic management is not displacing operational management, but is an additional activity to complement the current activities.
- Resources will have to be found to incorporate this new activity
- The MIS will have to be modified and developed to cope with the additional demands made upon it.
- Training and job changes may be required.
- New and broader performance indicators will need to be introduced e.g. market penetration in new business areas. This may provide the opportunity and incentive to introduce a new approach to performance assessment e.g. The Balanced Scorecard.
- The need to explore new products and new markets will inevitably create uncertainties and therefore a new approach towards risk will have to be adopted.
- The achievement of the new strategic plans will require operational decision makers to ensure that their activities are congruent with long term objectives. This new constraint upon their 'freedom of action' may cause discontent and needs to be handled with sensitivity.
Question 10 - MIS
Key answer tips
Although this question is framed from the viewpoint of MIS, it isreally an examination of your knowledge of the requirements of adivisionalised company.
Unitary to divisionalised structure
- Each division will now require its own accounts.
- There is now a need to assess the financial and non-financial performance of every division.
- Internal and external income will have to be identified â€“ a cross charging/transfer pricing system will have to be devised that ensures corporate goal congruence.
- Information concerning the various external markets is required to permit the performance of a manager to be distinguished from the performance of the business unit managed.
Central direction to empowerment
- There may be a need to separate the transmission of strategic and operational information. The empowered team leaders will not require strategic information, but principally, data concerned with the day-to-day management of the business. Whereas the senior management may now be able to dispense with information concerned with operational details.
- This may also require the development of new reporting formats that are understandable to the team leaders. They may need even more detailed information at more frequent intervals than was available previously.
- New control systems will be required to meet the needs of the newly empowered team leaders and the senior management. The shift from a few too many decision makers will necessitate control systems to ensure standardisation and consistency throughout the company.
The shift to outsourcing
- New information systems will be needed to facilitate access to the external providers of services e.g. approved contractor lists
- Authorisation/approval systems need to be developed to ensure procedures are being adhered to.
- Systems to monitor the price and quality of work undertaken by contractors will be needed.
- Financial appraisal systems may be installed to compare the 'life' costs of alternative suppliers in comparison with internal resourcing. If internal suppliers are permitted to bid for work and compete against contractors, then there is a need for the costing systems to clearly identify the activities driving costs.
Expansion in part-time and temporary employees
- The traditional personnel systems will need to adapt to the new situation.
- The employment of part-time staff to replace full timers will result in greater numbers of employees, perhaps by a factor of two or three times. Can the existing system cope? Is there sufficient storage and memory capacity?
- Part-timers and temporary staff tend to stay in jobs for shorter periods and hence creating more activity within the personnel department. Once again can the system cope with the additional workload?
- Long serving full-time employees will have more opportunity, and perhaps more incentive to understand and use effectively a complex MIS. On the other hand, part-timers and temporary staff will have less opportunity to 'come to grips' with a complex system, therefore it may be necessary to modify simplify the systems to suit the new staffing situation.
Customers adopting JIT systems
- The company could previously operate with low or zero stocks, and therefore a small/simple stock holding system might suffice. The advent of JIT for customers puts the onus on the company to replenish stocks immediately. This will necessitate the installation of a larger, accurate and responsive inventory system. The system adopted will need to provide information concerning minimum stock levels, re-order cycles and Economic Order Quantities. None of this information may have been required previously because stock levels were not so business critical.
Long print runs to high value low volume
- The new customers will have more complex, individualistic and diverse requirements. The established ordering and printing systems will need to be modified to manage the heterogeneous business activity.
- High value business normally permits lower margins of error and deficiencies in quality standards. This may entail close monitoring and low tolerance control systems being installed.
Note: This list of issues is not exhaustive and thereforeother considerations mentioned by the candidates should be credited. Thecrucial requirement is to assess whether the examinees are thinkingcoherently about the consequences on the organisation of the change inthe business environment.
Question 11 - NPV/IRR
(a)Calculation of NPV
Total investment in working capital
(b)Calculation of internal rate of return
NPV at 12% was calculated in part (a) and = $91,154
IRR = 12 + [(20 â€“ 12) Ã— 91,154/(91,154 + 92,387)] = 12 + 4 = 16%
(c)Acceptability of the proposed investment in Product P
The NPV is positive and so the proposed investment can berecommended on financial grounds. The IRR is greater than thediscount rate used by SC Co for investment appraisal purposes andso the proposed investment is financially acceptable. The cashflows of the proposed investment are conventional and so there isonly one internal rate of return. Furthermore, only one proposedinvestment is being considered and so there is no conflict betweenthe advice offered by the IRR and NPV investment appraisalmethods.
Limitations of the investment evaluations
Both the NPV and IRR evaluations are heavily dependent on theproduction and sales volumes that have been forecast and so SC Co shouldinvestigate the key assumptions underlying these forecast volumes. Itis difficult to forecast the length and features of a product's lifecycle so there is likely to be a degree of uncertainty associated withthe forecast sales volumes. Scenario analysis may be of assistance herein providing information on other possible outcomes to the proposedinvestment.
The inflation rates for selling price per unit and variable costper unit have been assumed to be constant in future periods. In reality,interaction between a range of economic and other forces influencingselling price per unit and variable cost per unit will lead tounanticipated changes in both of these project variables. The assumptionof constant inflation rates limits the accuracy of the investmentevaluations and could be an important consideration if the investmentwere only marginally acceptable.
Since no increase in fixed costs is expected because SC Co hasspare capacity in both space and labour terms, fixed costs are notrelevant to the evaluation and have been omitted. No information hasbeen offered on whether the spare capacity exists in future periods aswell as in the current period. Since production of Product P is expectedto more than double over three years, future capacity needs should beassessed before a decision is made to proceed, in order to determinewhether any future incremental fixed costs may arise.
(d)The primary financial management objectiveof private sector companies is often stated to be the maximisation ofthe wealth of its shareholders. While other corporate objectives arealso important, for example due to the existence of other corporatestakeholders than shareholders, financial management theory emphasisesthe importance of the objective of shareholder wealth maximisation.
Shareholder wealth increases through receiving dividends andthrough share prices increasing over time. Changes in share prices cantherefore be used to assess whether a financial management decision isof benefit to shareholders. In fact, the objective of maximising thewealth of shareholders is usually substituted by the objective ofmaximising the share price of a company.
The net present value (NPV) investment appraisal method advisesthat an investment should be accepted if it has a positive NPV. If acompany accepts an investment with a positive NPV, the market value ofthe company, theoretically at least, increases by the amount of the NPV.A company with a market value of $10 million investing in a projectwith an NPV of $1 million will have a market value of $11 million oncethe investment is made. Shareholder wealth is therefore increased ifpositive NPV projects are accepted and, again theoretically, shareholderwealth will be maximised if a company invests in all projects with apositive NPV. This is sometimes referred to as the optimum investmentschedule for a company.
The NPV investment appraisal method also contributes towards theobjective of maximising the wealth of shareholders by using the cost ofcapital of a company as a discount rate when calculating the presentvalues of future cash flows. A positive NPV represents an investmentreturn that is greater than that required by a company's providers offinance, offering the possibility of increased dividends being paid toshareholders from future cash flows.
Question 12 - Financial performance
Key answer tips
This question requires the use of a range of financial performanceindicators. Note the emphasis on responsibility accounting in that (a)is from the parent company viewpoint and (b) from the CEO's viewpoint.
(a)The rapid growth in turnover has beenexceeded by an even faster growth in costs and hence the growth in theannual loss sustained. The company's growth has been facilitated byextensive borrowing which has resulted in a substantial interest burden.In terms of key financial indicators we have:
The increasing loss and rising gearing would represent seriouscause for concern in a traditional/conventional assessment of financialperformance. In contrast, the increasing share price suggests that theshareholders are not taking a pessimistic view. They are aware of thefinancial results but still have confidence in the company â€“ we needto investigate this apparent dichotomy in viewpoints. Share price is ameasure of financial performance alongside sales and profit margins.Suggestions for the paradox:
- The company's financial performance is judged according to how it is performing in relation to a known business plan. The loss was predicted and revenues and costs are on target. The share price may begin to fall if the results do not adhere to the plan. Shareholder confidence and perceived performance is about the management delivering on their promises.
- The shareholders and the market are taking a long term view with the first four year results being regarded as only short to medium term. The long term financial performance is yet to be disclosed.
- The company owns substantial tangible assets in addition to intangibles that will provide the basis of future market growth. The licences and goodwill represent the purchase of future cash inflows and may be regarded as market entry costs.
(b)This is concerned with the issue of beingable to differentiate the performance of the organisation from theperformance of the manager. The COE may argue that they do not determineeither the amount of the assets under their control or the interest onthe debt - acquisition and financing policy is determined by the boardand therefore beyond their control. Instead of using the standardmeasure of profit as an indicator of performance, the COE may be judgedon Earnings Before Interest, Tax, Depreciation and Amortisation(EBITDA). This represents the surplus after excluding two significantcosts associated with the acquisition of the company's capital assetsâ€“ depreciation (of tangible and intangible assets) and interestcharges.
This shows a significant improvement in performance and thereforecould be used to justify the assertion that the team's performance hasimproved.
(c)The uncertain cashflows require to be adjusted for the alternative potential scenarios.
Calculate the expected values by multiplying the cashflows by the probabilities:
Total NPV = $10.674 billion.
Cost of capital = 689/8,997 â€“ 7.65% +4% = 11.65 or rounded up to 12%.
The cash inflow projections are likely to arise from the companyentering into a period of stable capital costs and increasing revenuesas the spare capacity in the network becomes utilised (mentioned inquestion brief).
The $10.7 billion is far in excess of the historic cumulativeloss. The rising share price would have probably been influenced bythese anticipated cashflows.
Question 13 - Divisional performance 1
(a)Best outcome situation for the quality improvement programme
(1)Using year 3 as an example: extra std. hours = (1,000 + 300 + 400) Ã— 1.05 = 1,785.
(2)Contribution (e.g. for year 1 = 1,050 hours Ã— ($1,200 Ã— 1.10) = $1,386,000.
(3)Training, consultancy & salary cost for each year = $100,000 Ã— 0.975 = $97,500.
(4)Depreciation provision per year = $4,000,000/4 = $1,000,000.
(5)Imputed interest charge (e.g. for year 2) = wdv. Ã— cost of capital (%) = (4,000,000 â€“1,000,000) Ã— 8% = $240,000.
(6)Return on investment (e.g. for year 4) = net profit/wdv. = $1,674,500/$1,000,000 = 167.5%.
(7)NPV = (Net margin Ã— discount factor at 8%)for each year â€“ initial investment = $1,288,500 * 0.926 + $1,704,300 *0.857 + $2,258,700 * 0.794 + $2,674,500 * 0.735 -$4,000,000 =$2,412,901.
(b) Bonus calculations â€“ Most Likely Outcome situation
Working notes: (giving an example for one year in each case):
(1)Year 2: Bonus = ($460,000 - $250,000) Ã— 1.5% = $3,150.
(2)Year 3: Bonus = ($740,000 - $250,000) Ã— (0.05 Ã— $40,000)/100,000 = $9,800.
(3)Year 1: ROI is positive (2.5%). Bonus = $40,000 Ã— 15% = $6,000.
(4)Year 4: Bonus = $1,233,700 Ã— 2.5% = $30,843.
(c) The programme manager's choice of bonusmethod will be influenced by factors such as the timing of the bonus,its size, the relative ease with which it is earned and his attitude torisk.
The most likely outcome figures calculated in (b) show that thelargest total bonus is $30,843 where 2.5% of NPV is used as the basis.The programme manager may, however, be influenced by the timing of thebonus payments. The NPV basis delays any payment until the end of year4. The other bonus methods â€“ ROI, net profit and RI â€“ have initialbonus payments in years 1, 2 and 3 respectively. The programme managermay have a strong preference for early cash inflows from his bonus andchoose the ROI basis which will yield $6,000 in year 1.
His choice may also be influenced by the relative ease with whichthe bonus is earned and the degree of control over the factorsincorporated into its calculation. The RI and NPV bases are affected bythe cost of capital percentage which is used. The programme manager mayview this as unacceptable because of lack of control by him over thecost of capital percentage used in the calculation. The higher the costof capital percentage, the lower the bonus paid even if the efficiencyof implementation of the programme has been improved.
The ROI basis ensures a bonus of $6,000 per year so long as netprofit is greater than $250,000. On the other hand, the net profit basisat a net profit of $250,001 per year will effectively yield a nilbonus.
The attitude to risk of the programme manager is also relevant. Arisk-seeking manager may view the $60,323 bonus from the NPV basiswhere the best outcome occurs as very attractive. On the other hand, arisk averse manager may view as unacceptable the possibility of a bonusof only $5,370 from the NPV basis if the worst outcome occurs. He maythen prefer the bonus of $18,000 from the ROI basis which is payableeven if the worst outcome occurs.
(d)The outcome of the implementation of theprogramme will be influenced by the effort of the programme manager, hisattitude to risk and the rationality of his decision-making. In thecase of the programme manager, his level of effort and motivation may beaffected by the bonus system or by promotion prospects. His attitude torisk may be related to the extent to which he feels he has control overthe implementation of the programme and how it is monitored. It is alsoimportant that the manager is selected on the basis that he is suitedto the job in hand and is capable of making relevant decisions about itseffective implementation.
It may be argued that it is the individual who chooses actionsand implements them. The strength of motivation to achieve the programmewill be affected by the expectation that its achievement will result insome benefit and in the strength of preference of the programme managerfor that benefit. His actions will be based on intrinsic and extrinsicfactors. His motivation to achieve the implementation of the qualityprogramme will be affected by both intrinsic and extrinsic factors andhis preference for them. How highly motivated is he to receive a highbonus payment or possible recognition for promotion within theorganisation? (extrinsic factors). How highly motivated is he by factorssuch as the 'feeling of achievement' or the driving force of'professional pride'? (intrinsic factors).
Question 14 - Divisional performance 2
(a)Comments on performance
The strategy of growth has been successful, as sales revenue hasdoubled, but has this been translated into profits being doubled?Looking at PAT in the accounts, there has only been a 25% increase,which seems to indicate inefficiency.
However, looking at the other three metrics, they all showsomething different. Comparing EVA and RI, which are both absolutemeasures, EVA shows an almost 60% increase between 20X8 and 20X9,however RI shows a 48% increase. The adjustments made to reach the EVAfigure enhanced the increase compared to RI, but both show asignificantly better outcome than if we are looking at PAT. ROI shows aless positive scenario with their only being a 21% increase inprofitability.
More information would be required on the cost structure of thebusiness between fixed and variable costs to actually see how theincreased level of revenue has been translated into profits.
It would also be useful to have some details from the balancesheet. Fixed assets have not changed significantly, but current assetshave increased. It would be useful to know if this is due to increasedcosts (ie in purchasing inventory), or a higher level of inventory held.It could also be due to a higher level of receivables, or even morecash being held.
ROI, RI and EVA
ROI (20X8) = $360k Ã· $2,480k = 14.5%
ROI (20X9) = $440k Ã· $2,520k = 17.5%
RI (20X8) = $360k â€“ ($2,480k Ã— 0.08) = $161.6k
RI (20X9) = $440k â€“ ($2,520k Ã— 0.08) = $238.4k
EVA (20X8) = $280k â€“ ($2,910k Ã— 0.063) = $96.7k (see workings below)
EVA (20X9) = $340k â€“ ($2,955k Ã— 0.063) = $153.8k (see workings below)
W1 NOPAT ($000)
W2 Economic value of capital employed
WACC = (0.4 Ã— 0.05 Ã— 0.75) + (0.6 Ã— 0.08) = 6.3%
(b)Similarities and Differences
All three measures consider the profitability of theorganisation, and all three do take into account the level if investmentthat has been made in the organisation, because all three measuresinclude a consideration of capital employed.
EVA and RI are both absolute measures where as ROI is a relativemeasure. If the company is pursuing a strategy of growth then ROI willallow a comparison to be made regarding the year on year on theefficiency in terms of profit generation of the company, where as RI andEVA will be able to show what the growth in profits are year on year.
EVA and RI are calculated differently though, and EVA will give aresult that can be compared to other divisions in this internationalorganisation, as it can be free from local differences in accountingstandards.
Question 15 - Transfer pricing
Full cost plus
Outsource to RS
Note: Internal recharges are removed upon consolidation
(b)The 'full cost plus' transfer pricing model isnot appropriate for FP, as it will result in the Sales Division making adysfunctional decision. To maximise their divisional profits and earn alarger bonus, the manager of the sales division will outsource to RS.This will ensure that a profit is generated, however it will leaveService Division with surplus capacity, generating insufficientcontribution to cover their fixed costs. This will ultimately reducegroup profit.
If RS are allowed to carry out the repairs then other factors should be considered, which could include;
- Quality of the service undertaken
- Impact upon customer satisfaction
- Prioritisation by RS of FP customer requests
- Future pricing stragegy
- How to utilize the surplus capacity within the Service Division.
(c)How to overcome the issues encountered
The respective Divisional managers could enter into negotiation tosettle their disputed transfer price and arrive at a compromise. Howeverit is difficult to ever reach a solution which appeals to both parties,and time may be wasted in lengthy discussions.
In the scenario, the Sales division hold the balance of power asthey have the freedom to outsource to RS, there are unlikely thereforeto want to pay more than the $180 per service as quoted by RS. This islikely to be unacceptable to the Service division as it will not covertheir costs.
Two Part Tariff
Sales Division could pay the Marginal Cost ($64,500) for theservices, and pay an annual lump sum ($33,000) to cover the fixed costsof the Service Division. However this would result in Sales reportingall the profit from the Guarantee scheme.
Two part tariff
An additional element of $11,250 could be paid to ensure profit isshared
This would allow each division to record the transaction as theysaw fit, with any discrepancy picked up by head office. This wouldappease both managers and ensure the work was completed within thegroup, however it may lead to manipulation of profit and larger thandeserving bonuses.
Sales would perhaps be willing to pay $500 per service, $90,000in total, whilst Service would be seeking $136,500. The balance of$46,500 would be absorbed at head office. All of these amounts remaininternal recharges, which are removed upon consolidation of groupaccounts.
Profit Maximisation Rules
In order to ensure profit is maximised, the opportunity cost rules could be applied as follows:
Question 16 - International transfer pricing
(a)If Europe supplied all 300,000 chips to America the impact would be;
(b)Europe has surplus capacity of200,000 units, which should thus be transferred at the Internal MarginalCost of $50 per chip. This was established as the European Manager waswilling to charge $95 which would earn the same contribution as externalsales. ($95 - $45 = $50) America would accept these units which wouldsave $40 per chip (Current cost â€“ Marginal Cost). The final 100,000would be transferred at Marginal Cost plus Lost Contribution ($50 + $45 =$95). America would reject these and source locally at $90 per chip.
(c)Conflict will arise as Europe willsuffer a decline in profit, whilst America gains an additional $8m. Thiscould be resolved by America contributing $6m to cover the additionalfixed costs incurred in Europe
This could be taken a step further, with an additional $1m paid($7m in total) to ensure the additional group profit is equally sharedbetween divisions.
(d)When a company has operations indifferent countries with separate taxation systems, they may seek tominimise their total tax liability by declaring low profits in thenations with high corporation tax rates, and high profits in nationswith low corporation tax rates. Using the example above, if we assumethat America pays tax at 20% whilst Europe pays 40%, then the total taxliability will be $600,000.
However the Annual Lump Sum payment could be adjusted to reduce theprofit declared in Europe. Let's assume that it will revert to $6m.This will result in the total tax liability being reduced to $400,000
National Governments are wising up to this manipulation, and areseeking greater transparency to ensure that the transfer prices have notbeen manipulated. They insist that the transaction is treated at as ifthe two subsidiaries are independent. Thus the charge should be basedupon Market Price.
Question 17 - Not for profit organisations
(a) The term 'value for money' is often used torefer to economy, efficiency and effectiveness. Value for money auditscan be undertaken in order to assess whether value for money has in factbeen achieved. In order for such an audit to be effective theobjectives of AV would need to be clearly understood by thoseundertaking the audit.
The management of AV could attempt to measure the value for moneyof its operating activities in terms of economy, efficiency andeffectiveness. Economy is only concerned with inputs acquired by AV, andis achieved by obtaining those inputs at the lowest acceptable cost.For example, the prices at which with the replacement fitted kitchensare purchased ($2,610) could be compared with those obtainable fromother vendors in order to assess whether the lowest acceptable cost isbeing achieved for the required level of quality. It is important thatthe management of AV realise that economy is measured by reference toquality of resource inputs. They need to recognise that the purchase ofpoor quality materials and inferior services represents 'false economy'.
Efficiency is focussed upon output, for example, maximisingoutput for a given level of input. For example with regard to thereplacement fitted kitchens, AV could use the tendering process in anattempt to maximise the number of fitted kitchens that would beinstalled for a given amount of money by the contractor awarded thetender. Efficiency is measured by the ratio of output to input. Theratio is not used in an absolute sense but in a relative sense and canbe improved in four ways:
- By increasing output for the same input.
- By increasing output by a greater proportion than the proportionate increase in input.
- By decreasing input for the same output; and
- By decreasing input by a greater proportion than the decrease in output.
The denominator (input) is often measured in monetary termswhilst the numerator (output) can be measured in either monetary amountsor physical units, e.g. per property.
Effectiveness is focussed upon the achievement of objectives. Anot for profit organisation will invariably have a number of objectives.For example AV may have the following objectives:
- To meet housing needs.
- To provide quality well-managed homes.
- To provide the services that clients want.
- To provide an effective care and repair service.
- To support the communities within which it operates.
The management of AV should be mindful that the three performancemeasures require individual consideration since for example, the degreeto which effectiveness is achieved gives no indication about how muchwas spent to achieve it.
The management of AV should also recognise that these performancemeasures may conflict with one another. For example, during the year AVincurred expenditure amounting to $234,900 in respect of 90 replacementfitted kitchens. If AV had purchased the same replacement kitchen unitsas BW, then AV would only have been able to refit 45 properties($234,900/$5,220). Hence, the efficiency ratio of inputs to outputswould have been halved. However, the purchase of replacement kitchenunits at a cost of $5,220 might have resulted in a higher level ofeffectiveness being achieved through factors such as the longer life ofthe replacement kitchen units, higher quality fixtures and fittings, andenhanced aesthetic 'appeal' to residents.
The management of AV should also give consideration tobenchmarking against other similar charities whose primary objective isthe provision of accommodation to the communities in which they operate.Benchmarking is probably the most significant recent development inmeasuring the performance of not-for-profit organisations. Themanagement of charities such as AV would be far more willing to shareinformation about performance with similar organisations for theirmutual benefit, than the management of many profit-seeking organisationswho often view the sharing of information as a commercial threat. Forexample, the management of AV could attempt to establish whether $2,610is the 'norm' in respect of the cost of a replacement fitted kitchenincurred by similar non profit-seeking organisations.
The time required in order to undertake repairs of an emergency nature, after notification of the requirement by a tenant.
The friendliness of staff employed by AV which could be measured via the completion of questionnaires by tenants.Flexibility
Mean waiting time for a house to become available to a tenant.
Mean waiting time to re-house a tenant in a different sized house after receipt of a request from a tenant.
(ii)The management of AV could use the following performance measures:
(1)The mean cost per week per house iscalculated by dividing the amount of staff and management costs by thenumber of properties held by each of the respective organisations.Although the same number of staff, (25), are employed by eachorganisation, staff costs incurred by BW are 37.7% higher than those ofAV. This could result from different pay structures and managementpolicies regarding remuneration that are likely to be employed within aprofit seeking organisation such as BW.
(2)AV currently pays, on average, $140 foreach emergency repair, $120 for each urgent repair and $116 for eachnon-urgent repair. BW has benefited from the fact that each repairundertaken by BW costs the same (i.e. $100), irrespective of theclassification of repair. This might be a result of a contractualarrangement with a subcontractor that each repair undertaken is chargedat the same fee in return for guaranteed business volumes for thesubcontractor. If this were the case, then AV would benefit fromentering into such an arrangement for the supply of repair services.
(3)BW did not have any unoccupied propertiesat any time during the year. This would seemingly indicate a high levelof demand for its properties. AV had potential gross rents receivableduring the year of $2,423,200. Unoccupied properties resulted in lostrevenues of $36,348. which amounted to 1.5% of gross rents receivable.Further information is required to in order to assess whether the lostrevenue is attributable to 'void periods', i.e. properties becomingvacant or perhaps due to tenants who have defaulted.
Note: other ratios and relevant comments would have been acceptable.
(c)The primary objective of any commercialorganisation such as BW is to maximise profit. Management may take ashort or long-term view regarding the ways in which they seek to achievethis objective. Management may have to choose between availableoptions, each of which might help them to achieve this objective.However, whilst many decisions may have to be made, the objectiveremains clear and identifiable.
The management of BW will most probably be concerned with theprovision of high quality accommodation in order to generate higherrevenues and profits. The management of BW are probably trying to appealto those who are willing to pay high rents for high qualityaccommodation. The fact that replacement fitted kitchens and replacementwindows and doors purchased by BW cost 100% and 50% respectively, morethan those purchased by AV may be an indication of this.
The objectives of not-for-profit organisations such as AV canvary significantly. AV's primary objective is 'to meet the accommodationneeds of persons within its locality'. This might distil down toensuring that any person, who is in need of accommodation, is in factprovided for.
The absence of a profit measure makes it more difficult tomeasure whether objectives are in fact being achieved. It is difficultto judge whether non-quantitative objectives such as meetingaccommodation needs of people have been met. This does not mean however,that such an assessment should be placed on the 'too difficult pile'and left unattended. A number of suitable measures need to be devised bythe management accountant in order to assess the extent to whichnon-quantitative objectives have been met.
The management of AV would probably be better served in comparingthe performance of their organisation with a similar non-profit seekingorganisation that provides accommodation to meet the needs of society.
Additional information that would assist in appraising theperformance of BW during the year ended 31 May 20X4 includes thefollowing:
- Estimates of the financial effects of changes in demand for different levels of rents charged.
- Estimates of the financial effects of changes in demand for different costs/quality levels of accommodation provision.
- A detailed analysis of net interest payable â€“ $750,000.
- A detailed analysis of sundry operating costs â€“ $235,000.
- Management accounts for the current and prior years.
- Budget information for 20X4, 20X5 and, if available, 20X6.
It would also be useful to have details regarding the location ofthe properties held by BW. It is quite conceivable that the houses heldby BW are situated in a sought after area. Benchmarking with a 'bestpractice' organisation from within the private sector would be of muchassistance in the appraisal of the operating and financial performanceof BW.
Question 18 - Financial/non-financial performance
There are various financial observations that can be made from the data:
- Turnover is up 5%. This is not very high but is at least higher than the rate of inflation indicating real growth. This is encouraging and a sign of a growing business.
- The main weakness identified in the financial results is that the net profit margin has fallen from 20% to 19.8% suggesting that cost control may be getting worse or fee levels are being competed away.
- Profit is up 3.9%. In absolute terms profits are impressive given that Richard Preston is the sole partner owning 100% of the business.
- Average cash balances are up 5% indicating improved liquidity. Positive cash balances are always welcome in a business.
- Average debtors days are down by 3 days indicating improved efficiency in chasing up outstanding debts. It is noticeable that Preston's days are lower than the industry average indicating strong working capital management. The only possible concern may be that Richard is being particularly aggressive in chasing up outstanding debts.
Overall, with a possible concern about margins and low growth,the business looks in good shape and would appear to have a healthyfuture.
(b)The extra non-financial information givesmuch greater insight into key operational issues within the business andpaints a bleaker picture for the future.
Internal business processes
- Error rates - Error rates for jobs done are up from 10% to 16%, probably a result of reducing turnaround times to improve delivery on time percentages. This is critical as users expect the accounts to be correct.
- Errors could lead to problems for clients with the Inland Revenue, bankers, etc. What is worse, Richard could be sued if clients lose out because of such errors. One could say that errors are unlikely to be revealed to clients. Businesses rarely advertise mistakes that have been made. They should of course put mistakes right immediately.
- Average job completion time - this has fallen by 30% from an average of 10 weeks to an average of 7 weeks. On the face of it this would look like a positive change since clients will appreciate the fast turnaround of their accounts/tax work. However, the quicker turnaround time could be linked to the increase in errors and should therefore be investigated further.
- Client retention - The number of clients has fallen dramatically â€“ this is alarming and indicates a high level of customer dissatisfaction. In an accountancy practice one would normally expect a high level of repeat work â€“ for example, tax computations will need to be done every year. Clearly existing clients are not happy with the service provided.
- Average fees - It would appear that the increase in revenue is thus due to a large increase in average fees rather than extra clients â€“ average fee is up from $600 to $775, an increase of 29%! This could explain the loss of clients in itself, however there could be other reasons.
- Market share - The result of the above two factors is a fall in market share from 20% to 14%. Looking at revenue figures one can estimate the size of the market as having grown from $4.5m to $6.75m, an increase of 50%. Compared to this, Preston's figures are particularly worrying. The firm should be doing much better and looks to being left behind by competitors.
Learning and growth
- Non-core services - The main weakness of the firm seems to be is its lack of non-core services offered. The industry average revenue from non-core work has increased from 25% to 30% but Richard's figures have dropped from 5% to 4%. It would appear that most clients are looking for their accountants to provide a wider range of products but Richard is ignoring this trend.
- Employee retention - Employee turnover is up indicating that the staff are dissatisfied. Continuity of staff at a client is important to ensure a quality product. Conservative clients may resent revealing personal financial details to a variety of different people each year.
Staff turnover is possibly a result of extra pressure to completejobs more quickly without the satisfaction of a job well done. Alsostaff may realise that the lack of range of services offered by the firmwill limit their own experience and career paths
In conclusion, the financial results do not show the full picture.The firm has fundamental weaknesses that need to be addressed if it isto grow into the future. At present it is being left behind by achanging industry and changing competition. It is vital that Richardreassesses his attitude and ensures that the firm has a better fit withits business environment. In particular he should seek to developcomplementary services and reduce errors on existing work.
- Financial performance indicators will generally only give a measure of the past success of a business. There is no guarantee that a good past financial performance will lead to a good future financial performance. Clients may leave and costs may escalate turning past profits to losses in what can be a very short time period.
- Non financial measures are often termed 'indicators of future performance'. Good results in these measures can lead to a good financial performance. For example if a business delivers good quality to its customers then this could lead to more custom at higher prices in the future.
- Specifically the information is appendix 2 relates to the non financial measures within the balanced scorecard.
- Internal business processes are a measure of internal efficiency. Interestingly these measures can indicate current cost efficiency as much as any future result.
- Customer knowledge measure how well the business is dealing with its external customers. A good performance here is very likely to lead to more custom in the future.
- Innovation and learning measures that way the business develops. New products would be reflected here along with indicators of staff retention. Again this is much more focused on the future than the present.
- Measuring performance by way of non-financial means is much more likely to give an indication of the future success of a business.
Question 19 - Corporate failure
Briefing document for Ears'n'eyes Inc:
(a)The Zâ€ scores may be estimated as follows.
At 1 April 20X6:
At 1 April 20X5:
In addition, it is useful to consider some ratios and trends over the two years:
W3 Market value of equity
Number of 50c shares = 150/0.5 = 300m.
Market value of equity at 1 April 20X6 is 108c * 300m shares = $324m.
Market value of equity at 1 April 20X5 is 133c * 300m shares = $399m.
W4 Book value of total liabilities
The Zâ€ scores
The Zâ€ score for year to 31 March 20X6 is below 3 and thereforeunder the cut-off point for companies which need further investigation.The score is also worsening. Although the score for the previous yearwas above 3, it was still low and should have been a signal to beginmonitoring the situation carefully.
Trends and ratios
There has been a considerable investment in non-current assetsover the year as now stores have been opened. However the low growth inturnover suggests that the increase in store space has not led to aproportionate increase in turnover â€“ in fact if the number opened overthe last year is similar to the plan for the coming year (an increaseof 10%), a growth in turnover of 4% suggests that sales could haveactually dropped in the existing stores.
There has been a decrease in profitability which is likely to be aresult of an increase in expenses through opening new stores which hasnot been matched by an increase in sales of a similar level.
There has also been an increase in inventory levels over the lastyear. The inventory turnover is also low and indicates that on averageinventory remains on shelves for several months, which seems a poorperformance for a retailer.
There has also been a worsening in other ratios.
All the above suggests that there is cause for concern over the future of this business.
(b)The financial analysis above indicates thatthere is a problem. However in order to come to a complete understandingthere is further work which needs to be done:
Suggested areas for further investigation:
- A more in-depth analysis of the accounting information looking at areas such as levels of debt, liquidity, payment periods, contingent liabilities, and post balance sheet events.
- An analysis of sales trends by sector (both geographical and comparing internet sales with store-based purchases), with comparisons for individual stores and types of store.
- Market information, especially an assessment of the current purchasing methods of consumers such as the use of the internet.
- Benchmarking against other companies in the same of similar markets.
- Actions and strategies of competitors.
- Any macro events which have affected the company, including inflation and foreign exchange rates.
(c)Other issues to consider.
At this stage, without having carried out the furtherinvestigation above it is difficult to comment on the non-financialissues. However one point which can be made at this stage is that themarket for books, CDs and DVDs has changed significantly over the lastfew years, in part due to changes in computer technology. There has beena move towards purchasing such goods over the internet, with on-lineretailers (such as Amazon) gaining a substantial share of the market.There is no reason to suppose that this will not continue. In addition,more and more customers are downloading music from the internet insteadof purchasing CDs. This is likely to be followed by downloading of filmsfrom the internet replacing DVD purchases. There is also a competitivemarket for DVD rental for which prices are decreasing. These changes inthe market are particularly significant when looking at the poorperformance of Ears'n'eyes Inc in the context of its current strategy ofopening new stores.
The company should stop its store expansion programme. This isexpensive and is not resulting in increased sales, as customers aremoving away from store-based purchasing.
Consideration should also be given to closing stores which arenot profitable. Further analysis may also show whether there areparticular types of store which are more profitable than others andwhich should form the focus for the future strategy (for example airportand station stores may be more successful than the superstores due tothe high level of impulse purchases).
The two actions above should release resources to focus onincreasing sales from the existing stores. This will probably only beachieved by enhancing the stores to improve the experience of visiting astore. With internet shopping becoming so easy customers need anotherreason to purchase there. Store prices will also need to be competitive.
Ears'n'eyes Inc should also examine the possibility ofestablishing its own internet shopping service alongside the storesrather than using a third party. As the company has a good reputationand an existing customer base it will be important to ensure that thosecustomers who want to buy online purchase from Ears'n'eyes Inc ratherthan a competitor.
Inventory management must be improved. The current level is muchtoo high. Again, reducing inventory carried will release resources.
The loyalty programme which seems to be popular with customersshould be continued and could be used for internet purchases as well asin store. However as well as being used to encourage repeat purchases itshould also be used to provide data for analysis of sales and toimprove the company's understanding of its customers, their interestsand buying habits.
(d)Possible performance indicators
The performance indicators chosen should relate to the actionsdescribed in (c) above. They will need to include both financial andnon-financial indicators and include areas related to marketing andinternal processes. However it is important to focus on a small numberof key areas.
- Profitability, overall and for individual stores.
- Sales growth at least on a quarterly basis, again overall and for individual stores and internet.
- Operating income.
- Inventory levels in stores and warehouses.
- Market share and pricing, including comparisons with internet based retailers.
- Numbers of new and repeat customers.
- Customer feedback, particularly concerning their experience of visiting stores.
Question 20 - Six sigma
(a)The Six Sigma approach to makingimprovements in existing processes involves a five stage processrepresented by the acronym DMAIC. The five stages are as follows:
Define an opportunity
A problem with quality is identified and then a problem statement isprepared. This statement will describe the nature of the problem, whichmust be defined in specific, quantifiable terms.
A 'mission statement' is then prepared. This is a statement ofwhat will be done in order to address the problem. Like the problemstatement the mission statement should also be expressed in specificquantifiable terms using the same units of measurement that are used inthe problem statement.
A project team is set up and given the required resources inorder to address the problem and make an improvement. The team shouldcomprise personnel from each of the areas within the organisation thatwill be affected by the Six Sigma project.
At this stage in the project, the project team should undertake apreliminary analysis in order to measure how the process is working andobtain data that can be analysed in order to identify what seems to becausing the problem. Where there are a number of factors causing theproblem the project team should focus their attention on what appear tobe the main causes of the quality problem.
Analyse the opportunity
At this stage the project team will investigate the preliminaryconcerns about what might be causing the quality problem in greaterdetail. The project team will test different theories in an attempt todiscover the main cause (or causes) of the problem. Each theory is thentested in order to establish whether it might be correct. Theories arerejected when it is decided that they cannot be correct.
The 'root' cause (or causes) of the problem is identified when all of the theories has been completed.
The cause (or causes) of the problem will be removed as aconsequence of re-designing the process that is causing the problem.Alternative methods of improving the process should be evaluated inorder to determine which will be the most effective method to achievethe 'mission statement' for the project. The chosen improvement is thendesigned in detail and implemented after being tested to prove itseffectiveness.
New controls are designed and implemented to prevent there-occurrence of the problem and to make sure that the improvements tothe process are sustained. Controls will include regular measurements ofoutput from the process, and a comparison of actual performance withtargeted performance. The controls should be audited periodically inorder to confirm their effectiveness.
The DMAIC framework can be applied to T4UC as follows:
The apparent problems are:
(i)A decrease in the number of contracted clients
(ii) An increase in the number of visits per clients
(iii)Very few clients being gained via recommendation
(iv)An increasing number of unanswered telephone calls for product support
(v) A lower percentage of issues resolved by telephone
(vi)A lower customer satisfaction rating than the industry average and much lower than that of Appliances R Us.
The primary source of information available to measure the issuesis the customer survey undertaken by Ken which could then be added toby other information. Other measures which could be undertaken include:
- Measuring the response times of T4UC staff to telephone calls made by clients
- Measuring the reliability of the website, e.g. Downtime, establishment of appointments
- Identification of the reasons why service engineers failed to arrive at customers' premises
- Identification of the reasons why service engineers don't have appropriate spare parts available.
Other measures which could be undertaken include:
- Measuring the rate of problem resolution via telephone
- Measuring the incidence of remedial visits to clients
Analysis should assist in providing an explanation for the following problems:
- Why is it difficult to contact T4UC at weekends?
- Why are remedial visits necessary?
- Why are there significant variations in the time taken by different service engineers to service central heating systems?
Suggesting solutions to the problems identified measured and analysed
The project team within T4UC should analyse each possible solutionpaying particular attention to the costs and benefits that would resultfrom their selection.
The Final phase would involve further monitoring of the relevantproblem variables, in particular the number of clients, clientrecommendations, weekend accessibility, staff training, stockavailability, and finally overall customer satisfaction with a view toexceeding the industry average as soon as possible and aspiring tosimilar results achieved by Appliances R Us.
Created at 5/24/2012 4:32 PM by System Account
(GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 5/25/2012 12:55 PM by System Account
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