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For Examinations to June 2017
REVISION QUESTION BANK
ACCA
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Paper P5 | ADVANCED PERFORMANCE MANAGEMENT
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ACCA
PAPER P5
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ADVANCED PERFORMANCE MANAGEMENT
REVISION QUESTION BANK
For Examinations to June 2017
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ISBN: 978-1-78566-347-5
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Acknowledgement Past ACCA examination questions are the copyright of the Association of Chartered Certified Accountants and have been reproduced by kind permission.
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) CONTENTS Question
Name
Page
Answer
Marks
The current exam format is a 50 mark case study question and a choice of two from three 25 mark questions as shown by the Pilot Paper and Exams from June 2013 included in this question bank. Current exam questions emphasise application to the scenario. Past questions prior to the change in exam format are of exam style but may have different mark allocations. Theory-based questions denoted ** are not exam standard but are useful in preparing to attempt exam standard questions.
1 2 3 4
Changing role of management accountant ** ENT Entertainment (ACCA J11) Amal Airline (ACCA J12 adapted) Ganymede University (ACCA J12 adapted)
1 1 2 3
1001 1002 1004 1006
10 20 25 25
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PERFORMANCE HIERARCHY 5 6 7
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STRATEGIC PERFORMANCE MANAGEMENT
Foodie Co (DipFM D06) ** Care For Dogs Company (ACCA D09) Film Productions Co (ACCA D10)
4 5 5
1008 1010 1012
20 20 25
6
1014
25
8
1017
25
9 10
1019 1021
25 25
1024 1027
25 25
13 14 14
1030 1032 1034
25 20 20
15 15 17
1036 1037 1040
10 25 25
PERFORMANCE MANAGEMENT AND CONTROL 8
Drink Group (ACCA D12)
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BUSINESS STRUCTURE 9
Green Foods Co
OTHER ENVIRONMENTAL AND ETHICAL ISSUES 10 11
EEE Flavourings FGH Telecom (ACCA D10 adapted)
EXTERNAL INFLUENCES ON ORGANISATIONAL PERFORMANCE 12 13
Global Hotel Group (ACCA J08 adapted) Stokeness Engineering (ACCA J13)
11 12
PERFORMANCE MEASUREMENT INFORMATION SYSTEMS 14 15 16
CDE Behavioural Consequences (ACCA J03) ** Contingency Theory (ACCA D04) **
INFORMATION RECORDING AND REPORTING 17 18 19
The Trendy Fashions Co ** Bluefin Schools (ACCA D11 adapted) Quark Healthcare (ACCA D13)
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(iii)
ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK Question
Name
Answer
Marks
18 20
1042 1044
25 25
22 23 24 27
1046 1047 1049 1052
25 20 25 25
28 30 31
1054 1058 1060
25 20 25
33
1064
25
1066 1067 1070 1073 1074
20 20 25 17 20
1076 1078 1080 1081
20 20 15 25
47 48 51 52 53 54 56 58
1083 1087 1089 1092 1094 1095 1098 1100
25 25 25 20 20 25 25 25
59 60 61
1102 1104 1106
20 17 20
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STRATEGIC PERFORMANCE MEASURES IN PRIVATE SECTOR 20 21
Children’s Toy Company (ACCA J08) Franchising For You (ACCA J09)
22 23 24 25
Easterpark Division (ACCA J96) NCL Co (ACCA J05) Alpha Division (ACCA D07) Stillwater Services (ACCA D12 adapted)
TRANSFER PRICING Landual Lamps SSA Group (ACCA D09) JHK Coffee Machines (ACCA J11 adapted)
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26 27 28
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DIVISIONAL PERFORMANCE EVALUATION
NOT-FOR-PROFIT ORGANISATIONS 29
Essland
NON-FINANCIAL PERFORMANCE INDICATORS AND QUALITY Telecoms At Work (ACCA J08) ** Better Agricultural Group (ACCA D08) Tench Cars (ACCA D11 adapted) Thebe Telecom (ACCA J12) Herman Swan & Co (ACCA D12)
35 37 38 39 39
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30 31 32 33 34
HUMAN ASPECTS OF PERFORMANCE MEASUREMENT 35 36 37 38
Astrodome Sports (ACCA D05) ** Better Gardens (ACCA J06) ** Universal University (ACCA J09) ** Lincoln and Lincoln (ACCA D12 adapted)
40 42 43 43
ALTERNATIVE VIEWS OF PERFORMANCE MANAGEMENT 39 40 41 42 43 44 45 46
Ornamental (ACCA D08 adapted) Armstrong Stores (ACCA adapted) Robust Laptops (ACCA D10 adapted) LOL (ACCA D10) APX Accountancy (ACCA J11) Cod (ACCA D11) Navier Aerials Co (ACCA J13) Graviton (ACCA D13)
COMPLEX BUSINESS STRUCTURES 47 48 49 (iv)
Blaina Packaging (ACCA D07 adapted) ** Callisto Retail (ACCA J12) Coal Creek Nursing Homes (ACCA D12)
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Question
Name
Page
Answer
Marks
63 64 67 70
1108 1115 1120 1124
50 50 50 50
CASE STUDIES 50 51 52 53
Royal Laurel Hospital (ACCA J09) Metis (ACCA J12 adapted) Kolmog Hotels (ACCA J13) Lopten Industries (ACCA D13 adapted)
RECENT EXAMINATIONS
June 2014 1 2 3 4
73 76 77 79
1129 1133 1135 1137
50 25 25 17
December 2014 1 Boltzman Machines (adapted) 2 Beeshire Local Authority 3 Maxwell Electricity Generation 4 Culam Mining
81 84 85 87
1139 1143 1145 1147
50 25 25 25
June 2015 1 2 3 4
2 6 8 10
17 19 20 21 25
50 25 25 25
September/December 2015 1 1 Iron Chicken 2 Perkin (adapted) 3 Posie 4 Soup Marking scheme
3 6 8 10
17 19 21 23 25
50 13 25 25
PILOT PAPER (from June 2013) 1 Mackerel Contracting 2 Albacore Chess Stores 3 Pharmaceutical Technologies Co 4 PLX Refinery Co Marking Scheme
2 4 5 6
12 16 17 18 20
50 25 25 25
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Cantor Group Booxe Turing Godel
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Examinations from June 2013 are in the current exam format. (See also the Pilot Paper included at the end of this question bank.)
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Merkland Sportswear Forion Electronics Victoria Beach Foods Marking Scheme
Tutorial note: The model answers to past ACCA exam questions (as referenced above) are considerably longer and more detailed than would be expected from any candidate in the examination. They should be used as a guide to the form, style and technical standard (but not length) of answers that candidates should aim to achieve. However, these answers may not include all valid points mentioned by a candidate for which credit would be given.
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Since the introduction of four exam sessions a year ACCA now publishes a “hybrid” of the September and December examinations.
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Question 1 CHANGING ROLE OF MANAGEMENT ACCOUNTANT Required: Discuss how the role of the management accountant has changed over the last forty years and explain the factors that have led to this change according to Burns and Scapens. (10 marks) Question 2 ENT ENTERTAINMENT
Restaurants Cafes Bars Dance clubs
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(1) (2) (3) (4)
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ENT Entertainment Co (ENT) is a large, diversified entertainment business based in Teeland. The company’s objective is the maximisation of shareholder wealth for its family owners. It has four divisions:
Recently, ENT’s board have identified that there are problems in managing such a diversified company. They have employed consultants who have recommended that they should perform a Boston Consulting Group (BCG) analysis to understand whether they have the right mix of businesses. The chief executive officer (CEO) has questioned whether using this analysis is helpful in managing the group’s performance. A business analyst has prepared information on each division in the table below. Revenue ($m)
Actual 20X4
Forecast 20X5
Forecast 20X6
54 10,752
56 10,860
59 10,968
62 10,968
31 3,072
34 3,348
41 3,717
47 4,051
349 9,984
342 9,784
336 9,491
336 9,206
197 1,792
209 1,900
219 2,013
241 2,195
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Restaurants ENT Market sector Cafes ENT Market sector Bars ENT Market sector Dance clubs ENT Market sector
Actual 20X3
In Teeland, the economy is generally growing at about 2% per annum. The restaurant, cafe and bar sectors are all highly fragmented with many small operators. Consequently, a market share of more than 3·0% is considered large as that is comparable to the share of the largest operators in each sector. There are fewer small late night dance club operators and the market leader currently holds a 15·0% market share. There have not been many new developments within the divisions except for a new wine bar format launched by the bars division which has surprised the board by its success. Each of the division’s performance is measured by economic value-added (EVA™). The divisional managers have a remuneration package that is made up in two equal parts by a salary set according to industry norms and a bonus element which is based on achieving the cost budget numbers set by the company board. The chairman of the board has been examining the consistency of the overall objective of the business, the divisional performance measure and the remuneration packages at divisional level. He has expressed the worry that these are not properly aligned and that this might lead to dysfunctional behaviour by the divisional management.
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ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK Required: (a)
Perform a BCG analysis of ENT’s business and use this to evaluate the company’s performance. (7 marks)
(b)
Critically evaluate this BCG analysis as a performance management system at ENT. (7 marks)
(c)
Evaluate the divisional managers’ remuneration package in light of the divisional performance system and your BCG analysis. (6 marks)
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(20 marks) Question 3 AMAL AIRLINE
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Amal Airline (Amal) is the national airline of Jayland. It was originally owned by the government but was listed on the local stock exchange when sold to private investors more than 20 years ago. The airline’s objective is to be the best premium global airline.
Amal provides long- and short-haul services all over the world and is based at its hub at Jaycity airport. Amal has been hit by a worldwide reduction in air travel due to poor economic conditions. The most recent financial results show a loss and this has caused the board to reconsider its position and take action to address the changed environment.
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As further background, the CEO has supplied the data below on Amal and two of its main competitors. Kayland Air is a government owned and run airline in the neighbouring country of Kayland. It has a similar mix of business to Amal and targets a similar market. Cheapo Air is currently one of the most successful of the new privately-owned airlines that have gained significant market share over the last 15 years by offering a cheap but basic short-haul service to customers in and around Jayland. Cheapo Air subcontracts many of their activities in order to remain flexible. The CEO wants you to calculate some suitable performance measures and explain the results. Data provided by the CEO:
Data for the most recent calendar year
Passengers (000s) Passenger kilometres (millions) Revenue $m Costs Fuel $m Staff $m Staff numbers Operating profit $m Number of aircraft Average aircraft size (seats) Seat kilometres (millions)
Amal 23,649 79,618 5,430
1,480 1,560 32,501 630 182 195 100,654
Kayland Air Cheapo Air 38,272 35,624 82,554 40,973 7,350 2,170 1,823 2,998 56,065 54 361 163 105,974
535 238 5,372 127 143 125 46,934
Note: A seat kilometre is generated for every one kilometre flown by an available seat on the company’s aircraft.
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Required: (a)
Explain benchmarking and discuss the advantages to Amal Airline of adopting such an exercise. (5 marks)
(b)
Describe the steps that should be undertaken in benchmarking the performance of Amal Airline. (8 marks)
(c)
Using the data provided, analyse the three airlines using appropriate performance indicators and comment on your results. (12 marks)
Question 4 GANYMEDE UNIVERSITY
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(25 marks)
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Ganymede University (GU) is one of the three largest universities in Teeland, which has eight universities in total. All of the universities are in the public sector. GU obtains the vast majority of its revenue through government contracts for academic research and payments per head for teaching students. The economy of Teeland has been in recession in the last year and this has caused the government to cut funding for all the universities in the country.
In order to try to improve efficiency, the chancellor of the university, who leads its executive board, has asked the head administrator to undertake an exercise to benchmark GU’s administration departments against the other two large universities in the country, AU and BU. The government education ministry has supported this initiative and has required all three universities to cooperate by supplying information.
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The following information has been collected regarding administrative costs for the most recent academic year: GU AU BU $000 $000 $000 Research contract management 14,430 14,574 14,719 laboratory management 41,810 42,897 42,646 Teaching facilities management 26,993 27,263 26,723 Student support services 2,002 2,022 2,132 Teachers’ support services 4,005 4,100 4,441 Accounting 1,614 1,571 1,611 Human resources 1,236 1,203 1,559 IT management 6,471 6,187 6,013 General services 17,049 16,095 18,644 ––––––– ––––––– ––––––– Total 115,610 115,912 118,488 Drivers: Student numbers 28,394 22,783 29,061 Staff numbers 7,920 7,709 8,157 Research contract value ($m) 185 167 152 The key drivers of costs and revenues have been assumed to be research contract values supported, student numbers and total staff numbers. The head administrator wants you to complete the benchmarking and make some preliminary comment on your results.
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ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK Required: (a)
Assess the progress of the benchmarking exercise to date, explaining the actions that have been undertaken and those that are still required. (8 marks)
(b)
Evaluate, as far as possible, Ganymede University’s benchmarked position.
(9 marks)
(c)
Evaluate the benchmarking exercise carried by Ganymede University
(8 marks) (25 marks)
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Question 5 FOODIE CO
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You have recently taken up the post of general manager with Foodie Co, a medium sized food processing company in the South West of England. The company is seeking to achieve market-led growth throughout the EU. The growth is seen as a development of the company’s success to date in supplying local retailers with a range of ready-prepared meals. The product range is noted for providing good quality meals at a keen price, and the company has a strong reputation for being responsive to customers’ needs. The company uses only quality-approved suppliers of raw materials and by carefully controlling quality it has been successful in avoiding the health scares that have arisen in the industry in recent years. The directors believe that careful promotion of the company’s quality management programme will also make it possible to improve margins.
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Market research has indicated that demand for the products is strong, and that the success of the expansion will depend on the company’s ability to maintain quality standards while increasing the volume of activity, and to create an effective distribution network that will allow retailers to obtain orders at short notice. The need to meet customer orders at short notice has led the directors to decide that the required expansion of the production facility will mean that a number of new factories will be established in key locations that are close to potential customers. To date the company has adopted a functional organisational structure with quality being the responsibility of the production manager. You have been invited to the next meeting of the board of directors in order to recommend whether or not the company should develop a mission statement and the changes in organisational structure and management responsibilities that will be required if the proposed expansion is to be successful. Required:
In preparation for your meeting with the directors of Foodie, prepare a briefing paper which: (a)
Discusses the purpose of a company mission statement, and the benefits and problems which the company may experience if a mission statement is developed; (7 marks)
(b)
Recommends and justifies an appropriate organisational structure, as well as the types of responsibility centres which the company should use; and (8 marks)
(c)
Indicates why a more structured approach to performance measurement is likely to contribute to the company’s success. (5 marks) (20 marks)
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Answer 1 CHANGING ROLE OF MANAGEMENT ACCOUNTANT In their seminal work, “Accounting Change Project” Burns and Scapens looked at how the role of the management accountant has changed over the last 30 years, and looked at the factors that had led to the change. The traditional role of the management accountant was to provide financial control of the business. The accountant would prepare monthly reports, such as variance analysis, and analysis of actual performance against budget. Much of the information was internal and almost all was financial. Three factors changed the role of the management accountant: Increasing competitiveness of the business environment; Changes in technology, particularly information systems; A change in management structure, with more decentralised management.
Increasing competitiveness
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Technology
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Because of increased competitiveness, organisations are more likely to recognise the weaknesses of focusing on profits. It is recognised that a focus on profits may lead to short termism. Management therefore requires a much broader measure of performance, and more information about how they are performing in relation to the strategy. They expect the management accountant to be able to provide much of this information. Thus the modern management accountant has to be much more commercially aware than the traditional. He has to be more of a business advisor, and less of a bean counter.
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Traditionally, information systems were mainly accounting systems, and the accounting staff performed most of the data input and processing. Few people in the organisation would have access to the system. With the development of company wide information systems, such as Enterprise Resource Planning Systems (ERP), the accounting department becomes one of the many users of the system. This means that other users may perform much of the data input to the system. Management structure
There has been a move towards decentralisation in many organisations, with senior management becoming less involved in operations aspects of management, and delegation to divisional managers.
Divisional managers often prepare their own forecasts, so do not rely on budgets prepared by management accountants. Similarly, they prepare their own reports to senior management, such as monthly accounts, showing their actual performance against the plan. Senior management may therefore not require the traditional monthly management accounts. The management accountant still has a role however which is to provide senior management with a broader picture of how the organisation is performing in relation to its strategic objectives. The management accountant will be able to provide a centralised view of how the business in performing.
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1001
ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK Answer 2 ENT ENTERTAINMENT (a)
Analysis of business units using the Boston Consulting Group matrix The Boston Consulting Group (BCG) matrix breaks a business into its component units and then considers their performance in terms of the growth of the unit (usually measured by revenue) and the relative market share of each unit. The sector growth and market share for each of ENT’s divisions is as follows: 20X5
20X6
1·0% 9·0% –2·0% 6·0%
1·0% 11·0% –3·0% 6·0%
0·0% 9·0% –3·0% 9·0%
0·5% 1·1% 3·5% 10·9%
0·6% 1·2% 3·6% 11·0%
0·18 0·37 1·18 0·73
0·19 0·39 1·22 0·73
0·5% 1·0% 3·5% 11·0%
0·5% 1·0% 3·5% 11·0%
0·17 0·33 1·17 0·73
0·17 0·34 1·17 0·73
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Market share Restaurants Cafes Bars Dance clubs
20X4
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20X3 Growth in sector Restaurants Cafes Bars Dance clubs
Relative market share Restaurants Cafes Bars Dance clubs
Market leader 3·0% 3·0% 3·0% 15·0%
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(Relative market share calculated as a ratio of division’s market share to market leader’s share. Figures calculated to nearest 0·1%)
Additionally:
Market growth (20X3–20X6) % per annum 0·67 9·66 –2·67 6·99
Restaurant Cafe Bars (Shrunk) Dance clubs
ENT divisional growth (20X3–20X6) % per annum 4·67 15·28 –1·34 6·98
Tutorial note: There are more calculations given here than are needed for a good answer. They are intended to illustrate useful analysis of the data given. The growth rates are calculated using the geometric mean.
Sales year n Geometric mean (%) = n 1 × 100 Sales year 1
So for ENT, divisional growth for the restaurants was calculated as: 62 3 1 × 100 = 4.67% 54
The restaurant and bar sectors are slow growth or in decline while the clubs and cafes appear to be growing at a pace well above the general economic expansion of 2% per annum. ENT has a strong position in the bar and club sectors but is relatively small in the restaurant and cafe sectors. 1002
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5)
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Consequently, the restaurant division would be seen as a dog with low growth and poor market share which would make it a poor candidate for investment. A disposal could be considered unless there are other reasons to keep it (e.g. it acts as a feeder to dance clubs). The cafe division is a problem child where there is the possibility of good growth in the sector but the division lacks market share in such a fragmented market. The sector appears ripe for consolidation and so either the division should be financed to grow by acquisition or else sold on to another consolidator. The bar division is a cash cow as it has a strong share of a low growth sector. It will be managed for its cash generative capabilities and will be heavily cost controlled. Finally, the dance clubs represent another problem child with strong growth and a large market share (near the market leader). They would not be considered a star as they lack market leadership but would be considered an excellent candidate for investment to achieve that position. This portfolio of divisions represents a good spread of businesses with the cash generative bar business supplying the financial resources for the development of the cafe and club businesses. It is unclear from this analysis how creative the company as a whole is at developing new businesses to replace the poorer performing entities. Evaluation of the BCG analysis
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(b)
The BCG matrix can be beneficial as it allows the company to view the prospects of its different divisions. A different style of management should be applied to each division based on this analysis. Those businesses which are in faster growing sectors will require more capital to be invested and may not generate cash as efficiently from profits. However, those businesses in slower growing mature markets should have a focus on cost control and cash generation. Business units identified as cash cows and, particularly, dogs should not be dismissed since if they are properly managed they can provide a rich source of cash as they are run down.
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The performance management systems and metrics used by the divisions should therefore be adjusted to reflect this analysis. The metrics for high growth prospects of cafes and clubs will be based on profit and return on investment, while those in lower growth (e.g. the bar division) will be focused on margins and cash generation. However, the BCG matrix is a very simple method of analysis. For example, using relative market share measured against the largest competitor, where a value of 1·0 is used as cut off between large and small, means there is only one star or cow per market. It was designed as a tool for product portfolio analysis rather than performance measurement. As a performance system, it seems to downgrade traditional measures of performance (e.g. profit and shareholder wealth) and therefore may not be well aligned with all of the key stakeholders’ objectives. It should be seen as a starting point for considering the appropriate performance management for a business unit but not the final result. Additionally, it may be that different products with each business unit may not fit the unit’s classification. For example, the newly launched wine bar format seems to be in a higher growth sub-sector and so applying the performance systems and management style of a dog business would not be appropriate. It may also be difficult to distinguish the sectors from each other as, for example, it may be difficult to define the difference between a cafe and a restaurant. The model also fails to consider the links between the business units (e.g. where the bars or cafes may serve as feeder businesses for late night dance clubs).
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1003
ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK (c)
Evaluation of divisional managers’ remuneration packages The existing remuneration system is primarily based on the division’s performance compared to budget. It is likely that the management style will be highly cost conscious and conservative as a result. This would be appropriate for the bar and restaurant divisions which foresee low growth. However, this could present particular problems for the divisions that are or could be grown (cafes and clubs). They will require a more entrepreneurial managerial approach and, therefore, should be using long-term profit measures of performance in order to align the manager’s motivation with the business unit’s needs.
(a)
Benchmarking
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Answer 3 AMAL AIRLINE
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The chairman is also correct to be concerned about the broad measure of divisional performance (EVA™) and whether this is coherent with the budgetary approach to management reward in the divisions. There is the possibility that if the budgets are not set in order to maximise EVA™ then the overall objectives are not reflected in the reward system at divisional level.
Benchmarking has been defined as “the establishment by collection of data of comparators that allow relative levels of performance to be identified. This involves comparing financial and non-financial performance against other organisations, rather than comparing against internally set standards which may not be sufficiently challenging to drive the organisation to achieve its potential.
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Competitive benchmarking is where the performance of one organisation is compared to another a competitor. The advantage of competitive benchmarking is that the organisation can see how it performs in relation to its competitors. This may highlight areas of underperformance which can be remedied. Best-in-practice benchmarking is where the individual activities of an organisation are compared to the organisation that performs those activities best. Such organisations may not be in the same industry. The major advantage of all types of benchmarking is that comparing performance with an external organisation is likely to lead to pressure to improve performance if the organisation is behind the comparator. Another advantage is that the organisation learns how the comparator achieves better performance. This involves sharing of information about procedures and how things are done. This data sharing can be of benefit to both organisations involved in the benchmarking process.
1004
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Steps involved in benchmarking Determine which areas or functions to benchmark. In the case of the information provided in respect of Amal Airline and its competitors, it appears that the main focus is on financial efficiency.
(2)
Identify the performance indicators and performance drivers that will be measured during the benchmarking exercise. Many of the measures already used by the trust could be used in the benchmarking exercise.
(3)
Select the organisations that will be used as the benchmark. Amal Airlines has chosen two competitors. Kayland Air has a similar mix of business to Amal, although it is state owned. Cheapo Air is a private airline, but operates in a different market to Amal. In spite of this, using Cheapo Air as a comparator may highlight efficiencies that Kayland should strive towards.
(4)
Measure the performance of the benchmark using the measures identified in step (2) above.
(5)
Measure own performance and compare it to the benchmark to identify the gaps. (See part (c) below.)
(6)
Specify actions and programmes to close the gap. This involves analysing how the benchmark achieves superior performance and identifying similar practices that could be adopted.
(7)
Implement and monitor the actions and programmes. Monitoring should not be a one off process, but should continue for a longer period after the benchmarking exercise.
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(1)
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(b)
(c)
Performance of the three airlines
The operating margin shows that overall Amal is being run efficiently. Also, the margin is relatively high which is to be expected as Amal has a strategy of differentiation. The load factor shows the utilisation of the expensive asset base of the companies and here, Cheapo is performing well ahead of its rivals. This may be due to its pricing policy but it may be possible for Amal to review its own pricing policy along the lines of Cheapo in order to boost the load factor. The danger of such a change to pricing policy is that it undermines the overall strategy of Amal as a differentiator. So, it may be that load factor is a secondary rather than primary measure of performance. The recent staff problems motivate looking at a measure of staff performance and workload. Amal is performing well ahead of Kayland Air in generating revenue per staff member although it is much lower than Cheapo. This may be due to the power of the staff in the publicly-owned Kayland Air and Cheapo offering a basic service with their use of outsourced staff. Finally, the fuel costs are causing concern in the industry and it is noticeable that Cheapo is managing its fuel bills more efficiently than either of the others. Amal should investigate possible savings by examining where Cheapo is sourcing its fuel, what quality of fuel it uses and whether its aircraft are more fuel-efficient. Tutorial note: Fuel cost per seat kilometre has been used rather than fuel cost per passenger kilometre since this reflects the fuel efficiency of the aircraft and does not confuse this with the ability to fill the aircraft with passengers.
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1005
ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK WORKING Data for the most recent calendar year
1,823 2,998 56,065 54 361 163 105,974 77·9% 0·7% 131 0·017
535 238 5,372 127 143 125 46,934 87·3% 5·9% 404 0·011
E
1,480 1,560 32,501 630 182 195 100,654 79·1% 11·6% 167 0·015
Kayland Air Cheapo Air 38,272 35,624 82,554 40,973 7,350 2,170
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Passengers (000s) Passenger kilometres (millions) Revenue $m Costs Fuel $m Staff $m Staff numbers Operating profit $m Number of aircraft Average aircraft size (seats) Seat kilometres (millions) Load factor (seat occupancy) Operating profit margin Revenue/staff member ($000s) Fuel/seat km $
Amal 23,649 79,618 5,430
Tutorial note: There is no need to represent the question data in the solution; it is given here for clarity. Credit would be given for other relevant calculations as it is not feasible to give an exhaustive list. Answer 4 GANYMEDE UNIVERSITY (a)
Progress of benchmarking exercise
SA M
The benchmarking process is often described using seven steps. The following are the steps with the current state of the exercise:
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(1)
Set objectives and decide the areas to benchmark – GU has set the objective of improving efficiency and is benchmarking all of its administration operations relating to teaching and research.
(2)
Identify key performance drivers and indicators – The performance drivers have been provided and the indicators are based on the activity per driver. The drivers might be improved by distinguishing between teaching staff and administrative staff.
(3)
Select organisations for benchmarking comparison – The government selected the three largest universities for benchmarking which excludes five other smaller universities. This can be justified if the large universities cover similar teaching and research areas while the smaller ones are narrower in focus (for example science and engineering subjects only). However, it may be that there are examples of good practice in university administration that will be missed as a result of restricting the exercise. It might be sensible to include foreign universities in the exercise. Differences in the mix of subjects researched and taught might also affect the results (e.g. managing teaching facilities in engineering and law will be different).
(4)
Measure performance of all organisations involved in benchmarking – The basic data has been gathered as required by government. This step would normally be more complex in a private sector situation as commercial secrecy would hinder the sharing of information.
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Compare performances – This is the stage that has been reached. See answer to part (b) for results.
(6)
Specify improvement projects – The results of the comparison should lead to identification of areas for improvement. If GU is not demonstrating leading performance then it should send staff to the top performer to identify their best practice processes and devise projects to implement these at GU.
(7)
Implement and monitor improvements – Management should perform a postproject review in order to identify if the improvement has achieved or exceeded its goals and consider lessons that have been learned from the project.
Evaluation of Ganymede’s benchmarked position
Research
GU $
AU $
BU $
78 226 951 71 506 204 156 817 2,153
87 257 1,197 89 532 204 156 803 2,088
97 281 920 73 544 197 191 737 2,286
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contract management laboratory management Teaching facilities management Student support services Teachers support services Accounting Human resources IT management General services
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(b)
(5)
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Research categories are considered per $000 of contract value supported. Teaching facilities and student support are considered per student. Other categories are considered per staff member.
From the results, it can be seen that GU is best at controlling costs associated with research contracts and it has the highest research funding ($185 million). This may indicate that the government monitors such cost control and that GU should ensure its continued good practice in this area. AU spends most per student on its teaching facilities and student support although it has the smallest number of students. It might be expected that this would lead to higher student enrolment which may imply that student enrolment is not significantly dependent on these factors. However, lower dropout rates and higher student pass rates and future success in gaining employment may reflect the more expensive teaching environment at AU. These quality measures are not being reflected in the benchmarking exercise. In accounting services, all the universities perform broadly in line. BU has achieved a small 3·5% advantage over the others. In human resources management, BU is 22% more costly which is surprising given the larger staff numbers at BU over which to spread such a central cost. In IT management, there is some variation of performance with BU costs being 10% lower than GU’s. These variations may well be due to the subjects being taught (for example, universities that are more orientated to science and technology will probably demand larger computing resources). In general services, all the universities perform broadly in line. AU has achieved a small 3% advantage over GU.
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1007
ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK It is necessary to give a warning about the difficulty of comparing the performance of the universities due to differences in location and the mix of subjects taught and researched. Tutorial note: The comments on accounting and general services are not significant and so not necessary in a good answer. They are included for completeness. (c)
Evaluation of the benchmarking exercise
E
Benchmarking shows what is being achieved by other organisations rather than simply using internal past performance as a guide to what is an appropriate level of performance. Thus it highlights those areas where Ganymede falls behind the benchmarks, giving management knowledge of what areas need to be improved. The exercise uses two other universities as benchmarks, so performance should be comparable as the benchmarks carry out similar activities. This means that differences in reported metrics will reflect differences in performance rather than differences in circumstances, and this should make the results of the benchmarking easier to understand.
PL
While the use of similar organisations as benchmarks makes comparison easier, benchmarking can often be more effective if “best in class” organisations are used as benchmarks. These are organisations that may be involved in totally different activities, but which achieve the greatest levels of efficiency at particular business processes. In the case of the research activities, there may be opportunities for using private sector research organisations as benchmarks. For the other activities, there may be private sector universities that are operating at much greater efficiency.
SA M
The metrics used are exclusively financial and are cost based. This is appropriate, given that the objective of the exercise, as stated by the chancellor, is to focus on efficiency. A range of different areas has been considered, so the exercise has been fairly comprehensive. A downside of using only financial metrics is that they do not tell the whole story, and do not reflect the quality of services provided (e.g. teachers support services are lower at Ganymede University which is good from an efficiency point of view, but does to show whether the support services provided are as good as those provided at the two other universities).
Answer 5 FOODIE CO (a)
Mission statement
A mission statement is effectively a statement of intent, and sets out the basic rationale for the company’s existence. If this is understandable, and accepted, it can provide a clear focus for the activities of each sector of the company as well as individuals in the company. It also acts as a clear statement of intent for suppliers, customers and investors. By clarifying the overall intent of the organisation, a mission statement can provide freedom for individuals to take action that will achieve the overall objective. It will also provide the framework within which operational plans will be prepared and a standard against which performance can be judged. By setting such a framework a mission statement can play an important part in defining the culture of an organisation.
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REVISION QUESTION BANK – ADVANCED PERFORMANCE MANAGEMENT (P5) Benefits that may arise from developing a mission statement Clarity – the expression of intent ensures that objectives are clear.
Goal congruence – by providing a focus for activities, the mission statement can help to ensure that all activities are directed towards a common objective.
Improved motivation – the sense of purpose, combined with the freedom discussed above will tend to produce a better motivated workforce.
Benchmark – an initial assessment of initiatives in terms of how they will contribute to achieving the overall objective is facilitated by the existence of a mission statement. This will avoid resources being wasted on the investigation of initiatives that do not fit with the existing strategy.
E
Problems that may be experienced
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However, mission statements are not universally accepted; problems can include:
Not understood – if the mission statement is not understood, it can lead to confusion, rather than clarity.
Not accepted – the mission statement may be seen as a top management initiative, and as such may lack widespread support.
Out-dated – external changes may lead to the mission statement becoming outdated, although if revisions are too frequent, this may lead to confusion.
Viable initiatives rejected – an initiative that may be perfectly viable, and might even open up a new area of activity may be rejected because it does not fit with the existing mission.
SA M
(b)
Organizational structure
There is no agreement as to whether a strategy should be developed first, followed by a suitable structure, or whether the strategy should follow the chosen structure. In this case, such a theoretical debate is irrelevant, as the strategy has been established. In addition, the key factors for success have been identified as product quality and distribution channels. It is also clear that strong marketing, procurement, finance and human resource functions must support these factors. Therefore, a functional structure seems appropriate, along the following lines: Responsibility centre Quality, including procurement and production Distribution Marketing Finance Human resources
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Type of centre Cost Cost Revenue Cost Cost
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ADVANCED PERFORMANCE MANAGEMENT (P5) – REVISION QUESTION BANK This structure is suitable as profitability will follow from ensuring that customers’ needs for quality products are met within a framework in which costs are tightly controlled. By ensuring that a suitable mix of targets is defined for the activities of the quality responsibility centre, it will be possible to meet that objective. The other responsibility centres, as support functions, must provide such support within a cost framework, while marketing will generate revenue. However the need to maintain quality standards will act as a constraint on marketing simply seeking short-term revenue growth. Such growth will only be sustained by meeting customers’ needs.
(c)
E
Tutorial note: Marks were also awarded for other valid structures, provided some justification was given. Structured approach to performance measurement
PL
A structured approach to performance measurement will lead to key activities being identified. Once this has been done, targets can be set to provide motivation and a benchmark against which performance can be monitored. Reasons for good performance can be identified and developed or exploited, while problems can be identified and strategies developed to overcome such problems. Such targets will link activities to the organisation’s strategy, and thereby contribute to strategic objectives being achieved. Thus, performance measurement will identify and communicate acceptable behaviour and activities.
SA M
By identifying appropriate lead indicators (such as in this case, quality) it will be possible to ensure that problems are identified and resolved at the earliest opportunity. It should be noted that in order to avoid confusion, targets should not conflict with one another, and that it is counterproductive to have a large number of targets.
Answer 6 CARE FOR DOGS COMPANY (a)
Mission statement (i)
Purpose, benefits and problems
A “mission” is the purpose of an entity and its reason for existence (i.e. what is it attempting to accomplish?). Henry Mintzberg has stated that “a mission describes the organisation’s basic function in society, in terms of the products and services it produces for its customers”. A large number of organisations provide a formal statement of their mission in a mission statement. Even though an entity might not have a clearly defined mission it may nevertheless have a mission statement! A mission statement should be both memorable and succinct. It should also be “enduring” (i.e. the statement should not change unless an entity’s mission changes) otherwise the mission statement would confuse the business community. The mission statement should guide all employees throughout an organisation to work collectively towards the accomplishment of the corporate mission and may contain references to many stakeholder groups such as, for example, shareholders, customers, employees and the general public.
1010
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PL E
Advanced Performance Management
Paper P5
Professional Level – Options Module
M
September/December 2015
Time allowed Reading and planning: Writing:
15 minutes 3 hours
SA
This question paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted Section B – TWO questions ONLY to be attempted Present Value and Annuity Tables are on pages 12 and 13. Do NOT open this question paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.
The Association of Chartered Certified Accountants
Section A – This ONE question is compulsory and MUST be attempted Iron Chicken (IC) is a multinational business which manufactures commercial building control systems. Building control systems include heating and air-conditioning systems, lighting controls, power and water monitoring and security systems (e.g. keypad access, alarms and CCTV). IC’s manufacturing takes place at a number of factory sites where some products have a long product life and are simple and mass-produced while other products are complex and have a short product life due to changing technologies. IC’s mission statement is ‘to create value for shareholders through control products which improve productivity, save energy and increase comfort and safety’. A new chief executive officer (CEO) has been appointed to address a decline in IC’s share price in the last three years. This CEO has identified that the business has grown through acquisition and as a result she stated, ‘senior management have focused on making corporate deals and not making control systems.’ The CEO has declared that the business must focus on optimising its value generation rather than just getting larger through acquisitions.
PL E
You are a performance management expert within IC. The CEO has tasked you with aiding her in aspects of her improvement programme. First, she wants your views on the use of EVA™ as the key performance metric at IC. You have been supplied with the current EVA™ calculation (Appendix 1) but there is some doubt about whether the junior management accountant who has done this work was sufficiently trained in the method. So, the CEO needs you to evaluate its accuracy and the assumptions which form part of the calculation. Second, the CEO believes that the poor performance of the company can be addressed by ensuring that the mission statement flows down into the performance management of the business. To that end, the following critical success factors (CSFs) have been identified and the CEO wants you to suggest additional key performance indicators (KPIs) for these. 1. 2. 3.
CSF Greater staff productivity Reduction of wastage in production Greater innovation of products
Associated current KPI Units produced per labour hour Power consumed per unit produced Number of new products launched
Your suggestions should be in addition to these current KPIs.
1. 2. 3.
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Third, in order to improve performance, the CEO plans to implement initiatives associated with ‘lean’ manufacturing. Specifically, there are three projects which have been suggested and the CEO needs your advice on these: Move to just-in-time manufacturing Use kaizen costing Examine the costs of quality in achieving a ‘zero defects’ approach to manufacturing
The CEO has stated, ‘I need to know briefly how the improvement projects will meet the three CSFs and also how they will impact on the existing three KPIs.’
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1
Finally, the CEO requested, ‘You must tell me the implications of the improvement projects for our information systems as I feel that they are not currently suitable for the plan that I have.’ The current information systems of the company are based around the functional departments of the business such as manufacturing, marketing, finance and logistics. Each department has developed its own system although all feed into the finance system which is the main one used for strategic decision-making. In order that the department systems can all feed through to the current finance system, these current systems only handle quantitative data. The company is considering the implementation of a new information system. This new system will introduce networking technology in order to bring together all of the departmental systems into a new, single, corporate database.
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[P.T.O.
Required: Write a report to the CEO of Iron Chicken to: (i)
Evaluate the accuracy of the EVA™ calculation and the assumptions in Appendix 1. Advise the CEO on your results, providing calculations as needed. (15 marks)
(ii) For each of the three critical success factors at IC, briefly explain a weakness of the current KPI associated with that CSF and then provide a justified alternative KPI. (6 marks) (iii) Explain what the three improvement projects are, how they will help to meet the CSFs at IC and comment on the impact of each project on the existing three KPIs. (15 marks) (iv) Assess the impact of the proposed, new information system on the three improvement projects.
PL E
(10 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer.
(4 marks)
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(50 marks)
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Appendix 1 Economic value added
Year ended 30 June 2015 $m 551·4
Operating profit Add back Non-cash expenses Marketing capitalised Operating lease expenses Less Tax Lost tax relief on interest
15·1 23·1 40·0
Capital employed From the statement of financial position Marketing spend capitalised Operating leases Adjusted capital employed
5
134·8 24·5 –––––––– 470·3
6 7
2,401·0 23·1 115·0 –––––––– 2,539·1
10 5 8
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Net operating profit after tax (NOPAT)
Note
WACC = (1/2 x 16%) + (1/2 x 6·8%) = 11·4%
EVA™ = NOPAT – (WACC x Capital employed) = 181 Assumptions and notes:
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Debt/Equity 100·0% Cost of equity 16·0% Tax rate 30·0% Cost of debt (pre-tax) 6·8% There has been $23·1m of marketing spent each year for the last two years in order to build the brand of IC long term. 6 Tax paid in the year was $130m while the tax charged per the accounts was $134·8m. 7 Interest charged in the period was $81·6m. Lost tax relief on this interest was 30% x $81·6m. 8 The operating leases have an average life of four years. 9 The only research and development spending identified in the last five years was $10m expensed during this year on a new product. The product has not been launched yet. 10 Capital employed during the period (from the statement of financial position): Opening 2,282·0 Change in period 119·0 ––––––– Closing 2,401·0
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1 2 3 4 5
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[P.T.O.
Section B – TWO questions ONLY to be attempted Perkin manufactures electronic components for export worldwide, from factories in Ceeland, for use in smartphones and hand held gaming devices. These two markets are supplied with similar components by two divisions, Phones Division (P) and Gaming Division (G). Each division has its own selling, purchasing, IT and research and development functions, but separate IT systems. Some manufacturing facilities, however, are shared between the two divisions. Perkin’s corporate objective is to maximise shareholder wealth through innovation and continuous technological improvement in its products. The manufacturers of smartphones and gaming devices, who use Perkin’s components, update their products frequently and constantly compete with each other to launch models which are technically superior.
PL E
Perkin has a well-established incremental budgeting process. Divisional managers forecast sales volumes and costs months in advance of the budget year. These divisional budgets are then scrutinised by the main board, and revised significantly by them in line with targets they have set for the business. The finalised budgets are often approved after the start of the accounting year. Under pressure to deliver consistent returns to institutional shareholders, the board does not tolerate failure by either division to achieve the planned net profit for the year once the budget is approved. Last year’s results were poor compared to the annual budget. Divisional managers, who are appraised on the financial performance of their own division, have complained about the length of time that the budgeting process takes and that the performance of their divisions could have been better but was constrained by the budgets which were set for them. In P Division, managers had failed to anticipate the high popularity of a new smartphone model incorporating a large screen designed for playing games, and had not made the necessary technical modifications to the division’s own components. This was due to the high costs of doing so, which had not been budgeted for. Based on the original sales forecast, P Division had already committed to manufacturing large quantities of the existing version of the component and so had to heavily discount these in order to achieve the planned sales volumes.
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A critical material in the manufacture of Perkin’s products is silver, which is a commodity which changes materially in price according to worldwide supply and demand. During the year supplies of silver were reduced significantly for a short period of time and G Division paid high prices to ensure continued supply. Managers of G Division were unaware that P Division held large inventories of silver which they had purchased when the price was much lower. Initially, G Division accurately forecasted demand for its components based on the previous years’ sales volumes plus the historic annual growth rate of 5%. However, overall sales volumes were much lower than budgeted. This was due to a fire at the factory of their main customer, which was then closed for part of the year. Reacting to this news, managers at G Division took action to reduce costs, including closing one of the three R&D facilities in the division. However, when the customer’s factory reopened, G Division was unwilling to recruit extra staff to cope with increased demand; nor would P Division re-allocate shared manufacturing facilities to them, in case demand increased for its own products later in the year. As a result, Perkin lost the prestigious preferred supplier status from their main customer who was unhappy with G Division’s failure to effectively respond to the additional demand. The customer had been forced to purchase a more expensive, though technically superior, component from an alternative manufacturer.
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The institutional shareholders’ representative, recently appointed to the board, has asked you as a performance management expert for your advice. ‘We need to know whether Perkin’s budgeting process is appropriate for the business, and how this contributed to last year’s poor performance’, she said, ‘and more importantly, how do we need to change the process to prevent this happening in the future, such as a move to beyond budgeting.’ Required:
(a) Evaluate the weaknesses in Perkin’s current budgeting system and whether it is suitable for the environment in which Perkin operates. (13 marks) (b) Evaluate the impact on Perkin of moving to beyond budgeting. Not reproduced
(12 marks) (25 marks)
6
Posie is a large business which manufactures furniture. It is made up of two autonomous divisions in Deeland. The manufacturing division purchases raw materials from external suppliers, and performs all manufacturing and packaging operations. All sales are made through the retail division which has 95 retail stores in Deeland, as well as through Posie’s own well-developed website. Posie has retail operations in eight other countries as well as in Deeland. These overseas businesses operate as independent subsidiaries within the Retail Division, each with their own IT and accounting functions. The furniture is sold in boxes for customers to assemble themselves. About 10% of the products sold by Posie are purchased already packaged from other manufacturers. All deliveries are outsourced through a third party distribution company.
PL E
Posie’s corporate objective is to maximise shareholder wealth by producing ‘attractive, functional furniture at low prices’. This is how customers generally perceive the Posie brand. The CEO of Posie is concerned about increasing levels of returns made by customers and increasing numbers of consumers complaining on online forums about products purchased from Posie. Concerned about the impact on the Posie brand and the cost-leadership strategy, the CEO has asked you as a performance management expert to help Posie implement the six sigma technique to reduce the number of products returned and in particular to define customers’ requirements and measure Posie’s existing performance. The production director has been appointed to sponsor the project and you will be supported by a small team of managers who have recently received training in six sigma. The board member responsible for manufacturing quality recently resigned because she thought it was unfair that the manufacturing division was being held responsible for the increased level of customer returns. You have been given access to some information concerning the reasons why customers return goods to help you measure existing performance in this area (Appendix 1). This is an extract from the management reporting pack presented to the board at their monthly meetings. The returns data, however, are only compiled every six months due to the lengthy analysis required of data from Posie’s overseas retail operations. It is included twice a year in the board report along with the KPIs for customer satisfaction. The last time this information was produced 93% of customers indicated they were satisfied with the quality of the manufacture of Posie’s products.
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The CEO has heard that six sigma requires ‘large amounts of facts and data’. He suggested that the returns data contain insufficient detail and that as part of your project you may need to do more analysis, for example, on why customers are not satisfied with the manufacturing quality. He also added, ‘I’m not sure that our current IT systems are capable of generating the data we need to identify which responsibility centres within the manufacturing division are the root causes of the problem of customer returns. We are planning to change the designation of the overseas retail businesses from profit centres to revenue centres, but again we need to know first how this will affect the information requirements of the business and any potential problems with doing so.’
SA
3
Appendix 1
Reasons given by customers for returning goods
Category 1 2 3 4 5 Total
Reason for return of goods Difficult to assemble or pieces missing Goods arrived damaged Goods were not as described or were defective Goods were of poor quality or no longer wanted Arrived late
8
% Responses 48% 14% 25% 11% 2% 100%
Required: (a) Advise the board how the six sigma project at Posie to reduce returns from customers could be implemented using DMAIC methodology. (15 marks) (b) Evaluate the impact on Posie’s information requirements arising from: (i)
The need to identify and improve on the level of customer returns.
(6 marks)
(ii) The proposed re-designation of the overseas subsidiaries from profit centres to revenue centres. (4 marks)
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(25 marks)
9
[P.T.O.
Soup operates passenger rail services in Deeland, a technologically advanced country, with high demand for fast reliable rail travel from business and leisure passengers. Many passengers choose train travel because they see it as less harmful to the environment than other forms of transport. Soup’s main objective is to maximise shareholder wealth. Since becoming licensed to operate routes in Regions A and B by the Deeland government five years ago, Soup has consistently delivered increased dividends and share prices for investors. In its initial appraisal of the licensing opportunity, Soup expected to operate the routes for at least 15 years, however, their licence may not be renewed when it expires in three years’ time. The government has warned Soup it ‘is unhappy about high returns to shareholders while there are many reports of poor passenger service, overcrowded trains and unreliable services on certain routes and at busy times’.
PL E
Soup owns its fleet of diesel powered trains. Each train in Region A has seven coaches with 70 passenger seats available per coach. In the less busy Region B, each train has six coaches each with 70 seats. As a condition of the licence, Soup runs a set number of services at both busy and quieter times in both regions. Soup has two larger rivals, both operating electric trains, which cause less harm to the environment than diesel powered trains. They run on the same routes in both regions. The government regulates fares charged to passengers, which are the same per distance travelled for every operator in that region. The railway track, stations and other infrastructure are managed by the government which charges the operators a fee. There are several stations along the route which are only used by Soup trains and others where Soup trains do not stop at all. Soup’s trains are 25 years old, originally purchased cheaply from an operator whose licence was withdrawn by the government. Soup believes the low price it paid is a key competitive advantage enabling them to steadily increase their return on capital employed, the company’s main performance measure, to a level well in excess of their rivals. The shareholders are pleased with the growth in passenger numbers over the last five years, which is the other performance measure Soup uses.
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Soup’s ageing trains spend increasing time undergoing preventative maintenance, safety checks or repairs. A recent television documentary also showed apparently poor conditions on board, such as defective heating and washroom facilities and dirty, torn seating. Passengers complained in the programme of difficulties finding a seat, the unreliability of accessing wireless internet services and even that the menu in the on-board cafe had not changed for five years. Soup’s CEO responded that unreliable internet access arose from the rapid growth in passengers expecting to access the internet on trains. She said Soup had never received any formal complaints about the lack of choice in the on-board cafe, nor had she heard of a recent press report that Soup’s trains were badly maintained, so causing harm to the environment. The CEO has asked you, as chief management accountant, for your advice. ‘In view of the government’s warning, we must develop performance measures balancing the needs of passengers with the requirements of the shareholders’, she has said. ‘I don’t want to know how to improve the actual performance of the business; that is the job of the operational managers, nor do I just want a list of suggested performance measures. Instead I need to know why these performance measures will help to improve the performance of Soup.’
SA
4
The following data applies to Soup: Number of services per day Peak times Other times Number of passengers per day Peak times Other times
Region A
Region B
4 6
4 8
2,500 2,450
1,400 1,850
10
Required: (a) Advise the CEO on how the use of the balanced scorecard could improve the performance management system of Soup. (10 marks) (b) Using the performance data given, evaluate the comments of the Deeland government that Soups trains are overcrowded. (7 marks) (c) Assess the problems Soup may encounter in selecting and interpreting performance measures when applying the balanced scorecard to its performance management system. (8 marks)
SA
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PL E
(25 marks)
11
[P.T.O.
Professional Level – Options Module, Paper P5 Advanced Performance Management Report To: Board of Iron Chicken (IC) From: A. Accountant Date: December 2015 Subject: Performance management issues at IC
Introduction This report evaluates the accuracy and assumptions used in the calculation of EVA™. It then suggests new KPIs for the current CSFs at IC. Finally it considers the impact of three quality improvement projects on these CSFs and a proposed new information system.
PL E
Economic value added (EVA™) There are a number of errors in the existing calculation of (EVA™). These are described below and then the corrected EVA™ is calculated. Non-cash expenses are correctly added back to profit as such costs are treated as unacceptable accounting adjustments on a cash-based view. Marketing activities for long-term benefit are correctly added back as they generate future value for the business and so the prior year expenditure is also added in to capital employed. Operating leases should be added back to profit and to capital employed and a suitable additional depreciation charged as these are now treated as assets of the business. Research and development (R&D) expenditure should be treated as for the long-term marketing spending (note that there was no R&D expenditure in the prior year). The tax cost in the calculation should be the amount paid adjusted for lost tax on interest and not the adjusted amount of tax charged in the accounts. The WACC is incorrectly calculated as it should be based on the post-tax cost of debt. The capital employed figure should be based on the year start figure. Economic value added
Year ended 30 June 2015 $m 551·4
Operating profit Add back Non-cash expenses Marketing capitalised Operating lease expenses Research and development Less Depreciation on leased assets (115/4) Tax Lost tax relief on interest
15·1 23·1 40·0 10·0
M
(i)
NOPAT
Capital employed At 2015 year start Marketing spend capitalised from YE 30 June 2014 Operating leases
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1
September/December 2015 Answers
Adjusted capital employed at 2015 year start
28·8 130·0 24·5 ––––––– 456·3 2,282·0 23·1 115·0 ––––––– 2,420·1
WACC = (1/2 x 16%) + (1/2 x 6·8% x (1 – 30%)) = 10·38% EVA™ = NOPAT – (WACC x Capital employed) = 205 The recalculated economic value added has increased from $181m to $205m which still indicates a positive position for the company as it adds to shareholder wealth. In addition to the corrections above, the following assumptions in the calculation require comment: 1.
There is an implicit assumption that accounting depreciation (included in operating profit) is equivalent to economic depreciation (which should be used for EVA™ calculations). This is questionable generally, although there is no information to allow a more accurate calculation. Also, there is additional marketing spending which will probably have a limited economic life in building the brand. No estimation of this life and the resulting additional economic depreciation has been attempted in the above calculation.
2.
It has been assumed that no amortisation needs to be charged on the research and development costs since the product has not yet launched. This is in line with the accounting treatment of such items.
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(ii)
Key performance indicators for the critical success factors Greater staff productivity The current measure of units produced per labour hour does not reflect the skill and effort which goes into producing different units. The products of IC range from complex to simple and so revenue per employee would better reflect the different skill levels involved in production. Reduction of wastage The weakness of the existing measure is that it only looks at one cost area of production (power consumption). Stock obsolescence will measure the wastage due to technological change which is present in the complex products produced by IC. Greater innovation of products The number of patents filed will reflect greater innovation at IC. Patents will legally protect groups of products. This will represent a stronger measure of innovation than new products launched since the patent gives legal exclusivity. [Tutor note: There are many possible acceptable answers to this question, e.g.
PL E
Greater staff productivity Actual staff hours as a percentage of standard hours for actual production as this would measure staff efficiency in producing a wide range of products. Reduction of wastage Input/output analysis of material which looks at the percentage of material purchased which goes into the final product.
Greater innovation of products Percentage of income earned from products which did not exist last year. This will measure the ability of IC to develop successful products. (The existing measure would record unsuccessful products as innovation.)] (iii) Lean manufacturing projects
The three projects link together as improvements to the quality of the manufacturing process at IC. There are common elements to these projects in the elimination of waste and empowerment of employees which will occur in the long term. In the short term, there may be increased costs due to these disruptive changes.
M
Just-in-time manufacturing (JIT) JIT seeks to produce on a pull-basis to meet the customers’ demands rather than to produce products for inventory, which then acts as a buffer between production levels and demand. The main impact of JIT is the reduction of inventory which is held. The main enablers for such a system are a need for close links to customers and suppliers in order to predict demand and to quickly supply that demand. In terms of IC’s CSFs, this project will improve productivity as production lines must be made more flexible to meet changes in demand, although it should be noted that there could be a negative impact as constant changes in production lines will require more time to be spent setting up new production runs. It will also help to reduce wastage through losses in inventory as there will be less inventory. It also pushes some of the responsibility for improved quality of components (and reduced wastage) on to suppliers. However, it does not directly impact on product innovation. The project will not necessarily immediately change any of the existing KPIs as it is about producing the right products at the right time not just more products for any given input and does not impact directly on new product launches.
SA
Use kaizen costing Kaizen costing aims to reduce current costs of production through continuous improvement. Each period, goals for lower costs are set and then performance monitored against these using variances. At the end of the period, a new lower cost goal is set for the next period. The process also often uses target costing to set the initial planned cost of a product thus incorporating the idea of only producing what the customer values. The purpose is to build into the control of the production process the idea of continuous improvement. This project has the explicit aim of reducing waste and improving productivity and so is directly linked to the first two CSFs. As a result, it will have an impact on the KPIs which are related to productivity and resource consumption. The project will also require the empowerment of staff to make improvement decisions within their quality circles (teams) and so it may give scope for more innovative thinking. However, this thinking is not aimed at producing new products but at improving the production process, so new product innovation may only be affected indirectly. Costs of quality and a ‘zero defects’ approach to manufacturing Costs of quality can be broken down into four parts: – – –
–
prevention costs which occur before or during production and aim to prevent the production of defective products; appraisal costs which occur after production and aim to check that products meet quality standards; internal failure costs which occur when products are identified as defective before delivery to the customer and so are scrapped or reworked; and external failure costs which occur when defective products are delivered to the customer.
The ‘zero defects’ approach is also known as ‘total quality management’ (TQM). The TQM philosophy is that it is better to spend money on prevention, which involves challenging all aspects of the production process in order to improve and so avoid failure costs.
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This project will affect the CSFs relating to improved productivity and waste by reducing defective products, provided that staff time is not adversely affected by aiming for perfection in production. In terms of the KPIs, it may lead to increased time in production but reduced wastage. It will not have a direct impact on power consumption. Again, this project is unlikely to affect the number of new products launched as it focuses on the production process not product development. (iv) New information system The move to a single database for the organisation will integrate the subsystems from different functions (such as production and sales). It will require existing systems to be networked and compatible or else be replaced. It will affect overall decision-making by improving the visibility of each function’s operations to the others and to the strategic decision-makers. This shift is often achieved by using an enterprise resource planning system and a strategic enterprise management system.
PL E
The unified database will be critical in achieving the goal of JIT manufacturing as close links between production scheduling and demand forecasts will be required in order to match production runs with demand forecasts/orders. Also, the production schedules will need links to inventory levels in warehousing so that inventory is run down before new production is initiated. As closer communication with suppliers and customers will also be required, some change to existing information systems will be necessary in any case. It may be worthwhile to consider including electronic data interchange (EDI) in the specifications of the new system. In using kaizen costing, cross-functional communication will be important. The design team will need to communicate with the production team so that the design is more easily streamlined for production. The financial systems will need to be frequently updated for information from the quality circles as improvements are made. This will affect the kaizen cost targets which need to be continually monitored and new targets set regularly. Quality circles often involve groups from across the business and so a common information system will facilitate communications amongst them. The introduction of TQM will require clearer reporting of quality costs to assist in the on-going motivation of staff, which is often a problem in TQM. Informing the quality teams of the impact that increased prevention costs are having on lowering failure costs will be important in maintaining the push to zero defects. The quality improvements and changes to production processes will need to be communicated across IC’s different sites which the new database can facilitate. The nature of the data used in the current system is quantitative but with the new projects, there will be a need to communicate qualitative information, for example, relating to the nature of defects or the new production processes put in place. This will require a fundamental change to existing systems which again motivates the change to a new database.
Tutor note: This is a detailed solution and candidates would not be expected to produce an answer of this length. Weaknesses in the current budget process at Perkin
M
(a)
Perkin uses a traditional approach to budgeting, which has a number of weaknesses. First of all the budgeting system does not seem aligned with Perkin’s corporate objective which focuses on innovation and continuous product improvement. Innovation is a key competitive advantage to both component and device manufacturers in this industry and the products which incorporate Perkin’s components are subject to rapid technological change as well as changes in consumer trends. The markets in which the two divisions operate appear to be evolving, as seen by the high popularity of the smartphone model which was designed for playing games. This may mean the distinction between smartphone and gaming devices could be becoming less clear cut. Management time would probably be better spent considering these rapid changes and currently the budgeting process does not facilitate that.
SA
2
In reality, the budget process at Perkin is time consuming and probably therefore a costly exercise. Divisional budgets go through a lengthy process of drafting and then revision by the main board before they are approved. The approval often happens after the start of the period to which they relate, at which point the budgets are already out of date. This also means divisional managers are trying to plan activities for the next financial year without a set of finalised targets agreed, which could impact the effectiveness of decisions made. Another weakness is that the budgets are only prepared annually, which is clearly too infrequent for a business such as Perkin. The process is also rigid and inflexible as deviations from the planned targets are not tolerated. Sticking to rigid, annual budgets can lead to problems such as P Division not being able to cope with increasing popularity of a particular product and even other short-term changes in demand like those driven by seasonal factors, or one-off events such as the factory fire. Linked to this problem of budgetary constraints is that to cut costs to achieve the budgeted net profit, managers closed one of the three research and development facilities in G Division. As identified at the outset, a successful research and development function is a key source of long-term competitive advantage to Perkin. It also appears that Perkin fails to flex the budgets and consequently the fixed budgets had discouraged divisional managers from deviating from the original plan. P Division did not make technical modifications to its components due to the cost of doing so, which meant they were unable to supply components for use in the new model of smartphone and had to discount the inventories of the old version. It is unclear why G Division did not take on additional staff to cope with increased demand following reopening of their customer’s factory, but it may be because managers felt constrained by the budget. This then caused long-term detriment to Perkin as they lost the preferred supplier status with their main customer. Another problem created by annual budgeting is the management of short-term changes in costs and prices. A key component of Perkin’s products is silver, which fluctuates in price, and though it is not clear how much effect this has on Perkin’s costs,
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any problems in supply could disrupt production even if only a small amount of silver were required. Also Perkin exports goods worldwide and probably also purchases materials, including silver, from overseas. The business is therefore exposed to short-term movements in foreign currency exchange rates which may affect costs and selling prices. Similarly, there also seems to be considerable uncertainty in sales volumes and prices which creates problems in the forecasting process for the two divisions. P Division did not anticipate the high demand for the new component which meant P Division had to discount products it had already manufactured in order to achieve its forecast sales volumes. G Division did correctly forecast the demand, but based on past growth in the market which may be too simplistic in a rapidly changing industry. Lack of up-to-date information will hinder decision-making and overall performance at Perkin. Perkin would perhaps be better adopting a rolling basis for forecasting.
PL E
The two divisions share manufacturing facilities and are likely to compete for other resources during the budgeting process. The current budgeting system does not encourage resource, information or knowledge sharing, for example, expertise in forecasting silver requirements. Divisional managers are appraised on the financial performance of their own division and hence are likely to prioritise the interests of their own division above those of Perkin as a whole. P Division would not re-allocate its manufacturing facilities to G Division, even though G Division needed this to cope with extra demand following reopening of the customer’s factory. The current system is therefore not encouraging goal congruence between the divisions and Perkin as a whole and a budgeting system, if done effectively, should encourage co-ordination and co-operation. Managers may find the budgeting process demotivating because it is time-consuming for them and then the directors override the forecast which they had made. It is also unfair and demotivating to staff to appraise them on factors which are outside their control. This also identifies another weakness in Perkin’s budgeting system related to control as there does not seem to be any planning and operating variance analysis performed to assess exactly where performance is lacking and so no appropriate management information is provided. In fact it is not even clear just how often divisional managers receive reports on performance throughout the year. Any budgeting system without regular feedback would be ineffective. It should even be noted that for the industry in which Perkin operates the use of only budgetary targets as a measure of performance is narrow and internal. It should be utilising information from external sources as well to assess performance in a more relevant and contextual way. Given the rapidly changing external environment and the emphasis on innovation and continuous product development, the current traditional budgeting method does not seem appropriate for Perkin.
reproduced (b) Not Beyond budgeting moves away from traditional budgeting processes and is suitable for businesses operating in a rapidly changing external environment and has the following features: Encourages management to focus on the present and the future. Performance is assessed by reference to external benchmarks, utilising rolling forecasts and more non-financial information. This encourages a longer term view.
2.
More freedom is given to managers to make decisions, which are consistent with the organisation’s goals and achieving competitive success.
3.
Resources are made available on demand, for example, to enable a division to take advantage of an opportunity in the market, rather than being constrained by budgets.
4.
Management focus is switched to the customer and managers are motivated towards actions which benefit the whole organisation, not just their own divisions.
5.
Effective information systems are required to provide fast and easily accessible information across the whole organisation to allow for robust planning and control at all levels.
SA
M
1.
Taking each of the elements of beyond budgeting in turn, the impact of introducing this technique into Perkin can be assessed. At Perkin, there are rapid technological changes in the products being produced by customers and competitors as a result of changes demanded by the market, which mean that Perkin must respond and continuously innovate and develop its products. This will support Perkin’s corporate objective. Consequently, this means that Perkin must change its plans frequently to be able to compete effectively with other component manufacturers and therefore will need to move away from annual incremental budgeting to introducing regular rolling forecasts. This process will need supporting by KPIs which will have a longer term focus. The impact of this will be that Perkin will need to develop a coherent set of strategies which supports its corporate objective, which will then need to be translated into targets and appropriate KPIs selected and developed. It will also mean that performance measures at the operational level will need to be revised from annual budgetary targets to these longer term objectives. Management at all levels will require training on the production of rolling forecasts and Perkin will need to assess if additional resources will also be required to run this new system. Beyond budgeting focuses on the long-term success of the business by division managers working towards targets which may be non-financial. The use of external benchmarks and non-financial information will mean Perkin will need to put processes in place to collect this information and analyse it to assess performance. This will be a learning process as Perkin does not currently do this. The status of preferred supplier with key customers, for example, would be important to the long-term success of the business and this could be an objective which Perkin sets for its divisional managers. Beyond budgeting allows authority to be delegated to suitably trained and supported managers to take decisions in the long-term interests of the business. It allows managers to respond quickly and effectively to changes in the external environment, and encourages them to develop innovative solutions to external change. In Perkin, budgets proposed by divisional managers are changed by the board to reflect its overall plans for the business. This means that a change in the
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approach to communication between the board and the divisions will be necessary as Perkin would need to switch from the top down process currently adopted to a more devolved decision-making structure. This will again require training for management to enable them to be ready to deal with this delegated authority as it will be very different from their existing approach. Traditional budgeting may constrain managers who are not allowed to fail to meet the approved budget. This can be seen when P Division did not adapt its components because it did not want to incur the costs of doing so, which had not been budgeted for. Similarly, prices of raw materials are known to be volatile. Beyond budgeting makes resources available for managers to take advantage of opportunities in the market, such as the smartphone designed for playing games. Managers would also be able to react to changes in the price of materials or changes in foreign currency exchange rates, for example, by having the authority to purchase silver for inventory at times when the price of silver is low. This will mean that as a result there will be fewer budgetary constraints; however, these resources and targets will still need to be effectively managed. This management will mean that strategic initiatives invested in will need monitoring rather than closely scrutinising departmental budgets, which will be a significant change in Perkin.
PL E
In Perkin, the two divisions share some manufacturing facilities and are likely to compete for other resources, for example, when setting budgets. When manufacturing facilities are in short supply, each division will prioritise its own requirements rather than those of the business as a whole. Beyond budgeting encourages managers to work together for the good of the business and to share knowledge and resources. This is important in a business such as Perkin where product innovation is key and where the activities and products of the two divisions are similar. This coordinated approach will be new to Perkin so there will be a culture change. Also, the customer-oriented element of beyond budgeting is key here and will require the setup of customer focused teams which will require more harmonised actions in the divisions. Each division currently has its own IT systems. In order to effectively share knowledge and to be able to respond to the external environment, which are key elements of beyond budgeting, it would be preferable for them to have shared IT facilities. This will mean that Perkin may have to invest in new technology capable of sharing information across the organisation in a rapid and open fashion but also be able to collect all relevant comparative data to allow for continuous monitoring of performance. This will facilitate better planning and control across all levels of Perkin. With appropriate training of managers and investment in information systems, it would be relevant for Perkin to adopt beyond budgeting because of the rapid changes in the external environment in which it operates.
The DMAIC process is a technique used to implement six sigma to improve existing processes and is split into five phases as described below. Define the process
The CEO is concerned that the increase in returns from customers is increasing costs and threatens to affect the Posie brand. Six sigma focuses closely on the requirements of the customer and it is important to be clear exactly what customers’ requirements are and in this case specifically why products are returned.
M
(a)
The objective of the project needs to be clear, in this case to reduce the number of customer returns. Customers will expect certain minimum requirements from the manufacturing and packaging process, for example, that the furniture is able to be properly assembled and all the necessary components are included in the box. They will also expect the goods to be delivered undamaged within a reasonable time and at the time and date promised when the order was placed. Customers’ perceptions of quality should correspond to the price paid, though different customers will have different expectations of this.
SA
3
Beyond this basic requirement, there may be aspects of the manufacturing product which further enhance the customers’ experience of the product and presumably of the Posie brand. Customers may be particularly pleased with furniture which is delivered early or at a time especially convenient to them, or which is robust, durable and ‘well-made’. These perceptions are subjective and may equally relate to design or the quality of raw materials as to the manufacturing process. By identifying where the products exceed customers’ expectations, it may be possible to focus more on these aspects in the future. While products which significantly exceed customers’ expectations will enhance the Posie brand, it may also indicate a quality of manufacture which is too high and allow Posie to reduce manufacturing costs in accordance with its cost leadership strategy whilst still having mainly satisfied customers. Measure the existing process
The current returns figures do give some data to as to why products are returned, but its usefulness is limited as it is unclear which of the categories relates to defective manufacture, and which relate to activities of other divisions. The ambiguity of the data and category definitions will need addressing to enable the process to be measured effectively. Returns in Category 1 could be because the goods were not manufactured or packed properly in the manufacturing division, but could also be due to poor design, customers losing components or simply being unable to assemble furniture. Damaged goods in Category 2 probably do not arise because of defective manufacturing either, though customers may wrongly categorise defective goods as damaged. For the other categories it is less clear. Though goods may become damaged by the distribution company, it seems that only a small number of returns relate directly to them. Returns in Categories 3 and 4 could be due to defective manufacture or if the customer had simply changed their minds and no longer wanted the product. In Category 3, the identification of ‘defective’ items is too broad.
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Returns in Category 5 which arrived late are clearly not due to manufacturing defects and as this causes only 2% of returns, is relatively insignificant. Currently 10% of Posie’s sales are of products from other manufacturers. There is no indication from the data given how many of the returns relate to these products, nor of the total number of returns relative to the number of items sold. Therefore the existing data are insufficient to reliably measure existing performance and take no account of inputs such as raw materials. Only items which customers value should be measured. The CEO has suggested more detailed data are required, for example, on overall customer satisfaction with the manufacturing, but this is at 93% which already seems high and there is little point in incurring costs to measure what customers are already satisfied with. In the context of the six sigma project at Posie, there is little that can be done to improve this particular area and such items should not be measured. Analyse the process
Improve the process
PL E
This stage is where the root causes of the problems are identified. Additional information may be needed, for example, to analyse customer returns by type of product, by country of sale or with a clearer definition of what is meant by ‘defective’. By doing so, Posie may identify areas of the business where customer returns are particularly high and so be able to focus on these.
At this stage the proposals for improving the process are implemented and availability of resources and likely costs of making the improvements need to be carefully considered. Posie may need to consider which aspects of the production or packaging process could be improved, for example, by better maintenance or calibration of machinery. Additional training of staff may also be required. Control
This is the on-going monitoring that the reduction in customer returns due to defective manufacturing is being maintained. Reporting on the number of returns may be done by exception if they reach a particular level. In Posie, it seems likely that the data on customer returns used to manage this process will need to be redesigned to make it clearer in which responsibility centre the problems arise. The ongoing monitoring may indicate that some of the earlier stages in the DMAIC process need to be revisited. The CEO wants to identify which responsibility centres are the root causes of the problem of customer returns. A responsibility centre is a part of the business where a manager has specific authority and accountability for its performance and so Posie will need information relating to aspects of performance specific to the centre. For example, performance data relating to the reasons for customer returns need to be clearly segregated between responsibility centres. Currently, the information compiled on customer returns does not do this and some categories of return may result from manufacturing defects but some will be from problems outside the manufacturing division, or even outside Posie itself, for example, from poor quality raw materials purchased externally, or because of late deliveries or damaged goods caused by the distribution company.
M
(i)
Once information has been analysed and responsibility has been identified, then the managers of those areas will need the information drilled down into even further, as in order to improve they need to know which specific areas they can control. It would be unfair to make managers responsible for aspects of performance which they are unable to control, and the board member responsible for manufacturing quality has recently resigned because of this. Posie needs to ensure it produces performance data to an appropriate level of detail so as not to overload the users with too much data. For board level reporting, the information in the current board reporting pack may be too detailed and it would be sufficient just to produce summary data on the overall level of returns relative to sales. Responsibility centres would need much more detailed information, perhaps even down to product or production line level.
SA
(b)
However, Posie should also consider the costs and resources required to provide more detailed performance data. Given Posie’s cost leadership strategy, the costs of data collection may outweigh the benefits of doing so. Performance data should be provided at an appropriate frequency. For the Posie main board, monthly reporting may be sufficient to alert them to any problems. Responsibility centres will need much more frequent, even daily or weekly details of the levels of customer returns so that they can react quickly to any problems identified. At the moment, the returns data are compiled every six months, possibly due to the difficulties in obtaining data from the IT systems in the overseas businesses. Even for a board level report, this seems much too infrequent.
(ii)
At the moment, the overseas subsidiaries are being designated as profit centres and managers will be held accountable for both revenues and costs. As they do not manufacture, it seems reasonable to designate them as revenue centres. As such, managers would be held accountable for just revenues as they have little or no control over costs as most goods for resale are purchased from the manufacturing division. The performance data produced by Posie’s subsidiaries’ IT systems will therefore switch to focus more on revenues rather than costs. As revenue centres they may well have some freedom to change selling prices. Posie will need to ensure the subsidiaries have information to monitor the impact of different pricing strategies and will need to provide the management of these subsidiaries with information gleaned from the external environment. It will be important to evaluate competitors’ pricing strategies when making pricing decisions.
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A potential problem with providing only performance data relating to revenue is that managers could focus too much on achieving revenue targets rather than maintaining or improving profitability. As they are autonomous subsidiaries, there will be aspects of their own costs, such as staffing costs and other overheads, which they will be able to have some control over. It is important that Posie ensures the management still has sight of this information to ensure that such costs are still controlled effectively. Furthermore, if the overseas managers are only held responsible for sales, this may mean they do not focus sufficiently on addressing reasons why goods are returned, and so levels of returns may increase. This means that once Posie undertakes the exercise to identify the root causes of the returns from customers, this information is shared and monitored. Posie needs to be aware of these issues when determining information requirements if the reclassification of the subsidiaries goes ahead. It will not be as simple as assuming that they will now only need information on revenues.
PL E
The balanced scorecard consists of four perspectives: customer, internal, innovation and learning and financial. It requires an organisation to have a number of goals supported by performance measures in each perspective. The customer perspective measures what it is that customers value from the business; internal looks at what processes does the organisation need to be successful; innovation and learning considers how future value can be created and financial measures whether performance is acceptable to investors. It is useful because it uses both internal and external information to assess performance and measures financial and non-financial aspects of a business to ensure long-term future success, rather than just focusing on historic results. It can also be used as a mechanism to link KPIs into the CSFs which are vital to deliver strategy. Soup currently uses return on capital employed (ROCE) as its key financial performance measure, but this does not correlate directly with the objective to maximise shareholder wealth and could encourage short-term decisions to be taken at the expense of long-term success. This is the case at Soup which purchased old trains and subsequently failed to reinvest, meaning that Soup’s ROCE is probably higher than its rivals. However, the trains are becoming unreliable and their condition is deteriorating. In the long term this will reduce customer satisfaction and financial performance. Using the scorecard, Soup should have a broader range of financial measures which encourage managers to take decisions, such as investment decisions, consistent with the objective to maximise shareholder wealth in the long term. EVA would be a suitable measure to help achieve this, and would be preferable to the current focus on ROCE. Soup does measure growth in passenger numbers which could be a measure of customer satisfaction. However, it is a limited, quantitative measure. Though Soup does have rivals and is likely to be required to operate a specified level of service under the terms of the licence from the government, some passengers may be forced to travel on Soup trains, rather than those of another operator because of where they live or the times they need to travel. The number of operators (competitors) is limited by the capacity of the railway infrastructure as well as by passenger demand. This means that the level of repeat customers may not be appropriate for Soup.
M
(a)
Passenger numbers are also externally focused but again this fails to fully consider the environment in which Soup operates. Within the customer perspective Soup could use a range of performance measures. This will be beneficial as where passengers are able, they are likely to choose to use Soup if they provide a good service. This can be easily measured by surveying or asking passengers’ opinions. This will give Soup more qualitative information about their customers and their expectations, which will vary, for example, passengers will have different perceptions of overcrowding, or what is an acceptable delay. Certain groups may be more affected by overcrowding like frequent travellers and the elderly. Passengers who are unable to find a seat will probably be the most dissatisfied, though this will depend on how long their journey is. Other aspects of Soup’s service may be less valued than reliability and occupancy, like wireless access and the on-board cafe, but will be important to certain groups.
SA
4
Another key element of customer satisfaction will relate to the amount of fare paid. Fares are regulated in Deeland so the interaction between fares and other aspects of the service is unknown. Many customers while valuing a particular aspect of the service may be unwilling to pay more for it; some may accept a reduction in the level of service if fares were reduced. This detailed information about customers will allow Soup to focus performance improvements on key areas using more external data to make decisions. Measures of the internal processes are likely to be closely linked to customer satisfaction. Soup apparently neglects this area in its performance management system. The scorecard could be used to help to address reliability, overcrowding and environmental factors. Reliability will be highly valued by customers especially those who travel frequently and who rely on rail travel to get to work. The number of trains arriving late would be a suitable measure of reliability, as would the number of train services cancelled, though the length of the delay is also critical and should be carefully defined. The scorecard would allow more detailed measures as some of the factors affecting reliability will be within Soup’s direct control but others such as failures in the railway infrastructure are controlled by the government. This is useful information for Soup to effectively assess their controllable performance and feedback as necessary to external parties. Seat occupancy, the number of passengers on a train compared to the number of available seats on different routes and at different times, is a suitable measure of train overcrowding and is important for passenger safety. To fully utilise its trains and
23
achieve its objective of maximising shareholder wealth, Soup must try and maximise both the seat occupancy and the amount of time its trains are actually running. These internal measures would then help to support financial targets. Soup’s licence to operate rail services in Regions A and B expires in three years’ time, and as with the operator from whom Soup purchased the trains, it may not be renewed. Soup must balance the needs of shareholders for short-term increases in dividends and share price with the long-term need to renew to its operator’s licence. The creation of long-term future value can be addressed by the innovation and learning perspective. The immediate scope to innovate the service experienced by the passenger is limited, but there are some quick wins available in the choice in the on-board cafe and improving the reliability of the internet access. Also time spent training staff may improve customer satisfaction and reduce maintenance time. Fundamental innovation like the use of faster or environmentally less harmful trains requires long-term planning and large capital investment. The scorecard will encourage Soup to be forward looking, unlike the present system which is limited to historic performance. To measure the extent of overcrowding, some measure of occupancy is needed. The number of passengers per available seat can be used as a measure of occupancy.
PL E
(b)
Seats available per train is 490 (7 coaches x 70 seats) in Region A and 420 (7 coaches x 60 seats) in Region B. Seats available per day Peak times Other times Seat occupancy Peak times Other times
Region A 1,960 (490 x 4) 2,940
Region B 1,680 3,360
Region A 128% 83%
Region B 83% 55%
Total seat occupancy = 82·5% (8,200/9,940)
Overall occupancy is below 100% which means on average there are more seats available than passengers, which is not consistent with the government’s claims that the trains are overcrowded. However, these averages may be misleading as trains running on certain days or at certain times may be relatively overcrowded. This may generate customer dissatisfaction even on services which are on average not fully occupied. The total number of passengers without seats would be a better measure. There are significant variations between regions and times travelled with only the trains in Region A travelling at peak times being over occupied. This affects only 18% (4/22) of all services.
M
Most affected by this will be the 28% of the passengers travelling at peak times in Region A who are unable to obtain a seat. This represents only 9% (28% x 2,500/8,200) of total passengers per day. There is some overcrowding but the claim that Soup’s trains are overcrowded seems exaggerated given the data provided. However, certain routes or specific times or sections of the trains may be more affected and more analysis is needed. The impact of overcrowding on passengers also depends on journey times, with passengers being less satisfied by not obtaining a seat on longer journeys rather than on short ones. Assuming trains are available for 14 hours per day and there are 22 services, each service is on average almost 1·5 hours which may be a significant length of time for passengers to stand on a train. When applying the balanced scorecard in Soup, the measures need to be chosen carefully. A balance needs to be struck and only measures which help Soup to achieve its objectives should be chosen. Currently Soup focuses on short-term financial measures such as return on capital employed, whereas the balanced scorecard considers more long-term measures.
SA
(c)
Some measures are more important than others, so prioritising measures will be difficult. Customers may value some aspects of the service more than others, for example, the choice available in the on-board cafe is probably unimportant to most passengers provided they can obtain some food and drink. The punctuality of Soup’s trains or whether they even run at all is fundamental to achieving customer satisfaction and needs careful measurement. Soup must have measures for regulatory or safety reasons too. Some aspects of the business may be harder to measure than others. For example, it may be relatively easy to measure seat occupancy as a measure of overcrowding, but passengers’ perceptions of overcrowding may differ. Non-financial aspects such as customer satisfaction may be subjective and any surveys done may not reflect the experience of the majority of passengers. Performing and analysing surveys would also be time consuming and resource intensive. Measures chosen may conflict. Overcrowding may be unwelcome by passengers but making them less crowded conflicts with Soup’s presumed objective of fully occupied trains. Time spent maintaining trains to reduce their impact on the environment or ensure reliability will mean they are not operational for periods of time, though safety will be a key factor here. Care must be taken to avoid overloading with too many performance measures. The current objective to maximise shareholder wealth is very broad. Having a clearer strategy would enable Soup to determine suitable performance measures so it is not overloaded with KPIs which do not contribute towards achieving this strategy.
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Professional Level – Options Module, Paper P5 Advanced Performance Management (i)
Economic value added Calculation: 1 mark for each of: Research and development Depreciation on leased assets Tax paid Capital employed year start figure Non-cash expenses Research and development WACC Economic value added Maximum 8 marks
PL E
1
September/December 2015 Marking Scheme
Assumptions and corrections 1 mark per point Maximum of 8 marks Maximum 15 marks (ii)
KPIs for CSFs Up to 2 marks per CSF Maximum 6 marks
(iii) Quality projects Definitions and descriptions up to 2 marks Analysis up to 6 marks per project Maximum 15 marks
M
(iv) New unified database Definition and general points up to 3 marks Interaction with each project up to 3 marks each Other comments up to 3 marks Maximum 10 marks
Professional presentation: up to 4 marks Total 50 marks
(a)
Weaknesses in current system Environment Conclusion
SA
2
10 5 1
Maximum 13 marks
(b) Not Beyond budgeting reproduced General description 1 mark per point up to Application and impact
4 10
Maximum 12 marks
Total 25 marks
25
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(a)
Use of DMAIC Define 1 mark per point up to Measure 1 mark per point up to Analyse Improve Control
4 6 3 3 3
Maximum 15 marks (b)
(i)
Definition Impact on information requirements 1 mark per point up to
1 6
(ii)
Impact on information requirements 1 mark per point up to Maximum 4 marks
Total 25 marks
(a)
1 mark per relevant point No marks for a list of new measures without justifying why they would benefit Soup 1 mark only for a generic description of the balanced scorecard without clear references to the scenario Maximum 10 marks
Calculation 1 mark each for: Seats available per train Seats available per day by region/time Seat occupancy by region/time Total seat occupancy Comment on whether consistent with governments claims about overcrowding – 1 mark Other comments – 2 marks Up to 2 additional marks for identifying journey time is an important factor and for attempting to quantify journey times from the data given
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(b)
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Maximum 7 marks (c)
Maximum of 3 marks if general points not applied to Soup Selection of appropriate measures – up to 2 marks Prioritisation of measures – up to 2 marks Difficulties of making measurements – up to 2 marks Conflicting measures – up to 2 marks Overload of measures – up to 2 marks
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Maximum 6 marks
Maximum 8 marks
Total 25 marks
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Advanced Performance Management
Paper P5
Professional Pilot Paper – Options module
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Time allowed Reading and planning: 15 minutes Writing: 3 hours
This paper is divided into two sections:
Section A – THIS ONE question is compulsory and MUST be attempted Section B – TWO questions ONLY to be attempted Do NOT open this paper until instructed by the supervisor. During reading and planning time only the question paper may be annotated. You must NOT write in your answer booklet until instructed by the supervisor. This question paper must not be removed from the examination hall.
The Association of Chartered Certified Accountants
Section A: THIS ONE question is compulsory and MUST be attempted
1 Mackerel Contracting (Mackerel) is a listed defence contractor working mainly for its domestic government in Zedland. You are a consultant brought in to advise Mackerel on a number of issues facing the company. The board need a report from you: • outlining the external factors affecting the profitability of a potential new contract and how these factors can be built in to the choice of the design budget which is ultimately set, • advising on a proposed change to the company’s information systems and • advising on suitable performance measures for Mackerel. Firstly, Mackerel is currently considering tendering for a contract to develop a new armoured personnel vehicle (APV) for the army to protect its soldiers during transport around any future battlefield. The invitation to tender from the government specifies that the APV should take two years to develop and test, and be delivered for a full cost to Mackerel of no more than $70,000 per unit at current prices. Normally, government contracts are approximately priced on a cost plus basis with Mackerel aiming to make a 19% mark-up.
At the last briefing meeting, the institutional shareholders of Mackerel expressed worry about the volatility of the company’s earnings (currently a $20.4m operating profit per annum) especially during the economic downturn which is affecting Zedland at present. They are also concerned by cuts in government expenditure resulting from this recession. The Zedland minister for procurement has declared ‘In the current difficult economic conditions, we are preparing a wide ranging review of all defence contracts with a view to deciding on what is desirable within the overall priorities for Zedland and what is possible within our budget.’ The government procurement manager has indicated that the government would be willing to commit to purchase 500 APV’s within the price limit set but with the possibility of increasing this to 750 or 1,000 depending on defence commitments. In the invitation to tender document, the government has stated it will pay $7.5m towards development and then a 19% mark-up on budgeted variable costs.
Mackerel’s risk management committee (RMC) is considering how much to spend on design and development. It has three proposals from the engineering team: a basic package at $7.5m (which will satisfy the original contract specifications) and two other improved design packages. The design packages will have different total fixed costs but are structured to give the same variable cost per unit. It is believed that the improved design packages will increase the chances of gaining a larger government order but it has been very difficult to ascertain the relevant probabilities of different order volumes. The RMC need a full appraisal of the situation using all suitable methods.
The risk manager has gathered information on the APV contract which is contained in appendix A. She has identified that a major uncertainty in pricing the vehicle is the price of steel, as each APV requires 9.4 tonnes of steel. However, she has been successful in negotiating a fixed price contract for all the steel that might be required at $1,214 per tonne. The risk manager has tried to estimate the effect of choosing different design packages but is unsure of how to proceed to evaluate the different options.
Secondly, the board is also considering a change to the information systems at Mackerel. The existing systems are based in the individual functions (production, sales, service, finance and human resources). Currently, reports are submitted by each function and then integrated at head office into the board papers that form the main strategic information system of the company. The board are considering the implementation of a new system based on an integrated, single database that would be accessible at any of the company’s five sites. The company network would be upgraded to allow real-time input and update of the database. The database would support a detailed management information system and a high-level executive information system.
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Finally, the chief executive officer (CEO) of Mackerel believes that this new information system will provide the opportunity for a change in how performance is evaluated within the company. The company’s mission is to maximise shareholder wealth and currently, the board use total shareholder return (TSR) as an overall corporate measure of performance. The CEO has asked you consider the general impact of the new information system and also, how profit based measures such as return on capital employed (ROCE) compare to newer measures such as economic value added (EVATM) with regard to meeting the overall goals of Mackerel and its external measure of performance.
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Appendix A Budgeted cost for APV Variable cost per unit $ Steel 11,412 9.4 tonnes at contracted prices Engine/transmission 9,500 Electronics 8,450 Other 4,810 Labour 13,800 Design and development (fixed total) $ Package Type 1 7,500,000 Type 2 8,750,000 Type 3 10,000,000 Risk manager’s assessment of likely government order: Probability Demand Type 1 Type 2 Type 3 500 85% 25% 20% 750 10% 50% 50% 1,000 5% 25% 30% Required: Write a report to the board of Mackerel to:
(i) Analyse the risks facing the management of Mackerel and discuss how the management team’s attitude to risk might affect their response. (9 marks) (ii) Evaluate the APV project using metrics and methods for decision-making under risk and uncertainty. and assess the suitability of the different methods used. (19 marks)
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(iii) Recommend an appropriate choice of method of assessing the project and therefore, a course of action for the APV contract. (3 marks) (iv) Evaluate the potential impact of the introduction of the new executive information system on operational information gathering and strategic decision-making at Mackerel. (8 marks) (v) Assess how profit based measures such as return on capital employed (ROCE) compare to newer measures such as economic value added (EVATM) given Mackerel’s overall goals. (7 marks)
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Question 1 includes professional marks for the format, style and structure of the discussion of your answer. (4 marks)
(50 marks)
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Section B – Two questions from the three given must be attempted.
2 Albacore Chess Stores (Albacore) is a chain of twelve shops specialising in selling items associated with the game of chess: boards, pieces, clocks, software and books. Three years ago, the company was the subject of a venture capital buyout from a larger group. A new senior management team was put in place after the buyout. They have the aim of running the business in order to maximise profits. The Chief Financial Officer (CFO) along with the other members of senior management sets the annual budget and uses a standard costing approach with variance analysis in order to control individual shop performance. The head office handles all capital purchases and brand marketing. All inventory purchasing is done centrally and the shop opening times are set as standard across the company. As an illustration of senior management attitude, the CFO had set the budget for 2011 staff costs at $7 per hour for part-time staff and this was rigorously observed in the period.
Each shop is run by a manager who reports their financial results to the operational director at head office. The shop managers recruit and manage the staffing of their shop. They have some autonomy in setting prices locally and have been given authority to vary prices by up to 10% from a master list produced by the CFO. They also have a local marketing budget agreed each year by the shop’s manager and the marketing director as part of the annual appraisal process.
The shop managers have approached the Chairman of Albacore to complain about the way that they are managed and their remuneration. They feel that their efforts are unrecognised by senior management. One manager commented ‘I have had a successful year in hard economic circumstances. I have run a number of promotions in the shop that have been well received by the customers. However, the budgets that are set are impossible to achieve and as a result I have not been paid any bonus although I feel that I have done everything in my power to bring in good profits.’
The shop managers at Albacore are paid a basic salary of $27,000 with bonuses of up to 30% of basic salary dependent on two factors: performance above budget and the operational director’s assessment of the manager’s performance. The budget for the next year is prepared by the CFO and presented by the operational director at the shop manager’s annual appraisal.
The Chairman has come to you to ask if you can consider the system of performance assessment for the shop managers and give an independent perspective on the reward systems at Albacore. She has heard of variance analysis but is unsure as what would be relevant in this situation. She has provided the following illustrative branch report from the previous year for one shop:
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Albacore Chess Stores Tunny Branch Year to Sept 2011 Budget Actual $ $ Sales 266,000 237,100 Cost of sales 106,400 94,840 Gross profit 159,600 142,260 Marketing 12,000 11,500 Staff costs Manager 27,000 27,000 Part-time staff 38,000 34,000 Property costs 26,600 26,600 Shop profit 56,000 43,160 Notes: Property costs includes heating, lighting and rental. Positive variances are favourable.
End of report
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Variance $ -28,900 11,560 -17,340 500 0 4,000 0 -12,840
The manager of this shop commented at the appraisal meeting that she felt that the assessment was unfair since her failure to make budget was due to general economic conditions. The industry as a whole saw a 12% fall in revenues during the period and the budget for the period was set to be the same as the previous period. She was not paid a bonus for the period.
Required: (a) Evaluate the suitability of the existing branch report as a means of assessing the shop manager’s performance and draft an improved branch report with justifications for changes. (13 marks) (b) Analyse the performance management style and evaluate the performance appraisal system at Albacore. Suggest suitable improvements to its reward system for the shop managers. (12 marks) (25 marks)
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3 Pharmaceutical Technologies Co (PT) is a developer and manufacturer of pharmaceuticals medical drugs in Beeland. It is one of the 100 largest listed companies on the national stock exchange. The company focuses on buying prospective products drugs from small bio-engineering companies that have shown initial promise in testing from small bioengineering companies. PT then leads these through three regulatory stages to launch in the general medical market. The three stages are: to confirm that the safety of the drug product (does it harm humans?), with small scale trials;, to test the efficacy of the product (does it help cure?), again in small scale trials; and finally, large scale trials to definitively decide on the safety and efficacy of the product.
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The drugs are then marketed through the company’s large sales force to health care providers and end users (patients). The health care providers are paid by either health insurance companies or the national government dependent on the financial status of the patient.
The Beeland Drug Regulator (BDR) oversees this testing process and makes the final judgement about whether a product can be sold in the country.
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Its objectives are to protect, promote and improve public health by ensuring that: • medicines have an acceptable balance of benefit and risk;, • the users of these medicines understand this risk-benefit profile; and • new beneficial product development is encouraged.
The regulator is governed by a board of trustees appointed by the government. It is funded directly by the government and also, through fees charged to drug companies when granting licences to sell their products in Beeland.
PT has used share price and earnings per share as its principal measures of performance to date. However, the share price has underperformed the market and the health sector in the last 2 two years. The chief executive officer (CEO) has identified that these measures are too narrow and is considering implementing a balanced scorecard approach to address this problem.
A working group has drawn up a suggested balanced scorecard. It began by identifying the objectives from the board’s medium term strategy: • Create shareholder value by bringing commercially viable drugs to market • Improve the efficiency of drug development • Increase shareholder value by innovation in the drug approval process
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The working group then considered the stakeholder perspectives: • Shareholders want an competitive return on their investment • Payers Purchasers (governments, insurers and patients) want to pay a reasonable price for the drugs • Regulators want an efficient process for the validation of drugs • Doctors want safe and effective drug products • Patients want to be cured
Finally, this leads to the proposed scorecard of performance measures: • Financial – share price and earnings per share • Customer – number of patients using TTPT products • Internal business process – above exceed industry-standard quality of on design and testing; time to regulatory approval of a product • Learning and growth – training days undertaken by staff; time to market of new product; percentage of drugs bought by TTPT that gain final approval.
This balanced scorecard now needs to be reviewed to ensure that it will address the company’s objectives and the issues that it faces in its business environment.
Required:
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(a) Evaluate the performance measures proposed for PT’s balanced scorecard.
(10 marks)
(b) Briefly describe a method of analysing stakeholder influence and analyse the influence of four different external stakeholders on the regulator (BDR). (8 marks) (c) Using your answer from part (b), describe how the application of the balanced scorecard approach at BDR would differ from the approach within PT. (7 marks) (25 marks)
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4 PLX Refinery Co is a large oil refinery business in Kayland. Kayland is a developing country with a large and growing oil exploration and production business which supplies PLX with crude oil. Currently, the refinery has the capacity to process 200,000 barrels of crude oil per day and makes profits of $146m per year. It employs about 2,000 staff and contractors. The staff are paid $60,000 each per year on average (about twice the national average in Kayland). The government of Kayland has been focussed on delivering rapid economic growth over the last 15 years. However, there are increasing signs that the environment is paying a large price for this growth with public health suffering. There is now a growing environmental pressure group, Green Kayland (GK), which is organising protests against the companies that they see as being the major polluters.
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Kayland’s government wishes to react to the concerns of the public and the pressure groups. It has requested that companies involved in heavy industry contribute to a general improvement in the treatment of the environment in Kayland.
As a major participant in the oil industry with ties to the nationalised oil exploration company (Kayex), PLX believes it will be strategically important to be at the forefront of the environmental developments. It is working with other companies in the oil industry to improve environmental reporting since there is a belief that this will lead to improved public perception and economic efficiency of the industry. PLX has had a fairly good compliance record in Kayland with only two major fines being levied in the last eight years for safety breaches and river pollution ($1m each).
The existing information systems within PLX focus on financial performance. They support financial reporting obligations and allow monitoring of key performance metrics such as earnings per share and operating margins. Recent publications on environmental accounting have suggested there are a number of techniques (such as input/ output analysis, activity-based costing (ABC) and a lifecycle view) that may be relevant in implementing improvements to these systems.
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Currently, the refinery has the capacity to process 200,000 barrels of crude oil per day and makes profits of $146m per year. It employs about 2,000 staff and contractors. The staff are paid $60,000 each per year on average (about twice the national average in Kayland). PLX has had a fairly good compliance record in Kayland with only two major fines being levied in the last eight years for safety breaches and river pollution ($1m each).
PLX is considering a major capital expenditure programme to enhance capacity, safety and efficiency at the refinery. This will involve demolishing certain older sections of the refinery and building on newly acquired land adjacent to the site. Overall, the refinery will increase its land area by 20%.
Part of the refinery extension will also manufacture a new plastic, Kayplas. Kayplas is expected to have a limited market life of five years when it will be replaced by Kayplas2. The refinery accounting team have forecast the following data associated with this product and calculated PLX’s traditional performance measure of product profit for the new product:
2012 25.0
2013 27.5
2014 30.1
2015 33.2
2016 33.6
13.8 5.0 5.6
15.1 4.0 3.0
16.6 3.0 0.0
18.3 3.0 0.0
18.5 2.0 0.0
0.6
5.4
10.5
11.9
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All figures are $m’s Revenue generated Costs Production costs Marketing costs Development costs Product profit
Subsequently, the following environmental costs have been identified from PLX’s general overheads as associated with Kayplas production. 2012 2013 2014 2015 2016 Waste filtration 1.2 1.4 1.5 1.9 2.1 Carbon dioxide exhaust extraction 0.8 0.9 0.9 1.2 1.5 Additionally, other costs associated with closing down and recycling the equipment in Kayplas production are estimated at $18m in 2016.
The board wishes to consider how it can contribute to the oil industry’s performance in environmental accounting, how it can implement the changes that this might require and how these changes can benefit the company.
Required:
Write to the board of PLX to:
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(a) Discuss and illustrate four different cost categories that would aid transparency in environmental reporting both internally and externally at PLX. (6 marks) (b) Explain and evaluate how the three management accounting techniques mentioned can assist in managing the environmental and strategic performance of PLX. (9 marks) (c) Assess the impact of implementing an input/output analysis on the information systems used in PLX. (3 marks) (d) Evaluate the costing approach used for Kayplas’s performance compared to a lifecycle costing approach, performing appropriate calculations. (7 marks)
(25 marks)
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Pilot Paper P5 Advanced Performance Management
Answers
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To: From: Date: Subject:
Introduction Mackerel has to make a decision on which level of design expenditure and so on which type of APV to tender. This choice will be dictated by the objectives of the business and its appetite for risk.
Board of Mackerel Contracting A Accountant XX XXX 20XX APV contract, new information system and performance measurement
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(i) Risks and risk appetite for APV contract It is natural to assume that the main objective of a business is the maximisation of shareholder wealth and in the context of the APV project the main measure of performance will be the profit made on the contract as this will drive the earnings over which the institutions are concerned. However, in a decision where there is risk and uncertainty, the company also has to decide on its appetite for risk. Risk appetite is usually divided into three categories: • risk averse individuals tend to assume the worst outcome and seek to minimise its effect • risk seekers are interested in the best outcomes and seek to maximise their returns under these circumstances • risk neutral individuals are interested in the most probable outcome
The risks for Mackerel arise from uncertainties in its external environment. The key stakeholders in this situation are the government (the customer) and Mackerel’s shareholders. The other factor giving rise to uncertainty is the forecast price of steel, the main raw material in the APV’s construction.
The shareholders have indicated a concern over earnings volatility and so seem to be risk averse. This is commercially sensible in a recessionary situation where the company’s survival could be placed at risk if a large project (such as the APV) were to fail. The project can be seen to be large for Mackerel as the expected profit is $5m if package 1 is chosen and this is material when compared to the current operating profit of $20.4m.
A risk averse approach might also be called for where winning the bid could lead to additional future work so that securing a deal is more important than optimising profit. This appears to be the case here as the government is the major customer of Mackerel.
The demand level for the APV is also uncertain as the recession could lead to cuts in government expenditure. Defence spending is often considered more discretionary than spending on public services (such as pensions) especially if there is not an immediate threat of conflict. Thus, it has been difficult to predict the probabilities of the different demand levels. Given that there are significant fixed costs of design and development, these different levels have a material impact on the return from the project.
These problems in quantifying the level of risk will affect the choice of method of analysing the return from the contract. Mackerel should evaluate the contract using different methods and come to a conclusion based on the most appropriate one for its objectives and risk appetite.
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A further source of risk is the danger of cost over runs. If successful in its tender, Mackerel will be working towards a fixed price for the contract ($7.5 m + budgeted variable cost per unit plus 19%). Any over runs of actual cost as compared to budget will reduce the profit margin earned.
A major cost risk is the cost of the primary raw material of production (steel). However, this has been fixed by the forward purchase of the steel for the contract. This has eliminated the risk of price fluctuations during the contract.
(ii) Risk evaluation methods and results
As was stated earlier, it is natural to assume that the main objective of the business is the maximisation of shareholder wealth and in the context of the APV project the main measure of performance will be the profit made on the contract. Although discounted cashflow would be a superior approach, there is insufficient data available here to calculate it.
The first priority is too ensure that the contract complies with the government requirement of a maximum per unit cost of $70,000 to Mackerel. The results per the Appendix 2 are:
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Cost per unit Demand 500 750 Package 1 62,972 57,972 2 65,472 59,638 3 67,972 61,305
1,000 55,472 56,722 57,972
This complies with the contract specifications.
The total profit for each design package under the different demand levels is calculated at the Appendix 2 as: 1,000 9,114,604 7,864,604 6,614,604
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Profit ($) Demand 500 750 Package 1 4,557,302 6,835,953 2 3,307,302 5,585,953 3 2,057,302 4,335,953
There are four possible approaches to selecting a package. The methods depend on the information available and the risk appetite of the decision-maker.
If we assume that there is insufficient information to make an estimate of the probabilities of the different demand levels then we are making a decision under uncertainty and there are three common methods of approach which depend on the risk appetite of the decision-maker (maximax, maximin and minimax regret). I have calculated payoff and regret tables in Appendix 1. The results can be summarised as follows:
Risk seekers and the risk averse will use profit under the different demand scenarios to make the appropriate choice.
Risk seekers will aim to maximise the possible returns from the different demand scenarios. The maximax method would be appropriate in this situation and here the company would be advised to choose design package 1 which will have a maximax profit of $9.1m.
Risk averse decision-makers will aim to maximise the minimum possible returns from the different demand scenarios. The maximin method would be appropriate in this situation and here the company would be advised to choose design package 1 which will have a maximin profit of $4.6m.
Pessimistic decision-makers will choose to focus on the lost profit (regret) compared to the best choice under that demand scenario. They aim to minimise the maximum level of regret that they can suffer under any demand scenario. This minimax regret method shows the company would be advised to choose design package 1 which will lead to no regret.
These conclusions should not be surprising as design package 1 has considerably lower fixed costs and yet is scalable to cope with all levels of demand.
A risk neutral manager does not take an optimistic or pessimistic stance. They will choose the option that yields the maximum expected value. This method depends on the use of probabilities for each of the outcomes. The risk manager has attempted to quantify the probabilities of the different levels of demand given the different design packages employed. It would be wise to involve both the design and sales teams in these estimates as such estimates are usually highly subjective and a broad canvassing of opinion may help to gain more accurate values.
The estimated probabilities allow the calculation of an expected profit for each choice of design package. Appendix 2 shows that the maximum expected profit of $5.6m arises if design 2 is chosen. This is due to the much greater likelihood of higher demand in that case. Design 3 does not seem to increase the chances of higher demand sufficiently to outweigh the extra fixed cost of $1.25m compared to design 2.
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(iii) Recommendation
In this situation, the choice of method will depend on the risk appetite of Mackerel, whether this type of decision is likely to be repeated many times and the accuracy of the probability estimates. As Mackerel shareholders seem risk averse, the profit under the contract is significant compared to the operating profit of the whole company and the economic environment is difficult so the low risk method of maximin seems appropriate. The use of expected values appears questionable as the probability estimates have not been widely debated and in the current economic circumstances, the company’s survival may be at risk and so the repeated trials necessary to make this method valid may not arise.
Design package 1 should be chosen as with unknown probabilities, it carries the least risk. The company could seek to sharpen the probability estimates and review the implications for company survival before considering the use of expected values although there is the potential to make an additional expected profit of $573k if we could justify choosing design 2 over design 1.
The risk over steel prices has been removed by using forward (advance) contracts to cover the purchase of the material required. As steel is used in many of the company’s products, this should be investigated as a general risk management technique for the company.
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(iv) New information system The executive information system (EIS) will bring a number of benefits in decision-making at the strategic level at Mackerel but at certain costs and with certain problems at the operational and strategic levels. The key danger is that the tangible increase in costs is not balanced by the intangible (and difficult to quantify) benefits of the new system.
At the operational level, the data gathering will generate new costs as the expectations of users for immediate update of the system drive demand for less batch input of data. This problem represents an opportunity to automate the input of data in order to fully benefit from real-time data availability.
At the strategic level, the benefits relate to improved decision-making as the EIS should allow drill-down access to the more detailed operational records but the initial presentation of data should be based on the key performance indicators for the company. This system should also be linked to external data sources so that senior management do not fall into the trap of only looking inwards in the organisation at the risk of ignoring wider issues in the business environment (for example, the risks associated with the APV contract such as the effect of the recession and the attitude of government). These will represent new data sources and so again increase the cost of the system.
The new system will increase the amount of information and analysis that it will be possible for senior managers to perform. It will present opportunities for better decision-making using the more up-to-date information. However, it may present the problem of information overload for senior managers. Therefore, the system will need to be designed to give access to only those areas that it is appropriate for any given manager to see.
The data used in decision-making will be more robust as a single database will reduce the problem of redundancy where multiple copies of the same data are held on different systems. This will remove the danger of inconsistencies and reduce the storage required by the company. This benefit will be felt at the tactical level of the company were such data consistency will aid inter-functional communication.
The EIS would allow access to decision support systems such as large spreadsheet models built in order to pull data out of the database for use in forecasting and appraising projects (for example, demand forecasting and risk modelling of the APV contract).
The EIS will also give access to tactical information such as budgets in order to help the executive control the business.
In order to gain the maximum benefit from the new system, executive managers will need to be trained and this training should occur just before the new system is available so that they are in a position to use it immediately.
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(v) Performance measures at Mackerel
The proposed new performance measures should be judged against the overall mission which is to maximise shareholder wealth and so optimise total shareholder return (TSR). It should be noted that TSR reflects both dividend returns and capital gains and so deals with both the current performance of the business (current dividend payments) and its expected future performance (as this dictates the share price).
The return on capital employed (ROCE) is calculated on profit before interest and tax divided by capital employed in a project or at the company as a whole. ROCE is a simple, commonly used measure of performance. However, it can encourage delays to investment in new assets since this measure improves as assets are depreciated with age. ROCE has the disadvantage of being based on profit measures of performance rather than cash. Measures such as NPV use cash flows which are less subject to the interpretation of accounting rules and are more directly aligned with shareholder interests. It is unclear that ROCE will align with the overall performance measure of TSR since TSR depends on share price and dividends paid. In particular, the fact that share price is based on a long-term view of dividend prospects makes the use of short period-based measures (such as profit) less valuable.
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EVATM is an absolute performance measure. It involves a more complex calculation than ROCE with many adjustments to the accounting figures of profit and net assets, such as the use of replacement costs for asset values and economic depreciation rather than accounting depreciation.
Many of the EVATM adjustments are intended to avoid distortion of results by accounting policies that are present in ROCE. EVATM has the advantage that by treating certain costs as investments it encourages appropriate capital expenditure.
However, EVATM depends on historical data while shareholders will be focused on future performance. Thus, while EVATM is more directly aligned with the objective of increasing shareholder wealth, it too falls short of measuring shareholders’ expectations which are present in the share price.
Conclusions Given the current risk appetites of key stakeholders and economic environment, it is recommended that the design package 1 for the APV be chosen, as it carries least risk.
The new EIS represents an opportunity to gain considerable strategic advantage provided the costs of the new system are properly understood and controlled.
Neither ROCE nor EVATM represent a perfect match to the company’s main external measure of performance (TSR) due to their backward looking nature. However, EVATM may be closer to the spirit of TSR in measuring increased shareholder wealth.
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