Download - ACCA P5 GTG Question Bank - 2011

P5 ADVANCED PERFORMANCE

MANAGEMENT (INT)

QUESTION BANK

ACCA

A GTG Get Through Guides

Edition 3,Version 1

ISBN No. 978-1-84808-250-2

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P5 - A D V A N C E D P E R F O R M A N C E M A N A G E M E N T (INT)

About the paper 1 - vi

Quest ion number Topic Name Marks Page Numbers

l Quest ion

bank Solut ion I

bank j

Section A Strategic Planning and Control 1 Strategic Management Accounting 25 1 - 1 45-47

2 Zero Based Budgeting National Electronics Ltd 20 1 - 1 47- 49

3 Beyond Budgeting Model Hope and Fraser 20 2 - 2 4 9 - 5 1

4 Strategic planning Diverse Holdings Pic 20 2 - 3 52-53

5 External environment 20 3 - 3 54- 56

Section B External Influences on Organisational Performance

6 Ethical issues and Mendelow's matrix Toyworld Ptc 20 5 - 6 57 -59

Section C Performance Measurement System and Design

7 Contingency theory. BPR 20 7 - 7 61 -63

8 Behavioural aspects in performance measurement Astrodome Sports Ltd 20 7 - 8 63 -65

9 Internal and external aspects of performance measurement

Ochilpark Pic 35 8 - 9 65 -68

10 Information requirement Moffat Ltd 20 1 0 - 1 0 68 -70

11 Benchmarking and information system

IN A Ltd 20 10- 10 71 -73

Section D Strategic Performance and Measurement

12 Mission Statement 20 11 - 11 75 -76

13 Usage of standards in decision-making 15 11 - 11 77-78

14 Performance analysis Sunflower Hospital 35 11 - 13 78 -80

15 Evaluation of strategies 40 13 -14 8 0 - 8 5

16 Strategic performance measurement Big Bucks Bank Pic 40 14 - 16 85 -88

17 Measures of performance 20 1 6 - 1 6 88 -91

18 Performance analysis Taliesin Ltd 20 17- 18 91 - 94

19 Strategic performance measurement Pack and Dispatch Co 20 1 8 - 1 9 9 4 - 9 5

20 Measures of performance Tannadens Division 35 1 9 - 2 0 9 5 - 9 7

21 Divisional performance Galaxy pic and Milky-way group 25 2 0 - 2 1 97-101

P5 - A D V A N C E D P E R F O R M A N C E M A N A G E M E N T (INT)

Quest ion number Topic Name Marks Page Numbers I

Ques t ion bank

Solut ion bank

SGCtion D Strategic Performance and Measurement - Continued

22 Divisional performance NAW Group 40 2 2 - 2 4 102-108

23 Product Vs. Customer profitability NAW Group 20 2 4 - 2 5 109-112

24 Transfer pricing- Able and Baker 20 25- 26 113-115

25 Transfer pricing - Alpha and Beta division 6 2 6 - 2 6 115-117

26 Not-for-profit organisation AVand BW 20 26- 28 117-119

27 Not-for-profit organisation GA and EA 40 2 8 - 3 0 120-124

28 Behavioural aspects of performance management 15 3 0 - 3 0 124-125

29 Performance measurement Sportstown and Totaleisure 40 3 0 - 3 2 126-130

Section E Performance Evaluation and Corporate Failure

30 Balanced scorecard and Building blocks 20 3 3 - 3 3 131 - 132

31 Performance measurement systems 15 3 3 - 3 3 132-134

32 Key performance indicators The Eatwell Restaurant 20 3 3 - 3 4 134-135

33 Performance measurement BLA Ltd 20 3 4 - 3 5 136-139

34 Performance measurement Compuaid Ltd 35 3 5 - 3 6 140-145

35 Performance measurement Mack-King 20 3 7 - 3 8 145-149

36 Performance measurement The Dental Health Partnership 20 38 - 39 149-153

37 Performance measurement Alisha Pic 40 4 0 - 4 1 153-157

38 Corporate failure Fashion Plus 25 41 - 4 2 157-159

q a- p Current Developments and Emerging Issues in Performance oeciion r Management

39 Contemporary management accounting techniques 20 4 3 - 4 3 161-164

40 Traditional vis-a-vis modern management accounting 15 4 4 - 4 4 164-165

Appendix I Present Value Table 1 - 1

[Annuity Table 1 - 1 | Total Page Count:176|

Examination structure

The examination will be a three hour paper in two sections:

Section A

Section A will comprise two compulsory questions comprising between 50 and 70 marks in total. Each question will comprise of between 25 and 40 marks

Section B

In section B candidates will be asked to answer two from three questions comprising of between 15 and 25 marks each

Total 100 marks

Reading and planning time

For all three hour examination papers. ACCA has introduced 15 minutes reading and planning time.

This additional time is allowed at the beginning of each three-hour examination to allow candidates to read the questions and to begin planning their answers before they start writing in their answer books. This time should be used to ensure that all the information and exam requirements are properly read and understood.

Dunng reading and planning time candidates may only annotate their question paper. They may not write anything in their answer booklets until told to do so by the invigilator.

Effective time management - a key to success

Remember you have 1.8 minutes per mark. Aim to solve a 20 marks question in 36 minutes.

About the GTG Question Bank

This Question Bank of 40 questions covers all important topics of the syllabus.

The Solution Bank has the following features, in addition to solutions to the questions:

Strategy to help you tackle the question Callouts and tips to give you additional guidance

Score More where students lose marks even when they have the required knowledge and notes how to avoid these mistakes

Answer plan to help you plan the answers for longer questions

QUESTION B A N K

« J L Z o p o

STRATEGIC PLANNING AND MX Z o p o CONTROL Ui (O

1. Strategic management accoun t ing

(a) Identify and discuss the circumstances that have brought about the proposition that traditional management accounting control systems have lost their 'relevance' to today's manufacturing and organisational environment.

(10 marks)

(b) Evaluate strategic cost management initiatives which may be used in order to restore the 'relevance' of management accounting control systems in today's manufacturing and organisational environment.

(15 marks) (25 marks)

(Adapted from June 2004)

2. Zero Base Budget ing - Nat ional E lect ron ics L td

National Electronics Ltd manufactures and markets a range of electronic office equipment. The company currently has a turnover of $50 million per annum. The company has a functional structure and currently operates an incremental budgeting system. The company has a budget committee that is comprised entirely of members of the senior management team.

No other personnel are involved in the budget-setting process.

Each member of the senior management team has enjoyed an annual bonus of between 12% and 24% of their annual salary for each of the past five years. The annual bonuses are calculated by comparing the actual costs attributed to a particular function with budgeted costs for that function during the twelve month period ended 31 December in each year.

A new Finance Director, who previously held a senior management position in a "not for profit' health organisation, has recently been appointed. Whilst employed by the health service organisation, the new Finance Director had been the manager responsible for the implementation of a zero-based budgeting system which proved highly successful.

Required:

(a) As the new Finance Director, prepare a memorandum to the senior management team of National Electronics Ltd which identifies and discusses:

(i) factors to be considered when implementing a system of zero-based budgeting within National Electronics Ltd;

(10 marks)

(ii) the behavioural problems that the management of National Electronics Ltd might encounter in implementing a system of zero-based budgeting, recommending how best to address such problems in order that they are overcome.

(6 marks)

(b) Explain how the implementation of a zero-based budgeting system in National Electronics Ltd may differ from the implementation of such a system in a "not for profit' health organisation.



2: Strategic Planning and Control € C.TG

3. Beyond Budget ing Model

Better budgeting in recent years may have been seen as a movement from 'incremental budgeting' to alternative budgeting approaches.

However, academic studies (e.g. Beyond Budgeting - Hope & Fraser) argue that the annual budget model may be seen as (i) having a number of inherent weaknesses and (ii) acting as a barrier to the effective implementation of alternative models for use in the accomplishment of

strategic change.

Required: 0) (b) Identify and comment on FIVE inherent weaknesses of the annual budget model irrespective of the

budgeting approach that is applied. (8 marks)

(c) Discuss ways in wtiich the traditional budgeting process may be seen as a barrier to the achievement of the aims of EACH of the following models for the implementation of strategic change:

(i) benchmarking; (ii) balanced scorecard; and (iii) activity-based models.


(June 2005)

4. Strategic p lann ing - Diverse Ho ld ings Pic

Diverse Holdings Pic has five wholly-owned subsidiary companies. These are:

(i) Organic Foods Ltd (OFL) which is involved in the production and sale of organically grown fruit and vegetables. OFL has built up a very good reputation as a supplier of quality produce,

(ii) Haul-Trans Ltd (HTL) which was acquired on 1 December 2005 and is involved in transporting a range of products on behalf of third parties,

(iii) Kitchen Appliances Ltd (KAL) which is involved in the manufacture and sale of small, manually-operated kitchen appliances. KAL has recently suffered from squeezed margins as a consequence of competition from low cost imports.

(iv) Paper Supplies Ltd (PSL) which manufactures and sells a narrow range of stationery products to two distributors,

(v) Office Products Ltd (OPL) which manufactures and sells computer workstations with unique design features which are highly regarded by health and safety experts.

The management accountant of Diverse Holdings Pic has gathered the following actual and forecast information relating to the five subsidiaries: Year ending 30 November

2003 2004 2005 2006 2007 Actual Actual Actual Forecast Forecast

(OFL) Market size (Sm) 100.00 120.00 150.00 180.00 225.00 Turnover (SSm) 5.00 8.00 10.0 13.50 18.00 Operating Profit ($m) 1.00 1.80 2.50 3.00 3.60 (HTL) Market size (Sm) Unknown Unknown Unknown Unknown Unknown Turnover (Sm) 40.00 40.00 41.00 42.00 42.00 Operating Profit (Sm) 4.00 4.00 4.00 5.00 5.60 (KAL) Market size (Sm) 252.00 250.00 245.00 242.00 240.00 Turnover (Sm) 37.50 37.50 35.50 32.00 29.00 Operating Profit/(loss) Sm) 1.50 1.10 0.70 0.30 (0.20) (PSL) Market size (Sm) 60.00 65.00 70.00 77.00 84.00

€ C.TG Question Rank: 3

Turnover (Sm) 2.00 2.00 2.00 2.00 2.10 Operating Profit (Sm) 0.60 0.60 0.60 0.50 0.50 (OPL) Market size ($m) 200.00 220.00 240.00 260.00 280.00 Turnover ($m) 15.00 16.00 16.50 17.00 17.50 Operating Profit (Sm) 1.50 1.60 1.65 1.70 1.75

The management accountant has also collated the following information relating to the market share held at 30 November 2005 by the market leader in those markets in which each subsidiary operates:

Subsidiary Market Market share (%) held by market leader

Organic Foods Ltd Food Production 6.66 Haul-Trans Ltd Transport Unknown Kitchen Appliances Ltd Kitchen appliances 16 Paper Supplies Ltd Stationery 35 Office Products Ltd Workstations 25

The management has decided not to undertake any further acquisitions during the next two years due to a shortage of funds.

Required:

(a) Identify and comment on FOUR advantages that may be gained as a result of the adoption of a formal system of strategic planning.

(4 marks)

(b) Explain how the use of SWOT analysis may be of assistance to the management of Diverse Holdings Pic. (3 marks)

(c) (i) Using ONLY the above information, assess the competitive position of Diverse Holdings Pic.

(7 marks)

(ii) Explain THREE strategies that might be adopted in order to improve the future prospects of Diverse Holdings Pic.


(December 2005)

5. E x t e r n a l e n v i r o n m e n t

You are responsible for managing the preparation of all revenue and cost budgets for a motor component manufacturer. You are aware that the external environment has a significant impact on the business activity and financial performance of your company and that the current information systems are underdeveloped and ineffective in this respect.

Required:

(a) Identify which aspects of the external environment you are likely to consider and give reasons for your choice. (10 marks)

(b) Identify where you might find the relevant sources of information. (5 marks)

(c) Suggest how an external environment information system could be introduced into your company. (5 marks)

(20 marks) (December 2002)

4: Strategic Planning and Control © f.TG

QUESTION BANK OQ Z o p

EXTERNAL INFLUENCES ON ORGANISATIONAL B

o 111 (0 PERFORMANCE

6. Ethical issues and Mendelow's matr ix - Toywor ld pic

Toyworld Pic is a private company which has been manufacturing plastic toys for the last three years. Its factory is located in a city called Farland. It sells goods worldwide. In spite of having many competitors, the company has been making good profits since its first year of operation. Toyworld's strategy is to keep its costs at a minimum and compete on the basis of price.

Grace has recently been appointed as the CEO of Toyworld after retiring as the CEO of a very successful toy making company. In Toyworld, she has observed the following:

^ A substandard material is used in making the toys. This material may be dangerous to health if children put the toys in their mouths. However, the company has not given any warning on the packaging of the toys. Rather, Toyworld products are advertised as being safe and are claimed to improve children's memory and motor skills at a faster rate than the toys manufactured by other companies (which has not been scientifically proven).

> All the workers (including child labourers) are required to work for more than 100 hours a week which is far above the maximum working hours prescribed through legislation. Since unemployment is high in Farland. people staying there are prepared to work for lower wage rates. Toyworld is successful in keeping its costs at a minimum by employing people in Farland at minimum cost (without paying fair wages or bonuses).

> Every year Toyworld donates 525,000 to a political party whose leader is Robert. This is because Robert is also the chairman of Easy-money, a financing company, which provides finance to Toyworld at low interest rates.

Furthermore, the company has recently received adverse publicity through a local newspaper which reported that the emissions from the factory are polluting the environment of Farland. There is no emission treatment plant in Toyworld. In addition, the material used by Toyworld is bad for the environment. The newspaper has also highlighted, and published photographic evidence of, the poor hygiene conditions in Toyworld and the fact that female workers who have young children are allowed to bring their children inside the factory, which could be dangerous.

After becoming aware of all the above facts and reading the newspaper, Grace immediately called a board meeting and communicated her view that "our dream is for the company to grow by leaps and bounds and become a market leader. However, this can only be achieved by incurring some cost in the short term and therefore we should stamp out all unethical practices."

However, Tony, the finance director disagreed, stating that "we are running the business for profit. If we give up all these practices, our costs will increase and will directly affect our performance. In addition, although we are asking workers to work for more than the maximum working hours, this helps them to earn more money, without which they might not be able to provide for their families."

About 80% of the shares in Toyworld are held by the directors (excluding Grace) and the remaining 20% of the shares are held by people outside Toyworld. There is no substantial holding by any shareholder: rather many people each hold a few shares. As a result, the directors are in a dominant position when it comes to taking strategic decisions (the external shareholders are dormant).

ft: Economic, Fiscal and Environmental Factors € GTG

Required:

(i) Discuss the ethical issues with reference to the case given above and their impact on the performance of Toyworld (long-term as well as short-term).

(10 marks)

(ii) Using Mendelow's matrix, map the following stakeholders of Toyworld:

> employees > customers > directors of Toyworld > shareholders (other than directors) > the government


QUESTION B A N K

C 7. Cont ingency theory, BPR

(a) Explain the contingency theory of management accounting and expand on ways in which its components highlight and allow explanations of differences in management accounting control systems.

(10 marks)

(b) (i) Explain the term 'Business process re-engineering' and how its application might enable overall

business performance to be improved. (7 marks)

(ii) Briefly discuss potential problems which may be encountered in the implementation of a business re-engineenng programme.


(December 2004)

8. Behavioura l aspects in per fo rmance measurement - As t rodome spor ts L td

Astrodome Sports Ltd was formed in December 2000 by seven engineers who comprise the board of directors of the company. The seven engineers previously worked together for Telstar", a satellite navigation company. In conjunction with one of the three largest construction companies within their country they constructed the '365 Sports Complex' which has a roof that opens and uses revolutionary satellite technology to maintain grass surfaces within the complex. The complex facilities, which are available for use on each day of the year, include two tennis courts, a cricket pitch, an equestrian centre and six bowling greens. The tennis courts and cncket pitch are suitable for use as venues for national competitions. The equestrian centre offers horse-riding lessons to the general public and is also a suitable venue for show-jumping competitions. The equestrian centre and bowling greens have increased in popularity as a consequence of regular television coverage of equestrian and bowling events.

In spite of the high standard of the grass surfaces within the sports complex, the directors are concerned by reduced profit levels as a consequence of both falling revenues and increasing costs. The area in which the "365 Sports Complex' is located has high unemployment but is served by all public transport services. The directors of Astrodome Sports Ltd have different views about the course of action that should be taken to provide a strategy for the future improvement in the performance of the complex. Each director's view is based on his/her individual perception as to the interpretation of the information contained in the performance measurement system of the complex. These are as follows:

Director

(a) 'There is no pcwnt whatsoever in encouraging staff to focus on interaction with customers in efforts to create a 'user friendly' environment. What we need is to maintain the quality of our grass surfaces at all costs since that is the distinguishing feature of our business.'

(b) 'Buy more equipment which can be hired out to users of our facilities. This will improve our utilisation ratios which will lead to increased profits.'

(c) 'We should focus our attention on maximising the opening hours of our facilities. Everything else will take care of itself.'

8: Performance Measurement System and Design €> fiTfi

(d) 'Recent analysis of customer feedback forms indicates that most of our customers are satisfied with the facilities.ln fact, the only complaints are from three customers - the LCA University which uses the cricket pitch for matches, the National Youth Training Academy which held training sessions on the tennis courts, and a local bowling team.'

(e) 'We should reduce the buildings maintenance budget by 25% and spend the money on increased advertising of our facilities which will surely attract more customers.'

(f) 'We should hold back on our efforts to overcome the shortage of bowling equipment for hire. Recent rumours are that the National Bowling Association is likely to offer large financial grants next year to sports complexes who can show they have a demand for the sport but have deficiencies in availability of equipment.'

(g) 'Why change our performance management system? Our current areas of focus provide us with all the information we need to ensure that we remain a profitable and effective business.'

As management accountant of Astrodome Sports Ltd you have recently read an article which discussed the following performance measurement problems:

(i) Tunnel vision (ii) Sub-optimisation (iii) Misinterpretation (iv) Myopia (v) Measure fixation (vi) Misrepresentation (vii) Gaming (viii) Ossification

Required:

(a) Explain FOUR of the above-mentioned performance measurement problems (i-viii) and discuss which of the views of the directors (a-g) illustrate its application in each case.

(12 marks)

(b) Discuss the relevance of each of the following actions as steps in trying to remedy performance measurement problems relating to the '365 Sports Complex' and suggest examples of specific problem classifications that may be reduced or eliminated by each action:

(i) Focusing on and improving the measurement of customer satisfaction. (ii) Involving staff at all levels in the development and implementation of performance measures. (iii) Being flexible in the extent to which formal performance measures are relied on. (iv) Giving consideration to the auditing of the performance measurement system.


(December 2005)

9. Internal and external aspects of per formance measurement - Ochi lpark Pic

Ochilpark Pic has identified and defined a market in which it wishes to operate. This will provide a 'millennium' focus for an existing product range. Ochilpark Pic has identified a number of key competitors and intends to focus on close co-operation with its customers in providing products to meet their specific design and quality requirements. Efforts will be made to improve the effectiveness of all aspects of the cycle from product design to after sales service to customers. This will require inputs from a number of departments in the achievement of the specific goals of the 'millennium' product range. Efforts will be made to improve productivity in conjunction with increased flexibility of methods.

An analysis of financial and non-financial data relating to the 'millennium' proposal is shown in Schedule 3.1.

€ C.TG Question Bank :*)

Required:

(a) (i) Prepare a table (Sm) of the total costs for the 'millennium' proposal for each of years 2000, 2001 and 2002

(as shown in Schedule 3.1), detailing target costs, internal and external failure costs, appraisal costs and prevention costs. The following information should be used in the preparation of the analysis:

2000 2001 2002

Target costs - variable (as % of sales) 40% 40% 40% - fixed (total) S2m S2m S2.5m

Internal failure costs (% of total target cost) 20% 10% 5% External failure costs (% of total target cost) 25% 12% 5% Appraisal costs S0.5m S0.5m S0.5m Prevention costs S2m 51m S0.5m

(4 marks)

(ii) Explain the meaning of each of the cost classifications in (i) above and comment on their trend and inter-relationship. You should provide examples of each classification.

(8 marks)

(b) Prepare an analysis (both discursive and quantitative) of the 'millennium' proposal for the period 2000 to 2002. The analysis should use the information provided in the question, together with the data in Schedule 3.1. The analysis should contain the following:

(i) A definition of corporate 'vision or mission' and consideration of how the millennium proposal may be seen as identifying and illustrating a specific sub-set of this 'vision or mission'.

(5 marks)

(ii) Discussion and quantification of the proposal in both marketing and financial terms. (6 marks)

(iii) Discussion of the external effectiveness of the proposal in the context of ways in which I. Quality and 2. Delivery are expected to affect customer satisfaction and hence the marketing of the product.

(4 marks)

(iv) Discussion of the internal efficiency of the proposal in the context of ways in which the management of I. Cycle Time and 2. Waste are expected to affect productivity and hence the financial aspects of the proposal.

(4 marks)

(v) Discussion of the links between internal and external aspects of the expected trends in performance. (4 marks)


Schedule 3.1. 2000 2001 2002

Total market size (Sm) 120 125 130 Ochilpark Pic sales (Sm) 15 18 20 Ochilpark Pic - total costs (Sm) 14.1 12.72 12.55 Ochilpark Pic sundry statistics: Production achieving design quality standards (%) 95% 97% 98% Returns from customers as unsuitable (% of deliveries) 3.0% 1.5% 0.5% Cost of after sales service (Sm) 1.5 1.25 1 Sales meeting planned delivery dates (%) 90% 95% 99% Average cycle time (customer enquiry to delivery) (weeks) 6 5.5 5 Components scrapped in production (%) 7.5% 5.0% 2.5% Idle machine capacity (%) 10% 6% 2%

10: Performance Measurement System and Design &f«T(i

10. In format ion requi rement - Moffat Ltd

Moffat Ltd. which commenced trading on 1 December 2002, supplies and fits tyres and exhaust pipes and services motor vehicles at thirty locations. The directors and middle management are base-d at the Head Office of Moffat Ltd. Each location has a manager who is responsible for day-to-day operations and is supported by an administrative assistant. All other staff at each location are involved in fitting and servicing operations.

The directors of Moffat Ltd are currently preparing a financial evaluation of an investment of S2 million in a new IT system for submission to its bank. They are concerned that sub-optimal decisions are being made because the current system does not provide appropriate information throughout the organisation. They are also aware that not all of the benefits from the proposed investment will be quantitative in nature.

Required:

(a) Explain the characteristics of THREE types of information required to assist in deasion-making at different levels of management and on diffenng timescales within Moffat Ltd. providing TWO examples of information that would be appropriate to each level.

(10 marks)

(b) Identify and explain THREE approaches that the directors of Moffat Ltd might apply in assessing the QUALITATIVE benefits of the proposed investment in a new IT system.

(6 marks)

(c) Identify TWO QUALITATIVE benefits that might arise as a consequence of the investment in a new IT system and explain how you would attempt to assess them.

(4 marks) (20 marks) (Dec 2005)

11. Benchmark ing & in format ion sys tem - INA Ltd

INA Ltd manufactures and distributes generic paper-based products and currently has an annual turnover of $100 million.

At present, the management of INA Ltd are uncertain whether the purchasing department is maximising its potential in terms of purchasing efficiency and effectiveness. The management are currently considering the introduction of a system of benchmarking to measure the performance of the purchasing department.

Required:

(a) Explain the term benchmarking' and briefly discuss the potential benefits that can be obtained as a result of undertaking a successful programme of benchmarking.

(6 marks)

(b) Descnbe how a system of benchmarking could be introduced to measure the performance of the purchasing department.

(8 marks)

(c) Discuss the problems that the management of INA Ltd might encounter in implementing a system of benchmarking and recommend how such problems should be successfully addressed.


QUESTION B A N K

Q Z o STRATEGIC PERFORMANCE n P AND MEASUREMENT o UJ CO

12. Miss ion Statement

(a) Explain the role and content of a Mission Statement. (5 marks)

(b) Explain how a Mission Statement could contnbute towards the planning and performance measurement process.

(9 marks)

(c) Identify the potential problems arising from using a Mission Statement to manage performance. (6 marks)


13. Usage of s tandards in dec is ion-mak ing

(a) Discuss ways in which standards may be seen as useful aids in management accounting decision-making. (6 marks)

(b) Suggest ways in which the use of standards may be seen as having a dysfunctional effect in relation to decision making about each of materials, labour and overhead cost.


(June 2001)

14. Per formance analys is - Sunf lower Hospi ta l

Sunflower Hospital is partially government-funded. It specialises in the provision of orthopaedic surgery and physiotherapy treatments. It is well-known for providing high quality services to all of its patients, who include both private fee-paying patients and government funded patients.

Some statistics regarding Sunflower Hospital for the year ended 30 June 2007 are as follows:

1. Budgeted operations

Orthopaedic surgery (25% of which are major surgeries) Physiotherapy treatments

60% 40%

2. Fees payable by each patient who received treatment from the hospital (40% of the fees are funded by the government on behalf of patients)

Fees payable by government Fees payable by private patients Type of service

Orthopaedic minor surgery Orthopaedic major surgery Physiotherapy treatments

Amount S 1,000 2,200 3.500

Amount $ 1,600 3,000 4,500

12:

3.

20: Strategic Performance and Measurement

Total yearly costs according to budget for Sunflower Hospital

€> fiTG

Costs Amount $'000 Fixed costs Variable costs Surgical costs 40,000 80% 20% Nursing costs 10,000 65% 35% Depreciation on equipment & operation accessories 2,500 100% -

Administration costs 5,000 100% -

Miscellaneous costs 6,000 50% 50%

Total yearly costs according to actual results for Sunflower Hospital

Costs Amount S'000 Fixed costs Variable costs Surgical costs 42,000 32,000 10,000 Nursing costs 10,500 6.500 4.000 Depreciation on equipment & operation accessones 2,500 2.500 -

Administration costs 5,800 5,800 -

Miscellaneous costs 6.300 3,500 2.800

5. Sunflower Hospital did not receive any grant, donation or loan during the year.

6. Variable budgeted surgical costs include a total amount of S1,250,000 related to emergency operations undertaken.

7. Variable actual surgical costs of emergency operations undertaken were $1,300,000.

8. The proportion of emergency operations as a percentage of total operations was according to budget.

9. Other statistics relating to Sunflower Hospital

Capacity utilisation (%) 90% Patient mix for each type of operation and treatments: Privately-funded patients 30% Government funded patients 70% Operation mix: Orthopaedic surgery (40% of which are major surgeries) 55% Physiotherapy treatments 45%

Additional:

Moonlight Hospital is privately owned and also specialises in the provision of orthopaedic surgery and physiotherapy treatments. (Assume that it does not carry out emergency operations). Summary of income statement of Moonlight Hospital:

Amount $'000

Fees earned 45,000 Less: Costs Surgery 12,000 Nursing 18.000 Depreciation 4.000 Interest on loan 600 Management 5,000 Sundry 1,000 Net profit 4.400

Each hospital comprises 20 wards, each of which can accommodate 6 patients. The average patient stay in both hospitals was 2 days. Each hospital is open for 365 days per annum.

€ C.TG Question Bank :I3

Required:

(a) Prepare a statement which shows comparative analysis of actual and budgeted results for Sunflower Hospital for the year ended 30 June 2007.

(14 marks)

(b) State four performance measures to assess the quality of surgical treatments provided by a hospital, indicating how each measure may be assessed.

(6 marks)

(c) Give your suggestions to Sunflower Hospital regarding the ethical issues which may arise as a result of considering patient mix as a key determinant of profitability.

(3 marks)

(d) Is it appropriate to make a direct companson of the financial performance of Sunflower Hospital and Moonlight Hospital? Explain four reasons for your view.

(6 marks)

(e) Using only information contained in the question, make three adjustments to the income statements you have prepared in your solution to (a) that you consider would assist in the development of a more appropriate comparison of the financial performance of both hospitals.


(Adapted from Pilot Paper) 15. Evaluat ion of s t rategies

A motor car manufacturer has been specialising in the production and sale of one model of car. The model is somewhat dated, and the current sales forecast indicates that the sales will decline from the current level (2003) of 170,000 cars per annum to 150,000 in 2004, 130.000 in 2005 and 110,000 in 2006. The company supplies to order and no stocks are held. Carbon monoxide emission regulations will prevent the model being manufactured and sold after December 2006. The compan/s current estimates of the selling price and costs in 2004 are as follows:

Per car $ Selling Price 9,500 Production costs: Material and labour (vary with production volume) 3.600 Assembly* 4,000

*75% of the assembly costs are fixed and the remainder vary with production volume. In addition, the company estimates that it will incur the following non-production costs: Marketing costs of $60 million. 50% of these vary with sales volume. Delivery costs of $75 million. 20% of these vary with sales volume. The Administration costs of S10 million are fixed. The selling price, variable costs per car and total fixed costs are expected to remain constant throughout the period from 2004 to 2006.

The compan/s Managing Director is unhappy with the current annual profit forecasts for 2004-2006 based upon the information above and believes that the company has the potential to increase the profit to $280m in each of the years 2004 to 2006. The Managing Director has undertaken a strategic review and developed the following strategies:

Strategy 1

A marketing proposal will enable the company to enter a new overseas market with the result that the total (including the overseas market) sales level will be stabilised at 160,000 cars per annum from 2004 to 2006. The market entry costs will be S30 million for each of the three years.

Strategy 2

A re-design of the car will enhance its sales appeal and will permit the company to increase its selling price to $10,000. The re-design costs are $30 million and are to be amortised over three years on a straight line basis.

14: Strategic Performance and Measurement €> fiTG

Strategy 3

A radical cost reduction programme will improve efficiency and lower all variable costs by 20%. This will add $70 million to the annual fixed overheads each year from 2004 to 2006.

Required:

(a) Prepare a financial analysis showing the current annual forecast of costs, revenues and profits for each of the years 2004 to 2006 and briefly comment on the figures. Ignore inflation.

(6 marks)

(b) Estimate the profit in 2004 if:

(i) Strategy 1 was implemented; (2 marks)

(ii) Strategy 2 was implemented; (2 marks)

(iii) Strategy 3 was implemented. (2 marks)

(c) Estimate the profit in 2004 if all three strategies were implemented. (4 marks)

(d) Explain why the total of the increase in profit arising from the three strategies implemented separately in (b) is different from the total profit calculated in (c). Illustrate your answer with a numerical reconciliation of the differences in the two profit figures.

(5 marks)

(e) Explain how "Gap Analysis' can be used to assist a company to plan the achievement of its strategic profit objective. Illustrate your answer with a diagram which quantifies the effect of your calculations in (a), (b), (c) and(d)above.

(7 marks)

(') (i) Explain how sensitivity analysis could be used in conjunction with the profit estimates that you have

made for the company and illustrate your answer with reference to each of the strategies;

(ii) Calculate and comment on the percentage change in the key variable in each of strategies 1, 2 and 3 from its original forecast level in order that the desired profit level of £280m for 2004 will be achieved in each case

(8 marks)

(g) What major external environmental factors need to be considered in assessing the success of the three strategies?


(June 2003)

16. Strategic per fo rmance measurement - B ig Bucks Bank Pic

Big Bucks Bank Pic (the Bank) is a clearing bank in the UK. It has 2,000 retail branches. It classifies its business into retail and corporate banking. Each type of business currently accounts for more or less half of the Bank's turnover.

Big Bucks Bank Pic's retail banking business provides banking facilities for retail customers and small businesses to which it does not lend in excess of $2,000,000 in any one year. On the other hand, the Bank defines 'corporate business' as "....where lending (both domestic and international) would exceed $2,000,000 in any one year."

Corporate lending is traditionally the most profitable business for the Bank, contributing 70% of the profit before taxation. Corporate lending operations comprise eight regional offices and a department at the head office in London. The London office is also responsible for international lending. There are 250 staff employed in corporate lending.

€ C.TG Question Bank :I5

On the other hand, the retail and small business customer strength ranges from 1,000 to 15,000 per branch, mean customer numbers being 7,500.

The Bank has the following mission statement for its retail banking: "To deliver a high-quality service to customers based on our managers' personal knowledge of customers' affairs."

The policy of the Bank is to cross-subsidise its retail banking operations (since this is a less profitable venture than corporate banking) in the hope that some retail customers will become corporate ones. The Bank has assigned its branch managers the responsibility of assisting in this process because of their financing expertise and deep knowledge of their customers.

Each branch of the Bank operates as a cost centre. The managers of each branch need to record and compare committed expenditure and budgeted expenditure on a quarterly basis. The Bank does not follow an accrual accounting system as regards branch expenditures for these quarterly reports. However, year-end adjustments reconcile committed, actual and budgeted expenditures. These accounting activities are performed by management accounting staff based at head office.

The managers' remit is to operate within their expenditure budgets. Moreover, they are set targets (e.g. number of new accounts opened, amount of holiday insurance sold, level of bad debts). The managers are not consulted about the size of their budgets or their targets. These are imposed by head office.

Proposals for change

The Bank is reviewing its corporate attitude. Its corporate lending business has shown a dedining trend in profitability as a result of problems with international debt and movements in foreign exchange rates. The Bank has also become concerned about the attitudes which it believes have become dominant in its retail banking business. Most of its managers have found their targets relatively easy to achieve. They have been criticised for a lack of entrepreneurial awareness and for not taking sufficient account of environmental forces. The managers have defended their behaviour by arguing that, as soon as a retail customer becomes a corporate customer, they lose their business. Therefore there is no incentive for them to convert retail customers into corporate customers. Due to these factors, the Bank has decided upon the following changes:

Retail banking must, in future, contribute 50% of the Bank's profit before taxation.

^ A programme of branch rationalisation will be entered into in which half the branches will close.

> A new type of branch, referred to as "superbranches", will be introduced. These will be at the centre of a network of 4 to 6 existing branches. The superbranch manager will make all major decisions for the network of branches. He will be assisted in this by two assistant managers who will probably be drawn from the existing managers in the network.

> Each superbranch will be designated an investment centre and must earn a return of 15%. No target has been set for residual income, although the Bank intends to set such targets after it has gained some experience of the superbranches' operations.

r An expenditure budget has been allotted to each superbranch. The budgets are set based on the cumulative total spent by the superbranch's network branches in the previous year. No extra funds have been allocated for the establishment of the superbranches. The manager of the superbranch has the power to decide where the superbranch will be located. This could be inside an existing branch or in new premises.

> The manager of the superbranch will be responsible for the design and operation of all of the network's information systems. They will be accountable to the head office. The head office will continue to draw up the statutory accounts.

^ The manager of the superbranch will be responsible for deciding the number of employees working in the network. If there are to be any redundancies, head office will negotiate nationally to determine the terms for redundant staff. The superbranch will need to bear the costs, if any, of redundancies in its network.

The CMD of the Bank has described the new philosophy for retail banking thus: "We are operating in a very competitive environment. In order to survive, we must change. We must never forget that earning profit is our ultimate objective. Retail banking has been subsidised for a long time and as a result, has become inefficient. Our proposed steps will enable us to deliver an efficient, low-cost service. However, I arn afraid the days of the bank manager being a personal friend and adviser are over"


Required:

(a) Explain the implications of the new philosophy for retail banking for the staff, customers and shareholders of the Bank. You should contrast the new philosophy with the mission statement of the organisation.

(12 marks)

(b) Discuss the advantages and disadvantages of the proposal to make superb ranches investment centres.

(8 marks)

(c) (i) Describe the reports you believe will be necessary for the manager of a superbranch to manage

successfully. Your answer should include the reasons for your suggestions. (12 marks)

(ii) Suggest, and fully justify, THREE qualitative performance indicators you consider would be of assistance to a superbranch manager.


17. Measures of per formance

A large conglomerate with diverse business activities is currently considering whether it should commence a project and has gathered the following data:

Project data

An initial investment of S60 million will be required on 1 January, year 1. The project has a three-year life with a nil residual value. Depreciation is calculated on a straight line basis.

The project is expected to generate annual revenue flows of S90m in year 1. S100m in year 2 and S110m in year 3. These values may vary by ±5%.

The incremental costs will be $60m in year 1, $70m in year 2 and $80m in year 3. These may also vary by ±5%.

The most likely cost of capital is 12%.This may vary from 10% to 14% for the life of the project.

Additional information:

Assume that all cash flows other than the initial investment take place at the end of each year.

Use the written down value of the asset at the start of each year to represent the value of the asset for the year.

Note: Ignore taxation

Required: (a) Prepare two tables showing net profit, residual income and return on investment for each year of the project

and also net present value (NPV) for: (i) the best outcome; (ii)the worst outcome.

(8 marks)

(b) Explain the distinctive features of residual income, return on investment and net present value in measuring financial performance. Your answer should include a critique of the strengths and weaknesses of each measure.

(8 marks)

(c) What broader issues are likely to be considered when deciding whether the company should proceed with a particular project?



€ C.TG Qupsilon Bank :l<)

18. Per formance analys is - Tal iesin Ltd

Taliesin Ltd manufactures a range of ice-cream based confectionery products, which it sells to national supermarket chains which market the products under their own brand labels. The board of directors is committed to a policy of achieving growth. However because the company is a relatively small player within the industry the board of directors is focused solely upon internal development as opposed to growth by acquisition and has further agreed that it wishes to confine operations to the home market. Summary financial statements for the year ended 31 May 2005 together with prior year comparative figures are as follows:

Profit and Loss Account 2005 2004 $'000 $'000

Sales (note 1) 48,000 40,000 Cost of sales (note 2) 28,800 24.000

Gross Profit 19,200 16.000 Operating expenses 10,200 8.000 Interest 1,000 0 Depreciation 4,000 4,000

Net Profit 4.000 4.000

Balance Sheet

Fixed Assets (net book value) Net Current Assets

2005 $'000 42,000 24.000

2004 $'000 40,000 12,000

Total Assets less Current Liabilities Loan Finance

66,000 10.000

52,000

Net Assets 56,000 52,000

Capital Employed: Ordinary Share Capital (£1 each) Retained Earnings

30,000 26.000

30,000 22,000

Capital Employed 56.000 52.000

Other information relating to Taliesin Ltd is as follows:

(1) Sales information in respect of the years ended 31 May 2005 and 2004 is as follows:

2005 2004 Sales revenue $•000 $'000 1 June-30 November 33,300 26,000 1 December-31 May 14,700 14,000

(2) Cost of sales information:

2005 2004 $'000 $000

Materials 9.360 7.800 Labour 4.620 4.200 Manufacturing overheads 14.820 12.000 Cost of sales 28.800 24.000

18: Strategic Performance and Measurement

(3) Other Information:

€> fiTG

2005 2004 Number of employees: Permanent 204 200 Temporary 288 240 Number of customers 5 6 Number of new 6 5

(i) Temporary employees are hired on a full-time basis between 1 June and 30 November in each year. They were paid at the same rate as permanent employees.

(ii) Six new product lines were launched during the year ended 31 May 2005. The manufacture of each new product line required an investment in capital equipment of $1 million.

Required:

(a) Using the above information, appraise the performance of Taliesin Ltd during the year ended 31 May 2005 and evaluate the extent to which the objective of growth has been achieved.

(11 marks)

(b) Explain the major benefits of pursuing a policy of internal development. (4 marks)

(c) Explain how the use of activity-based techniques may benefit Taliesin Ltd. (5 marks)

(20 marks) (June 2005)

19. Strategic per formance measurement - Pack and Dispatch Co

Pack and Dispatch Co (PADC) is a well-known company in food products packaging. The management of PADC is currently considering whether to enter the fast food market. On average, fast food packs make up between 3% and 5% of the total cost of the purchaser's finished product.

The following information has been gathered by senior management:

(1) The machines used to manufacture fast food packs would differ on the basis of size as well as efficiency. The lowest cost machine is priced at S70.000 and requires only one operator. A one-day training course is required in order that an unskilled person can then operate such a machine in an efficient and effective manner.

(2) Fast food packs are made from high quality plastic which has been in short supply during recent years.

(3) The cardboard packs are made from specially formulated paper which, during recent years, has occasionally been in short supply.

(4) Currently, the six major manufacturers of fast food packs have an aggregate market share of about 75%. Among them, the current market leader has a 25% market share. The remaining five major manufacturers' market shares are equal in size. The product ranges offered by them are similar in terms of quality, size and price. In recent years, the market has grown by 2.8% per annum (approx.)

(5) There is an assumption in the present market that a foreign-based multinational company will expand its operations by opening a packaging division overseas. The company possesses large-scale automated machinery for manufacturing fast food packs of various sizes.

(6) Another company. Soft Packaging, produces cardboard packs for regular household products. Soft Packaging is increasing its goodwill in the market more quickly than any other company. However, Soft Packaging's prices are comparatively expensive. In fact, its prices are 25% higher than equivalent sized plastic packs available in the market.


Required:

(a) Using Porter's five forces model, assess the attractiveness of the option to enter the market for fast food packs as a performance improvement strategy for PADC.

(10 marks)

A rival company was the market leader with a share of 29% three years ago. The managing director of that company stated at a recent meeting of the board of directors that: "our loss of market share during the last three years might lead to the end of this organisation and therefore we must address this issue immediately".

Required:

(b) Discuss the statement of the managing director of the nval company and discuss six performance indicators, other than decreasing market share, which might indicate that the rival company will fail as a corporate entity.


(Adapted from Dec 2007)

20. Measures of per fo rmance - Tannadens Div is ion

Tannadens Division is considering an investment in a quality improvement programme for a specific product group which has an estimated life of four years. It is estimated that the quality improvement programme will increase saleable output capacity and provide an improved level of customer demand due to the enhanced reliability of the product group. Forecast information about the programme in order that it may be evaluated at each of best, most likely and worst scenario levels are as follows:

(i) There will be an initial investment of S4.000.000 on 1 January, year 1, with a programme life of four years and nil residual value. Depreciation will be calculated on a straight line basis.

(ii) Additional costs of staff training, consultancy fees and the salary of the programme manager are estimated at a most likely level of $100,000 per annum for each year of the proposal. This may vary by it 2.5%. This is the only relevant fixed cost of the proposal.

(iii) The most likely additional output capacity which will be sold is 1,000 standard hours in year I with further increases in years 2, 3 and 4 of 300. 400 and 300 standard hours respectively. These values may vary by

5%.

(iv) The most likely contribution per standard hour of extra capacity is S1,200. This may vary by 10%.

(v) The most likely cost of capital is 10%. This may vary from 8% to 12%.

Assume that cash flows other than the initial investment take place at the end of each year. Ignore taxation.

Required: (a) Present a table (including details of relevant workings) showing the net profit, residual income and return on

investment for each of years 1 to 4 and also the net present value (NPV) for the BEST OUTCOME situation of the programme.

(10 marks)

Using the information provided above, the net profit, residual income (Rl), and return on investment (ROI) for each year of the programme have been calculated for the most likely outcome and the worst outcome as follows:

Most likely outcome: Year 1 Year 2 Year 3 Year 4 Net profit (S) 100,000 460,000 940,000 1,300,000 Residual income ($) 300.000 160.000 740.000 1,200,000 Return on investment 2.5% 15.3% 47.0% 130.0% Worst outcome: Year 1 Year 2 Year 3 Year 4 Net profit (S) (-76.500) 231.300 641,700 949,500 Residual income (S) (-556.500) (-128,700) 401.700 629,500 Return on investment (-1.9%) 7.7% 32.10% 95.0%


In addition, the net present value (NPV) of the programme has been calculated as most likely outcome: $1,233,700 and worst outcome: $214,804. It has been decided that the programme manager will be paid a bonus in addition to the annual salary of $40,000 (assume that this salary applies to the best, most likely and worst scenarios).The bonus will be paid on ONE of the following bases:

(A) Calculated and paid each year at 1.5% of any profit in excess of $250,000 for the year.

(B) Calculated and paid each year at 5% of annual salary for each $100,000 of residual income in excess of $250,000.

(C) Calculated and paid at 15% of annual salary in each year in which a positive ROI (%) is reported.

(D) Calculated and paid at the end of year 4 as 2.5% of the NPV of the programme.

Required:

(b) Prepare a table showing the bonus to be paid in each of years 1 to 4 and in total for each of methods (A) to (D) above, where the MOST LIKELY outcome situation applies.

(9 marks) (c) Discuss which of the bonus methods is likely to be favoured by the programme manager at Tannadens

Division. You should refer to your calculations in (b) above as appropriate. You should also consider the total bonus figures for the best outcome and worst outcome situations which are as follow:

Total Bonus Best Worst

outcome outcome $ $

Net profit basis 43,890 16.368 Residual income basis 48,150 14,624 ROI basis 24,000 18,000 NPV basis 60,323 5,370

(11 marks) (d) The achievement of the quality improvement programme will be influenced by the programme manager's:

(i) level of effort (ii) attitude to risk and

(iii)personal expectations from the programme'.

Discuss this statement. (5 marks)


21. Div is ional per formance - Galaxy pic and Mi lky-way g roup

Galaxy Pic is considering measurement of divisional management performance and divisional economic performance. It considers the following performance measures for evaluation:

(i) Contribution margin = Sales - Variable costs (ii) Controllable profit = Contribution margin - Controllable fixed costs (iii) Divisional profit = Controllable profit - Non-controllable avoidable costs

Required:

(a) Discuss the relevance of all the measures mentioned above. (9 marks)

Note: The following can be considered in the discussion of the measures:

r internal transfers to the other divisions of Galaxy Group > costs fixed in short term such as labour costs > depreciation on non-current assets

finance costs not directly related to the division

€ C.TG Question Bank :21

Sun and Moon are the different divisions of Galaxy Group. The managers of Sun and Moon are considering two different projects, S and M. The following information is related to the projects:

Project S Project M Average annual profit (before interest & tax) 550,000 S35.000 Average investment (assets employed) $300,000 $300,000

Profit given is calculated after considering the depreciation on assets employed.

The cost of capital to Galaxy is 15%. The current ROI of Sun division is 20% and of Moon division is 11%.

(b) Evaluate the projects considering the ROI and comment on the decisions the divisional managers are likely to take regarding the projects and the impact of these decisions on the overall performance of the organisation.

(8 marks) Note: Remember. Galaxy Pic gives bonuses to the divisional managers based on the year's divisional performance.

The following information is related to Milky-way Group (another group):

20X6 20X7 Sm Sm

Sales 492 557 Profit before interest and tax 112.5 137.5 Interest 7.5 7.5 Profit before tax 105.0 130.0 Income tax 31.5 39.0 Profit after tax 73.5 91.0 Dividend 30.0 35.0 Retained earnings 43.5 56.0

20X6 20X7 Sm Sm

Non-current assets 190 171 Current assets 205 289

395 460 Equity 300 350 Long-term debt 95 110

395 460

Additional information

^ Capital employed at the beginning of 20X6 was S311 m. r- Milky-way amortises $5m every year including 20X6 and 20X7. Accumulated amortised goodwill (during the

years prior to 20X6) amounted to S60m. > Cost of equity for the year 20X6 is 15% and for 20X7 is 17%. > Cost of debt (before tax) is 10%. > Target capital structure is 60% debt and 40% equity. > Tax rate is estimated as 30%. > Accounting and economic depreciation are the same. ^ Other non-cash expenses amounted to S14m in 20X6 and $15 in 20X7.

(c) Measure the performance of Milky-way Group for the years 20X6 and 20X7 using EVA as a measure.


(Adapted from December 2007)


22. D iv i s iona l pe r f o rmance - N A W g r o u p

The NAW Group manufactures healthcare products which it markets both under its own brand and in unbranded packs. The group has adopted a divisional structure. Division O. which is based in a country called Homeland, manufactures three pharmaceutical products for sale in the domestic market. Budgeted information in respect of

Division O for the year ending 31 May 2005 is as follows:

Product 'Painfree' 'Digestisalve' 'Awaysafe' Sales packs (000's) NAW Brand 5.000 5,000 15,000

Unbranded 15,000 20,000 -

Selling price per pack ($) NAW Brand 2-40 4-80 8 0 0 Unbranded 1-20 3-60 -

Cost of sales information

Variable manufacturing costs per pack

Material and conversion cost

Packaging cost

Variable manufacturing costs per pack

$ $ Painfree' NAW Brand 0-85 0-15 Unbranded 0-85 0 0 5 'Digestisalve' NAW Brand 1 85 0-25 Unbranded 1 85 0-15 'Awaysafe' NAW Brand 2-80 0-40

Other relevant information is as follows:

1. Each of the three products is only sold in tablet form in a single pack-size which contains 12 tablets. During the year to 31 May 2005 it is estimated that a maximum of 780 million tablets could be manufactured. All three products are manufactured by the same process therefore management have the flexibility to alter the product mix. Management expect that sales volume will increase by 10% in the year ending 31 May 2006.

2. Advertising expenditure has been committed to under a fixed term contract with a leading consultancy and is therefore regarded as a fixed cost by management. Advertising expenditure in respect of the turnover of branded products in the year ending 31 May 2005 is apportioned as follows

Product Advert ising expenditure as a %

of turnover Painfree 5% Digestisalve 10% Awaysafe 12%

3. The average capital employed in the year to 31 May 2005 is estimated to be $120 million. The company's cost of capital is 10%.

4. The management of the NAW Group use both Return on Investment (ROI) and Residual Income (Rl) to assess divisional performance.

5. Budgeted fixed overheads (excluding advertising) for Division O during the year ended 31 May 2005 amount to S81.558.000.

6. There is no planned change in manufacturing capacity between the years ended 31 May 2005 and 31 May 2006.

7. Ignore taxation for all calculations other than those in part (c).


Required:

(a) (i) Prepare a statement of budgeted profit in respect of Division O for the year ending 31 May 2005. Your

answer should show the annual budgeted contribution of each branded and unbranded product. Calculate BOTH the residual income (Rl) and Return on Investment (ROI) for Division O.

(7 marks)

(ii) Name and comment on THREE factors, other than profit maximisation, that the management of the NAW Group ought to consider when deciding upon the product mix strategy for »he year ending 31 May 2006.

(3 marks)

(iii) Suggest THREE reasons why the management of the NAW Group may have chosen to use Residual Income (Rl) in addition to Return on Investment (ROI) in order to assess divisional performance.

(3 marks)

Division L of the NAW Group is based in Farland. The management of Division L purchases products from vanous sources, including other divisions of the group, for subsequent resale. The manager of Division L has requested two alternative quotations from Division O in respect of the year ended 31 May 2005:

1. Quotation 1 - Purchasing five million packs of 'Awaysafe'. 2. Quotation 2 - Purchasing nine million packs of 'Awaysafe'.

The management of the NAW Group has made a decision that a minimum of 15 million packs of 'Awaysafe' must be reserved for Homeland customers in order to ensure that customer demand can be satisfied and the producfs competitive position is further established in the Homeland market.

The management of the NAW Group is willing, if necessary, to reduce the budgeted sales quantities of other products in order to satisfy the requirements of Division L. They wish, however, to minimise the loss of contribution to the group.

The management of Division L is aware of the availability of another product that competes with 'Awaysafe' which could be purchased at a local currency price that is equivalent to £5-50 per pack. The NAW Group's policy is that all divisions are allowed the autonomy to set transfer prices and purchase from whatever sources they choose. The management of Division O intend to use market price less 30% as the basis for each of the quotations.

Required:

(b) (i) From the viewpoint of the NAW Group, comment on the appropriateness of the decision by the

management of Division O to use an adjusted market price as a basis for the preparation of Quotations 1 and 2, and the implications of the likely decision by the management of Division L.

(3 marks)

(ii) Recommend the prices that should be quoted by Division O for 'Awaysafe'. in respect of Quotations 1 and 2, which will ensure that the profitability of the NAW Group as a whole is not adversely affected by the decision of the management of Division L.

(3 marks)

(iii) Discuss the proposition that transfer pnces should be based on opportunity costs. (4 marks)

(c) (i) After much internal discussion concerning Quotation 2 by the management of the NAW Group. Division

O is not prepared to supply nine million packs of 'Awaysafe' to Division L at a price lower than market price less 30%. All profits earned in Farland are subject to taxation at a rate of 20%. Division O pays tax in Homeland at a rate of 40% on all profits.

Advise the management of the NAW Group whether the management of Division L should be directed to purchase 'Awaysafe' from Division O, or purchase a similar product from a local supplier. Supporting calculations should be provided.

(6 marks)


(ii) Identify and comment on the major issues that can arise with regard to transfer pricing in a multinational organisation.

(5 marks)

(d) Evaluate the extent to which the management of the NAW Group could make use of the product life cycle model in the determination of its product pricing strategy.


(June 2004)

23. Product vs. Cus tomer prof i tabi l i ty - NAW Group

Candidates are advised that information contained in Question 24 is also relevant to this question.

The management of the NAW Group has divided the customers of Division O into four customer groups: large pharmaceutical stores, independent specialist pharmacies, supermarkets and other retail outlets (such as petrol stations, newsagents, etc). The management accountant of the NAW Group has reviewed internal records relating to customer ordering, shipping and distribution patterns and also extracted information from the budget file for the year ended 31 May 2005.

Budgeted sales statistics (% of sales volume)

Customer group Large

Pharmaceutical stores

Independent Specialist

pharmacies Supermarkets

Other retail

outlets

Product 'Painfree' NAW Brand 60 20 10 10 Unbranded 30 - 70 -

'Digestisalve' NAW Brand 40 30 20 10 Unbranded 30 • 70 -

'Awaysafe' NAW Brand 40 30 20 10

Other budgeted statistics

Customer group Large Pharmaceutical

stores

Independent Specialist

pharmacies

Supermarkets Other retail

outlets No. of delivenes 400 2,400 800 3,000

No. of purchase orders 100 300 100 1,000 Promotion and exhibition events 4 - - -

Average kilometres per delivery No. of times delivery requirements were changed

300 30

150 400 10

150

The following information is available:

(1) The review of internal records undertaken by the management accountant has revealed new information. It has been established that S33.558.000 of the total of $81,558,000 costs which were categorised as fixed overheads in Question 1, do in fact vary with activities.

Note: Candidates need only consider this new information with regard to their answers to Question 2.

(2) The budgeted overheads of £33,558,000 for the year ending 31 May 2005 may be charged to the four customer groups using the following costs per unit of activity:


Activity Cost Delivery $6-40 per kilometre Changed delivery requirements $20000 per change Order processing $2000 per order Promotion and exhibition $27,500 per event

(3) NAW Group pays a retrospective rebate based on annual sales revenue to each customer group as follows:

% rebate Customer groups based on

sales value Large pharmaceutical stores 10 Independent specialist pharmacies 5 Supermarkets 15 Other retail outlets

Required:

(a) Prepare a statement of budgeted customer profitability for the year ending 31 May 2005 which shows the profit before fixed overheads for each of the four customer groups. Your answer should be based on the original budgeted sales volumes i.e. excluding Quotations 1 and 2.

(9 marks) (b)

(i) Discuss the proposition that 'customer profitability is as critical as product profitability.' (5 marks)

(ii) Discuss the initiatives that managers should consider in order to improve customer profitability. (6 marks)


24. Transfer pr ic ing - Able and Baker

(a) The transfer pricing system operated by a divisional company has the potential to make a significant contribution towards the achievement of corporate financial objectives.

Required:

Explain the potential benefits of operating a transfer pricing system within a divisionalised company. (6 marks)

(b) A company operates two divisions, Able and Baker. Able manufactures two products X and Y. Product X is sold to external customers for S42 per unit. The only outlet for product Y is Baker.

Baker supplies an external market and can obtain its semi finished supplies (product Y) from either Able or an external source. Baker currently has the opportunity to purchase product Y from an external supplier for $38 per unit. The capacity of division Able is measured in units of output, irrespective of whether product X. Y or a combination of both are being manufactured. The associated product costs are as follows:

X Y

Variable costs per unit 32 35

Fixed overheads per unit 5 5 Total unit costs 37 40


Required:

Using the above information, provide advice on the determination of an appropriate transfer price for the sale of product Y from division Able to division Baker under the following conditions:

(i) when division Able has spare capacity and limited external demand for product X: (3 marks)

(ii) when division Able is operating at full capacity with unsatisfied external demand for product X. (4 marks)

(c) The design of an information system to support transfer pncing decision making necessitates the inclusion of specific data.

Identify the data that needs to be collected and how you would expect it to be used. (7 marks)

(20 marks) (December 2001, Pilot paper)

25. Transfer pr ic ing - A lpha and Beta d iv is ion

(a) Alpha division has an external market for product A which fully utilises its production capacity.

(i) Explain the principle which would suggest that Alpha division should transfer product A to Beta division of

(ii) Explain the circumstances in which Alpha division may offer to transfer product A to Beta division at less than the external market price and yet report the same total profit.

(4 marks)

(b) The transfer pricing method to be used for an intermediate product between two divisions in a group is under debate.

The supplying division wishes to use actual cost plus a 25% profit mark-up. The receiving division suggests the use of standard cost plus a 25% profit mark-up. A suggested compromise is to use revised standard cost plus 25% profit mark-up.

The revised standard cost is arrived at after taking into account the appropriate elements of a planning and operational variance analysis at the supplying division.

Discuss the impact of EACH of the above transfer pncing methods and their acceptability to the supplying and receiving divisions.

(6 marks) (Dec 1999)

26. Not- for-prof i t o rgan isat ion - AV & BW

AV is a charitable organisation, the primary objective of which is to meet the accommodation needs of persons within its locality. BW is a profit-seeking organisation which provides rented accommodation to the public.

Income and Expenditure accounts for the year ended 31 May 2004 were as follows:

AV BW $ $

Rents received 2.386,852 2,500,000 Less: Staff and management costs 450.000 620.000 Major repairs and planned maintenance 682.400 202.200 Day-to-day repairs 478,320 127,600 Sundry operating costs 305.500 235,000 Net interest payable and other similar charges 526,222 750.000

Total costs 2.442,442 1,934,800 Operating (deficit) / surplus (55,590) 565,200

€>GTG Quesilon Bank :27

Operating information in respect of the year ended 31 May 2004 was as follows:

(1) Property and rental information:

Size of Property

Number of

Properties AV

Rent payable

per week S

Number of

Properties BV

1 bedroom 80 40 40 2 bedrooms 160 45 80 3 bedrooms 500 50 280 4 bedrooms 160 70 nil

AV had certain properties that were unoccupied during part of the year. The rents lost as a consequence of unoccupied properties amounted to S36.348. BW did not have any unoccupied properties at any time during the year.

(2) Staff salaries were paid as follows:

AV BW Number of Salary per Number of Salary per

staff staff member staff staff member ($) per annum (S) per annum

2 35.000 3 50,000 2 25,000 2 35,000 3 20,000 20 20,000

18 15,000 - -

(3) Planned maintenance and major repairs undertaken:

Nature of work AV BV Number of Cost per Number of Cost per properties property properties property

$ $ Miscellaneous construction work 20 1,250 - -

Fitted kitchen replacements (all are the same size) 90 2,610 10 5.220

Heating upgrades/replacements Replacement sets of windows and doors for

15 1,500 - -

3-bedroomed properties 100 4,000 25 6,000

(4) Day-to-day repairs information:

Classification of repair

Number of repairs

Undertaken AV Total cost

Number of repairs

Undertaken BW Emergency 960 5134.400 320 Urgent 1,880 5225,600 752 Non-urgent 1.020 S118.320 204

Each repair undertaken by BW costs the same irrespective of the classification of repair.

Required:

(a) Critically evaluate how the management of AV could measure the 'value for money" of its service provision during the year ended 31 May 2004.

(7 marks)


(b) (i) Identify TWO performance measures in relation to EACH of the following dimensions of performance

measurement that could be used by the management of AV when comparing its operating performance for the year ended 31 May 2004 with that of the previous year:

> Flexibility > Service quality

(2 marks)

(ii) Calculate and comment on THREE performance measures relating to "cost and efficiency' that could be utilised by the management of AV when comparing its operating performance against that achieved by BW.

(6 marks)

(c) Explain why differing objectives make it difficult for the management of AV to compare its operating and financial performance with that of BW. and comment briefly on additional information that would assist in the appraisal of the operating and financial performance of BW for the year ended 31 May 2004.


(June 2004)

27. Not- for-prof i t o rgan isat ion - GA and EA

General Airways (GA) is a US-based company in which the US government is a substantial shareholder both directly as well as indirectly through investments by government-run pension funds. Its operations are spread all over the world. GA is divided into four divisions according to the nature of operations namely Domestic, International, Cargo services and Helicopter services.

Excellent Airways (EA) is a pnvate company which provides all the services that GA provides except for the helicopter services.

The following is a summary of the financial performance of General Airways and Excellent Airways for the year ended 31 December 20X6 and 20X7.

GA EA 20X6 20X7 20X7 20X6 20X7 20X7

Actual Actual Budget Actual Actual Budget $'000 $'000 $'000 $'000 $'000 $'000

Revenue

Domestic 4,730,880 4,300,800 5,160,960 4,386,816 5,849,088 5,483,520 International 6.481.280 6.451.200 6.200.960 4,386.816 5.849.088 5.483.520 Helicopter services 716,800 645,120 750,320 - - -

Cargo 3.541.160 3,221.600 3.810,720 3.290.112 3.886.816 3.612.640

Total revenue 15,470.120 14,618.720 15.922.960 12,063,744 15,584,992 14,579,680 Costs Variable costs Domestic 2.071.700 2.057.920 1,214.937 1,523.200 International 2,727,656 2,709.504 1,457,924 1,827,840 Helicopter services 757.681 752,640 Cargo 1.503.443 1,493.440 911.203 1,142.400

Total variable costs 7,060,480 7,013,504 7,040,000 3,584,064 4,493,440 4,480,000 Salaries 3,430.000 3,470,000 3,500,000 3,472,000 4,000,000 3,500.000 Repairs and maintenance 285,000 348,000 306,000 112,000 112,000 117,600 Depreciation 96.000 96.000 96.000 700,000 700,000 700,000 Other operating costs 672,000 698.400 682,000 784,000 940,000 896.000 Loan interest 200,000 200,000 200.000


Total costs 11,543,480 11,625,904 11,624,000 8,852,064 10,445,440 9,893,600 Net profit 3,926,640 2,992,816 4,298,960 3,211,680 5,139,552 4,686,080

Route Domestic International Helicopter services Car P °

GA EA GA EA GA EA GA EA Capacity utilisation per aircraft (%) year 2006 55 60 65 57 85 - 50 60 Capacity utilisation per aircraft (%) year 2007 48 67 60 70 82 - 50 75

Additional information for the year ended 31 December 2007:

^ From time to time, EA announces various schemes offering reductions in domestic airfares. However, GA cannot offer similar schemes (because these schemes require government approval) and therefore the fares charged by EA are usually lower than those charged by GA. For international and cargo services. GA fares are 10% lower than EA fares.

> GA works for 325 days and EA works for 345 days a year.

> A 50% concession is provided by GA to senior citizens using its domestic services. No such concession is provided by EA. Dunng both the year's l.e.20X6 & 20X7, about 10% of the aircraft capacity is occupied by senior citizens.

^ The actual average variable costs of operating the aircraft service during the year ended 31 December 2007 amounted to S52 per km for GA and $50 per km for EA. Only these costs can be avoided if any service or route is discontinued.

> GA, being more concerned about its social responsibility, has taken higher insurance cover for the passengers and on board staff.

^ The managing director of GA is of the opinion that the helicopter service should not be discontinued.

^ The wntten down values of non-current assets are as follows:

2006 2007 $ m $ m

Aircrafts GA 1,280 1,152 EA 4,620 4,158 Other GA 960 864 EA 2,380 2,142

Neither company acquired / disposed of assets during the year.

> The budgeted occupancy rates for all buses on all routes in operation, for the year ended 30 November 2007, were as follows:

Company Budgeted occupancy rate % Passengers Helicopters Cargo

GA 58 85 50 EA 65 - 70

Required:

(a) Evaluate the operating performance and financial performance of GA and EA for the years ended 31 December 2006 and 2007.

(17 marks)


(b) (i) Give reasons why GA and EA cannot be compared.

(5 marks)

(ii) Give any five items of additional information that would have helped in assessing the operating and financial performance of GA and EA and explain how these items would have helped in assessing performance.

(5 marks)

(iii) Identify the decisions taken by GA which indicate that GA is concerned about its corporate social responsibility and discuss the impact of such decisions on its short-term financial performance.

(5 marks)

(c) Explain the importance of qualitative information in assessing the performance of GA and EA. (8 marks)

(40 marks) (Adapted from December 2007)

28. Behavioura l aspects of per formance management

To focus on specific performance measures may lead employees or managers to take action which is not in the best interests of the organisation. Examples of problems which may occur are: (i) Over-emphasis on the short term (ii) Over-emphasis on the achievement of specific measures (iii) Over-simplification of the meaning of specific measures (iv) Deliberate distortion

Required:

(a) Expand briefly on each of the above problems, giving a specific example to illustrate how each may occur. (10 marks)

(b) Name and comment on any FOUR actions which may be implemented in order to overcome problems in the operation of a performance measurement system.


(December 1999)

29. Per formance measurement - Spor ts town and Totale isure

John Wizard has recently won a contract to act as a financial consultant to Sportstown, a publicly owned organisation that provides a range of community services to its inhabitants. Wizard's first brief is to prepare a report on the Operating Efficiency and Financial Performance' of the leisure centre that is owned and managed by the public body. The governing body of Sportstown has become increasingly concerned by the growing financial subsidy that it has to provide to its leisure centre. Sportstown onginally owned and operated two identical leisure centres, but sold one of them in 19X5 to a private leisure company. Totaleisure, who continue to manage a successful leisure business. Totaleisure have kindly provided Wizard with recent operating and financial data to permit a comparative study to be undertaken. The two leisure centres both offer the same four sporting activities: squash, swimming, gym and badminton. The following data and information is available for the Sportstown leisure centre and for Totaleisure.

Data categorised by leisure activity for 20X1

Squash Swimmin

9 Gym Badmint

on S T S T S T S T

Number of hours per day that the facility is open 12 13 10 15 12 15 6 8 % utilisation of facility* Day time 50 20 70 40 15 25 50 40 Evening 80 85 70 80 50 85 50 60 The average number of people attending per hour who pay 6 n/a 29 n/a 20 n/a 6 n/a Pnce per person per hour S4 n/a $2 n/a S3 n/a $4 n/a Annual cost savings if activity is discontinued ($000) 21 25 120 105 51 60 60 52


S = Sportstown T = Totaleisure

* = includes free access customers

Cost data ($'000) Actual Budget

20X0 20X1 20X1 S T S T S T

Salaries 450 350 500 400 550 350 Maintenance contract 150 75 200 100 200 90 Depreciation 25 50 25 50 25 50 Other costs 125 100 75 150 125 150 Loan interest None 200 None 200 None 200

S = Sportstown T = Totaleisure

Additional Information

(1) Both leisure centres are open for 350 days per year. (2) The income of Totaleisure is derived from an annual membership fee of $500 per person in both 20X0 and

20X1. No additional charges are made for using the facilities. (3) The membership of Totaleisure has risen from 1,700 to 2,000 between 20X0 and 20X1. The management

has budgeted for membership to rise from 1,700 to 1,900 during this period. (4) Sportstown compels its centre to offer free access to all facilities to local schools to encourage sports

development and to those over 60 years of age to promote healthy living styles. It is estimated that 60% of those provided with free access would continue to use the facilities if they had to pay the standard charges to use the facilities. The remaining 40% would not use the facilities if free access were to be withdrawn. The free access users comprise 30% of all users.

(5) Although both centres are identical in terms of the capacity, range and quality of facilities provided, the Sportstown building is five years older than the Totaleisure premises. The realisable values of both buildings are equal to their market values which are:

20X0 20X1 Sportstown centre Totaleisure

$400,000 $800,000

$375,000 $750,000

(6) The annual subsidy to the Sportstown centre equals its financial deficit (loss) for the year. (7) The Sportstown opening hours and hourly charges remained the same during 20X0 and 20X1. (8) The average hourly attendance during 20X0 and budgeted for 20X1 for the Sportstown centre was as

follows:

20X0 20X1

Squash 9 8 Swimming 31 37 Gym 23 25 Badminton 5 10

(9) With the exception of the avoidable costs identified i.e. the annual costs savings if an activity is discontinued, all costs are general fixed overheads.

(10)The Sportstown centre had all its long-term debt repaid in full by the local authority in 19X8. It has no outstanding debts.


Required:

(a) Compare the operational and financial performance of the Sportstown centre with Totaleisure. (18 marks)

(b) Assess the validity of appraising their relative performance from the data made available to you. (5 marks)

(c) Make any necessary adjustments to the data used to appraise performance above in section (a) to develop an alternative and more appropriate comparison of their financial performance.

(6 marks)

(d) What additional information would you require to provide a more appropriate and comprehensive comparison of the financial performance of the two centres?

(4 marks)

(e) Traditional financial measures of performance have been criticised for not providing a broad enough basis for the assessment of organisational performance.

Identify a range of appropriate Non Financial Performance Indicators for the leisure centres which, when taken in conjunction with traditional financial indicators, would provide a comprehensive assessment of performance.


(December 2001)

QUESTION B A N K

SE

CT

ION

E

PERFORMANCE EVALUATION AND CORPORATE FAILURE E

30. Balanced scorecard and Bu i ld ing b locks

(a) Discuss the advantages which may be claimed for Kaplan and Norton's balanced scorecard as a basis for performance measurement over traditional management accounting views of performance measurement.

Your answer should include specific examples of quantitative measures for each aspect of the balanced scorecard.


(b) Explain rewards for performance' as relevant elements of performance measurement systems.

Note: your answer should consider clarity, motivation and controllability. (5 marks)

(20 marks)

31. Per formance measurement sys tems

Discuss ways in which each of the following may be viewed as relevant elements of performance measurement systems, explaining each of the terms emphasised.

(i) Dimensions of performance will comprise the results and the determinants of such results. (ii) Standards of performance must consider the ownership, achievability and equity of the standards set. (iii) Rewards for performance must consider issues of clarity, motivation and controllability.

(15 marks) (Adapted from June 2001)

32. Key per formance indicators - The Eatwell Restaurant

The owners of The Eatwell Restaurant have diversified business interests and operate in a wide range of commercial areas. Since buying the restaurant in 1997 they have carefully recorded the data below.

Recorded Data for the Eatwell Restaurant (1998 - 2001) 1998 1999 2000 2001

Total meals served 3,750 5,100 6,200 6,700 Regular customers attending weekly 5 11 15 26 Number of items on offer per day 4 4 7 9 Reported cases of food poisoning 4 5 7 7 Special theme evenings introduced 0 3 9 13 Annual operating hours with no customers 380 307 187 126 Proposals submitted to cater for special 10 17 29 38 events 10 17 29 38

Contracts won to cater for special events 2 5 15 25 Complimentary letters from satisfied 0 4 3 6 customers 0 V

Average number of customers at peak times 18 23 37 39 Average service delay at peak times (mins) 32 47 15 35 Maximum seating capacity 25 25 40 40 Weekly opening hours 36 36 40 36 Written complaints received 8 12 14 14 Idle time 570 540 465 187 New meals introduced during the year 16 8 27 11

34: Performance Evaluation and corporate. Failure € GTG

Financial Data $ $ $ $ Average customer spend on wine Total Turnover

3 83,000

4 4 7 124.500 137,000 185,000

Turnover from special events Profit Value of food wasted in preparation

2,000 11,600

1,700

13,0001 25.000 55.000 21,400 43,700 57,200

1.900 3.600 1.450 Total turnover of all restaurants in 895,000 1,234,000 980,000 1,056,000

Required:

(a) Assess the overall performance of the business and submit your comments to the owners. They wish to compare the performance of the restaurant with their other business interests and require your comments to be grouped into the key areas of performance such as those described by Fitzgerald and Moon.

(14 marks)

(b) Identify any additional information that you would consider of assistance in assessing the performance of The Eatwell Restaurant in comparison with another restaurant. Give reasons for your selection and explain how they would relate to the key performance area categones used in (a).

33. P e r f o r m a n c e m e a s u r e m e n t - B L A l td

BLA Ltd is a design consultancy that provides advice to clients regarding property maintenance and improvements. Three types of consultant are employed by BLA Ltd. These are:

(1) Architectural consultants who provide advice with regard to exterior building improvements. (2) Interior design consultants who provide advice regarding intenor design, and (3) Landscape consultants who provide advice regarding landscaping of properties and garden design

improvements.

BLA Ltd does not undertake building work on behalf of its clients and will only recommend contractors that undertake the three types of work when requested to do so by its dients.

The following information is relevant:

(i) Each consultation, other than those detailed in notes (iv) and (v), is charged at a rate of $150 per consultation.

(ii) The consultants are each paid a fixed annual salary of $45,000. In addition they receive a bonus of 40% of the fee income generated in excess of budget. The bonus is shared equally among the consultants employed by BLA Ltd on 31 October in the year to which the bonus relates.

(iii) Other operating expenses (excluding the salaries of the consultants) were budgeted at $2,550,000 for the year to 31 October 2003. The actual amount incurred in respect of the year to 31 October 2003 was S2.805.000. which exdudes payments to subcontractors per note (vii) below.

(iv) In an attempt to gain new business, consultants may undertake consultations on a 'no-fee' basis. Such consultations are regarded as Business Development Activity by the management of BLA Ltd.

(v) Consultants will sometimes undertake remedial consultations with clients who experience problems at the time when work commences on each client's site. Remedial consultations are also provided on a non-chargeable, i.e. 'no fee' basis.

(vi) In November 2002. BLA Ltd purchased 'state of the art' business software for use by its consultants in simulating design improvements. The software was used throughout the year by consultants who specialise in landscape and garden design. It is now planned to introduce the use of the software by the other categories of consultant within BLA Ltd.

(vii) BLA Ltd has a policy of maintaining staff at a level of 45 consultants on an ongoing basis, irrespective of fluctuations in the level of demand. Also. BLA Ltd has retained links with retired consultants and will occasionally subcontract work to them at a cost of £150 per consultation, if current full-time consultants within a particular category are fully utilised. During the year ended 31 October 2003 subcontractors only undertook non-chargeable client consultations.


(June 2002)


BLA Ltd Sundry statistics for year ended 31 October 2003

Budget Actual Number of consultants by category Exterior designer 18 15 Interior designer 18 18 Landscape and garden design 9 12 Total client enquiries New business 67.500 84,000 Repeat business 32.400 28,000 Number of chargeable client consultations New business 24.300 22.400 Repeat business 16.200 19,600 Mix of chargeable client consultations Exterior designer 16,200 13,830 Interior designer 16,200 17,226 Landscape and garden design 8,100 10,944 Number of non-chargeable client consultations undertaken by BLA consultants: Number of business development consultations 1,035 1,200 Number of remedial consultations 45 405 Number of non-chargeable client consultations undertaken by subcontractors 120 -

Other statistics: Number of complaints 324 630

Required:

(a) Fitzgerald and Moon have suggested that business performance should be measured in a number of ways.

Using FIVE different performance indicators and the quantitative data contained above, comment on the performance of BLA Ltd.

{15 marks)

(b) Briefly discuss THREE factors that should be considered in the determination of expected standards in a performance measurement system.


34. Per formance measurement - Compua id Ltd

Compuaid Ltd provides advisory services to home computer customers. Three types of advisor are employed offering advice by telephone, wntten/e-mail replies and home visits respectively.

Appendix 1.1 shows sundry statistics for the past 12 month penod for Compuaid Ltd and also for two competitor companies A and B.

Additional information relating to Compuaid Ltd for the past 12 month period is as follows:

(i) Home visit travel and remedial work hours are not charged directly to customers. (ii) All service workers incur some 'idle time' which is not charged directly to customers. (iii) A number of customers pay a fixed annual fee of $100 for the advisory service. This entitles them to 24 hour

priority access to the service and a maximum of five hours of advice without further charge. Appendix 1.1 shows the total hours of advice (both budget and actual) taken up by customers. Assume that no customer requires more than the five hours allowable.


(iv) All other time for the advisory service and home visits is billed to customers at S20 per hour. (v) The budgeted wage rate per hour for advisory service staff is S8.This was also the actual rate paid. (vi) Sundry operating expenses (other than advisor wages) were budgeted at S950.000. Actual operating

expenses incurred were $1,000,000.

Actual information for the penod under review for competitor companies A and B is as follows:

(i) Similar policies to those used by Compuaid Ltd are operated with regard to idle time, home visit travel and remedial hours.

(ii) Fixed annual fee advisory service schemes, similar to that of Compuaid Ltd. are operated. The annual fee charged per customer by company A and company B is $75 and £100 respectively.

(iii) Other revenue and cost information is as follows:

Company A $

Company B $

Total revenue (excluding annual fee income)

Enquiry advice 756.180 1.266.000

Home visits 87,500 810.000

Total wage costs 720.000 1,099.000

Sundry operating expenses 650.000 1,250.000

Required:

(a) (i) Prepare budgeted and actual profit and loss accounts for the 12 month period under review for

Compuaid Ltd and also actual profit and loss accounts for companies A and B. (8 marks)

(ii) Discuss the financial performance of Compuaid Ltd. incorporating details of relative customer billing rates, company service wage rates and annual agreement advice 'level of uptake' in your answer.

(12 marks)

(b) Comment on the performance of Compuaid Ltd, incorporating relevant percentage and ratio statistics in the context of each of the following: (i) Competitiveness; (ii) Quality; (iii) Resource utilisation.


(December 2000)

€>GTG Question Bank :37

Appendix 1.1 Sundry Statistics for the previous 12 month period

Compuaid Budget

Compuaid Actual

Competitor Compuaid

Budget Compuaid

Actual A Actual

B Actual

Number of service employees: Telephone advisor 22 27 25 44 Written/e-mail advisors 15 17 8 10 Home visit staff 12 14 2 21 Service employee hours analysis: Home visit travel hours 2,500 4,800 390 4,500 Idle time - home visit staff 2,000 2,600 2,800 6,000

- advisors 4.000 4.800 1.000 7,000 Remedial work for home visits 500 2.000 600 5,200 Annual agreement advisor call uptake 14,600 15.300 29.700 35,000 Advisor time billed to customers 58.400 72.100 42.010 63.300 Home visits billed to customers 22.000 23.200 3.500 36.000 Total hours 104.000 124.800 80.000 157,000 Number of home visit enquiries received 15.000 16.000 2.000 24,000 Number of home visits obtained/completed 10.000 8.000 1.400 15,000 Number of home visits requiring remedial work 300 1,200 400 3,400 Number of customer complaints- home visits 100 160 70 225 Number of customer complaints- advisors 73 131 35 196 Number of annual agreement customers 5.840 7.650 6.600 10,000

35. Per formance measurement - Mack-King

Mack-King, a long established UK fast food chain expanded its operations abroad for the first time in 1999 in Coja. Although the UK business is much larger than the new operation in Coja, they both operate as semi-autonomous business divisions with their own performance targets. Compared with the UK. the Coja business environment is characterised by significant political uncertainty and limited general awareness of Mack-King products and outlet locations.

Financial Data for Mack-King (£'000)

2000 ACTUALS 2001 ACTUALS

UK COJA TOTAL UK COJA TOTA L

Turnover 780 70 850 845 106 951 Less: Labour 200 10 210 216 12 228 Materials 150 20 170 165 24 189 Other operating costs 80 5 85 85 5 90

430 35 465 466 41 507 Marketing 60 30 90 70 70 140 Interest (Group) - - 14 - - 41 Depreciation and amortisation 100 8 108 100 16 116

160 38 212 170 86 297

Total Costs 590 73 677 636 127 804 Profit 190 (3) 173 209 (21) 147


NBV of Fixed Assets (year end) 520 40 560 520 90 610 (includes capital expenditure in the in the year)

Capital expenditure in year 90 30 120 100 66 166 Long-Term Debt (Group) - - 140 - - 340 Capital and Reserve 600 744

Required:

(a) Provide an assessment of the total corporate financial performance of Mack-King and of the contribution made towards it by each of the two divisions between 2000 and 2001.

(8 marks)

(b) Identify and explain the purpose of any additional information that would be required to provide a more complete assessment of Mack-King's financial performance.

(4 marks)

(c) Explain the problems that may arise in endeavouring to assess the comparative financial performance of the management in the two divisions. Suggest any allowances/adjustments that could be made to improve the validity of any comparisons between managers operating in different countnes.

(4 marks)

(d) Suggest two separate measures of performance that would be appropriate for a fast food chain, for each of the following areas:

> Service quality > Marketing effectiveness > Personnel > Food preparation

{4 marks) (20 marks) (Dec 2002)

36. Per formance measurement - The Dental health par tnership

The Dental Health Partnership was established in 1992 and provides dentistry and other related services to the population of Blaintopia, a country in which the public health service is partially funded by the Government.

Additional information relating to the Dental Health Partnership for the year ended 31 May 2005 is as follows:

(1) The partnership was open for five days per week during 48 weeks of the year.

(2) Each dentist treated 20 patients per day. The maximum number of patients that could have been treated by a dentist on any working day was 24 patients.

(3) (i) The partnership received a payment from the government each time any patient was consulted as

shown in the following table:

Category of treatment Payments from Government $

No treatment required 12 Minor treatment 50 Major treatment 100

(ii) In addition, adult patients paid a fee for each consultation which was equal to the amount of the payment shown per category of treatment in the above table. Children and Senior Citizens were not required to pay a fee for any dental consultations.

€ GTG Question Bank

(4) The partnership received an annual fee of $20,800 from a well-known manufacturer of dental products under a fixed-term contract of three years' duration. The contract commenced on 1 June 2004 and relates to the promotion of the products of the manufacturer.

(5) The total of material and consumable costs (which are 100% variable) during the year ended 31 May 2005 amounted to $446,400.

(6) Staff costs were paid as follows:

Category of Employee Salary per annum, per employee $

Dentist Dental Assistant Administrator

60.000 20,000 16.000

Note: A fixed bonus payment amounting to 4% of their basic salary was paid to each Dental Assistant and Administrator.

(7) Establishment costs and other operating costs amounted to £85,000 and S75.775 respectively for the year ended 31 May 2005.

(8) All costs other than materials and consumables costs incurred by the Dental Health Partnership are subject to contracts and are therefore to be treated as fixed costs.

(9) A table of non-financial information relating to the Dental Health Partnership for the year ended 31 May 2005 is as follows:

Number of Dentists 6 Dental Assistants 7 Administrators 2 Patient 'Mix' Adults 50% Children 40% Senior Citizens 10% Mix of patient appointments (%) No treatment required 70% Minor treatment 20% Major treatment 10%

Required:

(a) Prepare a summary Profit and Loss Account of the Dental Health Partnership for the year ended 31 May 2005 and calculate the percentage of maximum capacity that was required to be utilised in order to break even in the year ended 31 May 2005.

(12 marks)

(b) Discuss FOUR factors that distinguish service from manufacturing organisations and explain how each of these factors relates to the services provided by the Dental Health Partnership.

(5 marks)

(c) Excluding the number of complaints by patients, identify and briefly explain THREE quantitative non-financial performance measures that could be used to assess the "quality of service' provided by the Dental Health Partnership.


(June 2005)


37. Per formance m e a s u r e m e n t - A l i s h a Pic

Alisha Pic has been running a naturopathy centre for the last fifteen years. The naturopathy treatment is a 30 day course. It is conducted in batches, each batch having a capacity of 1.000 patients. The naturopathy treatment offered by Alisha is famous all over the world. The occupancy rate is 100% and it is necessary to book the course in advance. 10 batches of naturopathy treatment are conducted per year.

The company has also been conducting 10 day meditation courses for the last three years. Each batch for the meditation course has a capacity of 2.000 people and two batches can undergo the course at the same time. The occupancy rate for meditation classes is 80%. In a year, 70 classes of meditation can be conducted.

Alisha Pic is situated on a hill called Sify (near Wonderland city). The only way to travel between Wonderland and Sify is using vehicles owned by Alisha Pic, as there is no public transport to this area from the city and private vehicles are not allowed. Once a patient / visitor enrol himself on a course, he has to stay at the centre until the completion of the course.

The following information is available in respect of the year ended 31 December 2006 and the year ended 31 December 2007.

(1) Admission fees per visitor were as follows:

Category Naturopathy centre Meditation classes for the first time

$ $ Adults 4,000 500 Children (only above 12 years) 5,000 500 Senior citizens 6,500 650

A 10% discount is given to customers who take the medication course more than once. Around 20% of attendees re-enrol on the meditation course.

(2) The patients / visitors 'mix' was as follows:

Naturopathy Meditation Adults 40% 60% Children 5% 10% Senior citizens 55% 30%

(3) In addition to any admission fees payable. $2.5 per person one way is charged as a transportation fee for the journey to and from Sify Hill.

(4) The management of Alisha Pic categorises all operating costs, including accommodation, catering and the operating cost of vehicles as fixed costs. The allocation of the fixed cost is as follows:

Naturopathy centre Meditation classes $50m $40m

Meditation classes $50m

(5) Alisha Pic received an annual fee of $3 million from Sanjivini Group under a fixed-term five-year contract. The contract commenced on 1 January 2005 and relates to the nghts to advertise programmes which were filmed in the naturopathy and meditation centre. Therefore the fee should be equally allocated to the naturopathy and to the meditation centre.

(6) Admission fees to the naturopathy centre and meditation classes will increase by 10% and 5% respectively with effect from 1 January 2006. Transport fees will increase by 4%.

(7) All operating costs will increase by 7% per annum during the year ended 31 December 2007.

(8) Assume that the number of visitors and the visitor mix remain constant during the year ended 31 December 2007.

€ GTG Question Bank :41

Required:

(a) Prepare the following for Alisha Pic:

> actual statement of comprehensive income for the year ended 31 December 2006 > budgeted statement of comprehensive income for the year ending 31 December 2007

(17 marks)

(b) The management of Alisha is considering discontinuing the practice of giving a 10% discount for repeat business. Determine the impact on the profitability of meditation centre if a 10% discount is not provided for repeat business. Assume that 95% of repeat visitors will attend the class even if the 10% discount is not offered.

(4 marks)

(c) Calculate the percentage of maximum capacity at which the meditation course will break even during the year ended 31 December 2007.

Note: use the original information. (7 marks)

(d) Explain the importance of qualitative information for assessing the performance of Alisha and suggest five dimensions which could be used to assess the service quality.

(7 marks)

(e) Briefly discuss six initiatives that management might consider in order to enhance profitability. (5 marks)

(40 marks) Note: ignore taxation in all your calculations.

(Adapted from Dec 2006)

38. Corporate fai lure - Fashion Plus

Fashion Plus is a manufacturer of leather bags. It is a well known brand in the market. Robin was appointed as the CEO of Fashion Plus four years ago (after the death of his father who was the previous CEO). He has a dominant and arrogant style of working and does not take into consideration the ideas suggested by other board members.

Waterman, a newly appointed director of Fashion Plus, wonders why Fashion Plus has not come up with any new product over the last three years and also has no projects under consideration. In his opinion, in this competitive era, the company should try to give something innovative to the customer. At the same time, diversification could also help Fashion Plus to remain in competition. Therefore. Waterman suggests that, along with manufacturing leather bags, Fashion Plus should start manufacturing leather shoes. However, Robin does not like the idea. In addition, Waterman expects that other members of the board will not support him because they appear to him to be passive.

With the growth in retail chains (where many varieties are available), Fashion Plus is facing tough competition. The sales of Fashion Plus have been showing a decreasing trend over the last two years, as have the profits. In addition, the market share of Fashion Plus has declined from 33% to 17% over the last four years.

The financial information of Fashion Plus is as follows:

Statement of financial position

31 March 20X7 $ million

31 March 20X6 $ million

Non-current assets Land and buildings (net) PPE (net)

216.00 249.75 465.75

195.75 237.60 433.35

Current assets Inventory Receivables Cash & bank

162.00 46.50

0.75 209.25

135.00 37.10

2.05 174.15


675.00 607.50

Shareholders' funds Ordinary shares (50 cents par share ) Reserves

67.50 145.80 213.30

67.50 141.75 209.25

Loan funds 15% debenture ($100 par) Term loans

152.55 94.50 247.05

152.55 60.75 213.30

Current liabilities Dividend payable Tax payable Payables

12.15 6.75

195.75 214.65

12.15 10.80

162.00 184.95 675.00 607.50

Extracts from statement of comprehensive income

20X7 $m

20X6 $m

Sales 586.80 633.60 Earnings before interest and taxes 56.70 66.50 Interest 27.00 23.50 Earnings before taxes 29.70 43.00 Taxation @ 30% 8.91 12.90 Available to shareholders 20.79 30.10 Dividend 19.00 19.00 Retained earnings 1.79 11.10

The share price in the market is currently 52 cents.

Required:

(a) Calculate the Z score for Fashion Plus and comment on the probability of the failure of Fashion Plus. (10 marks)

(b) Identify the qualitative information which indicates that Fashion Plus might fail. (5 marks)

(c) Recommend the performance improvement strategies that may be adopted by Fashion Plus (10 marks) (25 marks)

Q U E S T I O N B A N K

u. CURRENT DEVELOVEMENTS Z o AND EMERGING ISSUES IN c p o UJ CO

PERFORMANCE MANAGEMENT • 39. Contemporary management account ing techniques

Performance through Quality' has been a theme adopted by many successful organisations that operate in highly competitive business environments. The diagram below entitled Costs and Quality illustrates the alternative paths (as depicted by the arrows) that a business can take from a starting point A.

Costs a n d Qua l i t y

qualify

Required:

(a) Briefly explain the probable business consequences of pursuing the alternative paths available and arriving at points B to F. Identify the path that is most likely to bnng business success.

(5 marks) Traditional management accounting activities have had their original scope broadened by the development of a variety of techniques that incorporate a growing recognition of the cost and quality issue in the management decision making process.

Required:

(b) Explain how contemporary management accounting/management techniques such as Total Quality Management, Just In Time, Value Analysis, Activity Based Costing and The Balanced Scorecard could contnbute towards the analysis of the relationship between costs and quality.


(June 2002)

44: Current Development and emerging Issues In Performance Management € GTG

40. T rad i t i ona l v i s -a -v is m o d e r n managemen t a c c o u n t i n g

A traditional view of the environment in which goods are manufactured and sold is where stocks of materials and components are held. Such stocks are then used to manufacture products to agreed standard specifications, aiming at maximising the use of production capacity. Finished goods are held in stock to satisfy steady demand for the product range at agreed prices.

Required:

(a) Discuss aspects of the operation of the management accounting function which are likely to apply in the above system.

(5 marks) (b) Describe an alternative sequence from purchasing to the satisfaction of customer demand, which

may be more applicable in the current business environment. Your answer should refer to the current 'techniques or philosophies' which are likely to be in use.

(5 marks) (c) Name specific ways in which changes suggested in (b) will affect the operation of the management

accounting function. (5 marks)


SOLUTION

BANK

1

El j? < E I

SOLUTION B A N K

A 1. Strategic management accoun t ing

This question deals with issues such as the shortcomings of traditional management accounting systems and how strategic management accounting has restored the 'relevance' of management accounting in the modern manufactunng environment. Your answer to part (a) of the question should be brief, justifying the marks allotted. However, the answer given below is comparatively large as it is intended to give you a complete overview of the topic. Your answer to part (b) should be elaborate but specific to the requirements of the question.

In the 1980s, advanced manufacturing technologies such as computer-aided manufacturing and just-in-time (JIT) manufacturing techniques dramatically changed the production processes in many organisations. In order to compete successfully, it was necessary to produce innovative products of high quality at a relatively low cost and also to provide the best possible customer service. Many companies responded to these competitive demands by investing in advanced manufactunng technologies, implementing JIT manufacturing philosophies and emphasising their corporate objectives such as quality, delivery innovation and a flexibility to meet customers' needs.

Some organisations have found that their existing cost systems have hindered, rather than helped, the introduction of the required changes. This has resulted in ciaims by some writers that traditional management accounting techniques are obsolete and that a radical change in management accounting is required to match the revolution in manufacturing technology. There is a growing consensus that traditional cost control and performance management systems do not provide the appropriate information to control the activities of companies which operate in an advanced manufacturing environment.

Investment in advanced management technology has dramatically changed cost behaviour patterns. Computer engineers, software programmers and technocrats are replacing direct labour and vanable costs tend to consist of only direct materials and energy costs to operate the machinery. More of the firm's costs are becoming fixed and direct labour costs are becoming only a small proportion of the total manufacturing costs. Overhead costs are a much higher percentage of total manufacturing costs and consequently need to be understood and controlled much more carefully than in the past.

The main reasons why traditional management accounting systems have lost their "relevance' in a rapidly changing business environment are as follows:

> Competitive pressures

Most significant was the application of flexible manufactunng technologies by the Japanese to produce a greater diversity of high-quality, low-priced products more quickly. Specific modes of work organisation, production systems and motivational incentives were seen to differ radically from those used traditionally.

> Emergence of new technologies

The adoption of flexible technologies in manufacturing and service-oriented enterprises including manufacturing and enterprise resource planning systems, computer-aided design and computer-aided manufacturing (CAD and CAM), robotics and other features of computer integrated manufacturing (CIM) led to questioning of the conventional accounting methods for cost allocation. Management accounting techniques are therefore seen to be outdated given the new manufacturing environment. Similar problems have been raised about cost accounting techniques in service industries.

46: Strategic Planning And control € C.TG

> Dominance of financial accounting

From the post-first world war period, progress in management accounting was seen as virtually ceasing, principally as a result of the growing importance of external reporting priorities. Some critics of traditional management accounting therefore assert that management accounting has. for over seventy years, been subordinated to the requirements of financial statements preparation for external parties.

> The diverse role of management accounting

Critics have questioned the usefulness of complex methods of organisational costing and pricing in the face of the belief that the price of a product must ultimately meet the expectations of the marketplace rather than reflecting the procedures involved in its manufacture. Others have given weight to the argument that management accounting has for too long remained isolated and divorced from other enterprise functions. Conventional accounting practices have installed, within the organisation, channels for information flow and routes for data-exchange which have rendered some organisations static, inflexible and excessively structured, especially in the case of organisations operating in dynamic and fast-moving markets.

(b)

The strategic cost management initiatives suggest several ways to restore the 'relevance' of management accounting control systems in today's manufacturing and organisational environment.

The fundamental objective of strategic management accounting is to use management accounting information for strategy implementation, management planning and control in organisations. The distinguishing feature of strategic management accounting (SMA) is that it considers the relationship of the organisation with its external business environment. It focuses attention on suppliers, customers and competitive rivals. Information may be quantitative or qualitative in nature, and some information will be of a non-financial nature.

The basic features of strategic management accounting include external onentation (I.e. competitor information, suppliers and customers) and long-term process. These features are described below, along with other important features of strategic management accounting:

Features of SMA

(a) External orientation

(i) Competitor information: (related to cost, pnces. market share etc.) in developing and monitoring the business strategy.

(ii) Suppliers and customers: they should be considered from a value chain perspective. Several authors have widely demonstrated that external information is useful in that it enables organisations to develop a relationship with suppliers as well as customers that can be exploited in the business's interest.

Ultimately "external" refers to the "market"; it means focusing on the product's on offer to satisfy customers' needs while taking into account the cost of adding new product features.

(b) Long-term process

SMA is a long-term process only which focuses on utilising qualitative and quantitative information (both internal and external to an organisation) in the strategy formulation of a business.

(c) Forward-looking

SMA provides information about potential changes in the market, competition, consumer preference, supplier profile etc.

(d) Holistic approach

SMA does not confine itself to collecting external information. Rather, it involves collecting any relevant information that may have an impact on the business from all spheres of the business, including the internal sources of the organisation.

Major techniques used in strategic management accounting are activity-based costing, benchmarking, competitive position monitoring, life-cycle costing, target costing, value chain analysis, strategic pricing, etc.

Since virtually all organisations are subject to environmental change, one of the prime objectives of strategic planning and control is to gain a sustainable competitive advantage. This process is aided by the information gathered within a strategic management accounting system.

€ GTG Solution Bank : 47

Moreover, it is critical that all aspects of a business are monitored so that a holistic approach is taken when strategic plans are being developed. The strategic management accounting system is capable of coping with changes that can and will inevitably occur in a dynamic business environment. Hence it identifies changes such as the emergence of a new competitor or the emergence of new market areas and ensures that these are detected and reflected within strategic plans at the earliest opportunity.

A strategic management accounting system provides information that is relevant and reliable thereby enabling management to make correct decisions. This is critical to any business, given that decisions of a strategic nature affect the entire organisation and are irreversible in the short term and often the long term.

Strategic cost management promotes the need to revitalise management accounting by extending cost estimates over the entire life cycle of a product, a practice that many Japanese organisations have adopted for many years.

The development of strategic management accounting initiatives can be viewed as management accounting's attempt to regain relevance and maintain a focus on upon matters of strategic importance and long-term effectiveness.

2. Zero Base B u d g e t i n g - Nat iona l E lec t ron i cs L td

• no hucoiivii deals with the different aspects of the implementation of zero-base budgeting in an organisation.

> Your answer should be specific to the question and should make reference to the case of National Electronics Ltd.

> Remember that answering the question without referring to the given case will reduce your prospect to earn high marks.

(i) Memorandum

To: Board of Directors From: Finance Director Date: 12 June 20X8 Re: The implementation of zero-based budgeting in National Electronics Ltd

During recent years, the management of National Electronics Ltd has used the traditional approach of incremental budgeting.

Incremental budgeting involves preparing a budget on the basis of the previous year's budget with some additions and deletions for the forthcoming budget penod. Incremental budgets are suitable for all kinds of organisations. They are widely used by organisations since they are easy to prepare.

However, incremental budgets are cnticised for not justifying the cost elements for inclusion in the budgets. This approach can lead to inefficiencies since the previous year's budget is rolled forward to the next year's budget purely by virtue of the fact that the previous year's budget is the starting point for the construction of the new budget.

The implementation of a system of zero-based budgeting will require consideration of the following: > the need for major input by management ^ the fact that it will prove extremely time consuming > the need for a very high level of data capture and processing > the subjective judgement inherent in its application > the fact that it might be perceived as a threat by staff

whether its adoption may encourage a greater focus upon the short-term to the detriment of longer-term

Zero-based budgeting was developed to overcome the shortcomings of the technique of incremental budgeting. The implementation of zero-based budgeting will effectively require each manager within National Electronics Ltd to start with a blank sheet of paper and a budget allowance of zero. The managers will be required to defend each of their budget proposals at the beginning of each and every year. Accordingly, the entire planning process for coming up with budget proposals will have to be reconsidered.

(a)

planning


The development and implementation of the zero-based budgeting model will require managers and others in the organisation to engage in major planning, analysis and decision-making. National Electronics Ltd has already established mission and goal statements. However, taking into account the major changes that have occurred in the internal and external environment of our business, I feel it is prudent to redefine the mission and goal statements of our company.

It is worth mentioning here that zero-based budgeting can be made successful in National Electronics Ltd if we, the senior management team, can ensure the following:

> Objectives are more sharply defined and alternative means are explicitly considered. Managers become more heavily involved in a well-structured budget process that fosters communication and consensus.

> Priorities among activities are pinpointed. > Knowledge and understanding of inputs and outputs are enhanced and moreover inputs can be linked

clearly with the output as far as practicable. ^ Resources are reallocated more effectively and efficiently.

A zero-based budgeting decision unit is an operating division for which decision packages (described below) are to be developed and analysed. It can also be described as a cost or a budget centre.

The manager responsible for each cost centre within National Electronics Ltd will be responsible for developing a description of each programme to be taken up for operation in the next budget year. In the context of zero-based budgeting, such programmes are referred to as decision packages and each decision package will usually have three or more alternative ways of achieving its objectives. Accordingly, each decision package alternative must contain, as a minimum, objectives, activities, resources and their associated costs.

Each decision package should contain a description of how it will contribute to the attainment of the mission and goals of the organisation. Each manager within National Electronics Ltd will be required to evaluate each alternative decision package in order to assess and justify its operation. National Electronics Ltd will have to establish a mechanism in the organisation that estimates the workload and performance of each decision package effectively. Based on the merit of each decision package and its importance to the organisation, the decision packages will be ranked in order of priority for resource allocation. Sometimes, the senior levels of management may ask the managers of the decision packages to revise and resubmit their decision packages for additional review and analysis.

The company's budget will be prepared following the acceptance and approval of the decision packages. As soon as the company's budget has been approved, the managers of the decision units will put into operation all approved decision packages during the budget year.

The last major process of zero-based budgeting is monitoring and evaluation. The processes of planning, analysing, selecting and budgeting for decision packages will prepare the company for operation during the next year.

(ii) In a bid to implement a zero-based budgeting system, the senior managers of National Electronics Ltd need to keep in mind possible behavioural issues that may anse. Successful implementation of the new budgetary system will largely depend on how successfully the company can address these issues.

The budgetary process entails the setting of goals. If the budget is overemphasised or viewed as a rigid monitor of performance, managers and employees are often induced toward behaviour that is not in line with the goals of the organisation as a whole.

For example, managers in industry are often disindined to reduce costs because they feel that cost cutting may lead to temporary praise or rewards but, in the long run, will make the job tougher because the future budget will not be as easy to attain.

In National Electronics Ltd. a fragile balance needs to be struck between careful definition of responsibility, on the one hand, and a too rigid division of responsibility amongst the managers, on the other hand. Passing the buck is a pervasive tendency that is supposedly minimised when responsibility is fixed unequivocally.

All these behavioural issues relating to budgeting can be overcome by successful implementation of zero-based budgeting. Successful implementation of zero-based budgeting will require a major planning effort by National Electronics Ltd's personnel. It is through the planning process that important guidelines and directions are provided for the development and ranking of the decision packages.

The zero-based budgeting process addresses and supports comprehensive planning, shared decision-making, the development and application of strategies and resource allocation as means of achieving established goals. In addition, zero-based budgeting supports the processes of monitoring and evaluation.


Zero-based budgeting, when properly implemented, has the potential to assist the personnel of an organisation to plan and make decisions about the most efficient and effective ways to use their available resources to achieve their defined mission and objectives.

As a consequence of the adoption of zero-based budgeting, the managers of National Electronics Ltd should be able to make decisions on the basis of an improved reporting system. It is quite possible that zero-based budgeting will help to identify and eliminate any budget bias or 'budget slack' that may be present. Budgetary slack is 'a universal behavioural problem' whereby managers intentionally create slack as a protective device. Slack involves intentionally overstating cost budgets and/or understating revenue budgets to allow some padding in actual performance. Zero-based budgeting can reduce the possibility of the presence of slack in the budget since greater justification is needed for a manager to get his decision package approved for resource allocation. It is important to assure the managers of National Electronics Ltd that the reason for implementing a zero-based budgeting system in the organisation is to bhng in a culture of justifying expenditure before it is spent. Moreover, any sort of blame-culture will be discouraged. Finally, it needs to be emphasised to the senior management that the zero-based budgeting process will not yield the desired results without the support and active involvement of the senior managers.

Signed: Finance Director

(b) The basic differences between the implementation of a zero-based budgeting (ZBB) system in National Electronics Ltd (a profit seeking, manufacturing organisation) and the implementation of ZBB in a 'not for profit' health organisation are descnbed below:

ZBB is implemented in profit seeking, manufacturing organisations primarily as a management tool in planning for and controlling the staff and support functions. Typically, a ZBB review is conducted for a relatively small portion of a manufacturing company's total budget. ZBB has proved to be most useful in managing discretionary fixed costs. Direct costs that incur more or less in proportion to the output volume can be better planned through the traditional approach to budgeting. On the other hand, for a not for profit' organisation. ZBB is used as the main system of budget justification (and, in most cases, presentation) for all functions within an organisation.

Accordingly, the finance director of National Electronics Ltd is probably aware that the application of zero-based budgeting within National Electronics Ltd might prove most fruitful in the management of discretionary costs where it is difficult to establish standards of efficiency and where such costs can increase rapidly due to the absence of such standards. Direct production and service costs incurred in National Electronics Ltd which change according to production volume can be planned and accordingly resources can be allocated more appropriately following traditional budgeting methods utilising standard costs. Since the major costs incurred by a 'not for profit' health organisation will be of a discretionary nature, one might conclude that the application of zero-based budgeting techniques is more appropriate for service organisations such as the not for profit' health organisation than for a profit-seeking manufacturer of electronic office equipment. A further difference lies in the fact that the ranking of decision packages is likely to prove less difficult (sometimes a decision package may not have any alternative) within an organisation such as National Electronics Ltd which is only involved in the manufacture and marketing of electronic office equipment. In contrast, there is likely to be a much greater number of decision packages of a dissimilar nature, competing for allocation of the available resources within a 'not for profit' health organisation.

3. Beyond Budget ing Model

Part (a) of the answer should be divided into points. A critical approach towards budgeting systems is expected in the answer.

Although the answer contains several relevant points related to the weaknesses of budget model, you should confine your answer to five such points, as asked for.

Part (b) of the question contains three questions each of which is worth 4 marks. In order to get high marks make your answer brief and to the point.


(a) Advocates of beyond budgeting have criticised conventional budgeting processes on several counts. Inherent weaknesses of the annual budget model irrespective of the budgeting approach that is applied are enumerated below. It is argued that budgets:

> cannot cope with a fast-changing environment and that they are often out-of-date before the start of the budget period

> focus too much management attention on the achievement of short-term financial targets. Instead, managers should focus more on the things that create value for the business (e.g. innovation, building brand loyalty and responding quickly to competitive threats)

^ reinforce a command and control' structure that prevents junior managers from exercising autonomy. This may be particularly true where a top-down approach, that allocates budgets to managers, is being used. Where managers feel constrained, attempts to retain and recruit able managers can be difficult.

> take up an enormous amount of management time that could be better used. In practice, budgeting can be a lengthy process that may involve much negotiation, reworking and updating. However, this may add little to the achievement of business objectives.

> are based around business functions (e.g. sales, marketing and production). However, to achieve the business's objectives, the focus should be on business processes that cut across functional boundaries and reflect the needs of the customer.

> encourage incremental thinking by employing a "last year figure plus a certain per cent' approach to planning. This can inhibit the development of break out' strategies that may be necessary in a fast-changing environment.

can protect costs rather than lower costs. In some cases, a fixed budget for an activity, such as research and development, is allocated to a manager. If the amount is not spent, the budget may be taken away and in future periods, the budget for this activity may be either reduced or eliminated. Such a response to unused budget allocations can encourage managers to spend the whole of the budget, irrespective of need, in order to protect the allocations they receive.

^ promote a negative mentality amongst managers. In order to meet budget targets, managers may try to negotiate lower sales targets or higher cost allocations than they feel is really necessary. This helps them to build some slack' into the budgets and so meeting the budget becomes easier.

> Moreover, one of the biggest problems with budgets is that they tend to promote an inward-looking, short-term culture that focuses on achieving a budget figure, rather than on implementing business strategy and creating shareholder value over the medium to long term.

(b)

(i) Benchmarking

Benchmarking is a process for improving performance by constantly identifying, understanding and adapting best practices and processes followed inside and outside the company and implementing the results. The main emphasis of benchmarking is on improving a given business operation or process by exploiting best practices'. The prime objective of benchmarking is to assess an organisation's strategic capability in relative terms since it concerns the ability to meet and beat the performance of competitors. There are different ways in which relative performance might be understood. In order to understand the relative performance of an organisation, organisations are compared with each other in terms of their overall strategic characteristics and in terms of how customers perceive them.

In simple terms, benchmarking is an approach which involves setting goals and measuring productivity based on best industry practices. It developed out of the need to have information against which performances can be measured.

Traditional budgeting processes focus on the achievement of short-term targets and accordingly the targets set in the budgeting process do not consider the adoption of 'best practices' since this may require significant change in the work process which is not feasible in the short term.

Since the budget is perceived to be predominantly a control exercise, managers feel that there is very little real incentive to seek out benchmarks which may be used to raise budgeted performance targets. Benchmarking may sometimes invite behavioural issues. The managers may view benchmarking as an attempt by top management to impose impossible targets upon operational managers.

Moreover, organisations which do not measure their success relative to their competition do not resort to benchmarking and remain happy with favourable performance based on budgetary targets.


(ii) Balanced scorecard

Realising the need for a balanced measurement system. Robert S. Kaplan and D.P. Norton developed a new measurement system called the balanced scorecard. The balanced scorecard links the short-term operational goals of an organisation to its long-term objectives and strategy by forcing it to monitor and control day to day operations. It defines the entire road map for achieving the goals and constantly reveals what is happening in an organisation.

The balanced scorecard starts by defining the mission, outlining the strategies to achieve the mission, understanding the core customer requirements, defining the internal business process and assessing the organisational infrastructure needed to achieve the objectives. This continually tests the theories underlying management's strategy. The emphasis of the balanced scorecard is on progress and improvement rather than on meeting any specific standards.

A useful approach for a complete, strategic performance evaluation is to include both financial and non-financial factors for an organisation, using the balanced scorecard. The balanced scorecard measures an organisation's performance in four key areas:

> customer satisfaction > financial performance ^ internal business process > learning and growth

The main concept of the balanced scorecard is that no one measure can properly evaluate the organisation's progress to strategic success. Rather, multiple measures typically grouped in the four key areas, provide the desired comprehensive evaluation of the organisation's performance. Moreover, by attending directly to the firm's critical success factors, the balanced scorecard effectively links the performance measurement / evaluation to the organisation's strategy. Unfortunately, any shift from a traditional budgeting approach might lead to dysfunctional behaviour at every level of the organisation.

The balanced scorecard is often misperceived as a consequence of the failure by top management to ensure that it is implemented effectively within the organisation. Accordingly, it may be viewed as the addition of a few non-financial measures to the traditional budget targets. In order to overcome this incorrect perception, many organisations now establish a reward system based upon the achievement of scorecard targets for the forthcoming budget period.

Even in situations where the scorecard has been well-designed and well-implemented, it is difficult for it to gain widespread acceptance. This is because managers often like to maintain an organisational culture which places high importance upon the achievement of the fixed annual targets in order to avoid the loss of status, recognition and rewards.

The balanced scorecard approach contains a mix of long-term and short-term measures and therefore dnves the company in the direction of medium-term strategic goals which are supported by cross-functional initiatives. On the other hand, the focus of the budgeting process is on the achievement of short-term financial goals supported by the initiatives of individual departments. Budgets can also act as a hindrance to the acceptance of responsibility by local managers for the achievement of the scorecard targets. This is often the case in situations where a continued emphasis exists on meeting short-term, e.g. quarterly, targets.

(iii) Activity-based models

Traditional budgets consider the costs of functions and departments (e.g. staff costs and establishment costs) instead of activity costs (e.g. receipt of goods inwards and processing and dispatch of orders). Accordingly, managers do not focus on identifying the real 'cost drivers' of their business. Moreover, it is probable that a traditional budget contains a significant amount of non-value-added costs that are not apparent and accordingly steps are not taken to eliminate the activities that give rise to non-value-added costs. The annual budgets are prepared considering a fixed capacity level for the forthcoming budget period thereby undermining the potential of activity-based management (ABM) analysis to determine the required capacity from a customer demand perspective.

52: Strategic Planning And conirol € C.TG

4. Strategic p lann ing - Diverse Ho ld ings Pic

Jr PfffTHny > The question relates to strategic planning and SWOT analysis as a tool for strategic planning.

> Your answer should be with reference to the case discussed in the question.

Remember that your examiner will prefer a point-by-point answer and therefore you should present your answer in this manner as far as possible in order to get high marks.

Strategic planning is an organisation's process of defining its strategy, or direction, and making decisions on how to allocate its resources to achieve its corporate objectives, including its capital and people. Various business analysis techniques can be used in strategic planning induding SWOT analysis and PEST analysis (analysis of the influence of the political, economic, social and technological components of the organisation's external environment).

There are a variety of perspectives, models and approaches used in strategic planning. The way that a strategic plan is developed depends on the nature of the organisation's leadership, the culture of the organisation, the complexity of the organisation's environment, the size of the organisation, the expertise of the planners and so on.

The following are some of the advantages that may be gained as a consequence of the adoption of a formal system of strategic planning:

(i) Strategic planning determines the future course of action of an organisation. The focus of a strategic plan is usually on the entire organisation, while the focus of a business plan is usually on a particular product, service or programme.

(ii) Strategic planning identifies business risks and accordingly equips an organisation to run its business smoothly and effectively.

(iii) A strategic plan draws management attention to the need to give due consideration to the ever-changing environment and to the threats from competition. A strategic plan considers potential change and guides an organisation to cope with changes to ensure long-term sustainability.

(iv) Strategic planning ensures that planning and controlling activities are consistent with the organisation's long-term, medium-term and short-term objectives. Strategic planning also helps to identify whether the business objectives are leading an organisation in the right direction or whether they require re-assessment.

(b)

SWOT analysis is a technique used in strategic planning to evaluate the Strengths, Weaknesses. Opportunities and Threats that might affect business strategy. It involves specifying the objective of the business venture or project and identifying the internal and external factors that are favourable and unfavourable to achieving that objective. The aim is to identify the extent to which the current strengths and weaknesses are relevant to. and capable of, dealing with the threats or capitalising on the opportunities in the business environment.

Senior managers in an organisation might have their own opinion about the strengths and weaknesses of the organisation, but a management information system should be in place to provide measured and reliable information about strengths or weaknesses.

The use of SWOT analysis will focus management attention on the current strengths and weaknesses of each subsidiary company which, in turn, will assist in the formulation of the business strategy of Diverse Holdings Pic. It will also enable management to monitor trends and developments (which may present opportunities or threats) in the constantly changing environments of their subsidiaries. Management will accordingly assess the feasibility of the actions required in order that the organisation may take advantage of the opportunities whilst eliminating or minimising the effect of any threats.

€ GTG Solution Rank : 53

(c)

(i) The competitive positions of all the constituents of Diverse Holdings Ltd are analysed below:

Organic Foods Ltd (OFL) had a market share of 6.66% and was the market leader at 30 November 2005. According to the forecast, it will have a market share of 8% by the end of 2007. Operating profits appear to be reasonably good and moreover OFL has built up a very good reputation as a supplier of quality produce. Accordingly, therefore it seems reasonable to regard OFL as a current 'strength' of Diverse Holdings Pic.

Haul-Trans Ltd (HTL) was acquired on 1 December 2005 and has a record of reasonable profitability. The turnover and profit of the company have remained more or less static over the last few years. However, it has an optimistic profit forecast. The total market size of the transport market segment is unknown and accordingly it is not possible to identify the market share of HTL or any other company. Therefore it is not possible to compare the performance of HTL with that of the market leader. Management may have identified avenues through which to achieve significant cost savings or may have been able to attract more profitable customers while discontinuing its service to less profitable customers.

The information collected by the management accountant of Diverse Holdings Pic suggests that the turnover and operating profit of Kitchen Appliances Ltd (KAL) is gradually decreasing and, more alarmingly, its market share is decreasing at an even faster rate. At 30 November 2005, KAL had a market share very close to the market leader. Since then. KAL has developed into a weakness of Diverse Holding Pic. According to the forecast, it will enter into the loss region during the year ended 30 November 2007. KAL has suffered from reduced margins as a consequence of competition from low cost imports. The situation may worsen as competition from abroad intensifies.

The available information shows that the sales (and profit) of Paper Supplies Ltd (PSL) have not changed at all although the market size of the products it manufactures has expanded over time. The market for the stationery items that PSL manufactures is dominated by a single manufacturer (holding a 35% market share). PSL appears to be struggling to achieve any growth in turnover, profits and therefore cash flow. It is not a feasible proposition for PSL to continue to compete with a narrow range of products and only two customers.

Office Products Ltd (OPL) is growing slowly in terms of turnover and the operating profit of the company has continually increased in exact proportion to the turnover (the operating profit ratio being 10%). It is alarming to note that, despite operating in a rapidly growing market, the company could not boost its sales and increase its market share in spite of the fact that its products are highly regarded by health and safety experts.

(ii) The forecast situation of Diverse Holdings PIc indicates some problems (in particular, in regard to the performances of KAL, PSL and OPL). KAL and OPL require the immediate attention of management. Continuation of the business of KAL is in question since the forecast predicts that the company will gradually enter into loss territory.

Any one of the following strategies may be adopted by Diverse Holdings PIc:

> outsource the manufacture of kitchen appliances > set up a manufacturing operation overseas in order to cut costs > withdraw from the market

Each alternative must be assessed. Whatever decision is taken, it is unlikely to affect the other four subsidianes.

PSL is also independent of the other subsidiaries. A strategic decision to increase its range of products and outlets will surely improve its turnover and profit position. In an expanding market, it will not be difficult for management to find new markets for its products, which are separate and distinct from those markets served by its appointed distributors.

In order to improve the prospects of OPL. management needs to put more emphasis on market promotion strategies since, in spite of operating in a high growth market, the company could not capture a reasonable market share.

Management should endeavour to develop a strategy to integrate its subsidianes further so that they can benefit from each other and also derive as much synergy as possible from the acquisition of HTL.

It is of paramount importance that management ensure that sufficient funds are channelled into expanding OFL and HTL, which are both showing an upward trend in profitability. The group has exhausted its cash reserves, mainly due to the purchase of HTL. In order to make good its cash position. Diverse Holdings PIc may consider divestment of KAL, which has shown a consistent downwards trend.


5. E x t e r n a l e n v i r o n m e n t

(a)

J In this question you are asked to assess the external environment. Whenever it comes to external environment, you should consider both the micro as well as the macro-environment and, when considering the macro-environment, try to remember PESTEL. Then it will be very easy to answer this question.

You will earn 2 marks for identifying each area and explaining it, up to a maximum of 10 marks.

Here, all related areas are identified but you should not mention all of these in the exam. This is because you will be given a maximum of 10 marks for this part of the question and too long an answer will eat up your valuable time.

The external environment, being influential factors outside the organisation, is beyond the control of the organisation. It is necessary to. study the external environment since it has an impact on the organisation, its strategies and its performance. The areas in which the external environment affects the organisation include the following:

financial performance activity level (volume of production / sale) costs product quality and features business strategies survival and growth of the business

The external environment consists of the micro-environment and the macro-environment. Competitors, customers, suppliers etc. come under the micro-environment. The macro-environment is made up of PESTEL i.e.

(i) Political; (ii) Economic: (iii) Socio-cultural; (iv) Technological; (v) Environmental; And (vi) Legal Factors.

The components of external environment, information related to them and the way in which they influence the organisation are presented in the following table:

Presenting your answer in tabular format will save time and also highlight the important points.

Components Related information Influence / Reason

Competitors

^ identifying the competitors > information related to marketing and pricing

strategies > performance > market share

> market share > market trend > pricing policy > product line / features

Suppliers

> availability > quality /» financial viability > pricing policy > quality of product and after sales service

^ quality of the final product r price of the product > production schedule

Customers > expectations and preferences > financial capability > liking / demand for a particular product

> market share > market trend > pricing strategies


Political

> stability of government > composition of government > governmental rules and regulations > involvement of government in trade agreements

> production methods > pricing policy

Economic

> inflation rate > interest rate > foreign exchange rate > business cycle > taxation

level of export and import > financial performance > level of production > financial performance

Socio-cultural

> demographic patterns > consumer tastes and preferences > overall societal trends ^ beliefs and customs in the society

> market share > market trend > pricing strategies > product line

Technological > technological developments > new innovations

> product development > product line / features > production methods

Environmental & legal

> related laws and regulations > compliance requirements

> production methods > costs

(b) Sources of Information

i Here, the information provided' column is additional. In order to manage your time in the exam, you should write only succinct, specific answers without including extra information. Identifying each source will earn you one mark therefore do not write more than 5 sources.

The information about the external environment (the components mentioned above) can be gathered from the following sources:

Sources Information provided

Government (statistics given by government in vanous reports, journals etc. published by it)

> industry trends and statistics > government policies (fiscal, monetary) > demographic statistics > economic growth, GDP > economic indicators (such as inflation rates and interest rates.) > consumer spending statistics > import / export statistics

International agencies e.g. World Bank and IMF (global information is provided)

> industry trends > consumer spending statistics > import / export statistics > economic indicators > technological developments in any industry > other industry statistics

Market research and focus group studies

> tastes and preferences of customers > suggestions from customers > expectations about prices of products

Newspapers, television and other media

Trade journals

> industry trends and statistics > competitors, suppliers, customers > share prices > market conditions > technological developments

Suppliers' pnce list and brochures

> product prices > features / quality of products > various products and substitutes available > product launching

Customers' feedback / consumer association

> customers' tastes and preferences > customers' suggestions

Encyclopaedia / the internet Almost all kinds of information are available from the internet (paid / unpaid)


(c) Development and implementation of the system

Answering this question is very easy. Think what you would do if you wanted to develop a system. Consider the requirements of the system and. accordingly, start writing the answer.

The development and implementation of a system includes the following:

> Data capture: identifying various sources of information and gathering relevant data is the basic requirement for any system.

> Data process: all the gathered data are to be converted into meaningful information. Who will require what kind of data should be decided in advance and the data should be processed accordingly. Data categorising: categorising the data according to the requirements of the different levels such as strategic, tactical and operational.

In addition, the frequency of the requirement of information should be identified and information should be made available accordingly.

> Monitoring & controlling the system: the system should be monitored to assess whether it is working according to the requirement.

> Distribution of Information on a need to know basis: whether or not the information is distributed to the people who require it and is in the required format.

Once the requirements are specified, the next job is to assign the duties to the personnel involved in the implementation of the system.

1 4

SOLUTION B A N K

B 6. Ethical issues and Mendelow's m a t r i x - Toywor ld pic

(a)

While answering this part of the question, you are expected to point out all the unethical practices adopted by Toyworld. Therefore, if you note down the points while reading the question, it will save you time.

In addition, do not forget to discuss the impact of the unethical practices on Toyworld's long-term and short-term performance.

Previously, it was assumed that organisations were responsible only to their shareholders and their responsibility was to maximise the wealth of the shareholders by earning more and more profit. Later on. this view changed and nowadays organisations also have an ethical responsibility towards their various other stakeholders, including the society at large.

Organisations are expected not to take dedsions or engage in activities that will hurt the interests of any of these groups. However, being ethical has a cost in the short term which affects an organisation's short-term performance.

It is clear from the following examples that the company has adopted unethical practices.

Use of substandard material

The use of substandard material saves cost but is unethical. Although it is known that the material could be dangerous to children's health. Toyworld has not stopped using it. This means that the company has put profit before the health of the children who play with its toys.

Although Toyworld has performed well until now. in the long term, customers will become aware that the material is dangerous to children's health and stop purchasing Toyworld's products. As a result. Toyworld's long-term performance will be affected.

Unethical labour practices

Vanous issues related to employees have been ignored by Toyworld such as its responsibility to enforce maximum working hours and provide good working conditions and fair pay to its employees. Toyworld has employed many unethical practices such as:

> employing children, which is prohibited by law > not paying fair wages to its employees > making it compulsory to work for more than the maximum working hours > not providing a creche facility for young children of its employees

By adopting these practices. Toyworld is saving costs, but is ignoring its ethical responsibility.

Since its workers are in need of employment and money, they will not take any action against these unethical practices. However, they are likely to come to the attention of the public. This will affect the reputation as well as the performance of Toyworld in the long term. This is because people prefer to deal with ethical companies.

58: Economic, Fiscal and Environmental Factors €>f.T(i

False advertising I marketing

The company is aware that the material it uses is dangerous to children's health (if they put the toys in their mouths, as children are likely to do!). In such a case, it is the ethical responsibility of the company to display a warning on the packaging of the toys. However, no warning is given.

In addition. Toyworld tries to attract customers by falsely advertising that Toyworld's products are safe and by giving exaggerated statements that Toyworld products are better than the products of other companies and help to improve children's memory and motor skills.

By adopting these practices, Toyworld may become successful in attracting customers and increasing revenues in the short term but in the long term, this will affect its reputation and therefore performance. Environmental issues

As stated in the question, the material used by Toyworld is not environmentally-friendly. In addition, Toyworld doesn't have a pollution treatment plant. Emissions from the factory are polluting the environment of Farland. An organisation should not improve its performance at the cost of society. Society as well as the government will not accept this and legal action may be taken against Toyworld. This will affect the reputation as well as performance of Toyworld in the long term.

Therefore, although it will be expensive and will affect the short-term performance of Toyworld, the company should establish a pollution treatment plant and should use environmentally-friendly material.

Unethical practices

Toyworld donates a huge amount to the political party led by Robert. Although this helps Toyworld to obtain easy finance at low interest rates, this also puts Toyworld's reputation at risk and it may become a target for legal and political investigations. The donations are a form of bribe and therefore this practice is not only unethical but also illegal. This is a poor management decision and could create difficulties for Toyworld.

By stamping out this practice, Toyworld may lose its ability to obtain finance at any time (from Easy-money) and may also have to pay higher interest rates but it will eliminate the risk to its reputation.

From the above discussion, it is clear that Toyworld has adopted several unethical practices. The finance director argues that stamping out such practices may affect the performance of Toyworld. Although this is true, adopting ethical practices will help to improve Toyworld's performance in the long term. This is because although an organisation may "get away with" unethical practices in the short term, they are likely to affect the organisation adversely when they come to the public's attention.

On the other hand, being ethical improves the performance of an organisation in the long term in the following ways:

> Employees are more loyal to ethical organisations. > Customers are willing to buy products from an ethical organisation. > Suppliers are more willing to maintain and improve relationships with an ethical organisation. > Potential business collaborators are more willing to associate with an organisation that has an established

reputation for behaving ethically.

(b)

In this part of the question, you are asked to categorise some of Toyworld's stakeholders in Mendelow's stakeholder mapping matrix. However, do not forget to give your reasons for categorising a stakeholder in a particular quadrant.

In addition, do not discuss what Mendelow's stakeholder mapping matrix is. Only categorisation is expected.


Mendelow's stakeholder mapping matrix

Employees

In Toyworld, although the employees have a high level of interest in the organisation, they have very little power to influence the organisation. This is evident from the ways in which Toyworld is exploiting them. The employees cannot speak out against their exploitation because their livelihood depends on their employment at Toyworld. Therefore they will be categorised in the high interest- low power quadrant.

Customers

Customers can influence the strategies of Toyworld. This is because there are many competitors in the market and therefore customers may easily shift to another competitor. In the absence of customers, Toyworld will have no business. For example, if customers stop buying Toyworld's products because they are not quality products, Toyworld will have to improve the quality of its products. Therefore customers have influencing power.

However, customers have low interest in Toyworld as they may shift to any other organisation. Therefore customers should be categorised in the high power - low interest quadrant.

Directors of Toyworld

It is clear from the case that the directors have the power to change Toyworld's strategies as well as having a high interest in Toyworld. This is because they are the decision makers and hold significant shares in Toyworld. Therefore they should be categorised in the high power - high interest quadrant.

Shareholders (other than directors)

It is given in the case that, other than the directors, each of the shareholders holds only a few shares and therefore has little influence over the strategies of Toyworld. However, they may have an interest in Toyworld since they are the owners. Therefore they should be categonsed in the high interest- low power quadrant.

The government

For any organisation, the government is always in a position to influence the strategies of the organisation. However the government does not have any interest in Toyworld, (it is not a publicly owned company, utility business or monopoly) therefore the government will be categorised in the high power- low interest quadrant.

60: Economic, Fiscal and Environmental Factors €>f.T(i

SOLUTION BANK

I PERFORMANCE g MEASUREMENT SYSTEM AND w DESIGN

C 7. Cont ingency theory, BPR

t Part (a) of the question deals with the contingency theory of management accounting and part (b) deals with application of 'Business process re-engineering' and the potential problems which may be encountered in the implementation of a business re-engineering programme.

Your answer to the question should be brief, justifying the marks allotted. However, the answer given below is comparatively large as it is intended to give you a complete overview of the related topics.

(a) There are many forms of contingency theory. In a general sense, contingency theories are a class of behavioural theory that contend that there is no one best way of organising / leading and that an organisational / leadership style that is effective in some situations may not be successful in others (Fiedler, 1964). In other words, the optimal organisation / leadership style is contingent upon various internal and external constraints.

Four important ideas of contingency theory are as follows: (i) There is no universal or one best way to manage. (ii) The design of an organisation and its subsystems must fit' with the environment. (iii) Effective organisations not only have a proper 'fit' with the environment but also between their

subsystems. (iv) The needs of an organisation are better satisfied when it is properly designed and the management

style is appropriate both to the tasks undertaken and the nature of the work group.

The contingency theory of management accounting represents an attempt to identify the most appropriate accounting control system for a given set of circumstances and to identify the most important contingent variables and assess their impact on the design of control systems.

Contingent variables will have a definite influence In designing management accounting systems and associated performance practices. David Otley has identified five sets of contingent variables that impact on the management accounting of an organisation, namely, the organisation's environment, competitive strategy, the business unit itself (i.e. size, diversification and structure) and knowledge and observation (of performance).

Since the purpose of a control system is to assist an organisation in adapting its business environment, then it would appear reasonable to accept that a management control system is subject to influence from the external environment in which it operates. A formal accounting control system is only one of a number of potential controls that could be adopted by an organisation. Whilst it is undeniable that the degree of sophistication of accounting controls is influenced by the intensity of competition faced by a firm, two other characteristics from within an organisation's environment, namely dynamism and heterogeneity, have been shown to affect the design of control systems. Each of these characteristics is associated with an emphasis on different aspects of accounting control. The view has also been put forward that other major influences on the design of control systems are the degree of structural complexity of an organisation and the extent to which 'turbulence' exists in its environment. Increasing structural complexity will lead to an increase in the number of accounting tools used by an organisation, whereas environmental discontinuity may require new tools to replace those which have become obsolete.

(>4: Performance Measurement System and Design € fiTf.

The nature of a manufacturing process determines the type of costing system that is required and the extent to which costs can be traced to products. The level of accuracy achieved in job-costing which is used in conjunction with batch production technology is higher than that which can be achieved in process costing due to the fact that a greater proportion of the costs are incurred jointly by the range of final products. It follows that there is a technological constraint on the design of accounting controls due to product interdependence.

One should also consider the direction of causality. Is it contingent factors that cause the system to be as it is or might the system itself be a contingent factor which is a cause of change?

(i) Business process re-engineering (BPR)

Business process re-engineering is the fundamental rethinking and redesign of business processes to achieve dramatic improvements in critical, contemporary measures of performance, such as cost, quality, service and speed.

A business process consists of a collection of activities that are linked together in a coordinated manner to achieve a specific objective. Business process re-engineering involves examining business processes and making substantial changes to how the organisation currentJy operates. It involves the redesign of how work is carried out through activities, seeking improvements in cost, quality, service and speed.

For example, material handling might be classified as a business process consisting of separate activities relating to scheduling production, storing matenals, processing purchase orders, inspecting materials and paying suppliers.

Applications of business process re-engineering

> BPR draws on the insights of Porter's value chain by viewing the organisation as a set of value-generating processes rather than as a segmented structure of departments and divisions. Techniques such as activity-based costing and activity-based management can also support this.

> BPR normally supports the marketing onentation since it re-engineers the business on the basis of the benefits sought by the customers.

> BPR has a role in furthering the network organisation. If it can be shown that outside suppliers can deliver certain benefits in comparison to managing the process in-house. then the conclusion should be to extend the network.

> BPR can be assisted by benchmarking. Management may direct BPR to those processes where relative performance is poor. In addition, benchmarking is a useful technique for measuring the improvements yielded by the BPR programme.

'r BPR also indicates the relationship of the firm with its suppliers. Re-engineering an organisation to provide streamlined performance is pointless if the organisation is held back by the inefficiencies of its suppliers and partners.

(ii) Potential problems which may be encountered in the implementation of a business re-engineering programme are:

> Often used as the pretext for staff reductions: for example, Ezzamel et al. (1995) concluded that much of the impetus for organisational change came from the cost-cutting potential and less from considerations of business effectiveness. Some writers (e.g. Willmott. 1995) present BPR merely as an excuse for senior management to assert their power over middle management and staff through increasing workload and cutting headcount. If true, this makes BPR entirely opposed to many of the modern 'trust-based' approaches to management.

> Conflicts with human resource-based approaches to business improvement: several of the new wave' management approaches, such as teamworking, TQM and empowerment, emphasise the value of unlocking human potential to make the firm more responsive and innovative. BPR suggests empowering the end-users and making them more responsive and innovative. However, it does not appear to accept that staff should determine the structure in which they work, nor that these structures should adapt through time. Instead. BPR envisages a group of specialists imposing their understanding on the business and designing a better process. The result will be that members of staff are still constrained within a new framework of operation that they did not design.

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> Overlooks the impact on human resources: advocates of BPR overlook the enormous implications of a BPR exercise for the staff involved. These changes will involve learning new patterns of work, the break-up of traditional workgroups, the loss of enriching parts of the job and redundancies. The firm will incur visible costs such as training and redundancies, but also less visible ones such as the loss of goodwill and uncontrolled staff losses.

> Increase stress of staff: a common outcome of BPR has been the reduction in staff numbers at middle and line management levels. The result of this is an overload on the remaining staff thereby reducing effectiveness.

^ Does not focus on business effectiveness: it is apprehended that BPR causes the loss of key competitive assets, namely the knowledge and creativity of middle management. Critics accuse BPR (and benchmarking) of focusing too much on improving the existing business rather than developing new and better lines of business.

> May destroy existing controls within the organisation: management control is exerted in a variety of ways. Widely used internal control measures are segregation of duties, management supervision, the quality of personnel and the accounting procedures used. BPR threatens these by combining tasks, stripping away levels of management and allowing the firm to use lower grade staff.

8. Behavioural aspects in per fo rmance measurement - As t rodome spor ts L td

(i) Tunnel vision

Tunnel vision is about focusing on performance measures in isolation without taking into consideration the other aspects of management. The first director's view i.e. 'There is no point whatsoever in encouraging staff to focus on interaction with customers in efforts to create a 'user fr iendly' environment. What we need is to maintain the quality of our grass surfaces at all costs since that is the distinguishing feature of our business' is an example of this problem; the director is focusing only on increasing the quality of the grass and ignoring other aspects, such as customer satisfaction and the ambience of the complex, which have an impact on the demand for the facilities.

(II) Sub-optimisation

Sub-optimisation occurs when managers concentrate on one area of management in order to achieve better results and overlook the other aspects which ultimately affect the overall profitability of an organisation. 'We should focus our attention on maximising the opening hours of our facilities. Everything else wi l l take care of itself' is an example of sub-optimisation where other important issues such as the possible need to increase the availability of horse-riding and bowling equipment for hire (since these sports are becoming increasingly popular) are ignored.

(iii) Misinterpretation

Misinterpretation is when a performance measure is interpreted incorrectly or in an over-simplified way. Performance might be a result of several complex and overlapping factors but management may attribute the success or failure to one or two specific factors, which is over-simplistic. In the given scenario, the director's view that 'we should reduce the buildings maintenance budget by 25% and spend the money on increased advertising of our facil it ies which will surely attract more customers' shows that the director has attributed the success of Astrodome Sports Ltd to its marketing strategy i.e. advertising. In reality, several complex factors, such as unemployment in the local area, have led to the fall in revenue. This is a serious factor. As a result of unemployment, the economy may slow down and result in falling demand for the facilities of Astrodome Sports Ltd.

In this question you are asked to discuss only four problems. Therefore, even though more than four problems are discussed in the answer below (to aid your understanding) in the exam you should not mention more than four problems. Instead, spend your valuable time on improving your answers to other questions.

(a)


(iv) Myopia

This is short-sightedness. In the context of performance management, it means concentrating on short-term performance measures which may lead to the neglect of longer term considerations. An example of myopia is the director's view that 'we should reduce the buildings maintenance budget by 25% and spend the money on increased advertising of our facilities which will surely attract more customers.' Asset maintenance, even if does not provide any direct and short-term benefit, is needed in the long term. Short-term decisions should not be taken at the cost of long-term benefits.

(v) Measure fixation

Measure fixation involves taking action to ensure that specific performance targets are reached without considering the probable consequences. An example of measure fixation is the director's opinion that 'we should buy more equipment which can be hired out to users of our facilities. This will improve our utilisation ratios which will lead to increased profits'. This strategy will not provide any additional benefit. This is because there have been no complaints from customers; on the contrary, they are satisfied. Therefore it can be assumed that the fall in revenue is because of unemployment in the town. In such a case, buying more equipment will only increase the burden and will not otherwise be helpful.

(vi) Misrepresentation

Misrepresentation is the tendency to give a false but satisfying picture of performance by suppressing the actual results i.e. creative reporting or window dressing. The information given should be complete so that the facts can be analysed. In this case, incomplete information is provided by the director's statement that 'recent analysis of customer feedback forms indicates that most of our customers are satisfied with the facilities. In fact, the only complaints are from three customers - the LCA University which uses the cricket pitch for matches, the National Youth Training Academy which held training sessions on the tennis courts, and a local bowling team.'

In order to analyse this fact, additional information about how much business the company receives from these customers is needed. If these customers constitute a major portion of the business, their dissatisfaction may be harmful to Astrodome Sports Ltd.

(vii)Gaming

Gaming is a deliberate attempt to distort performance targets so that the subsequent results appear better than they actually are.

(viii)Ossification

Ossification is management's unwillingness to introduce new performance measures in place of outdated and ineffective measures that are in use.

(b) (i) Trying to focus on and improve the measurement of customer satisfaction

Customer satisfaction is very important for an organisation. One satisfied customer can bring 4 new customers and, similarly, one dissatisfied customer can discourage 4 potential customers Therefore satisfying customers is very important. Management should not focus on only one aspect (tunnel vision) such as improving the quality of grass but should also consider the other aspects such as creating a customer-friendly atmosphere.

In addition, care should be taken to avoid taking sub-optimal decisions. All the decisions should be taken only after evaluating their impact on the organisation as a whole.

Instead of interpreting the measures in an over-simplified way (misinterpretation), the actual cause should be identified and all the complexities in the environment should be considered. For example, advertising may not be the proper solution for decreasing revenue and therefore an increase in advertising may not result in an increase in demand. Instead, emphasis should be placed on those measures that will result in an increase in customer satisfaction.

Focusing on short-term factors (myopia) at the cost of long-term benefits should be avoided. Customer satisfaction is a long-term measure which should not be sacrificed for short-term benefits.


(ii) Involving staff at all levels in the development and implementation of performance measures

The dimensions of the building block model required that the standards should be owned by individuals. This means that the individuals who are ultimately responsible for completing the task should be involved in the process of setting the standards and deciding the performance measurement criteria.

Involving staff in the process of developing and implementing performance measures motivates them. The involvement of all the employees of the organisation in performance measurement will help to reduce gaming i.e. deliberate distortion of target. In the given case, directors have made an attempt to understate the potential benefit of maintaining the buildings so that the funds available for maintaining buildings can be used for advertising. Management should understand that advertising alone will not be sufficient; the state of the facilities is also important.

In addition, the involvement of staff will also help management to understand the importance of creating a customer-friendly atmosphere. The staffs know the ground level difficulties and therefore they can contnbute to deciding attainable targets.

(iii) Being flexible in the extent to which formal performance measures are relied on

A 1994 study by Wyatt focused on identifying recent trends and best practices in performance management by examining the systems of a select group of 37 companies, recognised for financial success and innovative research programmes. As a result, a set of best practices that can help focus the process of designing, implementing and monitoring performance management emerged. Flexibility is one of those best practices.

The performance measurement system should be flexible. Management should be flexible while deciding the extent to which the system should be emphasised upon. This is because a notion given by a measure in short-term may be true in the long -term e.g. by cutting down marketing expenses (which are taken to increase the demand in long-term) may show increased profitability in short-term. However, this increase may not be long-term and in long-term the profitability may decrease. Therefore too much emphasis should not be placed on any performance measure. It should be flexible enough to balance the short-term and long-term performances. Flexibility helps in reducing measure fixation and misrepresentation. Flexibility in the system will help to avoid this and encourage management to take good decisions (i.e. any decision will not be taken to show good short-term performance on account of long-term performance.

In addition, if the system is flexible and too much emphasis is not placed on the performance measures, it will not force people to misrepresent the information. Instead, the facts will be quoted and then decisions will be taken to improve the performance.

(iv) Giving consideration to the audit of the performance measurement system

When an independent person evaluates a system and expresses his opinion on its efficiency and effectiveness, value is always added. This helps in reducing the incidence and impact of measure fixation, misinterpretation and gaming.

For example, if Astrodome Sports Ltd carried out an audit, it would be drawn to management's attention that the directors have misinterpreted equipment availability as key to customer volume and high profitability and, accordingly, have given this factor too much emphasis. In addition, evidence that the benefits of one course of action have been deliberated understated in order to release funds for an alternative course of action (i.e. evidence that gaming is taking place) would be provided.

However, the audit should be free from bias and should be conducted by an independent person.

9. Internal and external aspects of per formance measurement - Ochi lpark Pic

^ Read the question carefully and note down the key requirements before answering the question. > Be careful not to lose marks by accidentally missing out some of the requirements ^ In the case of numerical part of the answer, it is necessary to think about presentation before you

start writing your answer. Such planning saves time by avoiding repetition of the same information and moreover planning eliminates any unnecessary information and makes your answer clear.

Before answering this question, keep in mind the following points:


(I) Statement showing the total costs for 'millennium' proposal

2000 2001 2002 Sm Sm $m

Target cost - variable (W1) 6.000 7.200 8.000 - fixed (W1) 2.000 2.000 2.500

Internal failure cost (W2) 1.600 0.920 0.525 External failure cost (W3) 2.000 1.104 0.525 Appraisal cost 0.500 0.500 0.500 Prevention cost 2.000 1.000 0.500 Total cost 14.100 12.724 12.550

Workings

2000 2001 2002 W1 Target costs - variable S15m x 40% $18m x 40% S20m x 40%

(as % of sales) = $6m =$7.2m =$8m Target costs - fixed

$2m $2m $2m

Total target costs S8m $9.2m $10.5m

W2 Internal failure cost $8 x 20% $9.2 x 10% $10.5x5% (% of total target costs) = S1.6m = $0.92m = 0.525m

W3 External failure cost $8m x 25% $9.2m x 12% $10.5m x 5% = $2m = $1,104 = 0.525

Score More The question does not specify that working will have to be given along with the statement showing the total costs for millennium' proposal. Accordingly if the workings are not given in the answer, the answer will not be wrong but will be considered bad and will earn fewer marks.

(ii) The target cost is that which will provide the required return (target profit) for the 'millennium' proposal given the sales amount. In order to achieve the target cost, it is likely that Ochilpark PIc will have to make some improvements over the current expected level of performance. This will include all areas in the cycie from product design to after-sales service to customers. The target vanable cost is stated as 40% of sales.

The target fixed cost rises in 2002 to S2.5m. This indicates a stepped fixed cost that increased due to increased activity.

The cost gap between target cost and current expected cost levels may be divided into internal and external failure costs.

Internal failure costs occur when work fails to meet the design quality standards and the failure is detected before the product is sold to the customer. Examples will include high levels of production losses or excessive machine idle time.

External failure costs occur when the product fails to reach design quality standards and failure is not detected until after the product is sold to the customer. An example is the free replacement of defective product units returned by the customer.


Internal failure costs are expected to fall from 20% of target cost in 2000 to 5% of target in 2002. External failure costs are expected to fall from 25% of target cost in 2000 to 5% in 2002. The trend indicates a gradual improvement in the work process.

Appraisal and prevention costs are incurred in an effort to reduce the incidence of internal and external failure costs in order that the total cost may be brought closer to the target cost. Appraisal costs are incurred due to evaluation of the work process and services in the cycle in order to ensure conformance with the agreed specification. Examples include checks on design and quality negotiation procedures with customers and checks that machines are performing within the efficiency tolerance limit specified. Prevention costs originate from the implementation of procedures I actions to ensure that the company reaches the quality standards for the achievement of target cost. Examples include staff training costs or fees to consultants to improve operating procedures.

Appraisal costs are expected to remain at the level of S0.5m over the three year period from 2000 to 2002. Prevention costs are expected to fall from S2m in 2000 to S0.5m in 2002. This may be construed as a gradual reduction in requirements for staff training or consultancy services as improvements are achieved.

(i) Corporate vision is a short, succinct and inspiring statement of what the organisation intends to become and to achieve at some point in the future, often stated in competitive terms. Vision refers to the category of intentions that are broad, all-inclusive and forward-thinking. It is the image that a business must have of its goals before it sets out to achieve them. It describes aspirations for the future, without specifying the means that will be used to achieve those desired ends.

Ochilpark Pic has come up with the 'millennium' proposal for one of its product ranges as a specific market opportunity. It focuses on competing through the identification of key competitors and by close co-operation with its customers in providing products to meet their specific design and quality standards. The corporate vision is seen as being achieved through a focus on internal efficiency and external effectiveness. The 'millennium' proposal may be seen as illustrating a specific sub-set of the corporate mission since it:

> has its own distinct business concept and mission - the 'millennium' focus ^ has identified the key competitors > is a suitable area for the management of its own strategies and close cooperation with customers and

the provision of products to meet customer requirements

(ii) The 'millennium' proposal may be measured in both marketing and financial terms. It is apparent that it has achieved market growth and improved market share. The projected sales in Schedule 3.1 show growth of 20% in 2001 on year and a further 11% in 2002 on a year to year basis. In addition, market share is anticipated to improve, which is evident from the market shares of 125%, 144% and 154% in years 2000, 2001 and 2002 respectively.

The net profit to sales ratio is expected to increase each year. The profit increase is partly linked to the projected fall in quality costs, both costs of conformance and costs of non-conformance. It is partially attributable to the increase in the volume of business.

(iii) The marketing success of the proposal is linked to the achievement of customer satisfaction. The success will require an efficient business operating system for all the phases of the life-cycle from product design to after-sales service to customers. Improved quality and delivery should lead to improved customer satisfaction. Schedule 3.1 shows a number of quantitative measures.

The percentage of production achieving design quality standards is expected to rise from 95% to 98% between 2000 and 2002. In the same period, returns from customers for replacement or rectification are expected to fall from 3% to 0.5% and the cost of after-sales service is expected to fall from £1.5m to £1m. All these measures are indicative of improvement in the quality of the products.

Delivery efficiency improvement may be measured in terms of the increase in the percentage of goods achieving the planned delivery date. This percentage rises from 90% in 2000 to 99% in 2002.


(iv) The financial success of the proposal is linked to the achievement of high productivity. This should be helped through reduced cycle time and decreased levels of waste. Schedule 3.1 shows a number of quantitative measures of these factors:

The average total cycle time from customer enquiry to delivery should fall from 6 weeks in 2000 to 5 weeks in 2002. This indicates both internal efficiency and external effectiveness.

Waste in the form of idle machine capacity is expected to fall from 10% to 2% between 2000 and 2002. Moreover, component production scrap is expected to fall from 7.5% in 2000 to 25% in 2002. These are measures indicating improved productivity. Both will be linked to the prevention and appraisal costs, which are intended to reduce the level of internal and external failure costs.

(v) The marketing and financial success of the proposal is linked to the achievement of customer satisfaction and high productivity.

Increased flexibility of methods is expected to be achieved. This should help in achieving improved productivity and also in an improved level of customer satisfaction. High quality standards will improve customer satisfaction and in turn will assist in market retention and growth.

10. In format ion requi rement - Moffat Ltd

Read the question carefully because it asks you to do more than one thing. Identify the three levels of management with their responsibilities. This will help you to identify the kind of information required. You are also asked to give two examples of the information required at each stage. These examples should not be general but should be related to the scenario given in the question.

I

(a) Relevant, reliable and timely information facilitates better execution of controls. In an organisation, controls are exercised at three levels i.e. the strategic, tactical and operational levels. The information needs tboth nature and content) are different at these different levels.

(i) Strategic level

This level of management is responsible for setting the strategic direction and long-term objectives of the organisation. Strategic information should be related to the organisation as a whole and summanse the main points.

The information required by the management of Moffat Ltd at the strategic level indudes the following: > What additional I extended service can be given to customers? > Have there been any technological advances related to the business which could be used by Moffat

Ltd?

4 Score More Many candidates do not relate their answer to the given scenario. For example, if you write that the external information required at strategic level includes the following:

> competitors' activities: ^ customer preferences, style: > economic trends; > technological advancements: and

> new laws, rulings;

This will not get you many marks because you have not related the information required to the scenario.

Note: Do not forget to relate your answer to the given scenario.


(ii) Tactical level

At this level, the plan for implementation is prepared and various decisions are taken regarding the ways in which the strategies deaded at the strategic level can be best implemented and the objectives achieved.

External information required at this level includes information on the following:

price changes changes in demand or supply This is for your information. You do credit availability during procurement 1 n o l n e e d t 0 w r i t e t h i s i n t h e e x a m

credit policy for receivables need to open a unit / branch

The information required by the management of Moffat Ltd at tactical level includes the following: If the additional / extended service is provided, what additional resources are required?

> Is there any need to change the pricing policy?

(iii) Operational level

Operational control is normally exercised by the supervisory level (i.e. the team of managers at the base of the management hierarchy) of an organisation. At the operational level, managers are responsible for routine, day-to-day decisions and for overseeing the activities of the organisation which do not require much judgement or discretion.

External information required at this level includes the following:

r sensitive changes affecting material supplies and sales -- political disturbances causing interruption in normal operations

The information required by the management of Moffat Ltd at operational level includes the following: ^ the number of vehicles serviced and the number of complaints received during a week ^ the way to deal with the unanticipated increase in the demand such as requirement to ask workers to

work overtime

(b)

J ^ j g ^ X For each approach you mention, you will get a maximum of 2 marks.

The approaches that the management of Moffat Ltd can adopt to assess the qualitative benefits arising from investment in the IT system include the following:

> ignoring the qualitative benefits

One can evaluate the proposal ignoring the qualitative benefits. However, the drawback of this approach is that the areas on which quantitative analysis do not provide sufficient information will not be evaluated properly.

Qualitative information provides additional information over quantitative information. In addition, cost benefit evaluation will not give the correct results since, although all costs will be considered, only the quantitative benefits will be ignored and therefore the proposal may not be attractive. Therefore this approach is not suggested.

> assessing the qualitative benefits by making an attempt to attribute values to those benefits

Under this approach, the cash flows are derived in order to carry out the cost benefit analysis. These cash flows are based on management estimates which involve various assumptions. However, the problem associated with this approach is that the various parties involved in the proposal may not agree on the assumptions. In addition, if the proposal is taken up, the assessment of the results i.e. whether the benefits are derived as anticipated will be difficult.


> assessing the qualitative benefits in a reasonable manner i.e. a manner acceptable to all the parties involved

Instead of expressing these benefits in financial terms and making certain assumptions, they can be assessed in a manner which is acceptable to all the parties involved in the proposal. For example, the time saved as a result of using the IT system can be assessed without expressing it in monetary terms.

> assessing the qualitative benefits by expressing them in specific terms linked to a hierarchy of organisational requirements

This is another way of interpreting and analysing qualitative information. The information can be categorised as being: * essential to the business J very useful * desirable, but not essential s possible, if funding is available * doubtful and difficult to justify

The information can then be assessed according to its importance to the business. The qualitative benefits arising from using the IT system can be assessed in the same way.

(c)

For each benefit you mention, you will get a maximum of 2 marks. Remember that you need to write how you will assess the qualitative benefits of the new IT system. One mark is for identifying the benefit and one for assessing the benefit so do not forget to mention the benefit. You are required to write only two benefits (three benefits are given here for your information) so do not waste your time by writing too much.

Generally, before taking any decision, a cost-benefit analysis is made. While doing so, one should keep in mind that all the benefits (both quantitative as well as qualitative) should be considered for better analysis. Some of the qualitative benefits from the investment in the new IT system are as follows:

(i) Improved service quality

With the help of the new, improved IT system, better service quality can be provided to the customers by reducing the waiting time. This can be done through scheduling the appointments and improving inventory management.

This improved service quality can be assessed by obtaining feedback from customers. For example, customer feedback registers may be kept at several of Moffat's locations and customers asked to give their views on the quality of the service they received. Alternatively, customers may be asked to fill in questionnaires containing specific questions on the time taken to service the vehicle, the cleanliness of the vehicle, the behaviour of staff, the skill and competence of staff etc..

(ii) Improve internal business processes

The new IT system could also help in improving the internal business processes. This can be achieved through better inventory management, better distribution of the information within the organisation etc.

The improvement to the internal business processes can be assessed by the number of customer complaints, the reduction in waiting times, the reduction in the cost of inventory management etc.

(iii) Improve customer loyalty I satisfaction

If the customers are provided with a better quality service, they will be satisfied with the services provided by Moffat and this will help in improving customer loyalty. This will give Moffat a competitive advantage.

At the end of the period, the improvement in customer loyalty / satisfaction can be assessed by the number of customers who pay for Moffat's services on repeated occasions, the number of customer complaints etc.


11. Benchmark ing & in format ion sys tem - INA l td

(a)

ebbzsqf™ This question tests your understanding of benchmarking'. There are two requirements in this part of the question:

> explain the concept of benchmarking > explain the benefits of benchmarking

Therefore do not forget to meet both the requirements. In addition, do not foraet to relate vour answer to the aiven scenario.

Definition of benchmarking

Benchmarking is a process for improving performance by continuously identifying, understanding and adapting best practices and processes followed inside and outside the company and implementing the results.

The aim of benchmarking is to improve the existing processes / operations using best practices. In benchmarking, the working process of an organisation is examined and compared with another unit of the same organisation or with a leading organisation so that the good practices adopted by them can be identified and implemented. In short, benchmarking involves setting goals and measuring productivity based on best industry practices.

INA can implement benchmarking in any of the following ways:

^ External benchmarking: benchmarking against other organisations (which may or may not be competitors).

> Competitive benchmarking: benchmarking against competitors. ^ Internal benchmarking: benchmarking against organisation's own units or branches. r Functional I process benchmarking: benchmarking against organisations from different business sectors

or areas of activity but which are involved in similar functions or work processes z' Strategic benchmarking: examining the core competencies, product I service development and innovation

studies of best practice' companies.

However, the greatest difficulty in benchmarking is identifying the peer for comparison purposes. Even if a peer is identified, it may be difficult to obtain information about them. This is because they may not want to share their confidential information. Even if such information is obtained, it is difficult to establish its reliability. Therefore it may be problematic for INA to adopt external benchmarking. Instead, it may choose to adopt internal benchmarking (although internal benchmarking offers a more limited scope and fewer benefits compared to external benchmarking).

In such a case, INA may choose an organisation with a similar function, which is not its competitor (perhaps not from the same industry) and is ready to share information with INA, provided its purchasing department is efficient and effective.

The ultimate objective of benchmarking is to improve performance through minimising costs and improving quality. If two organisations mutually agree to share their information, both the organisations will benefit. This is because both the organisations will then review their policies and procedures and come up with innovations to define best practices in the purchasing department.

The benefits of benchmarking include the following:

> Benchmarking will highlight any weaknesses in the purchasing department and help to remove those weaknesses.

^ Benchmarking will help in identifying the areas where there is scope for improvement i.e. the areas where cost can be reduced or quality can be improved. This will help in improving the overall performance of the purchasing department.


Along with the practices adopted by the peer, benchmarking also considers innovative ideas from the employees. Therefore INA should ask the staff of the purchasing department to communicate their innovative ideas for improving the efficiency and effectiveness of the purchasing department. In this way. benchmarking provides the basis for establishing targets and accordingly, quantitative and justifiable targets can be set for the purchasing department. INA should design its reward system (linked to targets) after considenng the measurable and realistic targets set using benchmarking. This will motivate the purchasing department team.

(b)

I Do not make the mistake of discussing common performance measures for the purchasing department since this is not asked for. You are expected to discuss how benchmarking can be implemented in the purchasing department of INA.

In addition, do not forget to relate the implementation of benchmarking to the purchasing department instead of discussing it in general.

There is no standard procedure for implementing benchmarking but the following steps are generally followed (which could also be used to implement benchmarking in the purchasing department of INA).

^ Identifying the need for benchmarking and defining the objectives

Under this step, the existing practices / processes in the purchasing department are reviewed and assessed, the existing processes are mapped and the need for benchmarking, the type of benchmarking and the objectives of benchmarking are established.

This is an important point. You should discuss this in detail.

> Establishing targets and performance measures

Once the need for and objectives of benchmarking have been determined, performance measures and quantifiable and realistic targets should be established for the purchasing department. In order to be effective, benchmarking requires well-defined and measurable targets. While establishing targets and performance measures, certain factors such as terms and conditions of supply, annual expenditure and number of orders should be taken into consideration.

> Identifying best processes I practices and selecting peer

The next step is to identify the best practices which make the purchasing department efficient and effective. These best practices may be within the organisation or external to the organisation. Moreover, the best processes / practices may be from a different industry entirely. If an organisation is selected as a best practice organisation, it should be ensured that this organisation is willing to participate in the benchmarking process and to share information with INA.

'r Comparing own processes and performance with those of others

The performance of the purchasing department is then compared with the performance of the peer, the differences are examined and the practices which are performed better by one organisation compared to the other are identified.

> Designing and implementation

Once the comparison has been made, the next step is to combine the best practices of the two organisations (considering innovations), design the steps needed for implementation and carry out these steps. > Evaluation

Once the necessary steps have been earned out, it is necessary to evaluate the results of the benchmarking process in terms of improvements vis-a-vis objectives and other criteria set for the purpose. In addition, periodical evaluation and changes in benchmarks may be required in light of changes in the conditions that affect the performance.


For the successful implementation of benchmarking, the involvement and support of management as well as the staff of the purchasing department and the cooperation of the peer are necessary.

(c)

A While answering this part of the question, do not forget to address the behavioural problems which may arise dunng the implementation of benchmarking, as these problems may be of vital importance. In addition, only identifying the problems is not sufficient; you should also recommend how these problems can be resolved. Identifying problems and giving recommendations are worth equal marks i.e. 3 marks each.

> Obtaining critical information

Obtaining critical information about an organisation whose purchasing department is working efficiently and effectively is very difficult.

Recommendation Therefore, as stated earlier, while selecting the best practice' organisation, it is necessary to obtain the organisation's consent to the benchmarking and the organisation should also be prepared to share its critical information with INA. It should be understood that the sharing of information is beneficial to both the organisations. Furthermore, it should be remembered that meaningful comparison is possible only when two similar business functions are compared. This means that the peer should have a similar business function.

> Behavioural problem

The most commonly faced problems during the implementation of benchmarking are behavioural problems. Therefore INA should be prepared to encounter such problems. For example, the purchasing department staff may resist the idea of benchmarking. This is because there is the possibility that major changes will be made in their existing working style, their existing payments and their existing reward systems (especially those which are linked to performance).

In addition, benchmarking is often wrongly perceived as being adopted only when a unit or organisation is not performing well. However, in reality, benchmarking is not directly related to performance. It is a process improvement measure which ultimately results in improving performance. However, as a result of this wrong perception, additional behaviour problems may emerge. The staff of the purchasing department may feel that benchmarking has been resorted to because the management of INA feels that the department's performance is not up to the mark. However, in reality, this may not be true. Benchmarking is a continuous process of searching for and implementing better practices.

Recommendation In order to ensure the full cooperation of the staff of the purchasing department, the management of INA should explain the need for benchmarking to them, listen to their views and obtain their consent to the process of benchmarking. In short, the management of INA should handle the behavioural problem tactfully.

> Imitation of the practices of peer

It is often the case that, through benchmarking, an organisation ends up adopting the practices of the other organisation. However, this is not the aim of benchmarking; in addition to adopting the practices followed by the peer, the organisation should come up with innovative ideas. Recommendation Therefore while designing the benchmarking process, the management of INA should keep this in mind and accordingly should ensure that benchmarking does not involve mere copying of the practices of the peer.

^ Catching-up exercise

Instead of carrying out innovative work to gain a distinct advantage, benchmarking may become a catching-up' exercise.

Recommendation

The management of INA should remember that, for the successful implementation of benchmarking, catching-up should be avoided.

74: Performance Measurement System and Design

SOLUTION B A N K

12. Miss ion Statement

This is a straightforward question to answer.

The following requirements about Mission Statement are included in this question:

> Role and content of it ^ How does it contribute towards the planning and performance measurement process > Drawbacks

Be careful not to lose marks by accidentally missing out some of the requirements. Read the question carefully and note down the key requirements before answering the question.

A Mission Statement may be described as a published statement that contains the fundamental objective(s) of an entity expressed in general terms. It sets out the broad directions that the entity should and will attempt to follow and summarise the reasoning and values on which these are based. It is an enduring statement of purpose for an organisation that identifies the scope of its operations in product and market terms, and reflects its values and priorities.

Content of a Mission Statement

(i) A purpose

Why does the business exist? Is it to create wealth for shareholders? Does it exist to satisfy the needs of all stakeholders (including employees and the society at large)?

(ii) A strategy and strategic scope

A Mission Statement provides the commercial logic for the business and so defines the following:

> the products or services the business offers (its competitive position) ^ the competences through which it tries to succeed and its method of competing

A business' strategic scope defines the boundanes of its operations. These are set by management.

These boundanes may be set in terms of geography, market, business method, product etc. The decisions management takes regarding strategic scope define the nature of the business.

(iii) Policies and standards of behaviour

A mission needs to be translated into everyday actions. For example, if the business mission includes delivering outstanding customer service, then policies in line with this mission should be drawn up and standards should be created to monitor the effectiveness of the policies.

(a)

These might include monitoring the speed with which telephone calls are answered in the sales call centre, the number of complaints received from customers or the extent of positive customer feedback via questionnaires.

76: Strategic Performance Measuremenl ©fiTf.

(iv) Values and culture

The values of a business are the basic, often unstated, beliefs of the people who work in the business. The values may be built upon an underlying philosophy. They would include:

> business principles (e.g. social policy, commitments to customers) > loyalty and commitment (e.g. are employees inspired to sacrifice their personal goals for the good of the

business as a whole? Does the business demonstrate a high level of commitment and loyalty to its staff?)

> guidance on expected behaviour (a strong sense of mission helps to create a work environment where there is a common purpose)

(b) The Mission Statement can play an important part in the planning process by:

> providing a basis for consistent planning decisions > assisting in translating purposes and direction into objectives suitable for assessment and control > providing a consistent purpose between different interest groups connected to the organisation > establishing organisational goals and ethics ^ improving understanding and support from key groups outside the organisation

This framework should impact upon both high level strategic plans e.g. which areas of business the organisation should venture into, and on operational planning decisions such as sources of supply and the way customers are dealt with by staff.

In terms of the owners, the Mission Statement may incorporate a broad intention to enhance shareholder wealth. It might provide a broad indication highlighting specific goals such as to provide a specified (say 20%) return on investment.

The Mission Statement will therefore result in the cascading down of increasingly more detailed plans and targets. These targets will be set for the corporate entity, business sub-units and individuals. The comparison between these targets and the actual outcomes will provide the basis for performance measurement.

Performance is concerned with assessing the extent to which an objective has been achieved. It is a matter of a comparative judgement. To what extent has the organisation achieved what it set out to achieve?

(c) Potential problems arising from using a Mission Statement to manage performance are as follows:

^ the expression of the statement may be rather vague and abstract and therefore provide limited assistance in developing strategies.

> the content of the statement may provide management with incongruent goals. For example, maximising shareholder wealth may conflict with any ethical statements made in the mission. Some of the targets in the Mission Statement may be quantified and others may be non-quantifiable, leading to complications in the assessment of managerial performance.

> there is potential for inconsistent goal setting between departments or diffenng managerial levels. > the Mission Statement is occasionally regarded by employees as a 'window dressing' exercise which

does not, in their view, reflect actual company strategy and the actions of management. Consequently, this may result in dysfunctional behaviour.

r the Mission Statement does not normally stipulate a time horizon for the achievement of the corporate objectives. This leads to problems in assessing how well the organisation is performing.

€ C.TG Solution Rank:77

13. Usage of s tandards in dec is ion-mak ing

— This question relates to usage of standards in management accounting decision-making and behavioural aspects of setting standards.

> The answer to the question should be elaborate but specific to the requirements of the question. > Remember to read the question carefully and note down the key information before start

answering.

(a) Standard cost systems have lost their importance in modern business systems. However, setting standards (such as production targets and cost standards) is becoming increasingly important in measunng performance and accordingly in taking a dedsion on the future course of action. Existing standards may be used as the starting point to estimate the costs for a proposed new product. In a target costing situation, where the product price, market size and required return have been identified, target costs may be estimated. The target cost may then be compared with a current standard in order to identify the quantum of any cost gap which might exist. This gap may then be investigated with a view to its reduction or elimination through the application of techniques such as value engineering.

Decisions about the need for actions for improvement and change may be aided through the monitoring of variance trends through time. For improvement and change to take place, new standards are set or existing standards are improved, taking into consideration both internal and external factors Trends in a business (such as customer tastes and preferences) may be monitored in order to identify situations in which the existing standard (of product quality) may need to be improved with a view to improving and changing product design, production methods etc.

(b) A standard cost system provides guidance and criteria for operations and performance evaluations. Variance analysis is stricUy a tool for controlling and improving operations; it should never be used to find a scapegoat. Research into organisational behaviour has shown that successful operations are often the result of proper rewards. The focus in using a standard cost system should be on influencing behaviour through positive support and appropnate motivation. Long-term success is seldom achieved by means of penalties and punishments.

Managers and employees' perception of a standard costing system affects its success or failure. A negative perception or motivation is often the result of unreasonable standards, lack of transparency in setting standards, authoritarian control procedures, poor communication or absence of communication, inflexibility, uneven reward systems or over-emphasis on profits. These situations can turn a good standard cost system into a failure. Managers or employees with highly negative perceptions may feel discouraged and adopt protective or defensive behaviour, or even sabotage the system. These tactics include cushioning in the budgets, subtle attempts to beat the system, decreased initiative and divulging trade secrets. On the other hand, managers and other employees who like a standard cost system, show enthusiasm, creativity, and productivity.

Examples of the possible dysfunctional effects on decision-making are as follows:

Undue focus on material price and the need to achieve a predetermined standard may be a detrimental decision strategy.

It may detract from other factors such as loyalty to suppliers, fostering relationships with suppliers with regard to quality and just in time deliveries of materials. Such problems could, for example, disrupt manufacturing and alienate customers with adverse effects on future profit.

78: Slrafeglc Performance Measuremeni ©6TC

The achievement of a labour efficiency standard may lead to the achievement of a pre-determined ratio of output and input as the major decision focus. Efforts to achieve the standard may lead to the decision to increase batch sizes and hence reduce overall set-up and idle time (or to resort to a continuous production system, if it is feasible). Such decisions could be dysfunctional in that they lead to increased work-in-progress. They may also lead to reduced responsiveness to customer needs and the loss of future orders and hence profit.

Overhead standards will encourage a focus on absorption of the costs by product units. Increased throughput will be seen as the decision strategy to ensure that absorption of overhead cost per unit becomes favourable. This is likely to lead to an increase in the production of goods which remain in stock incurring holding costs and will run the risk of items of materials becoming obsolete (for the products which have very short life-cycles) if they are not sold within a short span of time. It also detracts from management efforts to focus on the root causes of overhead expenditure and action to reduce costs, possibly through quality improvement initiatives.

14. Per formance analys is - Sunf lower Hospi ta l

Since this is a numerical question, it is necessary to think about the presentation before you start writing your answer. When planning your answer, note down the salient points of the case while reading the question itself since the question is long. Keep in mind the time available for writing the answer. Your answer should be with reference to the case discussed in the question.

(a) Income statement of Sunflower Hospital

Budget Actual Variance amount amount amount

$'000 $•000 $'000 Revenue received (W1) Government funded patients (budget 40% patients whereas actual 70% patients) ^ Orthopaedic major surgeries 1.182.60 3,035.34 1,852.74 " Orthopaedic minor surgeries 7.805.16 10,016.62 2,211.46 > Physiotherapy treatments 11.037.60 21,730.28 10,692.68 Private patients ( budget 60% patients whereas actual 30% patients) ^ Orthopaedic major surgeries 2.838.24 2,081.38 (756.86) > Orthopaedic minor surgeries 15,965.10 5,853.87 (10,111.23) > Physiotherapy treatments 21,286.80 11,973.83 (9,312.97) Total revenue 60.115.50 54.691.32 (5,424.18) Less: Vanable costs Surgical costs 7,200.00 10,000.00 (2.800.00) Nursing costs 3,150.00 4,000.00 (850.00) Miscellaneous costs 2,700.00 2,800.00 (100.00) Total variable costs 13,050.00 16.800.00 (3,750.00) Contribution 47,065.50 37,891.32 9,174.18 Less: Fixed costs Surgical costs 32,000.00 32.000.00 0.00 Nursing costs 6,500.00 6,500.00 0.00 Miscellaneous costs 3,000.00 2,800.00 200.00 Depreciation on equipment & operation accessories 2,500.00 2,500.00 0.00 Administration costs 5,000.00 5,800.00 (800.00) Total fixed costs 49,000.00 49,600.00 (600.00) Net profit / (Net loss) (1,934.50) (11,708.68) 9,774.18

€ C.TG Solution Rank:79

Note that fixed costs remain unchanged if capacity is not fully realised, whereas variable costs vary in accordance with production capacity utilisation. In this case, only 90% of capacity is utilised during a year. Hence, only 90% of variable costs will be considered.

W1 Revenue received

W1 Revenue received

Major surgery For budget: government funded 21.900 patients x 40% government funded x 60% x 25% major x 90% capacity x S1.000 fees

Minor surgery 21.900 patients x 40% government funded x 60% x 75% minor x 90% capacity x S2.200 fees Physiotherapy 21,900 patients x 40% government funded x 40% x 90% capacity x $3,500 fees

For actual: government funded Major surgery 21.900 patients x 70% government funded x 55% x 40% major x 90% capacity x S1.000 fees Minor surgery Physiotherapy

21,900 patients x 70% government funded x 55% x 60% minor x 90% capacity x S2.200 fees 21.900 patients x 70% government funded x 45% x 90% capacity x S3.500 fees

For budget: private I Major surgery 21,900 patients x 60% private funded x 60% x 25% major x 90% capacity x $1,600 fees

Minor surgery 21,900 patients x 60% private funded x 60% x 75% minor x 90% capacity x $3,000 fees Physiotherapy 21,900 patients x 60% private funded x 40% x 90% capacity x $4,500 fees

Major surgery For actual: private 21.900 patients x 30% private funded x 55% x 40% major x 90% capacity x $1,600 fees

Minor surgery 21.900 patients x 30% private funded x 55% x 60% minor x 90% capacity x $3,000 fees Physiotherapy 21,900 patients x 30% government funded x 45% x 90% capacity x $4,500 fees

Note: Number of patients per year:

2 3 1 2 5 6 1 2

(b)

20 wards x 6 patients x 365 annual days

Average 2 days = 21,900 patients

Performance measures that could be used to assess the quality of service provided by the management of a hospital are as follows:

number of successful operations as a percentage of total operations / surgeries performed > the percentage of total operations / surgeries actually performed compared to agreed / pre-planned

schedule, which could be measured by reference to committed operation schedules and their rescheduling > responsiveness of hospital staff to requests of patients, which could be measured via a patient survey > availability of medicines and other facilities on time r waiting time for non-emergency operations which could be measured by considering the time elapsed from

the date when an operation was deemed necessary until it was actually performed ^ tidiness and hygiene standards

A Score More

The above answer will be treated as inappropriate answer if the performance measures are not discussed in the context of the hospital and moreover the performance measures are not discussed point-by-point.

SO: Slrafeglc Performance Measuremeni ©6TC

(c)

Since private patients pay more than government-funded patients, the mix of government-funded to private patients is the key determinant of profitability. Therefore, if ethical issues are ignored and, in the next year, demands for total operations exceed their available capacity, the hospital should give priority to private fee-paying patients as they receive more fees from these patients for each type of treatment and surgery. However, the following ethical issues must also be taken into account while deciding on the correct mix of patients:

> Government-funded patients also require medical treatment. This fact should be taken into consideration, especially as Sunflower Hospital is a partially government-funded hospital.

> Finally, Sunflower Hospital is a not-for-profit organisation committed to providing high quality service to all kinds of patients: hence it should not give prionty to private, fee-paying patients.

(d)

It is not appropriate to make a direct comparison of the financial performance of the two hospitals, because:

r Sunflower Hospital is partially government funded whereas Moonlight Hospital is privately owned. > Sunflower does not paying any interest on its loan while Moonlight does. > Sunflower gives preference to emergency cases by providing treatments on-time. On the other hand.

Moonlight does not undertake operations on an emergency basis. r- The hospitals have differing objectives: one is a not-for-profit organisation and the other is a profit-oriented

organisation. The fees structure charged to patients may be different in Sunflower and Moonlight.

> The level of operating costs differs as evidenced by the fact that the annual depreciation in Moonlight is 60% greater than that of Sunflower.

Required adjustments in the income statement

Sunflower (2007) budget ($ 000)

Sunflower (2007) actual ($'000)

Moonlight (2007) actual ($'000)

Original profit / loss Attributable income to subsidised operations (W2) Cost of emergency operations Loan interest adjustment Operating profit / loss after effects of adjustments

(1,934.50) 9,855.00 1,250.00

(11,708.69) 17.936.10

1,300.00

4,400.00

600.00

Original profit / loss Attributable income to subsidised operations (W2) Cost of emergency operations Loan interest adjustment Operating profit / loss after effects of adjustments (684.50) (7,527.41) 5,000.00

W2 Attributable income

Budgeted:

21.900 patients x 90% capadty x 40% government funded x $1,250 budgeted surgical costs = S9.855.000

Actual:

21.900 patients x 90% capacity x 70% government funded x $1,300 actual surgical costs = S17.936.100

15. Evaluat ion of st rategies i r This question is designed to test your knowledge and understanding on the concept of strategic

analysis of a business induding sensitivity analysis and gap analysis. ^ In order to secure better marks, present the numerical parts of the answer in tabular form. > Your answer should contain workings, since workings are integral part of the solution.

€>GTG Solution Rank:8l

(a) Statement showing forecasted revenues, costs and profitabil i ty for each of the years 2004 to 2006

2004 2005 2006 Sales units 150,000 130,000 110,000

$m $m $m Revenues 1,425 1,235 1,045 Less: Vanable costs - Materials and labour (W1) 540 468 396 - Assembly (W2) 150 130 110 - Marketing (W3) 30 26 22 - Delivery (W4) 15 13 11 Total variable costs 735 637 539 Contnbution 690 598 506 Less: Fixed costs - Assembly (W2) 450 450 450 - Marketing (W3) 30 30 30 - Delivery (W4) 60 60 60 - Administration 10 10 10 Total fixed costs 550 550 550 Profit 140 48 (44)

Workings:

W1 Materials and labour costs

$3,600 per unit of production and sales x Sales units in respective years (e.g. for 2004, $3,600 x 150,000 units = $540m)

W2 Assembly cost

25% of assembly cost is variable i.e. $1,000 (25% of £4.000) per unit of sales / production is vanable. Therefore, variable assembly cost = assembly cost/unit x no. of units produced and sales in the respective years.

Fixed assembly cost = 75% of $4,000 per unit x number of units produced and sold in 2004. (Since fixed assembly cost per unit is calculated based on costs in 2004).

W3 Marketing costs

Variable costs For 2004, 50% of $60 million i.e. $30m For 2005. ($30m x 130.000)/150.000 = $26m For 2006, ($30m x 110.000)/150.000 = S22m Fixed marketing costs = 50% of $60 million = $30 million

W4 Delivering costs

Variable costs

For 2004. 20% of S75 million i.e. $15m For 2005, (S15m x 130,000)/150,000 = $13m For 2006, ($15mx 110,000)/150,000 = $11m

Fixed delivery costs = 80% of $75 million i.e.$60 million.

Comment: the forecast reveals that the contribution will continue to decline with the decrease in sales volume. Accordingly, the company will sustain a loss in the year 2006.


(b) Statement showing profit estimates in 2004 based on original forecast and if each of the strategies is implemented

Original Strategy Strategy Strategy forecast 1 2 3

Volume 150.000 160.000 150,000 150.000 Selling pnce S9.500 S9.500 S10.000 S9.500

Sm Sm Sm Sm Revenues 1,425 1,520 1,500 1,425 Less: Variable costs - Materials and labour 540 576 540 432 - Assembly 150 160 150 120 - Marketing 30 32 30 24 - Delivery 15 16 15 12 Total variable costs 735 784 735 588 Contribution 690 736 765 837 Less: Fixed overheads - Assembly 450 - Marketing 30 550 550 550 - Delivery 60 - Administration 10 - Strategy 1 30 - Strategy 2 10 - Strategy 3 70 Total fixed overheads 550 580 560 620 Profit 140 156 205 217

(c) Statement showing profit estimates in 2004 if all three strategies are implemented

Year 2004 Selling price S10,000.0 Volume 160.000.0

Sm Revenue 1,600.0 Less: Variable costs: - Materials and labour 460-8 - Assembly 128 0 - Marketing 256 - Delivery 12 8 Total variable costs 627-2 Contribution 972-8 Less: Fixed overheads - Assembly 450.0 - Marketing 30.0 - Deliver1/ 60.0 Administration 10.0 Strategy 1 30.0 Strategy 2 10.0 Strategy 3 70.0 Total fixed overheads 660.0 Profit 312.8

€ GTG Solution Rank :83

(d) Increase in profit from separate strategies:

Strategy 1

Increase in contribution as a result of increased sales CdCm volume ($690m x 10,000 units)/150,000 units f tOIII

Less: Market entry costs $30m Net increase in profit S16m

Strategy 2

Increase in contribution <t7Cm (@ $500 per unit x 150,000 units) 2>/om

Less: Redesign costs (as amortised) $10m Net increase in profit $65m

Strategy 3

Savings by reduction in all variable costs by 20% (i.e. S735 x 20%) $147m Less: Additional fixed overheads $70rn Net increase in profit $77rn Total increase in profit from the three strategies $158rn

The increase in profit from the implementation of 3 strategies simultaneously = S312.8 - S140 = 5172.8m The increase in profit is S14.8m greater when the strategies are applied together. There is a synergy between the three strategies that provides a contribution greater than the sum of the increased profits when each of the strategies is applied in isolation.

Numerical recoodliation of additional profit increase when all the three strategies are applied simultaneously with total increase in profit when the strategies are applied in isolation: Strategy 1 increases sates volume by 10,000 units Strategy 2 increases contribution by $500 per unit (since sales price is increased by $500 per unit)

Total variable cost/unit = $735m/150.000 units = $4,900

Strategy 3 increases contribution per unit by $980 (since 20% of the variable costs are saved) Therefore, the combined impact (increase) on profit is 1,000 units x ($500 +$980) =$14.8 million.

Gap analysis is concerned with the gap between the forecast position from continuing with the current activities and the position that the organisation expects to achieve. It is not the gap between the current position and the forecast position. The Managing Director is unhappy with the current profit / (loss) forecast of $140 million in 2004, $48 million in 2005 and S44) million in 2006. The strategies developed will enable a profit of $312.8m to be achieved in 2004.

Each strategy contributes towards filling in the gap ($312.8m - $140m) = $172.8m The company envisages that it has potential to achieve a profit level of S280 million in 2004 and to maintain this level in each of the years thereafter. Gap analysis can be illustrated with the following diagram.

84: Strategic Performance Measuremenl

£m Profir

©fiTf.

£3 I 2 .8m

£ 2 9 8 m

Desired outcome

£280m Current forecast £ 140m

Year 2 0 0 3 Year 2 0 0 4

(i) Sensitivity analysis is a technique that permits options to be tested for their sensitivity / responsiveness to changes in specified key variables such as sales volume, price and material costs. The strategies outlined above generate other predicted outcomes from specified changes in particular variables.

Strategy 3 Strategy 3 offers a 20% reduction in vanable costs in return for spending $70m on a cost reduction programme. What if the S70m cost reduction programme only reduced costs by 15% - is it still worthwhile? How sensitive is the success of the strategy on the original estimates?

Strategy 1 What additional profits would result from strategy 1 if the sales rose by only 1,000 units?

Strategy 2 What if a re-design enables the company to fetch a price of $10,200 instead of $10,000?

Sensitivity analysis can be used to assess the robustness of a strategy i.e. whether it will continue to deliver its major benefits in spite of some changes in key variables.

Therefore sensitivity analysis provides management with more information than a single point estimate of an outcome. It considers a range of estimated outcomes depending upon the behaviour of key variables. It considers risk and uncertainty by offering alternative scenarios - increasing realism and complexity.

(ii) Percentage changes / sensitivity data:

Strategy 1 (% change in volume) Contribution required = $580m + $280m = S860m Original forecast contribution = $690m Therefore, percentage increase in volume required = ($860m - $690m)/S690m = 24.6%

Strategy 2 (% increase in selling price from re-design) Additional profit required = $280m - S205m = $75m Therefore the revenue required = $1,500m + $75m =$1,575m This requires a selling price of $1,575m/150,000 = $10,500 per car Therefore the % increase in selling price = ($10,500 -$9.500VS9.500 = 10.5%

For example:

€ GTG Solution Bank:85

Strategy 3 (% reduction in variable cost from cost reduction programme) Additional profit required = S280m - $217m = S63m The variable costs required = S588m - S63m = S525m Therefore, the % reduction in variable costs required = (S735m - $525m)/$735m = 28.6% This indicates that a much greater percentage change from the current forecast is required in the key variable(s) for strategies 1 and 3 if the desired outcome is to be achieved as compared to the percentage change required for strategy 2.

(g)

The financial performance of the company may be influenced by the political, economic, social and technological changes in the environment within which it operates. These external variables are beyond the control of the company in most cases. Therefore, in order to assess the efficacy of the strategies, the influence of these factors needs to be considered carefully.

For example, an organisation needs to consider whether the overall economic activity is undergoing a boom or a recession. Local economic factors such as the availability of skilled manpower might be a matter for consideration by the organisation.Interest rate movements and the company's debt structure are other factors that may need to be considered. During a period of rising interest rates, a heavily indebted company will be operating in a particularly difficult financial environment.

The success of strategy 1 in the given case depends upon the company's success in entering a new overseas market. The condition of the overseas economy and exchange rate movements will be vital to the success of this strategy. Government policy towards car ownership may have a significant influence on the performance of the company as factors such as taxation, safety norms, environmental legislation and government policy on traffic congestion all have a potential impact on car sales.

The strategies adopted by competitors are also exogenous variables which are likely to affect the success of the companies' strategies. The competitors are unlikely to be passive and will take counter-measures to maintain their market share in response to the strategies applied by the company.

16. Strategic per fo rmance measurement - B ig Buck Bank PIc

t my?Tffiy" ^ The question discusses issues such as mission of a business, evaluation of strategies and

identification of appropriate performance measures (both quantitative and qualitative).

The question contains 40 marks and should therefore be allocated a large amount of time for answering.

When planning your answer, note down the salient points of the case while reading the question itself. Since the question is long, keep in mind the time available for writing the answer to that part (0.6 minute per mark should be allowed for careful reading of the question and planning the answer and 1.2 minutes per mark for writing the answer).

(a) The mission of retail banking was to provide a high quality service to customers, by developing a close relationship between the bank managers and their customers. The new philosophy of the Bank emphasises profitability through rendering an efficient yet low-cost service. It is expected that the proposed change will bring in significant change in the operational system. This change in the philosophy of retail banking will have an impact on the Bank's staff, customers and shareholders.

As a result of the closure of around 1.000 retail branches, a large number of employees will become redundant. However, some additional managenal posts will be created in the superbranches.

Approximately 130 superbranches will be formed and accordingly new employment opportunities will be created for about 400 existing managers. At the same time however, about 50% of the existing staff and 600 managers will be declared redundant. Although the redundant staff will be compensated, this will inevitably have an effect on employee morale within the whole organisation. This, in turn, might adversely affect the efficiency and motivation of the employees, in particular, during the transitional period.

86: SiralegIc Performance Measurement ©6TC

Moreover, the creation of the superbranches will substantially change the job profile for many of the staff. Most of the jobs within the branches will not require professional skills. This may lead to decreased job satisfaction and fewer opportunities for staff development.

The newly adopted policy of using profitability as a performance measure may also have an adverse impact on managers' behaviour.

The new performance measurement system will assign less importance to aspects such as customer satisfaction or expansion through the opening of new accounts.

It appears that assigning importance to the profitability criterion and ignoring criteria such as customer satisfaction is overly focused on short-term gains. There are reasons for apprehension that the focus on short-termism may be at the expense of the Bank's growth in the future.

It is clear that many customers depend on the managers' advice and assistance. Therefore, management should focus on the activities that establish a relationship of trust between bank managers and their customers.

It is essential for the Bank to reconsider its policy of not focusing on increasing the number of customers and not encouraging managers to advise customers about their businesses. In fact, the Bank should assess the impact of its change in philosophy on its customers. Predicting customer reaction to the change is important because the loss of a large number of existing customers will be detrimental to the Bank. Moreover, it is important that the sites of the superbranches are chosen carefully because if the superbranches are not conveniently located for most of their customers, customers might decide to move their accounts to another bank which is more conveniently located.

Basically, it is essential for the Bank to estimate the effect of the changed philosophy on its customers. This may be particularly significant if the Bank's competitors are still providing personalised service to its customers. In addition, the attitude of the customers to the "efficient yet low-cost service" must be predicted, as the loss of a large number of existing customers will be detrimental for the Bank. It is possible that the superbranches will not be conveniently located for many of the customers, and they may decide to move their accounts to a bank that has a branch that is more convenient. It is also possible that customers, who use many of the services offered by the Bank, will find that their total bank charges increase as a result of the changes at Big Bucks Bank Pic.

The shareholders will be primarily interested in the enhanced profits generated by the changed policy. If costs are reduced and profitable customers can be retained, it is likely that the profits will increase. However, the additional cost of the superbranches may reduce the profits to some extent. Moreover, the cost impacts of the one-off payments to the employees who are made redundant need to be considered in the calculation of profitability. Finally, the effect of the changes in the branches may also influence the corporate banking business. This is an aspect of the proposed changes which will be difficult to predict, but could be important when evaluating the consequences of the decision to increase the Bank's efficiency through reducing costs.

(b) Previously, all branches were treated as cost centres. The decision to make the superbranches investment centres requires attention to be paid to both the profitability of and capital employed in each superbranch. This new approach to performance measurement indicates that the management of each unit will enjoy more autonomy to take decisions regarding the best utilisation of the resources available, since the performance of the unit will be evaluated in terms of profitability.

Moreover, managers will have a greater degree of freedom and authority to undertake projects which are expected to meet the organisation's performance criteria. This will increase the managers' motivation and experience. In addition, it will enable senior management to compare the performance of each superbranch and accordingly this may encourage improved performance through generating inter-branch competition.

A possible disadvantage of using profitability as a performance measure is that it may lead to short-termism since the managers will take decisions that enhance current profit (even at the cost of the long-term growth and progress of the company). An example of this problem is the reduction in public relations expenditure and promotional expenditure in order to improve the profit in a particular accounting period. This will affect the future organisational growth. Moreover, concentrating only on projects which do not require large amounts of capital may result in the avoidance of capital intensive projects, since these projects will not meet the short-term profitability targets.

Another possible problem area is the bank managers' lack of experience of using profitability as a performance measure. Inappropriate targets may be set and this may affect the managers' motivation and behaviour.


(c)

(i) The branch managers, the superbranch managers and the senior management of Big Bucks Bank Pic will need reports to assess the performance of each branch. In order to be useful, the relevant reports will be needed to be generated at regular intervals (e.g. monthly, quarterly, and annually).

It is prudent to use residual income and return on capital employed as performance measures for the branches and superbranches. In order to calculate these performance measures, the managers should be provided with regular reports on the profit generated by each branch, the amount invested by each branch and details of other important factors. Moreover, a report on incremental profit attributable to the number of new accounts opened might be useful in justifying the opening of new accounts. The reports should provide information to both the superbranch managers and senior management within the Bank. This will enable appropriate action to be taken, if needed, and allow for companson of the performance of the different superbranches.

The annual budget should indude details of both the expected revenue from the different activities of the Bank and a forecast of the total expenses and their justification. The staff costs will be significant and therefore both staff strength and costs should be explicitly reported. The capital investment budget is another important aspect which should be reported, along with justification of the budgeted expenditure.

The monthly reports will contain details of the revenues, expenses and details of staffing for the current month and also for the year to date. Finally, the profit of the superbranch. the return on investment and the residual income will be shown in order to ensure that each manager is aware of the performance of each superbranch.

Details of the level of sales for each of the financial products will be needed regularly (at least on a monthly basis, if not more frequently). However, as a substantial part of the expenses of each branch is expected to be fixed (and therefore less controllable), a monthly report is likely to be adequate for the purpose of controlling these expenses. Since travel, advertising and entertainment costs are also likely to be substantial, management will need to monitor the monthly details of these expenses in order to control them. Finally, the managers will need various ad hoc reports to provide information about the profitability of different categones of customer, services or products offered by the Bank.

(ii) The following non-financial measures will help the Bank to monitor the performance of the branches: There are a number of non-financial areas which should be monitored continuously by the managers of the superbranches. These include:

> staffing levels > the number of new customer accounts opened ^ the quality of service offered to customers, especially in comparison with the service provided by the

Bank's competitors

The number of staff employed per branch or superbranch will be a good basis for measuring the performance of the branch / superbranch. Moreover, employee cost is one of the major costs of all the branches. Accordingly, it is essential that this is monitored. However, length of service, experience and training are qualitative indicators that should be available to management in respect of individual staff members. In particular, the level of staff competence in IT is an area which should be monitored, as the retail Bank's operations use computers extensively.

In order to monitor the Bank's growth, details should be provided of the number of new customers. This information, if provided on a regular basis, will reflect the growth of the business. Details of the different types of customer will be an important aspect in monitoring the success of the activities in attracting new customers and also in assessing the needs of the public.

As the Bank aims to offer an "efficient yet low-cost service", it is essential that management is aware of customers' opinions regarding the quality of service offered to them. This information may be difficult to measure accurately, but some possible qualitative measures are waiting times in branches, the number of mistakes in customers' accounts and the number of complaints lodged by the public. In addition, surveys could be conducted regularly to measure the reactions of the Bank's customers. A matter that should be of major concern to the management of the Bank is the nature and frequency of complaints that are received from the public. This information should be recorded to indicate the areas which need to be improved. This type of indicator will be crudal in a period of cost-cutting to ensure that the customers are not dissatisfied with the changes.


Another area which should be considered by the management of each superbranch is the activities of competitors. Within the Bank it will be possible to compare the performance of each superbranch. This information will be relatively easy to obtain and will allow the performances of the superbranches to be compared. However, it will be necessary to take into account differences between the superbranches in terms of the profile of their customers and the nature of their services. Although the performance of other banks is difficult to measure, appropriate measures should be devised in order to assess the relative performance of Big Bucks Bank Pic.

17. Measures of per formance

I In the case of part (a) (being a numerical question), it is necessary to think about the presentation before you start writing your answer. This is because:

Planning the presentation saves time by avoiding repetition of the same information > Good presentation provides better readability ^ Planning eliminates any unnecessary information and makes your answer clear, simple and

concise For part (b) and part (c), remember that your examiner will prefer a point-by-point answer and therefore you should present your answer in this manner in order to get high marks.

Highest possible revenue, lowest possible costs and lowest possible cost of capital (10%) are taken into consideration

(i) If revenue increases by~5% ana costs aecrease Dy ov«: 7 ^

BEST OUTCOME / ^ ^ Year 1

$m 2

Sm 3

$m Revenues 94.5 105 115.5 Less: Direct costs 570 66-5 76.0 Net cash flow 37-5 38.5 39.5 Less: Depreciation 20 20 20 Profit 17.5 18.5 19.5 Less: Imputed interest (10% on net book value) 6.00 4.00 2.00 Residual income 11.50 14.50 17.50 Net book value (= initial investments -accumulated depreciation at the beginning of the 60 40 20 year)

ROI 17.5'60 x 100 18.5'40x 100

19.5-20 x 100

= 29.17% = 46.25% = 97.50%

Year Cash flow ($m) Discount factor

(10%) DCF (Sm) 0 (60.0) 1.000 (60.00) 1 37.5 0.909 34.09 2 38.5 0.826 31.80 3 39.5 0.751 29.66

Net Present Value 35.55

Lowest possible revenue, highest possible costs and highest possible cost of capital (14%) are taken into consideration

(ii) If revenue decreases by 5% and costs increase by 5%:

WORST OUTCOME Year 1 2 3

Sm Sm Sm Revenues 85.5 95.0 104.5 Less: Direct costs 63.0 73.5 84.0 Net cash flow 22.5 21.5 20.5 Less: Depreciation 20.00 20.00 20.0 Profit 2.50 1.50 0.5


Less: Imputed interest (14% on net book value) 8.40 5.60 2.8 Residual income (5.90) (4.10) (2.3) Net book value (= initial investments -accumulated depreciation at the beginning of the year)

60.00 40.00 20.0

ROI 2.5/60 x

100 = 4.17%

1.5/40 x 100 = 3.75%

0.5/20 x 100 = 2.5%

Year Cash flow Discount factor (14%) DCF 0 (60.0) 1.000 (60.00) 1 22.5 0.877 19.73 2 21.5 0.769 16.53 3 20.5 0.675 13.84

Net Present Value (9.90)

Comment: the best outcome and the worst outcome are two extremes and in real life the outcome is expected to be somewhere in between.

(I) Residual income (Rl)

Rl is the net income earned after deducting a charge for the funds invested in the division or investment unit. The charge is determined by taking the organisation's desired minimum rate of return and multiplying it by the amount of the investment. It is calculated as follows:

Rl = Income - Charge on investment Charge on investment = (Investment x Desired rate of return)

In contrast to ROI, which is expressed as a percentage, residual income is expressed in absolute terms (i.e. as a dollar amount).

Strengths

Rl gives project sponsors an idea of the finance costs involved in a project. Rl can be used to discriminate between projects that generate returns above and below the cost of capital. It is a flexible tool as projects carrying differing risks can be attributed separate rates of interest.

Limitations

The major limitation of this method is that, because residual income is not expressed as a percentage, it is not useful for comparing units of significantly different sizes. It favours larger units that would be expected to have larger residual income, even with relatively poor performance.

It is difficult to decide what should be the desired rate of return. Considering a wrong rate of return may misguide the decision-maker.

(ii) Return on investment (ROI)

ROI is the ratio of profit to investment in operational assets. It is normally expressed as a percentage, and the larger the percentage, the better the ROI.

ROI is normally interchangeable with ROCE as a measure of profitability. ROI is normally used for divisional or investment centre performance appraisal. ROI is calculated as follows:

ROI = Return on sales x Operating asset turnover

EBIT Sales x

Sales Operatinga ssetemploy ed


ROI indicates the profit earned for each dollar invested in the operating assets of a business. It is a measure which takes into consideration the revenues, costs and investments, by combining these factors into a single percentage. ROIs for successful firms range from 10 to more than 50 per cent, although each firm's ROI must be evaluated in the light of the industry average ROI and the economic factors facing that particular entity or strategic business unit.

Strengths

It is directly related to the standard accounting process and is widely understood. ^ It appeals to investors who are interested in assessing the percentage return on an investment. ^ It permits comparison between projects that differ in their absolute size. > It permits the performance of semi-autonomous business units to be compared with each other and with an

aggregated figure.

Limitations of ROI

ROI may be a better alternative to profit as a performance measure for divisions or investment projects. However. ROI also has certain shortcomings that limit its use as a performance evaluation critenon. These shortcomings are:

> Ignores time value of money

ROI ignores the time value of money. The concept of the time value of money is that the value of money changes over time i.e. the value of a dollar / pound today is different from the value of a dollar / pound tomorrow and accordingly the purchasing power of the same unit of money undergoes a change.

^ Ignores risk associated with the project

ROI also ignores the risks associated with the project. While taking a decision regarding projects with different levels of risk, using ROI may result in ignoring a good project which has lower risk and accepting a project which offers a high return but with correspondingly high risks.

> Flexibility

It is an advantage that ROI can be modified to fit the situation. However, this advantage may turn into a disadvantage if this flexibility is used to manipulate the results by expressing them in a different way.

> Inconsistency

The terms income and investment can be interpreted in various ways. Income is sometimes taken as before interest and tax; sometimes as after interest and tax. Likewise, investment also sometimes considers net assets and, sometimes, the gross value of assets.

> Short-term analysis

The calculation of ROI only takes into consideration short-term investments. Long-term costs such as maintenance and software upgrades are ignored. Therefore, projects with heavy long-term costs may show a high return on investment in the initial period.

> Variation in calculations

If the methods of calculating depreciation are different for the different units, it is difficult to compare their performances.

(iii) Net present value (NPV)

The net present value (NPV) of an investment (project) is the difference between the amount of initial investment and the sum of the discounted cash flows which the investment is predicted to generate.

The value of money depends upon the timing of the cash flows. The same amount of money received or paid at different times has different values. To make the cash flows at different dates comparable, their present values are calculated. The net present values are calculated as:

€ GTG Solution Rank:0l

NPV = Present value of cash inflows - Present value of cash outflows

These present values can be either positive (cash inflow greater than outflow), negative (cash outflow greater than inflow) or zero (cash outflow and inflow exactly equal). The rule is to accept all the independent projects with a positive net present value or. for competing projects, the project with the highest NPV.

The discounted value depends on the date of expected cash flows. Some assumptions relating to NPV calculations include the following:

^ The initial cash outlay is incurred at the beginning of the first period, i.e. the year is taken as 0. The present value of this initial investment is the same as the amount of investment; it is not required to be discounted since the time is now'. The discount factor for year 0 is 1.000.

> Any transaction during a penod is assumed to occur at the end of the period. E.g. receipts dunng year 2 are assumed to have taken place at the end of year 2.

^ Cash flows occurring at the beginning of a period will be assumed to have occurred in the previous period for discounting purposes only.

Strengths

The biggest strength of NPV is that it recognises the time value of money. The emphasis on cash flows is particularly appealing to shareholders who are seeking short and long-term cash returns. The use of cash flows is subject to less manipulation and fewer subjective decisions than the use of profits based on accruals accounting. It considers the opportunity cost of not holding money. Risks can be considered by using different costs of capital for different money market situations.

Weaknesses

NPV estimates incorporate a number of assumptions concerning decision critical variables such as the duration of the cash flows. It is very difficult to predict the timing of the cash flows within the life of the project. Determining the appropriate cost of capital to apply to the project is difficult and moreover it is even more difficult to estimate whether or this should remain constant over the life of the project. This is especially difficult when the organisation is not able or is unwilling to arrange long-term fixed interest funding. The heavy reliance on estimates and subjective decision-making permits and encourages project sponsors and other interested parties to submit optimistic projections that cannot be easily refuted.

(c)

The broader issues that should be considered when deciding whether the company should proceed with a particular project are as follows: > The anticipated project nsk - can it be measured reliably? ^ Is the project an integral part of a larger and longer term business plan? Is it the first step in a series of

dependent projects? If the project is an integral part of a large business plan, the performance of the project should not be considered in isolation.

> The synergy and relationship between different projects- it may so happen that the combined outcome of the projects in an overall business plan will be greater than the sum of the outcomes of the projects in isolation.

> The potential for an individual project to alter the overall risk of a company's business activities. For example, a single project may have the potential, if combined with certain other projects, to lower the overall risk, and consequently the corporate cost of capital. The time of commencement of a project. This might be a vital issue as it may so happen that a project will lose its relevance it is not taken up on time.

18. Per formance analys is - Tal ies in L td

titiLty For case study based questions, read the question carefully and note down the key information before start answering. If the key information are noted down well in advance you can keep track of your answer and make sure that you have answered all the requirements. This will save you time and prevent you from losing marks. Moreover, your answer should be specific to the question and should make reference to the case of Taliesin Ltd. Remember that answering the question without referring to the given case will reduce your prospect to earn high marks.

4


(a) The overall performance of Taliesin Ltd during the years ended 31 May 2004 and 31 May 2005 can be measured by its return on capital employed (ROCE) as follows:

2005 2004

Profit before interest 5,000 4,000

Total assets less current liabilities 66,000 52,000

7.58% 7.69%

Performance analysis

An ROCE of 7.58% Is not good, especially when Taliesin Ltd has borrowed money at 10% with the intention of improving its activity in order to grow further. The ROCE for 2005 is slightly lower than that for 2004. Since this information was available at the start of the 2005 financial year, the directors should have reconsidered their growth target.

Sales have increased by 20% over the previous year. There is a considerable vanation in the sales achieved by Taliesin Ltd in the different halves of their accounting year which is mainly attributable to seasonal variations in demand. In order to cope with the additional demand for the period 1 June - 30 November during each financial year, temporary workforce is hired during these periods. Most of the growth in sales revenue occurred during the first half of the year ended 31 May 2005.

The cost of sales has remained constant at 60% of sales. It is interesting to note that the composition of cost of sales has changed during the year and management attention should be focused on this in order to ascertain the reasons for this change. The material costs as a percentage of cost of sales have remained unaltered whereas labour cost (in percentage terms) has decreased. Manufacturing overheads have increased slightly in 2005 compared to the preceding year. It may be noted that the cost of sales in 2005 (51.5%) mostly comprises manufactunng overheads. This is an increase of 1.5% over 2004.

2005 2004 % of cost of % of cost of

sales: sales: Materials 32-5 32-5 Labour 160 17 5 Overheads 51-5 500

1000 1000

Score More

Instead of presenting the information in tabular form, one could present the information in the following manner:

In 2004. materials, labour and overheads constitute 32.5%. 17% and 50% of cost of sales.

Such presentation will not make the answer wrong. However, tabular presentation of numerical information provides better readability and makes the answer clear, simple and concise.

Whilst the gross profit percentage has remained constant at 40% in 2005 (compared to 2004), the net profit percentage has reduced from 10% to 8.33% during the same period. However, Taliesin Ltd has earned the same profit in absolute terms during the year ended 31 May 2005 as it did in the previous year.

Operating costs have risen by 27.5% over the previous year's level. The company has also paid £1 million as interest on a loan in order to finance the infrastructure required to manufacture the six new products.

Details of the composition of net current assets are required in order to ascertain the liquidity position of Taliesin Pic and thereby obtain a broader view of the financial position of Taliesin Ltd.

€ GTG Solution RanK:<)3

From the information provided, it appears that Taliesin Ltd has lost a customer during the year ended 31 May 2005. It can be construed that this only happened towards the end of the year and therefore the income statement might not fully reflect the financial consequences of the lost customer. The loss of the customer could well be highly significant since the company had only six customers at the start of the year. It is highly probable; therefore, that each of the six customers, being supermarkets, purchased in relatively large volumes and accordingly significant turnover may have been lost. In order to make good the loss, Taliesin Ltd should attempt to attract a new customer as soon as possible, in order to replace the lost customer.

Growth may only have been achieved by introducing new products. There may be a limit to the number of times that this can be done effectively. It has already been noted that the six new products have led to a loan, the cost of which exceeds the return generated by Taliesin Ltd. It is essential, accordingly, to focus on growth of the customer base.

(b) The major benefits of pursuing a policy of internal development that may accrue to Taliesin Ltd are as follows:

By confining its activities to its internal environment, the company avoids the need to manage the integration of businesses which would have been necessary had the company opted for an acquisition. Management teams, when considering the acquisition of another organisation, very often underestimate the costs of integration.

> There is no need for the board of directors of Taliesin Ltd to make itself acquainted with different organisational and national cultures, values etc., thereby avoiding many potential problems.

^ The board of directors of Taliesin Ltd considered it to be prudent to control the activities of the business. It was felt that going for more complex supply chains and strategic alliances with foreign organisations would be unnecessary.

> All investments in tangible capital assets are made at market price whereas if the board of directors had attempted to acquire another business then significant outlays would probably have been required in respect of purchased goodwill.

> As the organisation develops and expands, staff are provided with development and learning activities that may give them the impetus to increase the level of their commitment to the organisation.

(c) Use of activity-based techniques in Taliesin Ltd

(i) For pricing

Switching to ABC can substantially change the costs per unit calculations. Consequently, if an organisation's selling pnces are determined by cost-plus pricing then the selling prices will be altered. Specifically, the prices of the products assigned a higher amount of overheads will go up whereas the prices of the products allocated a lower amount of overheads will go down.

This may result in the non-acceptance of the price of a product (whose price has gone up) by the market or loss of revenue due to a decrease in the pnce of a product.

Keeping in mind the above consequences, Taliesin Ltd might prefer prices to be market driven and accordingly might not make any change to the price due to a change in the method of overhead absorption. Only the profit per unit would change. Nevertheless, even when the pnces are market driven, management may come to know about the real profitability of products by switching to ABC.

(ii) For sales strategy

There is a likelihood of attitudinal change within the organisation due to the changed profitability of the products. After switching over to ABC from a traditional system, the allocation of overheads to the products will change and, accordingly, the profitability of the products will change if the prices are market driven. The focus of the marketing team will be redirected into rescheduling the sales target, aiming at higher profitability.

(iii) For performance management

ABC points out the fact that activities give rise to costs i.e. a greater number of activities would mean greater costs. Therefore, costs can be controlled only if activities are controlled. The management of Taliesin Ltd needs to consider that organisations implementing the ABC system mainly use it to plan and manage activities i.e. as an aid to performance management.


(iv) For decision-making

In order to make the correct decisions, one needs to have accurate information about costs. The ABC system can provide the accurate costs of the products by refining the method of overhead cost allocation. Management decisions regarding making or outsourcing', 'adding or dropping any new product', 'alternative design choices to improve efficiency and reduce non value-added costs', etc. can be perfected through using activity-based costing.

19. St ra teg ic pe r f o rmance measu remen t - Pack and D ispa tch C o

i This Question relates to Strategic Management Accounting model (Porter's Five Forces model) and different performance indicators. Your answer should be with reference to the case discussed in the question.

In order to get high marks make your answer brief and to the point. However, the answer given below is comparatively large as it is intended to give you a complete overview of the topic.

(a) In order to assess the attractiveness of the option to enter the market for fast food packs, the directors of PADC could make use of Michael Porter's 'five forces model' in order to make a qualitative evaluation of the firm's strategic position. The five forces that determine an organisation's strategic position are the threat of substitute products, the threat of the entry of new competitors, the intensity of competitive rivalry, the bargaining power of customers and the bargaining power of suppliers.

In applying this model to the given scenario, one might conclude that the relatively low cost of the machine together with the fact that an unskilled person would only require one day's training in order to be able to operate a machine, constitute relatively low costs of entry to the market. Therefore one might reasonably condude that there is no entry barrier i.e. the threat of the entry of new competitors might be high.

Products are usually purchased in very large quantities by customers. Moreover, there is little real difference between the products of alternative suppliers. Under these circumstances, customer (buyer) power is likely to be very high. The fact that the paper packs, on average, make up only between 3% and 5% of the total cost of the purchaser's finished product, also suggests that buyer power might be very high.

The specially formulated paper from which the packs are made is sometimes in short supply. Accordingly, the bargaining power of suppliers will also be very high. Hence suppliers might increase their prices with a consequential reduction in the gross margin of the firms in the marketplace.

The threat from competitive rivals will be strong as the six major players in the market are of similar size and the market is a slow growing market. The market leader currently has 25% of the market and the remaining five nearest competitors each hold approximately 10% of the market.

The fact that Soft Packaging produces a narrow range of cardboard packs constitutes a threat from a substitute product. This threat will increase if the product range of the company is extended and the price of cardboard packs is reduced.

The fact that a foreign-based multinational company is considering entering this market represents a significant threat from a potential new entrant as it would appear that the multinational company might be able to leverage economies of scale from large scale automated machinery and has manufacturing flexibility.

Low capital barriers to entry might appeal to PADC but they would also appeal to other potential entrants. The low growth market, the ease of entry, the existence of established competitors, a credible threat of backward vertical integration by suppliers, the possible entry by a multi-national, a struggling established competitor and the difficulty of differentiating an industrial commodity should call into question the potential of PADC to achieve any sort of competitive advantage.

Entry into such a market will be considered to be a good move only if PADC can achieve the position of lowest cost producer within the industry. In order to assess whether this is possible. PADC must consider any potential synergies that would exist between its cardboard business and that of the packaging operation.

From the information available, the option to enter the market for cardboard packs appears to be unattractive. The directors of PADC should seek alternative performance improvement strategies.


(b) It would appear that the rival company's market share has declined from 29% to 10% (i.e. (75% • 25%)/5] over the last three years. A 12% fall in market share is very significant due to its effect on profits and resultant cash flows. Obviously such a declining trend needs to be stopped immediately and this will require a detailed investigation to be undertaken by the directors of the rival company. Consequently loss of market share can be seen to be an indicator of possible corporate failure.

Other indicators of corporate failure are as follows:

Poor cash flow

Poor cash flow might render an organisation unable to pay its debts as and when they fall due. Consequently, providers of finance might invoke the terms of a loan covenant and commence legal action against an organisation which might eventually lead to its winding-up.

Lack of new production I service introduction

Innovation can be viewed as a move towards growth (or even as a survival strategy) since it does not only improve the marketability of a company's products but also makes a clear distinction between the company and its competitors who do not innovate new products or new product features. A lack of new product / service introduction may arise from a shortage of funds available for research, product development and marketing.

General economic conditions

Falling demand and increasing interest rates can lead to the failure of organisations. Organisations with highly geared capital structure will suffer as demand falls and the weight of the interest burden increases. Organisations can find themselves in a vicious circle as increasing amounts of interest payable are paid from diminishing gross margins leading to falling profits / increasing losses and negative cash flows. This leads to the need for further loan finance and even higher interest burden, further diminution in margins and so on.

Lack of financial controls

The absence of sound financial controls might prove to be costly to many organisations. In extreme circumstances it can lead to outnght fraud (as was the case in Enron and WorldCom).

Internal rivalry

The extent of internal rivalry that exists within an organisation can prove to be of critical significance to an organisation as managerial effort is effectively channelled into increasing the amount of internal conflict that exists to the detriment of the organisation as a whole. Unfortunately the adverse consequences of internal rivalry remain hidden until it is too late to redress them.

Loss of key personnel

In certain types of organisation, the loss of key personnel can spell the beginning of the end' for an organisation. This is particularly the case when individuals possess knowledge which can be exploited by direct competitors, e.g. sales contacts, product specifications and know-how of products.

20. Measures of per fo rmance - Tannadens Div is ion

This being a large question, before answering it, read the question carefully and note down the key requirements before answering the question.

Since the answer contains numerical part, it is necessary to think about the presentation before you start writing your answer.

This is because:

Planning the presentation saves time by avoiding repetition of the same information and > Planning eliminates any unnecessary information and makes your answer clear, concise.

i

%: Slralegir Performance Measuremenl ©GTG

(a) Best outcome situation for the quality improvement programme

Year 1 Year 2 Year 3 Year 4 Additional output capacity (Std. hours) (W1) 1.050 1.365 1,785 2,100

$ $ $ $ Contribution (W2) 1.386.000 1.801,800 2.356.200 2,772.000 Less: Training, consultancy, salary costs (W3) 97,500 97,500 97,500 97,500 Net margin 1.288.500 1,704,300 2.258.700 2.674.500 Less: Depreciation (W4) 1,000,000 1,000,000 1,000,000 1.000.000 Net profit 288,500 704300 1,258,700 1.674.500 Less: Imputed interest (W5) 320,000 240.000 160,000 80 Residual income (W6) -31,500 464.300 1,098,700 1.594.500 Return on investment (%) (W6) 7.2% 23.5% 62.9% 167.5% Net present value (NPV) at 8% (W7) $2,412,901

Workings

W1 Using year 3 as an example: additional std. hours = (1,000 + 300 + 400) x 1.05 =1,785

W2 Contribution (e.g. for year 1) = 1,050 hours x ($1,200 x 1.10) =$1,386,000

W3 Training, consultancy & salary cost for each year = $100,000 x 0.975 = $97,500

W4 Depreciation per year

W5 Imputed interest charge (e.g. for year 2)

W6 Return on investment (e.g. for year 4)

= $4,000,000/4 = $1,000,000

= WDV x cost of capital = (4,000,000 -1,000,000) x 8% = $240,000

= Net profit /WDV = $1.674.500/£1.000.000 = 167.5%

W7 NPV = (Net margin x Discount factor at 8%) for each year - Initial investment =$1,288,500 x 0.926 + $1,704,300 x 0.857 + $2,258,700 x 0.794 +$2,674,500 x 0.735 - $4,000,000 =$2,412,901

(b) Bonus calculation for most likely outcome situation

Year 1 Year 2 Year 3 Year 4 Total $ $ $ $ $

Net profit basis (W1) 0 3,150 10.35 15,750 29,250 Residual income basis (W2) 0 0 9.800 19,000 28.800 ROI basis (W3) 6,000 6,000 6.000 6.000 24.000 NPV basis (W4) 0 0 0 30.843 30.843

Workings: (giving an example for one year in each case)

Bonus = ($460,000 - $250,000) x 15% = $3,150 Bonus = ($740,000 - $250,000) x (0.05 x $40,000),'100,000 = $9,800

Bonus = $40,000 x 15% = < s i n c e R 0 ' i s positive)

Bonus = $1,233,700 x 2.5% = $30,843

W1: Year 2: W2: Year 3:

W3: Year 1:

W4: Year 4:

€ C.TG Solution Hanh:U7

(c)

The programme manager's choice of bonus method will be influenced by factors such as the timing of the bonus, its size, the relative ease with which it is earned and his risk perception.

The most likely outcome figures calculated in (b) show that the largest total bonus is $30,843 where 25% of NPV is used as the basis.

The timing of the bonus payments may concern the programme manager. The NPV basis delays any payment until the end of year 4. The other bonus methods based on ROI, net profit and Rl have initial bonus payments in years 1, 2 and 3 respectively. The programme manager may have a strong preference for eariy cash inflows from his bonus and choose the ROI basis which will yield $6,000 in year 1.

His choice may also be influenced by the relative ease with which the bonus is earned and the degree of control over the factors incorporated into its calculation. The Rl and NPV bases are affected by the cost of capital percentage which is used. The programme manager may view this as unacceptable because of his lack of control over the cost of capital percentage used in the calculation.

The bonus payment will inversely vary with the cost of capital even if the efficiency of implementation of the programme has been improved.

The ROI basis ensures a bonus of $6,000 per year so long as the net profit is greater than S250.000. On the other hand, no bonus will be payable on the net profit basis unless the net profit per year exceeds $250,000.

The attitude to risk of the programme manager is also relevant. A risk-seeking manager may view the S60.323 bonus from the NPV basis where the best outcome occurs as very attractive. On the other hand, a risk averse manager may view as unacceptable the possibility of a bonus of only $5,370 from the NPV basis if the worst outcome occurs. He may then prefer the bonus of £18,000 from the ROI basis which is payable even if the worst outcome occurs.

The outcome of the implementation of the quality improvement programme will be influenced by the effort of the programme manager, his attitude to nsk and the rationality of his decision-making. The programme manager's level of effort and motivation may be affected by the bonus system or by promotion prospects. His attitude to risk may be related to the extent to which he feels he has control over the implementation of the programme and how it is monitored. The success of the programme will also depend on the manager's capability to handle the job in hand and on whether or not he is capable of making relevant decisions about its effective implementation.

It may be argued that it is the individual who chooses actions and implements them. The strength of motivation to achieve the target (of the programme) will be affected by the expectation that its achievement will result in some benefit. His actions will be based on intrinsic and extrinsic factors. His motivation to achieve the implementation of the quality programme will be affected by both intrinsic and extrinsic factors and his preference for them. Examples of extrinsic factors are the extent to which the manager values the receipt of a high bonus payment or possible recognition for promotion within the organisation. Examples of intrinsic factors are the extent to which he is motivated by factors such as a 'feeling of achievement" or the driving force of 'professional pride'?

21. Div is ional per formance - Galaxy pic and Mi lky-way g roup

I Part 'a' of this question is not scenario-based but general. Vou need to have good knowledge of these measures, how they are calculated and their application.

Three marks are allotted for discussion of each measure therefore you should plan your answer accordingly. Do not make your discussion too long or too short. The explanation given below is sufficient for three marks.

In addition, it is specifically mentioned in the note that you should consider certain points; therefore make sure that you have covered all of these points in your explanation. The examiner will expect you to do this and therefore doing so will help you to get good marks.

98: Slrafeglc Performance Measuremenl ©fiTf.

It is very difficult to differentiate the performance of a division from the performance of its managers therefore measuring the performance of a division is always considered a measure of managerial performance. However, it is argued that the performance of the divisional managers should be measured considering only the revenues and costs within their control i.e. only the controllable costs and revenues.

In the absence of information on the extent to which the divisional managers have freedom to decide upon investments, it is difficult to choose a single measure for Galaxy Pic. However, the following analysis of the performance measures given in the question may help in choosing an appropriate measure.

(i) Contribution margin

This measure will be acceptable to the divisional managers as long as it does not contain any internal sale (i.e. sale of goods to another division of the same company) over which the manager has no control. In addition, if internal sales are included in divisional sales, the transfer pnce should be close to the market pnce so that the performance of any division is not significantly affected because of internal transfers. For example, if transfers are made at marginal cost, the selling division's performance will be affected since it also has to bear the fixed costs for the transferred units. On the other hand, the buying division's performance will be enhanced since it obtains goods at a price much lower than the market price.

In addition, this measure may not be acceptable to the management of the company since it ignores fixed costs which the divisional manager may control such as short-term fixed costs (fixed labour cost).

(Ii) Controllable profit

This is a well-accepted measure for assessing divisional performance. This is because it considers all the controllable revenues and costs. It is suggested that if controllable profit is used as a measure of divisional performance, internal sales should be either cancelled or considered at a pnce close to the market price.

Certain fixed costs, which the divisional manager can avoid in the long term through effective and efficient working, should be considered. This is because considering these costs will enable detailed measurement of the performance of the divisional manager. For example, if staff efficiency is improved, more work can be done within fewer employee hours and the additional employee hours can be utilised elsewhere leading to a reduction in the overall cost. Alternatively, the manager can get the same work done by fewer employees and save labour cost in the long run.

However, inclusion of depreciation on non-current assets is a debatable issue which should be decided on a case-by-case basis depending upon the control that the divisional manager has over investment decisions.

(iii) Divisional profit

Divisional profit is a widely used measure for evaluating the performance of divisions. However, it is greatly criticised and unacceptable to divisional managers. This is because it is calculated after deducting the non-controllable costs such as the finance cost of the company / group as a whole.

Such costs are generally allocated to the divisions to arrive at the divisional profits. However, since the divisional managers cannot control these costs, they may not like divisional profit as a measure of divisional performance. It can also be argued by the management of the group that where the costs are avoidable only if the division is closed or are specifically incurred for the division (such as depreciation on operating assets) then they should be considered while evaluating divisional performance.

Divisional profit can be used in evaluating divisional economic performance since it shows the contribution made by a division towards the overall profitability of the group.

Finally, the performance measure should be one which is acceptable to the divisional managers and will also enable the performance of the divisional managers to be assessed in the best possible manner.

€>GTG Solution Bank:09

1 This part of the question includes various sub-questions as follows (along with marking scheme):

> calculating ROI for both the divisions (2 marks)

> commenting on the views likely to be adopted by both of the divisional managers on taking up the projects

(4 marks) 'r commenting on the impact of such decisions on the overall performance of an organisation

(2 marks) Giving only the calculations of ROI will be considered a inappropriate answer and you will lose marks. Therefore read the question carefully and note down all the sub-questions you need to answer. This will help you to answer all the sub-questions and get good mariks.

Calculating ROI

Project S Project M

Profit 50,000 35,000 ROI = x 100 = x 100 = x 100

Investment 300,000 300,000

= 16.67% =11.67% The ROI of project S is 16.67%.

The current ROI of Sun division is 20%. If Sun division accepts project S, the current ROI of Sun division will decrease and therefore the manager of Sun division will not accept project S.

However, the ROI of the project is higher than the company's cost of capital. Therefore it is beneficial to accept the project considenng the company's objective to maximise the profits of the organisation as a whole.

The ROI of project M is 11.67%.

The current ROI of Moon division is 11%. Accepting project M will increase the current ROI of the division. Therefore the manager of Moon division will be will ing to accept the project.

However, the ROI is lower than the cost of capital of the company. Therefore, considering the overall profitability of the company, it is advisable that Moon division should not accept project M.

From the above discussion, it is clear that since the bonus is based on the yearly performance of the division, it is likely that the managers will accept the projects which are profitable to their divisions without considering their impact on the overall profitability of the company.

Under the abovementioned situations, a conflict arises between the goals of the managers and the goal of the organisation as a whole and finally suboptimal decisions are taken ignoring goal congruence. This is harmful for the growth of the company and therefore should be avoided.


(c)

rl This is a very good question to test your knowledge of EVA. This is because only knowing the formula is not sufficient to calculate EVA and will not help you to score good marks. Marks are allotted to the workings as follows:

> calculating adjusted profit after tax (3 marks) > calculating adjusted capital employed (2 marks) > calculating WACC (2 marks) > calculating EVA (2 marks) > comments {1 mark)

(Maximum. 8 marks) Therefore show your workings and give comments on the performance of Milky-way considering EVA as a measure. In addition, give explanations for your adjustments to the profit and capital employed. This will indicate that you have a thorough knowledge of the subject and help you to get good marks. Without these explanations, your answer will be a poor answer.

EVA is calculated as:

EVA = NOPAT - cK

Where,

NOPAT is net operating profit after tax c is the weighted average cost of capital K is capital employed

Capital employed will be the capital at the beginning of the year with certain adjustments. In the given case certain adjustments are made to the capital employed. These adjustments, along with the calculation of capital employed, are displayed in the table below:

Calculating adjusted capital employed

20X6 20X7 $ m Sm

Capital employed at the beginning 311 395 Add Goodwill amortised 60 65 Adjusted capital employed 371 460

In the absence of detailed information on the accounting treatment of capital employed, the book value of the total assets is taken as a base for calculating the economic value of capital employed at the beginning of the year.

In addition, goodwill acquired through a business acquisition adds value to a company and therefore represents an element of the total value of a business. Therefore, in order to show a more realistic value, the goodwill acquired (although subsequently amortised) should be added back to arrive at the economic value of capital employed.

Operating profit after tax requires the following adjustments:

Accounting depreciation should be added back and economic depreciation should be deducted to arrive at the adjusted profit. However, in the given case, since accounting and economic depreciation are the same we do not need to made any adjustment? The net effect will be the same. Non-cash expenses should be added back.

€>GTG Solution Rank:101

In addition, goodwill is an intangible asset of the business and therefore any amortisation should be added back to the profit.

Interest on debentures is to be added back subject to tax relief.

Hence, adjusted profit is calculated as follows:

Calculating adjusted profit

20X6 20X7 $m $m

Profit after tax 73.50 91.00 Add Amortised goodwill 5.00 5.00 Other non-cash expenses 14.00 15.00 Interest (net off tax benefit) (7.5 x 70%) 5.25 5.25 Adjusted profit 97.75 116.25

ifrrr-^ Alternatively, adjusted profit can also be calculated as:

$ EBIT 112.50 Add: Amortised goodwill 5.00 Non-cash expenses 14.00

131.50 Less: Tax 31.50 Less: Tax relief on interest 2.25 Adjusted profit 97.75

The third requirement for calculating EVA is WACC which can be calculated as follows:

WACC

WACC = R„(1-T c ) -^

20X6 = 10(1 - 0.30) x 60% + 15% x 40% = 10.2% 20X7 = 10(1 - 0.30) x 60% + 17% x 40% = 11%

Calculating EVA

EVA = NOPAT - cK

EVA 20X6 = S97.75m - (S371m x 10.2%) EVA 20X6 = 5(97.75-37.84) EVA 20X6 = $59.91 m

EVA 20X7 = 116.25 - ($460m x 11%) EVA 20X7 = $(116.25 - 47.60) EVA 20X7 = $65.65 m

The above calculation shows that Milky-way has added significant value during each year under consideration and thereby achieved a satisfactory level of performance.


22. Div is ional per formance - NAW group

(a)

(i) w ^ m m w m ^ m

Before answering this question, keep in mind the following points: > Read the question careful and note down all the requirements before answering the question. The following sub-requirements are included in this part of the question:

* preparing a statement of budgeted profit for Division O ^ showing annual budgeted contribution of each branded as well as unbranded product s calculating Rl and ROI for division O

Be careful not to lose marks by accidentally missing out one of the requirements.

In the case of numerical questions, it is necessary to think about the presentation before you start writing your answer. This is because:

S planning the presentation saves time by avoiding repetition of the same information ^ good presentation provides better readability • planning eliminates any unnecessary information and makes your answer clear, simple and

concise

> Do not forget to give step-by-step calculations such as sales revenue less cost of sales (including material / conversion costs, packaging costs) and contribution, as given in the answer below. This is because marks are allotted to each step and if you miss out any step then you will lose marks.

NAW Group: Division O Statement of budgeted profit for the year to 31 May 2005

Product Painfree Digestisalve Awaysafe Total Branded Unbranded Branded Unbranded Branded

$-000 $'000 $'000 $'000 $'000 $'000 Sales revenue 12.000 18.000 24.000 72,000 120.000 246.000 Cost of sales: Material 1 conversion costs 4,250 12,750 9,250 37,000 42.000 105,250 Packaging costs 750 750 1,250 3,000 6,000 11,750 Total variable costs 5,000 13,500 10,500 40,000 48,000 117,000 Contribution 7,000 4,500 13,500 32,000 72,000 129,000 Fixed costs: Fixed overheads 81.558 Advertising and promotion costs 17.400 Not profit 30,042

Residual income (Rl) .— Here, capital employed is $120m.

Rl = Income - Charge on investment I

Where. Charge on investment = (Investment x Desired rate of return)

Rl = $30,042,000 - ($120,000,000 x 10%)

Rl = $30,042,000 - $12,000,000

Rl = $18,042,000

€ C.TG Solution Rank:l03

ROI = Returnon Sales x Operating Asset Turnover

E B I T ROI = x 100

Capital Employed or Asset Employed or Invested

$30,042,000 ROI = x 100

$120,000,000

ROI = 25.04%

(II)

I j & m ^ X . T h i s question is worth only 3 marks therefore you should not write a long answer. Additional information is given below to aid your understanding. However, it is necessary to write the first paragraph (related to production capacity) since this information is important.

Generally, when an organisation is deciding upon its product mix strategy, profitability, production capacity and selling capacity (demand for the product) are amongst the important factors which need to be considered. However, in this question, we are asked to discuss factors other than profitability.

As far as demand for the product is concerned, this is not a problem for NAW Group. This is because the demand for the product is already more than the production capacity for the year ended 31 May 20X6. Therefore the important factor to be considered is production capacity.

It is stated that during the year to 31 May 2005. a maximum of 780 million tablets can be produced. Since tablets are sold in packs of 12, we can say that 65,000,000 packs can be produced whereas there is only demand for 60,000,000 packs

However, demand for the year ended 31 May 2006 is for 66.000.000 packs i.e. 10% more than that of the previous year (60,000.000 packs + 10%). This demand is 1,000.000 packs more than the current production capacity. This should be a major concern for NAW. This is because when a company is not in a position to satisfy the demand, this does not only affect the company's performance but also its goodwill which indirectly affects its performance in future. Therefore, considering the short-term as well as the long-term impact of the shortage of production capacity, NAW should take further steps to identify and resolve any problems and remove limiting factors.

In addition, internal factors such as allocation of resources, marketing strategies and pricing strategies need to be considered since these are the factors that are affected as a result of a change in product mix.

Apart from these internal factors, certain external factors should be considered while taking decisions about product-mix such as:

^ customers: they are important stakeholders who need to be considered before taking any decision. This is because, without customers, the organisation will have no income and therefore, in order to succeed, the organisation must keep its customers satisfied. Determining the extent to ^ which any decision will affect the customers is very important. E.g. if - - ^ j h i s is how you should NAW takes the decision to produce a particular product, say \ relate your answer to the

given scenario. Awaysafe, (whose contribution is the highest) In large quantities by reducing / eliminating production of, for example, Painfree unbranded (whose contribution is the lowest), this may affect the organisation adversely. This is because the customers who buy Painfree unbranded may become dissatisfied and may create a fear amongst the other customers of NAW Group that the group may stop producing other products at any time. This will affect the competitive position of the product. In addition, it will also affect the customer loyalty and customers of other products may also start buying from other companies.


suppliers: the change in product mix may also affect the suppliers. This is because, with the change in product mix. the raw material requirement also changes. This may result in changes in the terms and conditions related to the price, delivery schedule etc. and therefore require negotiation with the suppliers. Therefore, before taking any decision which may affect the suppliers, the long-term and short-term impact of the decision should be considered.

competitors: most of the strategies of an organisation are influenced by its competitors. Therefore the competitors of NAW may also be paying attention to the strategies of NAW. NAW should predict how its competitors will respond to its decision and the impact of their responses on the performance of NAW in the short as well as the long term.

(iii)

Both performance measures, i.e. ROI and Rl, have certain advantages and disadvantages. However. NAW might have chosen Rl as a measure of divisional performance because of the following advantages of Rl over ROI:

If ROI is accepted as a measure of performance evaluation, it tempts divisional managers to reject projects whose ROI is less than that of the division, even if they are profitable, which is not good for the performance of the organisation as a whole. This tendency of divisional managers may be avoided by choosing Rl as a performance measure instead of ROI so that divisional managers will accept projects with positive Rl which will, in turn, increase the profitability of the organisation.

Considering the above, it can be said that using Rl is more consistent and effective than ROI when it comes to maximisation of the overall profitability of the organisation.

By using Rl, it is possible to evaluate projects with different levels of risk by applying different cost of capital rates to projects with different risks.

Rl focuses on the cost of funds to divisional managers, which is essential information for divisional managers,

(b)

(i) Since the divisional managers of NAW Group have the autonomy to take decisions related to transfer priang and deciding the source from which to purchase, the impact of their decisions on NAW group will be as follows:

Quotation 1

It is stated that division O has decided to sell the product at a price which is 30% lower than the market price i.e.S5.60 (58 less 30%). However, division L can purchase the product from the local market at 55.50. Therefore it is likely that division L will purchase from the local market rather than from division O so as to increase the profitability of division L.

As a result of this decision, the additional cost to the NAW Group will be $11,500,000. This is because since division O has spare capadty available to produce 5.000,000 packs, it can sell the packs to division L at a marginal cost to the division i.e. S3.20. By doing this, the group can save S2.30 (S5.50 - S3.20) per pack and $11,500,000 ($2.3 x 5,000,000) in total. In these conditions, if division L decides to purchase from outside, the group will lose this saving of $11.500.000.

Quotation 2

Since the available production capacity is of 5.000.000 packs only, in order to meet the division L's order for 9,000,000 packs, division O will have to reduce production of another product which is likely to be product Painfree unbranded whose contribution per pack is S0.30. As a result, the contribution forgone for division O will be S1,200,000 (S0.30 x 4,000,000 packs).

The same logic used in the paragraph above is used here.

However, it is likely that division L will purchase from the local market which will cost the company S20,700,000 i.e. $2.30 ($5.50 - $3.20) x 9,000,000. However, the decision to purchase from the local market will save the above S1.200.000 contribution that would have been forgone if the product were purchased from division O. Therefore the net cost to NAW Group will be S19,500,000 ($20,700,000 -$1,200,000).

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(ii) To ensure that the profitability of the NAW group is not affected during the year ended 31 May 2005, division O should charge the following prices for both of the quotations:

The manager of division L will agree to pay any price below 55.50. The manager of division O can sell at S3.20 which is the marginal cost to the division. This is because division O has spare capacity available to produce the required packs. Any price between $5.50 and $3.20 will not affect the profitability of the group as a whole. However, if it is assumed that division O is offering S3.20 per pack, the quotation price will be $16,000,000 (S3.20 per pack x 5.000.000 packs).

In the case of quotation 2, for 5,000,000 packs, the discussion and the pricing policy will be the same as that given above. However, for the next 4,000,000 packs, division O has to forgo the contribution from one of its products which is likely to be Painfree unbranded as its contribution is the lowest. Considering this, the quotation price will be $30,000,000 (($3.20 per pack x 9,000,000) plus contribution forgone by division O i.e. $1,200,000].

(iii) Whenever an alternative is chosen from a choice of two or more options, the opportunity cost should be considered. The opportunity cost is the benefit forgone from the next best alternative. In this case, the opportunity cost is the maximum contribution margin forgone by division O if the products and services are transferred internally to division L. While discussing quotation 1, we can say that the opportunity cost is 0 since there is no opportunity / income forgone (the sale to division L will be out of spare capacity). However, while considering quotation 2. the opportunity cost will be equal to the market price minus the variable cost for selling externally.

It is evident from the answer given in (b) (ii) that if the opportunity cost is not considered, the profitability othe transferor division, i.e. division O, will not be maintained and will in fact be reduced. Like the selling division, the purchasing division should also consider the opportunity cost to its division, if any. before taking any decision. For the purchasing division, there will be an opportunity cost when the market price is lower than the internal transfer price. For example, in this question, if division L were forced to buy internally (this is not the company's policy), the price which division L would have agreed would have been the internal transfer price less its opportunity cost which is S5.50 ($5.60 - SO. 10).

This is because the opportunity cost for division L would be the internal transfer pnce less the market price (S5.60 - S5.50) since the market price is lower than the internal transfer price. However, in order to consider the impact of opportunity cost, it is necessary to obtain full information about the opportunity cost, which is quite difficult in reality.

(i) If Division L buys from a local supplier

Here we will consider only the differential revenues and costs (i.e. sale of Painfree unbranded and purchase from local market by division L) since the other revenues and costs will remain the same.

Quotation 1

Quotation 2

(c)

Here also, planning your presentation is essential.

S Division O sales Total contnbution from Unbranded 'Painfree' (15.000.000 packs x $0.30 per pack) Tax thereon @ 40% Net contribution after tax

4.500.000 (1,800,000)

2,700,000

Division L purchases Sale of Awaysafe (9,000,000 packs x S5.50 per pack) 49,500,000

Tax benefit thereon @ 20% Net purchase cost after tax

(9.900.000) 39,600,000

Net cost to NAW Group (S2.700,000 - $39,600,000) 36,900,000

l()6: Strategic Performance Measuremenl

If Division L buys internally from Division O

©fiTf.

Division O sales External Total contribution from Unbranded 'Painfree' (11.000.000 packs x $0.30 per pack) Total contribution from 'Awaysafe' to Division O (9.000,000 packs x $2.40 per pack)

Tax thereon @ 40% Net contribution after tax Division L purchases Sale of Awaysafe (9,000,000 packs x $5.60 per pack) Tax benefit thereon @ 20% Net purchase cost after tax

$ Division O sales External Total contribution from Unbranded 'Painfree' (11.000.000 packs x $0.30 per pack) Total contribution from 'Awaysafe' to Division O (9.000,000 packs x $2.40 per pack)


3.300,000 21.600,000



24.900.000 (9.960,000)



14.940,000



50,400,000 (10,080,000)

40,320,000 Net cost to NAW Group {$14,940,000 - $40,320,000) 25,380,000

From the above calculations, it is clear that the net cost to NAW Group will be $11,520,000 ($36,900,000 -$25,380,000) higher if Division L purchases product 'Awaysafe' from a local supplier. In addition, as a result of the decision to sell Awaysafe to division L, NAW Group can promote the brand in the international market. Therefore internal transfer will be the better decision for NAW Group.

(ii) When transfer between two divisions in different countries is under consideration, management should consider the following, before deciding the transfer price.

Issues in setting transfer prices in multinational companies

Taxation

When the operations of an organisation are spread all over the world, the major concern for management is managing the business in a way that minimises the tax paid by the organisation as a whole. Transfer price is largely used as a measure for tax avoidance. However, the management of NAW should keep in mind that avoiding tax using transfer pncing policies to divert profits to subsidiaries / divisions based abroad is legally not allowed. The transfer price should be the arm's length price i.e. close to the market price / the price that would have been agreed between two independent parties.

Charges such as custom duty and import duty

Apart from direct tax. i.e. income tax. other taxes such as custom duty and import duty should also be considered when deciding the transfer price. The higher the transfer price, the higher the import duties and customs charges. Therefore, the managements of multinational organisations try to keep the transfer price low so as to reduce this burden. However, anti-avoidance legislation may not allow organisations to do so.

Exchange rate fluctuations

A change in exchange rates leads to a change in the profitability of the transferee as well as the transferor division. It also affects the performance of the organisation as a whole (with the change in exchange rate, it is not only the case that the profit will not be transferred from one division to another: other factors such as import duty will also change which will affect the organisation as a whole). Therefore the management of NAW should take decisions about the currency in which to deal, i.e. to raise the invoices, and the currency in which to settle the payments. Generally, when one of the currencies in which the organisation deals is weak and the other is strong, management attempts to use transfer pnce to transfer the funds from the weaker currency to the stronger currency.

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Repatriation of funds and dividends

Generally, the organisation reports higher profits in the country where the taxation rates are lower. However, the organisation needs to repatriate funds from this country. In this case, if it is difficult to repatriate funds directly due to government restrictions, transfer price is used to transfer these funds. Before taking any decision, the management of NAW should bear in mind that governments are mindful of such practices and therefore legal practices should be adopted.

Competitive pressure

If the transferee division is facing competition in the local market, the cost is controlled by adjusting the transfer price i.e. by setting the transfer price at a minimum.

(d)

I In this part of the question, you are not expected to explain the product life cycle in general. Instead, you should apply the model to the given situation.

In addition, since the question is about evaluating the extent to which the model is used, you are expected to write about the use and limitations of the model (i.e. why the management of NAW cannot use it) etc. If you explain only the use, you may lose marks.

You are expected to write about each of the following points:

link between pricing strategies / expected returns and where product is in its life cycle > performance measures required for each stage in product life cycle > limitations of using product life cycle for NAW Group > link to product portfolio (appreciation of life cycle issues)

The product life cycle (pic) describes the phases through which a product passes. These phases are introduction, growth, maturity, decline and withdrawal. By identifying the phase at which the product is, the management of NAW Group can make a better estimate of the demand for the product. In addition, use of the product life cycle will help management to estimate the returns from each product. This will help management to formulate and develop a marketing plan and to allocate the resources accordingly. For example, the advertising and promotional budget will be higher for the products which are going through the growth phase and will be lower for the products which are going through the decline and withdrawal phase.

In this case, NAW Group's advertising and promotional budget for the year ending 31 May 2005 is 517,400,000 which is calculated as follows:

$ Painfree branded (5% x S12.000.000) Digestive branded (10% x S24,000.000) Awaysafe (12% x 120.000.000) Total

600.000 2.400.000

14.400.000

Painfree branded (5% x S12.000.000) Digestive branded (10% x S24,000.000) Awaysafe (12% x 120.000.000) Total 17,400,000

This comes to about 7% of the turnover i.e. 17,400,000/246.000.000 x 100

However, it is necessary to identify the phase in which the product is in the product life cyde, in order to allocate this amount to the products.

In addition, the product life cycle will help in deciding the pricing strategies in the following ways:


Introduction

At the introduction stage, a product is new in the market and therefore demand has to be created i.e. people should be encouraged to try the product. In such a case, the following pricing strategies can generally be adopted.

penetration pricing

Under this strategy, the price charged for products and services is set artificially low in order to gain market share. This strategy is generally used in the following cases: J when demand for the product is highly price elastic s to launch a new product in the market v' to launch an existing product in the new market

> price skimming

If an organisation has a substantial competitive advantage, or a product to be launched is with special features, a high price can be charged for the product.

At this stage, the pricing policy should be adopted considering the long-term objectives of obtaining good market share and earning more profit.

> Growth

At this stage, the product achieves recognition in the market and demand for the product begins to rise. Therefore, if a penetration pricing policy has been adopted earlier, at the time of launching the product, the prices may be gradually increased so as to earn more profits. However, at this stage, there may be more competition in the market therefore efforts should be taken to sustain and grow in the market. Since demand for the product is increasing at this stage, economies of scale can be achieved and thereby an organisation may attempt to maximise the profits.

> Maturity

At this stage, the demand for the product should be very high and it should be making a handsome profit, but the competition might also have increased. In order to enjoy higher demand and profits in the long term, an organisation should have a pricing strategy that is capable of maintaining the product's competitive position.

In addition, at this stage, an organisation should look for new opportunities for the product such as searching for a new market. If new markets are identified, the organisation may adopt a price discrimination strategy in which the same product is sold in different markets at different prices.

> Decline

At this stage, when the demand for the product is falling, the pricing strategy should be focused on increasing the profit without bothering about the market share.

At every stage, different performance measures to be adopted. For example, at the introduction and growth stages, the performance measures should be such that help in deciding the strategies to gain market share However, at the maturity and decline stages, measures such as ROI and profit can be used since the objectives at these stages include the allocation of resources, investment requirements and increasing profitability.

Although product life cycle is an important model that NAW Group can use to decide its pricing strategies, presently, it is difficult for the management of NAW Group to identify the stages at which the various products are. This is because only past sales data are available to the management of NAW Group which are not sufficient to identify the stage at which the product is at present. For example, if the sales volume is declining, it is not always because the product is in the decline stage. It may be because of another reason, for example an economic recession. On the other hand, an increase in sales may be due to a boom in the economy.

In addition, even if it is assumed that all other factors such as economic conditions are constant over the period, when the sales volume is increasing it is difficult to identify the exact stage i.e. whether it is a growth or a maturity stage. It is also difficult to predict how long a particular stage will last for.

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23. Product vs . Cus tomer prof i tab i l i ty - NAW Group

(a)

i In the ACCA exam, fifteen minutes are given for reading over the entire question paper.

In this question, you are asked to use information given in an earlier question (question 1). Therefore you should note down the information relevant to this question when you read the previous question (i.e. before answering question 1). In this way you will avoid reading the same question twice and therefore save time.

This is a calculation-based question therefore plan its presentation before you begin your answer. This will also save vou time.

Statement of budgeted customer profitability for the year to 31 May 2005 - Division O

Large pharmaceutical

stores

Individual specialist

pharmacies Supermarkets Others Total

$'000's $'000's S'OOO'S $'000*

S $'000'

s Contribution (W1) 49,350 27,050 43,350 9,250 129.00 Less: Delivery costs (W2) 768 2,304 2,048 2,880 8,000 Changed delivery requirements 6 - 2 - 8 Purchase order costs (W3) 2 6 2 20 30 Promotion and exhibition costs (W3) 110 110

I Retrospective rebates (W4) 9,180 2,280 13,950 - 25.410 I Total - other operating costs 10,066 4,590 16,002 2,900 33,558

Net profit before fixed overheads 39,284 22,460 27,348 6.350 95,442

Workings

W1 Contribution for customer groups

In calculation-based questions, do not forget to give workings as these are the basis for your calculations.

Painfree Digestisalve Awaysafe Total

Branded Unbranded Branded Unbranded Branded $'000 $'000 $'000 $•000 $'000 S'000

Contnbution 7.000 4,500 13.500 32.000 72,000 129,000 Large pharmaceutical 4.200 1,350 5.400 9.600 28,800 49.350 stores Independent specialist 1.400 - 4.050 - 21,600 27,050 pharmacies Supermarkets 700 3,150 2.700 22.400 14,400 43,350 Other retail markets 700 - 1.350 - 7,200 9.250

110: Strategic Performance Measuremenl © f i T f .

W2 delivery cost

Large Independent Other pharmaceutical specialist Supermarkets retail

stores pharmacies outlets

No. of deliveries (A) 400 2,400 800 3,000 Average kilometres per delivery (B) 300 150 400 150 Delivery cost $ (C) 6.4 6.4 6.40 6.40

Total delivery cost $ (A x B x C) 768.000 2.304.000 2.048.000 2.880,000

W3 Note the following formulae

Changed delivery requirements = No. of times delivery requirements were changed x Changed delivery requirements cost per change

Purchase order costs = No. of purchase orders x Order processing cost per order

Promotion and exhibition costs = Promotion and exhibition events x Promotion and exhibition cost per event

Instead of giving calculations for each figure, the formulae which are used for calculations are given.

However, in the exam, you should give at least a sample of the calculations from each group in order to show how

denved the figure.

W4 Retrospective rebate

Painfree Digestisalve Awaysafe Total Rebate

Branded Unbranded Branded Unbranded Branded $'000 $'000 $'000 $'000 $'000 $'000 $'000

Sales revenue 12,000 18.000 24.000 72.000 120,000 246,000 25,410 Large pharma. stores 7,200 5,400 9,600 21.600 48,000 91,800 9,180 Independent pharmacies 2,400 _ 7,200 _ 36,000 45,600 2,280 Supermarkets 1,200 12,600 4,800 50,400 24,000 93,000 13,950 Other retail markets

1,200 - 2,400 - 12,000 15,600

^ j g p ^ Although this part of the question is theory-based, you are expected to link your explanation to the given scenario. Even if the scenario is not given and the question is general, it is always good to give examples wherever possible. This shows that you understand the concept and how it is used in practice. This will help you to get good marks.

(i) Determining product profitability enables the most profitable and least profitable products to be identified so that various decisions such as product mix can be taken. Along the same lines, determining customer profitability helps customers to be identified in accordance with their profitability i.e. the most and least profitable customers. This determination of customer profitability will enable various decisions to be taken such as cost to customers. For example, when it is found that an important customer is unprofitable, the organisation should examine internal processes to see how they can be improved so that the cost of serving that customer can be reduced.

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Customer satisfaction, retention etc. are desirable only if such measures increase profitability. This means that only the customers who increase customer profitability should be concentrated upon. For example, if a customer group is not profitable but efforts are taken to improve the relationship with these customers, this is a waste of resources. Customer profitability measures expect that resources should be used only for those measures which are profitable. This helps an organisation to decide service price i.e. the price to be charged to a customer.

When products are sold in a highly competitive market, it is necessary to determine not only the product profitability but the profitability related to the customers, markets and distribution channels. This is because the long-term performance of the organisation may be affected by the profitability of such customers, markets and distribution channels. For example, if for a distribution channel, a competitor organisation is more profitable than NAW Group, then that distribution channel may not be interested in working with NAW Group.

Product profitability is affected by costs such as manufacturing costs. On the other hand, customer profitability is affected by selling and distribution costs i.e. post-manufacturing costs. However, in conventional accounting, post-manufacturing costs are treated as period costs. It is argued that, although such treatment is acceptable for financial reporting, for management reporting such costs should be allocated to the customers. This is because the requirements of different customers are different and accordingly their profitability is affected.

Therefore, use of activity-based techniques may be a better way to allocate such post-manufacturing costs to the customers. This will enable the cost consumed by different customers to be identified and accordingly help in controlling the costs to the customers.

From the statement of budgeted customer profitability given above, it is clear that all the customer groups are profitable. However, a significant amount of the contribution generated by the supermarkets and other retail outlets is consumed by customer specific costs as shown in the following table:

Giving calculations to support your answer will add value to your answer. These calculations provide the basis for your explanation.

Large pharmaceutical

stores

Individual specialist

pharmacies Supermarkets Others

Contribution (£"000) 49,350 27.050 43,350 9.250 Net profit (£'000) 39,284 22,460 27,348 6,350

48,464 24,740 41.298 Contribution/Net profit before fixed overheads ratio (%) 79.60 83.03 63.09 68.65

Contribution before rebate/Net profit before fixed overheads ratio (%) 98.20 91.46 95.27 68.65

For supermarkets, the major cost allocated is retrospective rebates. Further study of the costs attnbutable to individual customers under each group will facilitate finer analysis. For example, if delivery cost to a particular customer is very high or delivery requirements are changing frequently resulting in an increase in cost, the delivery schedule may be changed so as to decrease the delivery cost and increase customer profitability.

For such detailed analysis, detailed information (such as the profitability of a particular customer, customer group, a market in which such customers operate) is needed, which can only be provided by a good management information system. However, many organisations ignore this and do not have management information systems capable of providing such detailed information.

Detailed information is needed, especially in the case of service organisations. This is because these organisations are customer-focused and the cost of service depends on customer behaviour.

112: Strategic Performance Measuremenl © f i T f .

(») In order to improve customer profitability, the following should be considered:

> pricing policies > business process improvements > customer relationship management

Pricing policies

By having effective pricing policies, unprofitable customers can be converted into profitable customers. To do this, it is necessary to identify the costs attributable to the customers. This enables the organisation to price its individual orders and transactions which affects customer profitability. Effective pricing policies can be achieved by using activity-based costing where costs are identified with the activities.

As stated earlier, marketing and selling costs affect customer profitability but in practice, such costs are treated as period costs in financial as well as management reporting. Using activity-based costing, it is possible to identify the costs attributable to the customers which will help in deciding the price for individual orders and transactions. If accurate information on costs and prices is available (which can be gathered using activity-based costing), this will enable customers to identify their costs and take decisions to reduce such costs e.g. by changing their ordering, shipping and distribution pattern so as to increase their profitability. This will also help to strengthen the relationship between supplier and customer.

Business process improvements

Customer profitability requires the costs attributable to customers to be reduced. Although reductions in cost can be achieved by rescheduling the orders etc., an organisation should ensure that the organisation's internal operations are cost-effective. Cost-effective operations can reduce customer costs to a large extent. For example, if an organisation notices that most customers order in small batches and the number of orders is high, it should try to reduce order processing costs by improving its internal processes.

Therefore, as a measure to improve customer profitability, an organisation should conduct a detailed analysis of each function with respect to technology, utilisation, performance and planning. This will enable inefficiencies existing within such functions to be identified. However, only the inefficiencies existing within the functions will be identified and not the inefficiencies within the inter-functional relationships which are also an important part of an organisation's costs.

Using advanced technology, costs can be reduced to a great extent. For example, if the product is such that customers look for variety, an organisation may adopt modular design which will enhance the linkage from design to manufacturing so that a wider range of products can be offered and tailored to the individual customer's needs without increasing costs.

Customer relationship management

An organisation can achieve an increase in profitability, revenue and customer satisfaction through customer relationship management. Most modern performance measurement models, such as the balanced scorecard, require the customer perspective to be considered while evaluating an organisation's performance. The customer perspective, as explained in the balanced scorecard, indudes the outcome of measures such as customer satisfaction, retention rate and market share. However, it is necessary to measure whether loyal, satisfied customers are profitable or not. This is because most resources are consumed by these customers.

Detailed analysis of what makes customers profitable is unnecessary. This is because a large amount of investment is incurred on marketing a product and attracting new customers. If the management of an organisation is aware of the factors that make a customer profitable, this huge marketing cost will be best utilised in attracting only profitable customers. It is quite difficult to identify profitable customers. This is because initially, the cost to new customers may be high. Sales, marketing, customer service, training, professional development, performance management, human resource development and compensation etc. are the functions related to customers. It is necessary to improve the customer relationship using these functions so that new customers buy many products and services and prove to be profitable to the organisation. Therefore, caution should be taken while assessing the profitability of new customers. This is because initially, many of them may be found not to be profitable but may prove profitable over the penod.

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24. Transfer pr ic ing - Ab le and Baker

(a)

A transfer price is the price one department / division charges for a product or service supplied (i.e. transferred) to another department / division of the same organisation.

Benefits of transfer pricing system

> Facilitates performance evaluation

A need for a transfer price arises when, in any organisation, there is a huge transfer of goods I services between two independent divisions and it is important to evaluate the performance of the two divisions separately. This is because internal transfer of goods affects the divisional performance. Therefore the transfer pnce should be set in such a way that it will not affect the performance of any division involved in the internal transfer.

> Motivates divisional managers and maintains divisional autonomy

If a transfer pricing system exists, divisional managers can take decisions in the best interests of their divisions. This will motivate the divisional managers and will also help to maintain divisional autonomy. > Facilitates divisional performance measurement

When divisional managers have the autonomy to make decisions, they will always try to maximise the profit of their divisions. Internal sale of goods free of cost affects the performance of the selling division. In the case of internal sale, it is difficult to measure the performance of the division. This also affects the comparability i.e. it is difficult to compare the performance of a division which transfers its goods internally with the performance of another division which doesn't carry out internal transfer.

In such a case, setting the transfer price at a level that does not affect the divisional performance is the solution to all the above mentioned problems.

^ Tax minimisation

Usually, in the case of multinational companies, transfer price is used to minimise the tax expense of the company as a whole. This is done by setting the transfer price in such a way that the profit of the division for which the tax rates are higher is low and the division for which the tax rates are lower makes higher profits.

> Goal congruence

With the help of transfer price, divisional managers can be motivated to take decisions which improve divisional profit as well as the profit of the organisation as a whole.

Allocating divisional resources optimally

Transfer price provides information about the extent to which internal transfer is made by one division to another. This will help in deciding the level of output for particular goods I services and the investment requirement (investment in machinery, manpower etc.) of the selling division.

In this question, the explanation to justify your calculations is equally important as the calculations themselves. Therefore do not forget to give an explanation for your answer otherwise you will lose marks.

While answering such questions, remember that opportunity cost should be considered only when any of the divisions is losing income. In addition, remember that fixed cost is not relevant in taking transfer pricing decisions, unless it changes with the production capacity. Therefore only differential costs such as variable costs or any cost incurred if the product is marketed are relevant.

Do not miss out this point as it is very important!

(b)

114: Strategic Performance Measuremen l ©fiTf.

(i) When division Able has spare capacity and limited external demand for product X.

If Able has spare capacity, it can sell the product at any price, as long as it is above the variable cost of production of product Y, since this is the additional cost of production of product X. This means that Able can sell at any price above $35.

On the other hand. Baker will be ready to pay any pnce below $38 which is the price at which the same product can be purchased from outside.

Remember, since demand for product X is limited and Baker is the only customer for product Y there is no opportunity cost involved in deciding the transfer price.

This shows that the transfer pnce should be any price between $35 and $38. However, before taking any decision the following points should be considered:

> The price should provide some incentive to division Able. > The price should encourage division Baker to purchase internally. > Goal congruence should be obtained.

In the exam, do not give the alternative solution.

Alternatively. $3 ($38 - $35) can be split equally between the two divisions i.e. average of $35 & S38 can be taken as the transfer price. Therefore the transfer price should be $36.50.

(ii) When Able is operating at full capacity and demand for product X is unlimited, an additional unit of product Y can be produced only by eliminating a unit of product X. Therefore opportunity cost is involved in deciding the transfer price for product Y.

The opportunity cost to division Able is calculated as follows:

$

Selling pnce per unit of product X 42 Less: Variable cost of product X 32 Contribution 10

The contribution forgone of product X is the opportunity cost to division Able.

The variable cost of production of product Y plus the opportunity cost comes to S45 ($35 + $10).

Therefore. Able will not agree to sell product Y to division Baker at any price which is below $45.

However, division Baker will not agree to pay any price above $38, which is the price at which it can purchase product Y from the external market.

In the above situation, in order to obtain goal congruence, division Able should continue to make product X and sell at a contribution of $10 and division Baker should purchase product Y from the external market. As a result, division Baker has to pay $3 more than the price it would have paid had it bought the product from division Able at a variable cost i.e. ($38 - $35). This decision will be beneficial for the company a whole since effectively the company earns $7 ($10 - S3). In this way. the profit of division Able as well as of the company as a whole can be maximised.

Alternatively, if as a company policy, it is obligatory to purchase internally, the difference of $7 ($45 - $38) should be divided in two and borne by both the divisions. The resulting transfer price will be decided by adding S3.50 to $38 or subtracting $3.50 from $45 i.e. $41.50...

(c)

Remember, only including the data that are required from an information system is not sufficient. You should explain how these data are used in taking transfer pricing decisions, or else you will lose marks.

In order to save time, do not mention more than seven types of data that are required from an information system.


An information system should be able to provide the following information that can be used to decide the transfer price:

Data Use Whether a perfectly competitive market is in existence

As a basis for deciding transfer price To decide need to consider opportunity cost

If market is not perfectly competitive, whether any other customer is available

To calculate opportunity cost, if consideration is required

Availability of production capacity To decide need to consider opportunity cost Market demand for products To decide need to consider opportunity cost

Any other limiting factor To take make or buy decision To decide need to consider opportunity cost To decide how to overcome the limiting factor

External market price As a basis for deciding transfer price To calculate contribution from a product To calculate opportunity cost, if necessary

Variable cost As a basis for deciding transfer price To calculate opportunity cost, if necessary

Cost incurred only if the product is marketed To calculate opportunity cost, if necessary

Shadow price To determine whether the additional resources can be obtained and if so, at what price.

25. Transfer pr ic ing - A lpha and Beta d iv is ion

(a) m y ^ ^ ^ m

This is a very good question to test your understanding of how to set a transfer pnce. This is a scenario based question therefore do not give a general answer. In addition, give an appropriate example in support of the explanation given, to make it clear that you understand the concept thoroughly.

(i) A transfer price aims to achieve goal congruence, maximise the profitability of the group and maintain the autonomy of the divisional managers.

In order to achieve this, the receiving division agrees to pay an amount less than the external market price. The supplying division, when operating at full capacity, agrees to sell at the marginal cost plus opportunity cost. This means the price is dedded as the marginal cost to the supplying division plus the opportunity cost to the organisation.

When the supplying division is operating at full capaaty, the opportunity cost to the division (or to the organisation) is the contribution earned by selling in the external market, which is the external market price less the variable cost.

For example, if the external market pnce is S15 and the variable cost is $12. the opportunity cost is S3 (S15 - S12). Therefore the transfer price should be S15 (S12 marginal cost plus S3 opportunity cost).

Therefore, when Alpha division is operating at full production capacity and requires to transfer products internally, goal congruence suggests that the transfer price should be the market price.

(ii) The supplying division may transfer goods internally at a price which is lower than the market pnce when it is not operating at full capacity and when marketing the product would require additional cost to be incurred in comparison to transferring the product internally.

In the given case, it is stated that Alpha is operating at full capacity. In such a case, there is only one set of circumstances in which Alpha can sell the product at less than the market price and yet maintain the profitability of the organisation.

This is when it is incurring extra costs to market the product such as packaging costs and transportation costs. For example, consider that, out of a total cost of S12, the cost of packaging the product is S1 and the cost of transporting the product is S1.ln this case, the actual marginal cost to Alpha division would be S10 ($12 - S1 - S1). Therefore the internal transfer price would be S13 (S10 marginal cost plus S3 contribution forgone, as calculated above).


This part of the question requires you to comment on the following:

> the impact of all three bases > the acceptability of all three bases to the receiving division

the acceptability of all three bases to the supplying division

Therefore read the question carefully and note down the requirements so that you do not leave any of them out.

Actual cost plus 25% profit mark-up

When actual cost plus 25% profit mark-up is the basis, this allows the supplying division to transfer its inefficiencies to the receiving division. This will improve the performance of the supplying division and therefore will be acceptable to it. On the other hand, it will affect the performance of the receiving division adversely and therefore will be unacceptable to the receiving division.

For the group, this basis will not have any impact on its profitability since the cost is transferred from one division to another division within the organisation. However, this may discourage the receiving division and indirectly affect the performance of the group in future.

Standard cost plus 25% profit mark-up

As a result of this pricing strategy, the supplying division will be prohibited from transferring its inefficiencies to the receiving division. Therefore this basis will be acceptable to the receiving division and good for the group. However, if there is a significant difference between the standard cost and the actual cost and the supplying division is unable to control its cost (which is not because of inefficiency of the supplying division), then the supplying division may not agree to this.

Revised standard cost plus 25% profit mark-up

Under this method, the inefficiencies of the supplying division will be categorised as operational vanances and any increase in the cost for any reason beyond the control of the supplying division (e.g. an increase in the raw material prices or labour cost) will be categorised as a planning variance. Planning variances will be considered in order to revise the standards. Therefore, under this basis, the interests of both the divisions as well as of the group will be protected, as the supplying division will be able to pass on only the increase in the cost due to reasons beyond its control.

Therefore this basis will be acceptable to both the divisions.

This is a challenging question. In this question, you are required to calculate the transfer price for 3.000 units (which is the spare capacity) and also for the remaining units.

You need to read the question carefully and make sure that you understand its requirements. In addition, you should give explanations for your calculations since these explanations are the basis for your answer.

In order to answer this question correctly, you need to have a thorough knowledge of where to use opportunity cost. Opportunity cost is to be considered only when the division is operating at full capacity and it has an external market. In addition, do not forget to consider packaging cost which is avoidable.

In this case, Alpha is not operating at full capacity and therefore, by selling goods internally, it is not losing any contribution (i.e. there is no opportunity cost). Therefore it should sell at a marginal cost. However, the marginal cost should be calculated after deducting the packaging cost (which is avoidable if the product is transferred internally).


Therefore the transfer price for 3,000 units would be calculated as follows:

Selling cost = Total cost + 25% = $20

Therefore, Total cost = $20 x 100/125

= $16

Let the cost be S100 Profit given is 25% on cost Therefore, selling price = $100 + S25 = $125

Therefore if the selling price is given as $20, the cost will be calculated as follows: S20x 100/125

Variable cost = 75% of total cost = $12

Adjusted variable cost = Variable cost - Packaging cost = $12 -1 .5 = S10.5

The remaining units, i.e. any units produced over and above the 3,000 units, should be transferred at the adjusted selling price of $18.5 which is the selling price less the packaging cost ($20 - $1.5).

26. Not- for-prof i t o rgan isat ion - AV & BW

(a)

I In this part of the question, it is necessary to write about the following points:

> what value for money is > the 3 Es of value for money > how it can be measured (by management, benchmarking) > any other relevant comment

Only explaining the concept of value for money is not sufficient to get good marks.

Generally, value for money signifies economy, efficiency and effectiveness relating to the internal operations of an organisation and its use of money.

Economy implies the principle of prudence i.e. the minimum costs that should be incurred for acquinng / using resources, while maintaining quality. For AV, economy is related to purchasing the materials required. All purchases dunng the period such as those for maintenance and repair work e.g. fitted kitchen, heating equipment, windows and doors of 3-bedroomed properties, should be at minimum cost without compromising on quality. Therefore, while assessing the economy, the management of AV should keep in mind that cost cutting should not be at the cost of quality because this is not economy but "false economy'.

Efficiency is concerned with the relationship between resources (input) and the output of goods, services or other results. Ideally, it can be achieved by any of the following:

> using minimum input for the same output > obtaining maximum output with the same input ^ increasing output by a greater proportion than the increase in input > decreasing input by a greater proportion than the decrease in output

In the case of BW, efficiency may be in the form of employee efficiency i.e. more work is performed by the same number of employees for the same salary or more repair and maintenance work is carried out i.e. the maximum number of units are replaced for the same maintenance and repair cost. This can be achieved through obtaining the tender for repair work and selecting the one whose cost is less. Doing this, economy as well as efficiency may be achieved.

Effectiveness is concerned with the relationship between planned results and actual results. It measures the extent to which the outputs of goods or services successfully achieve operational goals. A non-profit seeking organisation, such as AV. may have a number of objectives, such as the following:.


> to meet accommodation needs > to provide quality service and accommodation > to meet customer expectations > to provide an effective care and repair service > to support the community within which it operates

The management of AV should be aware that the three performance measures require individual consideration since one measure alone may not give an indication of the other e.g. efficiency or economy in decisions may not give an indication of the efficiency. In the case of AV, the amount spent i.e. 5234,000, indicates that the decision was economical because if AV had purchased the same replacement kitchen units as BW. then AV would only have been able to refit only 45 properties ($234.900/$5.220). However this does not indicate that AV's equipment was of a similar or better quality.

The management should be aware that these measures may sometimes conflict with each other. For example, if we consider the above example where AV purchased more than BW (i.e. 90 kitchen fitted properties for S234.000 whereas BW could purchase only 45), AV may have compromised on effectiveness i.e. the properties purchased by BW may give a higher level of effectiveness i.e. longer life, enhanced aesthetic 'appeal' to residents, safety etc.

The performance of AV can bo better measured by adopting benchmarking against similar charities whose primary objective is the provision of accommodation to the communities in which they operate

Benchmarking is a good method of measuring performance because it enables a comparison of the processes, costs etc. with those of a close competitor. In addition, in the case of not-for-profit organisations where profit is not a prime objective, it may be possible to obtain such information which is usually quite difficult in the case of profit-seeking organisations (for them it may be a commercial threat to share sensitive information). However, it is often difficult to find a suitable benchmark with organisations sharing the same objectives and operating in the same environment under similar circumstances. For example, the management of AV can enquire about a norm' in respect of the repair charges or fitted kitchen or windows / doors replacement charges from similar non profit-seeking organisations.

Do not write a very detailed answer. Instead write only two points for each measure, since only 0.5 marks are allotted to each point. This part of the question is worth only 2 marks.

The building block model proposed by Fitzgerald and Moon, gives six dimensions of performance measurement including service quality and flexibility.

> service quality

Service quality can be measured by the number of complaints from customers, customer feedback, customer retention rate / loyalty etc. In the case of AV. the following performance measures can be used to assess the service quality:

v' behaviour, attitude, proactivity of staff employed by AV • extent of luxury / amenities provided

This could be measured by asking tenants to fill in questionnaires or by asking them to give more general feedback, complaints etc.

> flexibility

Generally, flexibility can be measured through delivery time, promptness in responding to customer requests, ability of employees to perform different kinds of work etc. In the case of AV the following performance measures can be used to assess the flexibility:

€ GTG Solution Rank:ll<J

J mean waiting time for a house to become available to a tenant v mean waiting time to give another house of a different size to a tenant after receipt of a request from a

tenant J waiting time for undertaking repairs of an emergency nature, once notified by a tenant

(ii) The management of AV could use the following performance measures:

You may consider other points such as percentage of rent collected, day-to-day repair cost per week per house.

The average staff & management cost, per week per house

This can be calculated by dividing the staff and management cost by the number of properties.

AV BW The average staff & management cost, per week per house. [450.000/(900 x 52)] and [620.000/(400 x 52)] $9.61 $29.81

The average staff and management cost per week per house of BW is $20.20 (67.76%) more than that of AV. In addition, although the number of staff employed is the same for organisations, the total staff and management cost to BW is S 170,000 (27.42%) more than that of AV. This is because of the different pay structures and remuneration policies in both the organisations.

\ The analysis is very important; don't The average day-to-day repair cost per week, per house just reproduce what is in the table

AV BW The average day-to-day repair cost per week, per house [478.320/(900 x 52)] and [127.600/(400 x 52)] $10-22 $6-13

The average day-to-day repair cost per week per house for BW is $4.09 less than that of AV. This is an increase of 40%. This may be due to the fewer repairs required and the fact that there is no extra cost required for emergency and urgent repairs. The cost of repairs whether emergency, urgent or non-urgent to BW is the same, $100 |127.600/(230 + 752 + 204)] whereas the cost of emergency repairs to AV is $140 ($134,400/960). urgent $120 ($225,600/1.880) and for non-urgent repairs it is $116.

BW's low cost of repairs (which is identical for all types of repairs - emergency, urgent and non-urgent) may have been achieved through entering into a contractual agreement for repairs. AV should also think of entering into such contracts in order to save money.

Percentage of rent lost

AV BW Percentage of rent lost [(36.348/(2.386.852 + 36.348)] and (2.500.000/2.500.000) 1.5% -

BW did not have any unoccupied properties at any time during the year; it has 100% occupancy. This shows that BWs properties are in high demand. On the other hand, AV has lost rent worth $36,348 through unoccupied properties; this is about 1.5% of the gross rent receivable.

The management of AV should identify the reason why the company's houses remained unoccupied when the occupancy rate is 100% for a competitor such as BW.


27. Not- for-prof i t organisat ion - GA and EA

For questions in which calculations are involved, while going through the question, note down the relevant information such as working days for GA and EA. This means that, after you finish reading the question, the information is already available and you can quickly work out where to use which information. This will save you time.

In addition, if any question is made up of two sub-questions make sure that you answer both. For example, in part a' of this question, you are asked to evaluate the operating as well as the financial performance of both the companies. In such a case you should not miss out any part i.e. you should consider both the companies and the operating as well as financial performances.

Do not forget to write calculations. Even if marks are not allotted, giving calculations in appropriate places will help you in writing your analysis and will help the examiner to identify the basis of your answer

Operating performance

Operating performance can be measured by determining the occupancy rate i.e. the companies' ability to serve customers.

Passenger fares and cargo income are the only sources of business therefore, while assessing the operating performances of GA and EA. the occupancies of the aircrafts and helicopters are critical.

The occupancy I utilisation rate can be compared with the budgeted rate and that of the previous year to give a better analysis.

The actual and budgeted levels of total occupancy (including concessional fare-paying passengers) achieved / to be achieved were as follows:

Year

GA EA

Year

Occupancy(%) \

Year 2006 2007 Budget

2007 Actual 2006 2007

Budget 2007

Actual Domestic 55 58 48 60 65 67 International 65 58 60 57 65 70 Helicopter services 85 85 82 - - -

Cargo 50 50 50 60 70 75

It is important to give the calculations as they are worth marks. This calculation, for example, is worth 2 marks.

This shows that, in the case of GA, for all other services except Cargo services, the occupancy rate has fallen from the level achieved during the previous year and is also below the budgeted rate. Moreover, the occupancy rate, in the case of domestic services, includes the senior citizens who receive a discount of 50%. The occupancy rate of the fully paying passengers is therefore even lower than what is shown in the table.

On the other hand, EA has exceeded expectations. Its occupancy has increased from that of the previous year and is also above the budgeted rate.

From the above, it can be concluded that EA is slowly taking over the market of GA. This will be harmful for the survival of GA.

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Financial performance

Sales volume, net profit, net profit ratio. ROI etc. r an organisation.

The following information is related to GA and EA:

Solution Rank:l21

can be used to assess the financial performance of

GA EA 2006

Actual 2007

Actual 2007

Budget 2006

Actual 2007

Actual 2007

Budget

Turnover (S'000) Net profit ($ 000) Net profit ratio (%) Assets (WDV)($'000)

15,470,120 3.926.640

25.38 2,240,000

14,618,720 2.992.816

20.47 2,016,000

15,922,960 4,298,960

27.00 2,016,000

12,063.744 3,211,680

26.62 7,000,000

15,584,992 5,139,552

32.98 6,300,000

14,579,680 4.686.080

32.14 6,300,000

GA When financial performance is considered. 20X7 proved to be a bad year for GA since it could not meet its targets and also performed badly as compared to the previous year i.e. 20X6.

The revenue of GA has fallen by 5.50% [S(15.470.120 - 14,618.720) / 15,470,120 x 100], from the previous year and is $1,304,240, i.e. 8.19% ($(15,922,960 - 14.618,720) /15,922,960 x 100], below the budgeted figure.

Profit for the year 20X7 has decreased by 23.78% [$(3,926,640 - 2,992,816) / 3,926,640 x 100], from 20X6 and is 30.38% [$(4,298,960 - 2,992,816) / 4,298,960 x 100], below the budgeted profit.

As stated in the question, one of the reasons for the increase in the costs of GA is its higher insurance cover for its passengers and on-board staff. Although this concern for society is good, it also affects the financial performance of GA.

Fixed costs have increased to a large extent. Repair and maintenance costs, in particular, have increased disproportionately. This has a great impact on the cost. ~ ~ Although the revenue has decreased, all the costs have A P a r t f r o m t h e general increased. This shows a very poor control over the costs. 1 discussion, such comments are

necessary since they will help

The WDV of the fixed assets of GA is much lower than that of EA. Therefore, it seems that GA is operating old aircrafts on flights, V ^ Th© analysis is very leading to higher maintenance and operation costs. This may also increase the risk of accidents leading to higher insurance premiums for the aircrafts (and further contributing to higher costs).

important; don't just reproduce what is in the table

EA In contrast to GA, EA performed very well in the year 20X7. Its revenue i profit for the year 20X7 have increased beyond the budgeted levels. The performance of EA. when compared with the previous year, shows fast growth. This may be because EA announces attractive schemes from time to time and operates for 345 days a year which is more than GA (which operates for only 325 days), amongst other reasons.

The net profit of EA has increased by 60% [$(5,139,552 - 3,211.680) / 3,211.680 x 100) in companson to the previous year and is 9.68% [5(5,139,552 - 4.686,080) / 4,686,080 x 100] above the budgeted figure

Although variable costs as well as fixed costs are higher than the figures for both the previous year and the budget, we can relate this to the increased revenue.


(b)

rt This part of the question is made up of three questions worth equal marks. Your answer should be in accordance with the number of marks available. Don't make any answer too long or too short.

In (i) each point is worth two marks and the maximum number of marks is five therefore writing 3 points is enough as long as you can explain them properly. In (ii) five items of additional information are asked for and there are 5 marks available therefore do not give more than 5 items. However, do not forget to explain how such additional information is helpful, otherwise you will lose marks. (iii) is worth 5 marks. Relate your answer to the given scenario.

(i) It is not feasible to compare the performance of GA with EA. This is because of the following reasons:

> funding pattern

GA is substantially funded by the government and therefore may have certain obligations to fulfil in order to ensure continued financial assistance. For example, GA may have to provide all the necessary services even if some of them are not profitable.

On the other hand, EA has raised funds by way of long-term loans for which it has to pay a heavy amount as interest which is not the case for GA.

> objectives

In the exam, make sure that you apply your knowledge to the given scenario; this will help you to earn

From the information given, it seems that GA is a not-for-profit company whereas EA is profit seeking company. This means that there will be basic differences in their primary objective. GA assumes its social responsibility and therefore continues to provide services / routes even if they are not profitable; provide concessions to senior citizens who affect its revenue; and takes higher insurance cover for its passengers and on-board staff which increases its cost substantially.

On the other hand, the decisions of EA are motivated only by profit.

> assets

The WDV of EA's assets is higher than that of GA's assets which suggests that EA uses good aeroplanes which may be more comfortable, newer etc. than those of GA. Since the WDV of EA's aeroplanes is higher, the depreciation cost is high which will affect EA's financial performance.

> unavailability of additional information

The given information is not sufficient to evaluate and compare the two companies. This is because, as mentioned in the above point, although the use of new aeroplanes may adversely affect the financial performance of EA it may also have improved EA's service quality and thereby attracted new customers. Additional information on the number of staff employed, the routes etc. of the two companies would be useful in order to compare them effectively.

In addition, GA is, to some extent, under the control of government. On the other hand, being free to take decisions. EA can change its policies frequently and thereby take advantage of the current circumstances in the market. For example, EA can offer discounts to customers who book tickets 2-3 months prior to the scheduled takeoff date in order to attract more customers and those who book just 2-3 days in advance can be charged heavily.


(ii) The additional information required for detailed analysis of the performance of GA and EA and how that helps in assessing performance includes the following:

In-flight services, quality of food / beverages provided Service quality Flight schedule delay, cancellation of flights Competitiveness Man-equipment ratio, staff employed, revenue / cost per staff Resource utilisation, productivity Quality of service provided to the customers, behaviour! attitude of staff Service quality

Models used for passenger service as well as for cargo services Service quality Safety / accident records Service quality

New routes added, number of aeroplanes Competitiveness, business growth, flexibility

Enquiries converted into sales Competitiveness Customer retention rate Customer satisfaction, competitiveness

The above mentioned information on measures such as competitiveness, quality of service, flexibility and resource utilisation may help in measuring the performance of GA & EA.

(iii) The following three decisions taken by GA indicate that GA is a not-for profit organisation:

> having higher insurance cover for the passengers and on-board staff > providing concessions to senior citizens

r- not eliminating any service / route only because it is not profit making

Impact of these decisions on the financial performance of GA ^ Higher insurance cover: as a result of this, the cost may increase to a large extent and affect the short-

term financial performance.

s Concession to senior citizens: the decision to provide a 50% discount to senior citizens has an adverse impact on the short-term performance of GA. This is because, out of the total occupancy, 10% are senior citizens and therefore, in the domestic market. GA is losing 50% of its fares on 10% of its clients, which is a significant amount.

v However, such decisions may result in increasing the financial performance of GA in the long term. For example, taking higher insurance will not only help the company to discharge its soaal responsibility but will also increase its customer and employee satisfaction and accordingly increase its customer retention rate and reduce employee turnover.

(c) Importance of qualitative information

From the information given on GA and EA, only their short-term performance can be measured. Net profit ratio, revenue generated, profit earned during a year etc. are all short-term measures. These measures do not highlight the strategies which have a long-term impact. GA's decisions to provide more insurance cover and to continue services in remote areas might prove fruitful in the long term. Only qualitative information can reveal the impact of such decisions in long term. Information that GA's decision to take higher insurance cover for its passengers and on-board staff shows that as a result of this decision, the overall cost has increased. However, more information (especially qualitative) is needed for detailed analysis.

Qualitative information gives information over and above quantitative information and therefore facilitates finer, more detailed analysis. For example, in the given case, the information that GA's costs for the year 20X7 were higher than those of EA would have misied the analyser by giving the impression that the increase in vanable cost is on account of the inefficiency of GA. However, the additional information that GA has taken out higher insurance cover for its passengers and on-board staff gives a clear reason for the increase in the costs.

In addition, the information that even if a route / service is not profit making. GA will continue to provide it. gives more evidence that the objectives of GA are different from those of EA.

The qualitative information provided in the question communicated that GA is a not-for-profit company and provided more detailed information about the objectives of GA. In the absence of this information, proper performance measurement may not be possible.


Other qualitative information such as information on-time departures / arrivals, employee behaviour, the customer as well as employee satisfaction and the number of individuals employed etc., if provided, will facilitate better companson between GA and EA.

In addition, information on customer satisfaction, customer complaints and retention rate will help in predicting the future performance of GA and EA. From the given information, it can be concluded that EA is performing very well and is growing very fast. However, this may be a result of its strong marketing strategies which may be effective only in the short term. Often decisions are taken which lead to good performance in the short term but at the cost of long-term performance. In such cases, qualitative information enables users to gain some idea about the future performance.

A Score More

Qualitative information provides additional information over the financial information and therefore facilitates better analysis. Qualitative information focuses on long-term organisational strategies whereas quantitative information, especially financial information, focuses on short-term performance and provides a short-term vision. If qualitative information is not used for performance evaluation, managers may be tempted to take dysfunctional decisions.

Note: the answer given above is not a wrong answer but it will not earn you good marks. This is because, according to the question, you should highlight the importance of qualitative information in assessing the performance of GA and EA. In addition, you have not provided a proper explanation of your points. For example, when you state that qualitative information gives information over and above quantitative information, you should explain how i.e. as explained in the original answer above, with the example of increase in operational cost.

28. Behavioura l aspects of per formance management

rt For this question, read the question carefully and note down the key information before start answering.

If the key informations are noted down well in advance you can keep track of your answer and make sure that you have answered all the requirements. This will save you time and prevent you from loosing marks.

(i) The term short-termism refers to the tendency to focus on immediate gain without considering the long-term consequences of the decision.

For example, in a machine shop {i.e. a cost centre), in order to reduce the costs of the period, the manager may decide not to spend money on preventive maintenance. This decision may improve the efficiency of the cost centre, but at the cost of running the risk of break-down of the machinery leading to a halt in production and potentially huge loss of profit.

Similarly, in the budgetary process, there may be unjustified focus on allocating scarce funds to help improve short-term performance measures, such as idle time percentages on existing machinery or the sales volume of a product which is in the declining phase of its life cycle. These scarce funds could, however, be better utilised in increased market research into new areas of customer demand or in research and development work into improved methods of production, perhaps focusing more on production layout dedicated to individual projects or products. These measures will ensure the long-term viability of the organisation.

Short-termism and financial manipulation of results are caused by over-emphasis on short-term performance evaluation and too much focus on immediate profitability. Managers whose incentives are linked to profitability will be interested in boosting immediate revenue or in postponing the costs as far as possible in order to improve profitability.


(ii) This implies behaviour and activity in order to achieve specific performance indicators which may not be effective. For example, machine output efficiency may be measured as the ratio of output achieved (in standard hours of work) to total operating hours.

Efforts to improve this measure from, for example. 95% to 99% may focus on increasing machine speed in order to increase throughput rates. This may not be an effective course of action. The increase in machine speed may create problems in maintaining the quality of output. This could lead to greater losses in process and/or problems with the finished product when It reaches the customer, resulting in returned goods and possibly the loss of future orders.

(iii) Oversimplification of performance measures may lead to their misinterpretation. It may involve failure to identify the intncacy of the environment in which the organisation operates. A drop in the volume of sales for a product may be seen as an indication that greater focus on market promotion activity is required. This interpretation ignores the likelihood that a number of other factors, both internal and external, may be contributing to the reduction in sales volume (for example, internal problems with the quality of output, with meeting delivery dates to customers or with maintaining good relationships with customers). External problems may include increased competition from alternative products, the introduction of new product features by competitors or increased sales efforts by competitors. In addition, factors such as a decrease in customers' purchasing power or changing customer tastes may be pertinent.

(iv) The deliberate distortion of a measure in order to increase strategic advantage may be resorted to for different reasons. It may involve purposeful under-performing in order to avoid higher targets being set for a future period. For example, the restriction of departmental consultancy earnings in a university department in order that the target for next year will not be increased and/or to hold back consultancy possibilities which are 'in the pipeline' in order to create slack.

(b) Examples of actions which may be implemented in order to overcome problems in the operation of a performance measurement system are as follows:

Involvement of staff at all levels in the development and implementation of the performance measurement system is important to overcome behavioural problems. Staff involvement in the development and implementation of the system helps in improving staff willingness to accept and work towards any performance measures which are developed to monitor their part in the operation of the organisation and the achievement of its objectives.

^ A flexible approach to the use of performance measures makes the measurement system more acceptable. It is best to acknowledge that they should not be relied upon exclusively for control. Sometimes performance may be improved through the informal interaction of individuals and groups.

> The 'dimensions of performance' need to be given careful consideration. Action here may indude efforts to quantify all objectives.

Quantifying all objectives should help to overcome a sub-optimal plan which omits some aspects of what is required. Moreover it is important to focus on customer satisfaction. This will help ensure an external focus, which is vital to the level of achievement and future effectiveness of the organisation.

Audit of the system is essential in order to make the system effective. This may include an external review of the system by an expert. An 'arm's length' review will help to eliminate any inefficiency in the system due to the views of those operating the system. In addition, there should be a careful audit of the data used. Any scheme is only as good as the data analysis and how the data are interpreted. A focus on key features is necessary in the system. These may include nurturing a long-term perspective among staff; restricting the number of performance measures to allow focus on key areas and developing performance benchmarks which are independent of past activity in order to focus on the way ahead and the achievement of plans for the future.

Relevant alternative examples and comment would I accepted


29. Per formance measurement - Spor ts town and Totale isure

(a)

I For case study based questions, read the question carefully and note down the relevant information. This means that, after you finish reading the question, the information is already available and you can quickly work out where to use which information. This will save you time. In addition, you can note down the sub-requirements of the question. For example, in this part of the question, you are asked to discuss the operating as well as financial performance of both the companies. In the exam, there is a possibility that you may lose marks by accidentally missing out one of the sub-requirements, e.g. the operational performance of Totaleisure. However, if the sub-requirements are noted down well in advance you can keep track of your answer and make sure that you have answered all the requirements. This will save you time and prevent you from losing marks.

(i) Operational performance

Operational performance can be measured by determining the facilities utilisation ratio. The utilisation ratio can then be compared with the budgeted ratio and that of the previous year for a better analysis of operational performance. The calculations of the utilisation ratio are as follows, considering daytime occupancy, evening occupancy and occupancy for the whole day.

It is important to give the calculations as they are worth marks.

Sportstown Totaleisure Daytime

(50 + 70 + 15 + 50) = 46.25

(20 + 40 + 25 + 40) = 31.25

Evening

(80 + 70 + 50 + 50) = 62.5

(85 + 80 + 85 + 60) = 77.5

For the whole day

(50 + 70 + 15 + 50 + 80 + 70 + 50 + 50)

8 = 54.4

(20 + 40 • 25 + 40 + 85 + 80 + 85 + 60)

8 = 54.4

The above calculations show that, during the daytime, the utilisation ratio of Sportstown is 15% higher than that of Totaleisure but in the evening, the utilisation ratio of Totaleisure is 15% higher than that of Sportstown. This means that the utilisation ratios of both Sportstown and Totaleisure for a day are equal i.e. 54.4% (assuming that the same weighting is given to daytime and evening).

However, in the case of Totaleisure. the usage varies to a great extent i.e. usage is 31% during the day and a very high 78% in the evening. On the other hand, the usage of facilities of Sportstown is balanced. Balanced usage is beneficial as it will allow maintenance of the facilities to be undertaken and will also ease traffic congestion. For Totaleisure. in the evening, when many people may want to use the same facility, this will cause chaos and potentially increase customer complaints.

Sportstown offers free access to all facilities to local schools which may be the reason behind its high utilisation ratio during the daytime.


(ii) Financial performance

It is important to give the calculations as they are worth marks.

Sportstown ($'000) Totaleisure ($'000)

20X0 20X1 Budget

20X1 20X0 20X1 Budget 20X1

Revenues (W1) 700.00 606.20 792.40 850.00 1,000.00 950.00 Less: Costs Salaries 450.00 500.00 550.00 350.00 400.00 350.00 Maintenance 150.00 200.00 200.00 75.00 100.00 90.00 Depreciation 25.00 25.00 25.00 50.00 50.00 50.00 Other costs 125.00 75.00 125.00 100.00 150.00 150.00 Loan interest - - - 200.00 200.00 200.00 Profit / (loss) (50.00) (193.80) (107.60) 75.00 100.00 110.00

Financial ratios

Assets (WDV) 400.00 375.00 375.00 800.00 750.00 750.00 Profit/Assets (%) (12.50) (51.70) (28.70) 9.40 13.30 14.70 Profit/Sales (%) (7.10) (32.00) (13.60) 8.80 10.00 11.58

Workings

W1 Revenue

Remember, even if separate marks are not allotted to any answer, giving calculations in appropriate places will help you in writing your analysis and will help the examiner to identify the basis of your answer. Therefore do not forget to give workings.

Revenue for Totaleisure 1,700x500 = $850,000 2,000 x 500 = $1,000,000 1,900 x 500 = $950,000

Sample calculation of revenue of Sportstown (20X1 actual)

Opening hours(A)

Paying people

(B) Price $

(C)

Number of days (D)

Total $ (A x B x C x

D) Squash 12 6 4 350 100,800 Swimming 10 29 2 350 203,000 Gym 12 20 3 350 252,000 Badminton 6 6 4 350 50,400

606,200

Totaleisure has performed well in the Year 20X1. It is a profit making company and profit has increased by $25,000 ($100,000 - $75,000) i.e. 33.33% from the previous year. However, this figure is $10,000 ($110,000 -$100,000) i.e. 9% below the budgeted figure.

The revenue of Totaleisure has increased by $150,000 ($1,000,000 - $850,000), i.e. 17.65%, from the previous year and is $50,000, i.e. 5.26%, above the budgeted revenue. Although the actual revenue is more than the budgeted revenue, the actual profit is j The analysis is very less than the budgeted profit. This fall in profit is due to an increase in important; don't just salaries and maintenance costs beyond the budgeted level. Salaries ) reproduce what is in the are $50,000 ($400,000 - $350,000), i.e. 14.08%, higher than the budget table and maintenance cost is S10.000 ($100,000 - $90,000), i.e. 11.11%, " higher than the budget.

Download - ACCA P5 GTG Question Bank - 2011

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