MOCK EXAM 01
Section A- This ONE question is compulsory and MUST be attempted
QUESTION 1- FLASH
Company information and mission
Flash Supermarkets (Flash) is a multinational listed business operating in several developing countries. The business is divided into two divisions: Metro, which runs smaller stores in the densely populated centres of cities, and Hyper, which runs the large supermarkets situated on the edges of cities. Flash sells food, clothing and some other household goods.
Competition between supermarkets is intense in all of Flash's markets and so there is a constant need to review and improve their management and operations.
Flash mission is to be: 'the first choice for customers by providing the right balance of quality and service at a competitive price. We will achieve this through acting in the long-term interests of our stakeholders: earning customer loyalty, utilising all our resources and serving our shareholders' interests.'
Performance report
You are a performance management expert working for Flash, and the Chief Executive Officer (CEO) wants your views on the company's performance report and whether it is fit for the purpose of achieving the company's mission. The CEO has provided you with a copy of the company's most recent report as an example (Appendix 1).
This report is used at Flash's board level for the annual review of the company's performance. The divisional boards have their own reports.
The CEO has mentioned to you that there has been criticism of the board of Flash in the financial press, saying that the board is 'short-termist'.
Therefore, the CEO has asked you to evaluate the performance report to see if it is fit for the purpose of achieving the company's mission. However, the CEO also wants your evaluation of the performance report to include comments in relation to the criticism that the board is short-termist.
Performance measures
The board is considering introducing two new performance measures to address the objective of 'utilising all our resources'. These are revenue per square metre, and operating profit per square metre. The CEO wants an evaluation of these two measures, explaining: how they might address the objective, what those ratios currently are, and how they could be used to manage business performance. The CEO told you that the information in the board report (Appendix 1) will assist in this work.
There have been disagreements between Flash's divisional management about capital allocation. The divisions have had capital made available to them. Both sets of divisional managers always seem to want more capital in order to open more stores but historically have been reluctant to invest in refurbishing existing stores. The board is unsure of capital spending priorities given that the press comments about Flash included criticism of the 'run-down' look of a number of its stores.
The CEO has asked you to assess the effectiveness of the current divisional performance measure of divisional operating profit and the possibility of replacing this with residual income, in the light of these problems. The CEO has told you that you are not required to calculate the current values.
New stores
As the company is opening many new stores, the board also wants an assessment of the use of expected return on capital employed (ROCE) as a tool for deciding on new store openings. You have been given data for a new store proposal (Appendix 2), as an example to use when making your assessment.
The CEO has told you that the board wants the focus of your comments to be on the use of an expected value, not on the use of ROCE, as this is widely used and understood in the retail industry.
With this in mind, the CEO asked you to calculate the expected ROCE for the new store, and assess its use as a tool for decision making at Flash.
Information system
The CEO has proposed to the board that a new information system be introduced. She wishes to spend $100 million on creating a loyalty card programme with a data warehouse collecting information from customers' cards regarding their purchases. Her plan is to use this information to target advertising, product range choices and price offers more efficiently than at present.
The CEO has asked you to include in your report an explanation of how the proposed new information system can help to improve business performance at Flash.
Required
Write a report to the board of Flash, in response to the CEO's instructions for work on the following areas:
i. Evaluation of Flash's performance report
(14 marks)
ii. Evaluation of the new performance measures (revenue and operating profit per square metre)
(8 marks)
iii. Changing the divisional performance measure
(8 marks)
iv. The use of expected ROCE
(8 marks)
v. proposed new information system
(8 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer.
(4 marks)
(Total = 50 marks)
Appendix 1
Board's performance report
FLASH YEAR TO 31 MARCH
|
Metro budget 20X6
$'000 |
Metro actual 20X6
$'000 |
Hyper budget 20X6
$'000 |
Hyper actual 20X6
$'000 |
Flash budget 20X6
$'000 |
Flash actual 20X6
$'000 |
Flash actual 20X5
$'000 |
Change on PY |
Revenue |
|
Food |
1,093,521 |
1,104,567 |
5,431,277 |
5,542,119 |
6,524,798 |
6,646,686 |
6,513,752 |
2.04% |
Clothes |
765,465 |
773,197 |
3,801,894 |
3,879,483 |
4,567,359 |
4,652,680 |
4,536,363 |
2.56% |
Other goods |
328,056 |
331,370 |
1,629,383 |
1,662,636 |
1,957,439 |
1,994,006 |
1,964,096 |
1.52% |
Total |
2,187,042 |
2,209,134 |
10,862,554 |
11,084,238 |
13,049,596 |
13,293,372 |
13,014,211 |
2.15% |
Cost of sales |
1,994,583 |
2,014,730 |
10,199,937 |
10,408,099 |
12,194,520 |
12,422,829 |
12,186,796 |
1.94% |
Gross profit |
192,459 |
194,404 |
662,617 |
676,139 |
855,076 |
870,543 |
827,415 |
5.21% |
Gross margins |
|
8.80% |
|
6.10% |
|
6.55% |
|
|
Other operating costs |
34,993 |
35,346 |
173,801 |
177,348 |
208,794 |
212,694 |
208,227 |
|
Operating profit |
157,466 |
159,058 |
488,816 |
498,791 |
646,282 |
657,849 |
619,188 |
6.24% |
Operating margins |
|
7.20% |
|
4.50% |
|
4.95% |
|
|
Finance costs |
|
|
|
|
76,993 |
79,760 |
75,482 |
|
Group profit before tax |
|
|
|
|
569,289 |
578,089 |
543,706 |
6.32% |
Tax |
|
|
|
|
142,322 |
144,522 |
135,926 |
|
Group profit after tax |
|
|
|
|
426,967 |
433,567 |
407,780 |
6.32% |
Total shareholder return |
|
|
|
|
|
3.10% |
2.70% |
|
Return on capital employed |
13.2% |
13.3% |
13.2% |
13.5% |
13.2% |
13.4% |
13.2% |
|
Number of stores |
|
533 |
|
208 |
|
|
|
|
Total square metres |
|
161,227 |
|
841,967 |
|
|
|
|
Appendix 2
New store
The following data has been forecast by the Marketing Department for the new store based on Flash's existing experience. There are three possible scenarios:
Demand scenarios |
Low |
Medium |
High |
Revenue ($m) |
12.5 |
13.0 |
13.5 |
Probability (%) |
20 |
50 |
30 |
Forecast operating margin (%) |
4.1 |
4.3 |
4.4 |
The new store is expected to cost $4.2m to buy, fit out and stock. The target ROCE for Flash has been set at 13%.
QUESTION 1- FLASH
Report
To: Board of Flash
From: A. Accountant
Date: [today's date]
Subject: Performance reporting and management issues at Flash
Introduction
This report evaluates the current performance report for Flash and the introduction of two new performance measures. Then, the effect of a proposed change in the divisional performance measure is assessed. Next, the use of expected ROCE for new store proposals is evaluated. Finally, the report explains how the proposed new information system can help to improve business performance at Flash.
i. Performance reporting at Flash
The current report has a number of strengths and weaknesses. These will be discussed according to whether the report:
- Addresses the mission;
- Contains appropriate information for decision making;
- Shows signs of being short term; and
- Is well presented.
The current mission can be broken down into two parts:
- To be the first choice for customers; and
- To provide the right balance of quality, service and price.
There are three strategies for achieving this mission, reflecting stakeholder concerns:
- Earning customer loyalty;
- Utilising all resources; and
- Serving shareholders' interests.
Addressing the mission
Customer loyalty. The report does not address the first part of the mission (earning customer loyalty). This can only be measured using external data but the report is utilising only Flash's internal data. This part of the mission relates to the first strategy to gain customer loyalty. Customer loyalty could be gauged through repeat purchases or market share information but neither is supplied. This is clearly important to a retailer and may be more easily gathered once the data from the new information system are available for inclusion in this report.
The current report provides no measures of the balance of quality, service and price other than through the historic growth in revenue. It would only be through comparison with competitors or customer survey data that a picture of the mix of these qualities could be gained.
Utilising all resources. The second strategy of utilising resources requires that the key resources be identified. Clearly, the stores themselves (and thus the capital invested) are an important resource and the introduction of the revenue and profit per square metre and comparison with competitors will indicate the efficiency of their use. However, there are likely to be other important resources such as staff and no measure of their performance is offered. Staff costs are not shown in the trading account, although a more sophisticated measure such as revenue per employee is a commonly used metric and would address this.
Serving shareholders' interests. The report is much better on the third strategy of serving shareholder interests as it supplies two helpful measures: total shareholder return and return on capital employed. However, most shareholders will want comparison with benchmark returns within the retail sector and the market more widely, since these represent their alternatives.
Short-termism. The criticism of the company's management as being short term is reflected in the performance reporting. The only benchmarks in the report to compare actual performance against are the budget information and the previous year's figures. There are no longer-term forecasts or information on future capital investment. Also, there are few indicators which would be described as determinants of performance. These are often non-financial and focused on the external business environment (behaviour of customers and competitors).
As already noted, there is a significant gap in the information in the report as it contains no external information. Also, although revenue is broken down into broad product categories, no further information about growth within these categories nor the margins being earned is supplied. As a result, it could be questioned whether this breakdown is worthwhile.
Presentation. In terms of presentation, the data is clear and in a form which would be easily recognisable to those used to reading accounts. However, no narrative commentary is provided which would highlight the key features in the report such as major deviations from the budget or performance well outside industry norms. There should be a comment on each of the five areas within the mission and strategies as well as comments about specific, material issues arising in the period covered. The report could be made easier to read by reducing the volume of numbers present both by cutting out unnecessary measures (see earlier discussion of product categories) and also by rounding all figures to millions.
ii. New asset utilisation indicators
Revenue and operating profit per square metre reflect the utilisation of the key capital asset used in their generation (the store). Therefore, they are directly addressing a major part of the aim of utilising all resources; however, they do not address all resources which the business uses. There are likely to be significant staff costs and so similar measures of revenue and operating profit per employee could also be introduced in order to reflect these human resources.
|
Metro |
Hyper |
Flash |
Revenue per sq. metre ($) |
13,702 |
13,165 |
13,251 |
Operating profit ($'000) |
159,058 |
498,791 |
657,849 |
Operating profit per sq. metre ($) |
987 |
592 |
656 |
These measures reflect the importance of the use of the store's space which is an area which the business does not give sufficient attention as is reflected in the problems with divisional performance measures. Focus on these measures will require addressing issues of volume of sales and the profitability of those sales. The two types of store at Flash will have different impacts on these measures. For example, the smaller Metro stores may be capable of earning higher margins as they are convenient to customers while selling lower volumes. The Hyper stores may concentrate on selling in volume to customers who come to buy in bulk. However, in terms of the overall performance of the business it is essential that Flash sells in high volumes as it is a low margin business but it must not sacrifice profitability, in effect buying customers' revenue by selling at or near a loss
iii. Divisional performance assessment
The current measure of divisional operating profit reflects the trading in the period under consideration. Profit will link to the whole business's operating profit which is the correct level to reflect the efforts of the divisional managers. However, this measure only indirectly addresses the capital being used by the divisions (depreciation charged to operating profit). This is distorting the behaviour of the divisional managers.
The managers are not investing in refurbishing their stores which is causing the press (and presumably customers) to notice their run-down appearance. This may reduce the depreciation charge against operating profit. They are prioritising new store capital expenditure over the refurbishment since they are not being charged for the use of that capital (financing charges are deducted after operating profit is calculated). This may not be optimal since small spending on existing capital assets often yields higher returns than new spending (which may be subject to greater risks).
The proposal to change the divisional performance measure addresses the issue of not reflecting the capital used since residual income (RI) deducts an imputed interest charge. Divisions can then be set targets in terms of their RI. The difficulties in calculating RI lie in correctly setting the imputed interest rate and calculating the capital being employed by the division. However, since both divisions are types of stores, they will have similar assets and so the same rules can be applied to each to fairly calculate the capital used.
An advantage of RI is that the imputed interest rate can be changed to reflect the different risks of the divisions. The two divisions here do not seem to have significant risk differences unless the geographical locations introduce these (city centres and city edges). However, it is worth noting that using RI can discourage investment. As net book values of assets fall over time, RI automatically increases and 'do not invest' could become an attractive option to the managers.
Overall, the proposed change addresses existing problems and would be considered a normal solution to measuring divisional performance in this industry.
iv. Use of expected ROCE in new store appraisal
The expected ROCE, based on the different demand scenarios, is as follows:
|
Low |
Medium |
High |
|
Revenue ($m) |
12.5 |
13.0 |
13.5 |
|
Forecast operating margin (%) |
4.1 |
4.3 |
4.4 |
|
Forecasting operating profit ($m) |
0.5125 |
0.559 |
0.594 |
|
Probability (%) |
20 |
50 |
30 |
|
Expected operating profit ($m) |
0.1025 |
0.2795 |
0.1782 |
0.5602 |
ROCE = Expected operating profit/Capital cost
= $0.5602m/$4.2m = 13.34%
The expected ROCE is greater than 13% which is Flash's required ROCE, so this should be an acceptable investment.
The use of expected values in the calculation of ROCE is appropriate if the probabilities used can be reasonably estimated and the decision is likely to be one which is made a number of times. Since Flash has opened many stores, it is likely to be able to predict volumes and margins with reasonable accuracy. Since Flash is going to continue to open stores, this decision will occur a number of times which makes using a probabilistic approach viable. In general, ROCE is considered neither as accurate nor as direct a measure of shareholder wealth as, for example, net present value (NPV).
v. Loyalty card system
The proposed new information system will collect data from customers' purchases and store it for data mining purposes in a data warehouse. The capital required will be significant at $100m (the equivalent of about 24 new stores at $4.2m each). There will also be considerable annual running costs. However, the benefits could be significant, although quantifying them will be difficult as they depend on influencing customer behaviour and so are not simply cutting costs.
Improved customer loyalty. The new system will help to address the mission of Flash as it will help the board to understand customers better and so improve their loyalty to the business. By focusing offers on those things which customers enjoy Flash can enhance the brand and also take the opportunity to sell greater volumes alongside the offered products.
The data warehouse will allow data mining for relationships, for example, geographical preferences for products; links between price offers and volumes sold; products which are often bought together; and seasonality of product purchases. These relationships can then be used to address the CEO's three target areas of advertising, product range choices and price offers.
Advertising. Potentially, there will be cost savings by more efficient advertising. The data on each individual customer can be searched to profile customers and identify their individual preferences. Marketing can then be targeted to groups of customers using products which they commonly buy. Data mining will also identify associated products (those often bought together) so that offers can be grouped, for example, with a price reduction on buying a linked pair of products.
Product range. A problem in most retail businesses is the size of the product portfolio which they offer since more products (and potentially more suppliers) require more effort to manage. The new system may allow a Pareto-style analysis where the least profitable non-essential products are identified and can be cut from the product range.