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.

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:

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.

a. 

Tulip Risk appetite The appetite for risk at Tulip will be determined by the three VCs, which collectively own 90% of the company. Each of the VCs hold a large portfolio of investments, and are prepared for some of these to fail provided that others show large gains. As such, the VCs are risk seekers. The other key stakeholders at Tulip are the management team, who own the remaining 10% of the company. The fact the management have been given an equity stake in the business, coupled with their ambition and their enjoyment of the challenges of introducing new products, suggests that they will be comfortable with the high-risk approach taken by the VCs.

Tulip's management are also likely to be attracted to projects which are innovative, such as the 8 MW unit. They enjoy the challenges of introducing new products, and are likely to be motivated by the prospect of developing a world-leading unit.

Method of decision making

Maximax – The fact that both of Tulip's key stakeholder groups (the VCs and management) are prepared to accept high-risk approaches suggests that Tulip will be a risk seeker. As such, the appropriate method of decision making under certainty for it will be Maximax.

Using the Maximax approach, the design choice selected will be the one which offers the highest maximum profit possible, across any of the three demand scenarios.

Rosy

Risk appetite

The risk appetite at Rosy is likely to be determined largely by its investors – particularly as it has recently had to seek emergency refinancing.

Rosy's shareholders are concerned about the survival of the business, and its debt providers will also be concerned about its survival – and therefore its ability to repay any loans.

Rosy's management are also primarily concerned with the survival of the business. Although they do not own any shares in the company, they will lose their jobs if the company collapses.

The fact that Rosy's shareholders and management both view T&R as a way to generate additional cash flow reinforces the fact that their primary concern is with identifying initiatives which can help secure the survival of the business.

The precarious nature of Rosy's current position suggests that all of its key stakeholders will be risk averse.

Equally, they are likely to favour projects which will start generating income soon. As such, the 8 MW unit – which takes two years longer to develop than the others – may be less attractive to Rosy than the two units which can be developed more quickly.

Method of decision making

Maximin – Rosy's focus on the survival of the business means that a maximin approach to decision making under uncertainty will be appropriate for it. Using the maximin approach, the design selected will be the one which maximises the lowest profit which could be achieved across the three demand scenarios.

b. Turbine design types

Maximax = $13,300 earned by the 8 MW units

Maximin = $3,980 earned by the 3 MW units

Due to the differences in their preferred methods of decision making under uncertainty, Tulip and Rosy would choose to build different turbine design types. Rosy would choose to build the 8 MW units, while Rosy would choose to build the 3 MW units.

c. Problems of managing performance in a JV

Decision making – As we have seen in part (b), one of the main problems in a JV will be that of reaching a consensus between the venture partners when making strategic decisions.

This could be a particular problem for T&R, given that both partners own 50% of the venture, and so it is difficult to prioritise the interests of one partner over those of the other.

Goals and objectives – As well as their differences in attitude to risk, it appears that the venture partners have different goals and objectives for the venture. In this case, Rosy's primary goal from the venture is to generate additional cash flow in the short term. However, Tulip appears to be more interested in the potential long-term returns which can be earned from designing and manufacturing the turbines. As such, it could be difficult for the venture partners to agree what T&R's goals and objectives should be.

Similarly, the venture partners could have different interests in relation to the performance measures they consider to be most important. Although T&R could measure a variety of different indicators – including profit, growth and cash flows – Rosy is likely to prioritise cash flow measures and short-term performance indicators, while Tulip is more likely to be interested in the growth and the longer-term prospects of the business, for example.

Management styles – In the same way that Tulip and Rosy have different attitudes to risk, it is also likely that they will have different management styles and organisational cultures. This could cause problems at an operational level at T&R, since it is run by a group of managers from each of the JV partners – and therefore who may adopt different management styles.

Sharing capabilities and information – One of the problems, in general, with JVs is that they require the venture partners to share information, capabilities and intellectual property with each other. However, many of these elements may be commercially sensitive, and so the venture partners will be reluctant to share too much information about their own business with each other.

In this respect, establishing a climate of trust between the venture partners is likely to be important for the success of the JV. However, if the venture partners have very different cultures and management styles – as Tulip and Rosy seem likely to – this trust could be harder to achieve.

a. 

Pluto uses a traditional approach to budgeting, which has a number of weaknesses.

First of all, the budgeting system does not seem aligned with Pluto’s corporate objective which focuses on innovation and continuous product improvement. Innovation is a key competitive advantage to both component and device manufacturers in this industry and the products which incorporate Pluto’s components are subject to rapid technological change as well as changes in consumer trends. The markets in which the two divisions operate appear to be evolving, as seen by the high popularity of the smartphone model which was designed for playing games. This may mean the distinction between smartphone and gaming devices could be becoming less clear cut. Management time would probably be better spent considering these rapid changes and currently the budgeting process does not facilitate that.

In reality, the budget process at Pluto is time consuming and probably therefore a costly exercise. Divisional budgets go through a lengthy process of drafting and then revision by the main board before they are approved. The approval often happens after the start of the period to which they relate, at which point the budgets are already out of date. This also means divisional managers are trying to plan activities for the next financial year without a set of finalised targets agreed, which could impact the effectiveness of decisions made.

Another weakness is that the budgets are only prepared annually, which is clearly too infrequent for a business such as Pluto. The process is also rigid and inflexible as deviations from the planned targets are not tolerated. Sticking to rigid, annual budgets can lead to problems such as P Division not being able to cope with increasing popularity of a particular product and even other short-term changes in demand like those driven by seasonal factors, or one-off events such as the factory fire. Linked to this problem of budgetary constraints is that to cut costs to achieve the budgeted net profit, managers closed one of the three research and development facilities in G Division. As identified at the outset, a successful research and development function is a key source of long-term competitive advantage to Pluto.

It also appears that Pluto fails to flex the budgets and consequently the fixed budgets had discouraged divisional managers from deviating from the original plan. P Division did not make technical modifications to its components due to the cost of doing so, which meant they were unable to supply components for use in the new model of smartphone and had to discount the inventories of the old version. It is unclear why G Division did not take on additional staff to cope with increased demand following the reopening of their customer’s factory, but it may be because managers felt constrained by the budget. This then caused long-term detriment to Pluto as it lost therefered supplier status with its main customer.

Another problem created by annual budgeting is the management of short-term changes in costs and prices. A key component of Pluto’s products is silver, which fluctuates in price, and though it is not clear how much effect this has on Pluto’s costs, any problems in supply could disrupt production even if only a small amount of silver were required. Also, Pluto exports goods worldwide and probably also purchases materials, including silver, from overseas. The business is therefore exposed to short-term movements in foreign currency exchange rates which may affect costs and selling prices.

Similarly, there also seems to be considerable uncertainty in sales volumes and prices which creates problems in the forecasting process for the two divisions. P Division did not anticipate the high demand for the new component which meant it had to discount products it had already manufactured in order to achieve its forecast sales volumes. G Division did correctly forecast the demand, but based on past growth in the market which may be too simplistic in a rapidly changing industry. Lack of up-to-date information will hinder decision making and overall performance at Pluto. Pluto would perhaps be better adopting a rolling basis for forecasting.

The two divisions share manufacturing facilities and are likely to compete for other resources during the budgeting process. The current budgeting system does not encourage resource, information or knowledge sharing, for example, expertise in forecasting silver requirements. Divisional managers are appraised on the financial performance of their own division and hence are likely to prioritise the interests of their own division above those of Pluto as a whole. P Division would not reallocate its manufacturing facilities to G Division, even though G Division needed this to cope with extra demand following reopening of the customer’s factory. The current system is therefore not encouraging goal congruence between the divisions and Pluto as a whole and a budgeting system, if done effectively, should encourage co-ordination and co-operation.

Managers may find the budgeting process demotivating because it is time consuming for them and then the directors override the forecast which they had made. It is also unfair and demotivating to staff to appraise them on factors which are outside their control. This also identifies another weakness in Pluto’s budgeting system related to control, as there does not seem to be any planning and operating variance analysis performed to assess exactly where performance is lacking, and so no appropriate management information is provided. In fact, it is not even clear just how often divisional managers receive reports on performance throughout the year. Any budgeting system without regular feedback would be ineffective. It should even be noted that for the industry in which Pluto operates the use of only budgetary targets as a measure of performance is narrow and internal. It should be utilising information from external sources as well to assess performance in a more relevant and contextual way.

Given the rapidly changing external environment and the emphasis on innovation and continuous product development, the current budgeting method does not seem appropriate for Pluto.

(14 marks)

b. 

As the shareholder representative noted, external factors have adversely affected Pluto's performance over the last year. However, the way Pluto has responded to the external events has also contributed to the problems it has faced. As such, it is important that Pluto doesn't simply use the external factors as an excuse for its poor performance, thereby failing to acknowledge the internal factors and behaviours which have also contributed to it.

The current lack of any detailed analysis into the reasons why Pluto's actual performance varies from budget means it is difficult to hold managers to account for their performance. However, as the three examples we evaluate below demonstrate, the factors that affect performance cannot be categorised entirely as controllable (internal) or as uncontrollable (external). Instead, Pluto's performance reflects a combination of both types of factors.

The unexpectedly high popularity of the new smartphone with the large screen was an external factor. However, P Division's inability – or unwillingness – to make the necessary technical modifications to its own components to support the new screen was an internal factor, resulting – as we noted in part (a) – from the fact that Pluto does not flex its budgets.

Similarly, the global shortage of silver during the year (and the corresponding increase in silver prices) was an external factor. However, the lack of communication between G Division and P Division which led to G buying silver when P already held large inventories reflected an internal weakness. If the two divisions had liaised more effectively, the impact of the short-term increase in silver prices could have been reduced (or perhaps even avoided) if Pluto was able to wait until prices fell again to top up its inventories.

Again, the fire which affected G's main customer was an external factor. However, G's refusal to recruit extra staff to fulfil increased demand when the customer's factory reopened, and P's refusal to allow some of its manufacturing facilities to be used to meet this demand, are both internal decisions. However, it was these responses – rather than the fire itself – which led to Pluto losing its preferred supplier status with the customer.

As we noted in part (a), the response to the silver price increase and the fire both reflect the lack of goal congruence between the divisions and Pluto as a whole. Again, though, this is an internal weakness, reflecting dysfunctional behaviour which has resulted from the way divisional performance is rigidly assessed against budget. Therefore, although external factors have contributed to G's poor performances, internal weaknesses have also played a significant part in G's poor performance.

(6 marks)

c. 

Planning variances result from actual events and circumstances differing from the assumptions used in the original budget. For example, the fire at its main customer meant that the annual growth of 5% anticipated in G's sales forecast was too high (because the budget had not anticipated the fire). The lost sales resulting from the fire should be treated as a planning variance.

In effect, a planning variance is the difference between the original budget and the budget as it would have been revised with the benefit of hindsight. Operational variances then reflect the differences between this 'revised' budget and actual performance.

Operational variances result from the ongoing decisions of divisional managers, rather than issues with the original budget-setting process.

We have already noted – in part (a) – that the lack of planning and operating variance analysis is a weakness, because it means Pluto cannot accurately identify the reasons why actual performance is below budget. Given the dynamic nature of Pluto's markets (and the fact that budgets are only produced annually) it seems likely that there could be significant planning variances.

By isolating these planning variances, Pluto could then get a fairer reflection (through the operational variances) of how well the divisional managers are performing. This will also increase the effectiveness of the budgeting system as a control mechanism – comparing the manager's actual controllable performance against budgeted targets.

Currently, the divisional managers are appraised on the financial performance of their divisions, so they are being held responsible for planning variances as well as operational variances. However, as the budgets are determined by the main board, the managers should not be held responsible for planning variances over which they have little (or no) control.

Equally, however, by isolating the planning variances, Pluto can get a better insight into the degree to which the original budget was inaccurate. If it becomes clear that the majority of the variances result from changes in circumstance, which couldn't have been known when the annual budget was originally set, this could reinforce the argument for moving away from the current budgeting system – for example, to rolling budgets.

(5 marks)