QUESTION 1- MEHERLAND SPORTSWEAR (MS)

To: The Board of MS

From: A Accountant

Date: June 2015

Subject: Performance management at Meherland Sportswear (MS)

This report addresses a variety of performance management issues at MS. The existing choice of performance metrics in the dashboard is assessed in the light of the strategy and SWOT analysis. The impact of the child labour scandal for MS is addressed. Specifically, the impact the proposed new factory will have on the metrics is considered. Finally, suggestions are made for the use of the value chain analysis in management of this factory.

a. Existing performance dashboard

In assessing the choice of metrics in the dashboard, it would be best to begin with a clear picture of the aims and broad strategy of MS. The main aims appear financial and this is appropriately reflected in the main heading of the dashboard and the fact that this heading has three metrics not just the two in the other areas. The first aim is growth, which is reflected in the change on previous year data given in the dashboard and most specifically in the revenue data given. The trend can be seen with three years of data reflecting the growing activities of MS. The second aim is to maximise shareholder wealth. This is measured indirectly through return on capital employed (ROCE). However, as ROCE does not take account of a number of issues (e.g., tax or financing costs), it does not directly measure shareholder wealth. It would be worth considering replacing ROCE with a value-based measure such as economic value-added which over the long term should more accurately reflect shareholder wealth.

1. The other elements contained in the broad strategy are seeking competitive advantage in two ways:
2. to create innovative products which reduce injuries and improve performance.

to be the leading marketing operation in Zealand. The current dashboard reflects these strategies in the design and brand headings. However, the metrics used in each seem to lack important aspects of the stated strategies.

The number of design awards won indirectly measures the quality of the products but it does not measure innovation. The number of new products or features on our products would more accurately do this. The design heading does not specifically address the key advantages mentioned of injury reduction and sporting performance. It will be difficult to provide two metrics which will cover all of these areas. However, if the criteria of the awards are injury reduction and performance and if a metric of number of new products launched is added, then the strategy is broadly covered by two measures.

The strategy of being a leading marketer is partially covered by the existing metrics of brand awareness, although without a comparator it is difficult to gauge whether this is a market leading figure. A more appropriate measure in the context of competitive advantage would be market share and in fact, looking at the data on footwear, we have 32% (= 2m/6.25m) of this important market which is 55% of our revenues (= $150m/$273m).

Also, brand awareness is only measuring the recognition of the brand, not whether there are positive sentiments towards the brand. Market share, however, gives a clearer picture of this as it reflects the purchasing choices of consumers.

The SWOT analysis suggests further possible areas for measurement such as supply chain management, but the board has ruled out new headings on the dashboard. This would have to be indirectly measured through the financial heading by using a metric such as gross or operating margin. Indeed, it may be worth replacing the absolute operating profit figure with the margin figure for this purpose. The SWOT analysis also identifies two issues in marketing:

There is a linked pair of points – weak IT expertise and the threat of change in marketing channels. This would affect MS’ marketing operations as they may lack the skill to exploit these new marketing opportunities. This issue falls under the brand heading and if it is felt that market share covers brand awareness, as previously mentioned, then the second measure under this heading should address MS’ management of the changes in marketing channels by looking at the number of followers of MS on social media who either read or more actively respond to our social media messages.

The loss of a brand ambassador which, as the business has only got 10 of these, may be significant. In addition, the fact that the loss is tied to an injury which should not happen with MS’ products is particularly problematic. This suggests measures under the brand heading of ‘number of ambassadors’ or else requires an injury reduction metric under the design heading – although we already have two metrics proposed under this heading (awards won and new products).

The board will need to prioritise between these issues to decide on a second metric within the brand heading.

(Max 16 Marks)

b. Impact of response 1

Change in operating profit due to response 1

Quantitative impact:

The main stakeholders affected financially are the shareholders. The increased compliance costs, both variable and fixed, lead to a loss of operating profit of $5.5m and would need to be covered by additional sales of 106,000 pairs of shoes. If MS can be seen to respond rapidly and decisively to the problems, it will gain a reputational advantage which may generate those extra sales.

Qualitative impact:

There are three stakeholder groups (customers, regulator and employees) who will be affected by the scandal and MS’ response. All three will be disappointed that the company may be involved with an unethical practice. The company must first establish if this is in fact the case. If it is, then the damage may occur through fines imposed by the regulator and lost sales due to the impact on MS’ reputation.

For the employees, the damage may be a loss of motivation and trust as the organisation would have broken its own code of ethics. For all three groups, the key solution is a rapid and public addressing of the problem and both responses 1 and 2 appear to do this. A key tactic in dealing with such issues is to be first into the public domain by owning up to any breaches of the MS code alongside the announcement of solutions.

(Max 8 Marks)

c. Expected profit from new factory

(Max 6 Marks)

d. Impact of new factory on performance dashboard

MS performance dashboard

Report for the year to March 2015

Workings:

The impact is to reduce the operating profit as the factory in Zealand is more expensive to run being in a higher cost environment. The basic variable cost per unit is about the same as the cost of purchasing from a third-party supplier, however, there are the additional fixed costs of the factory to be incurred as well. Consequently, the operating gearing of MS will increase.

As MS is a product development and marketing operation, it has little fixed capital. This results in a high ROCE. This is also a feature of operations which spend heavily to establish a brand in order to give them the pricing power to charge high margins.

The impact of setting up the factory is to reduce operating profit and increase capital employed. However, this might be offset by avoided costs such as regulators’ fines and lost sales due to damaged reputation.

The introduction of a significant manufacturing operation introduces problems which the existing dashboard does not reflect. Financially, there is no mention of how the factory will be funded. If it involves debt, then this may increase the financial risk of the business and there is no measure of such risk (e.g., by gearing on the dashboard). Non-financially, product quality will now be a direct management concern for MS rather than something which procurement can handle through the supply chain. As this is a new area, it may be wise to introduce a metric for this until the organisational knowledge of the factory operation has been gained.

(Max 10 Marks)

e. Value chain

Generally, the value chain is a model of business integration showing the way that business activities are organised. This model is based around activities rather than traditional functional departments (such as finance). A key idea is that it is activities which create value and incur costs. The activities are split into two groups: primary ones which the customer interacts with directly and can ‘see’ the value being created and secondary ones which are necessary to support the primary activities. By identifying how value is created, the organisation can then focus on improving those activities through its performance measurement system (the dashboard at MS).

Another feature of the value chain is the idea of a chain. This is the thought that value is built by linking activities and so there must be a flow of information between the different activities and across departmental boundaries. In performance management terms, this will affect:

• information systems which will have to ensure good communication across functional boundaries and
• job descriptions and reporting hierarchies as these will have to reflect activities.

The chain does not stop at the organisation’s boundaries. This is likely to be obvious to MS given the importance of supply chain management but the value chain will allow the organisation to focus on those relationships on which value most depends.

Specifically for MS, the value chain would emphasise the importance of supplier management and lead times for new product development within inbound logistics, showing how this fed through to the launch of new products and relationships with distributors in outbound logistics.

The sales and marketing activity of MS is clearly one of its primary areas of value enhancement and its relationship with outbound logistics and the distributors of the products should be notable.

Although the chain shows procurement and technology development as secondary activities, they will be vital for MS. As MS does not currently manufacture their own goods, control of the price/quality balance of supplier relationships will be important and linked to the importance of management of the supply chain noted for inbound logistics. As for sales and marketing, product (technology) development is one of the strategic areas of profit generation for MS and so should be treated as a key area for management activity and thus for performance measurement.

Tutorial note

This answer is lengthy as it tries to cover a large number of acceptable points which can be made in answering this part of the question.

(Max 6 Marks)

(Professional presentation up to 4 Marks)

QUESTION 02- JASON, LORA AND WATSON (JLW)

a. 

Assessing managerial vs divisional performance

A key characteristic of divisional performance measurement is that divisional managers, and the divisions themselves, should only be appraised on performance that they control. For example, costs which are not controlled by divisional managers, such as JLW's apportioned head office costs, should be added back to profit when appraising manager's performance. Similarly, as Export Division is a profit centre, divisional managers are not able to make capital investment decisions and so depreciation is out of their control and should be added back to profit for their appraisals. Domestic Division is an investment centre, so managers there can make investment decisions, and depreciation is a cost which they can control.

On 30 June 20X6, the $RL weakened by 15% against the £SL. This meant Export Division benefited from an increase in revenue which was not under the control of the divisional manager. This amount must be deducted from revenue when calculating the controllable net profit for Export Division.

The net profit arrived at after items which are not under managers' control are added back is known as the 'controllable profit'. This is what divisional managers should be appraised on. This is because it is unfair to appraise them on factors outside their control, and may mean they become demotivated or give up trying to improve performance, which is not in the interests of JLW as a whole.

Divisional performance should be evaluated on all the items which relate directly to the division which is its 'traceable profit'. Allocated head office costs do not directly reflect the activity of the division and should be excluded when calculating the traceable profit.

The traceable net profit for Export Division, after adjusting for allocated head office costs, was $RL905,000 (Working), and the traceable net profit margin was 11%.

A difficulty with calculating controllable and traceable profits in this way may be that it is difficult to determine which items are controllable or not. For example, though the new machine purchased for Export Division by head office did lead to improvements in productivity, the extent of this increase must be attributed to good management, or otherwise, by the divisional managers. This increase in productivity is therefore due partly to controllable factors, and partly to uncontrollable.

Working: Traceable net profit

(Max 7 Marks)

b. 

Export Division Manager's bonus

The controllable net profit is arrived at after items which are not under the manager's control are added back. The net profit margin controllable by the manager of Export Division is 10%. Given that it is difficult to assess the effect of the increased productivity on controllable net profit, the manager should be awarded her bonus for the year. This is because the controllable net profit margin of 10% exceeds the target of 8%.

Workings

1. Controllable net profit margin for Export Division; year ended 31 December 20X6

Controllable net profit margin (778/7,478) 10.4%

2. Currency gain

Six months revenue from 1 July 20X6 was increased by 15% due to currency gain.

Six months revenue before currency gain 4,000/1.15 = 3,478

Therefore, non-controllable currency gain is 4,000 – 3,478 = 522

As the exact increase in productivity resulting for the new machinery on Export Division is unclear, it is difficult to accurately adjust the controllable net profit margin to reflect this. It would seem the Divisional Manager is benefitting from productivity improvements which are not entirely under her control. To reduce the controllable net profit margin to 8%, the threshold at which the manager is awarded her bonus, the net profit would have to fall by approximately $RL179,760 (778,000 – (7,478,000 × 8%)). This is equivalent to 3.7% of cost of sales (179,760k/4,800,000). It is difficult to conclude, therefore, whether the 'significant' improvement in productivity would make the difference between the manager of Export Division receiving her bonus or not.

(Max 8 Marks)

c. 

EVA^TM as a performance measure for Export and Domestic Divisions

EVA^TM makes adjustments to the financial profit to calculate the economic value generated by each division, and then makes a deduction for the cost of the capital invested in the division. A positive EVA^TM indicates a division is creating value above that required by those who finance the business. It is therefore consistent with JLW's objective to maximise shareholder wealth. Appraisal of divisional performance on this basis would therefore align the interests of managers with those of JLW's shareholders.

EVA^TM involves making many adjustments to operating profit and capital employed. These may be time consuming, and be poorly understood by managers. The manager of Export Division has already commented that she finds the bonus calculations difficult to understand. Failure of managers to understand the EVA^TM calculations would make it difficult for them to work towards targets set for the division.

EVA^TM avoids distortion from estimates and financial policies

EVA^TM avoids the financial results from being distorted by accounting policies and estimates made by divisional managers, for example, the $RL75,000 bad debt provision made in Domestic Division, as increases in provisions are added back to operating profit in the EVA^TM calculation. Whilst this provides a consistent basis to evaluate performance of divisions within JLW, EVA^TM is not suitable for comparing divisional performance as it is an absolute measure and does not make allowance for their relative sizes.

EVA^TM encourages managers to take a long-term view

The advertising costs for the new range of paints would be capitalised as these generate future value. The use of EVA^TM would encourage managers to incur costs, such as these, which will benefit the business in the long term.

However, the calculation of EVA^TM is backwards looking, and based on historical financial information, whereas shareholders need information about future performance on which to base their decisions.

 EVA^TM takes into account the cost of capital

The current performance measure of net profit margin is a poor measure as it takes into account neither the absolute net profit achieved, the capital employed in the division, nor the cost of capital. By making a deduction for the cost of capital employed in the division, the EVA^TM calculation makes managers consider both the capital employed and the cost of capital in their divisions.

Export division is a profit centre and managers do not have control of investment decisions. Therefore, it is not a suitable measure for the evaluation of the performance on Export Division because there is no controllable capital employed. Domestic Division is able to control investment decisions, and does have controllable capital employed, so EVA^TM would be a suitable measure for evaluating Domestic Division's performance.

However, to use the weighted average cost of capital (WACC) in the EVA^TM calculation requires a number of assumptions and estimates to be made, for example, in calculating the cost of equity or market value of debt. The WACC is normally based on historic data, which may not reflect circumstances in the future, and may not be accurate.

(Max 10 Marks)

QUESTION 03- BENSON FOODS (BENSON)

a. 

EVA™ as a divisional performance measure

Advantages

Maximising wealth – Benson's overall objective is to maximise the family's wealth through their shareholding – in effect, to maximise shareholder wealth.

One of the main benefits of EVA^TM as a performance measure (rather than profit-based measures such as ROI) is that it is a value-based approach, and therefore it will be aligned to the overall objective of maximising shareholder wealth.

Goal congruence – Moreover, using EVA^TM as a divisional measure will help to ensure that decisions taken at divisional level support the best interests of Benson as a whole, rather than just the individual division.

The other advantages of EVA^TM are:

1. It gives an absolute measure of performance, and so shows the overall contribution the divisions make to the company.
2. The basic test of performance is simple. If a division has a positive EVA^TM, then it is generating a return above that required by the providers of finance. (ROI requires a target level to be set, usually based on benchmarking to the industry sector.)

• The adjustments required when calculating net operating profit after tax mean that it is closer to cash flows than traditional accounting profits are, and also mean that EVA^TM is less subject to choices in accounting policies.

1. EVA^TM encourages investment in the future (for example, in advertising and development) by adding back these costs to profit in the performance period and treating them like capital expenditure. This will reduce the temptation for dysfunctional, short-termist decision making, which could otherwise be a problem where the capital employed figure from the financial statements is used in ROI and RI. This is likely to be particularly appropriate at Benson where R&D is significant.

Disadvantages

However, EVA^TM does also have some disadvantages. Some of these are also disadvantages of ROI and RI, and some are specific to EVA^TM.

All three measures are dependent on historical data and so have limited use in forecasting future performance.

The directors' complaint that EVA^TM is complicated to understand appears reasonable, because of the number of adjustments which need to be made to the information from Benson's financial statements. By contrast, ROI and RI are derived from headline information in the financial statements which would be more familiar to the board. A related issue here would be the time and cost involved for Benson's management accountant in calculating the division's EVA^TM.

EVA^TM (like RI) uses a charge for the capital employed in the division. EVA^TM uses the weighted average cost of capital (WACC) for the company as a whole, which may not reflect the risks of the manufacturing divisions. Also, as an unlisted business, WACC may be difficult to estimate. By contrast, RI uses a notional cost of capital based on the risk of the divisions – although this will also be subject to an element of judgement and estimate.

Unlike ROI (which gives a percentage measure, rather than an absolute measure) EVA^TM will not help to assess relative divisional managerial performance at Benson if the divisions are of different sizes.

(8 Marks)

b. 

ROI and RI

A key consideration when calculating either ROI or RI for Baby is what profit figure to use for the calculations.

The data in Appendix 1 suggests three potential profit figures, which could be used for assessing the performance of Baby as a division, and its manager:

Controllable profit – The only costs included in controllable profit are those under the direct control of the Divisional Manager (i.e., the divisional operating costs of $121m).

R&D costs recharged – Although the Divisional Manager cannot influence the costs of the R&D Division, Baby's divisional revenue includes the profit which results from new products and ideas generated by the R&D Division. Therefore, in order to match costs with revenues more fairly, a proportion of the R&D Division's costs should be included in Baby's profit figure.

Divisional profit – The division's performance (as distinct from the manager's performance) should take account of all relevant costs, including Baby's share of the head office management fees. As such the divisional profit ($60m) would be an appropriate figure to use in this respect.

Performance analysis

Regardless of which profit figure is chosen, Baby seems to be performing relatively well. Baby's EVA^TM is positive ($35m) and its RI is also positive.

In terms of ROI, the return based on divisional profit (14.2%) is lower than the ROI for similar entities (20%), but the return based on controllable profit, or profit after R&D, is higher than the benchmark figure. However, we do not know which profit figures were used in the benchmark figure, which means we cannot tell whether Baby's ROI figure is above or below the average achieved by similar entities.

(7 Marks)

c.

Management styles for the divisions

Baby Division

Responsibility centre – Baby's position as the star in Benson's portfolio, coupled with the fact it is developing and introducing new products, means that the division's focus should be on growth rather than cost control.

As such, it might seem appropriate for Baby to be treated as an investment centre, giving its managers autonomy to develop their business as they see fit.

However, it is not clear whether the divisional managers have the authority to make capital investment decisions or whether these are taken by head office. (Chocolate had to get approval from head office to upgrade its production line.)

If the authority for investment decisions remains with head office, then Baby should be treated as a profit centre, and managed according to its ability to generate profit.

Management style – A profit-conscious style focuses on longer-term performance and objectives (such as growth) whereas a budget-constrained style focuses on short-term performance and cost control.

Therefore, given the nature of Baby's market – and the market's rapid growth – the profit-conscious style would seem more appropriate for Baby.

However, elements of a non-accounting style (such as new product development) may also be appropriate. Given the costs associated with new products and rapid growth (such as the publicity campaign Baby ran to support its new product launch), we recommend that a non-accounting style is applied initially.

However, once the market sector begins to mature, then given Baby's strong market share its focus should shift to optimising its profits – at which point, a profit-conscious management style should be adopted.

Chocolate

Division Responsibility centre – As the Chocolate Division is the cash cow in the portfolio, Benson needs it to generate the profits and cash necessary to support Baby's growth.

However, as a cash cow, and operating in a market with limited growth opportunities, Chocolate is unlikely to receive much investment. As such, it would seem appropriate to treat Chocolate as a profit centre.

Nonetheless, it appears that Chocolate does still makes some capital expenditure (for example, the upgrade to its main production line). As such, it could be appropriate to treat Chocolate as an investment centre, so that its managers have the autonomy to take these decisions, rather than having to wait for head office to approve them.

Management style – Because it is operating in a mature market with limited growth opportunities, cost control is likely to be crucial in maintaining Chocolate's profitability. As such, a budget-constrained style will be the most appropriate management style for Chocolate.

R&D Division

Responsibility centre – The R&D Division does not generate any revenue in its own right, and therefore should be treated as a cost centre.

Nonetheless, it is important that the contribution the division makes to the group (through the overall profit generated by the products it develops) is not overlooked. The complaints which Baby's managers make about the recharge suggests they are only thinking about the costs rather than the revenue which the new products have generated for them.

As such, whilst Benson should continue to treat the R&D Division as a cost centre for control purposes, it would also be useful to monitor the profit generated by each new product over its life cycle, to demonstrate the division's value to the group as a whole.

Management style – As the R&D Division is a cost centre, it might seem appropriate to apply a budget-constrained management style.

However, it is important that potentially profitable developments are not rejected simply to keep the division's costs within a fixed budget – and there is a danger this could be the case under a budget-constrained management style.

Therefore, elements of a non-accounting style might also be appropriate – with a focus on the number of new product ideas being generated, and the market reaction to new products being developed.

As such, it may be necessary to adopt a management style which combines some elements of the budget-constrained style with others from the non-accounting style.

(10 Marks)