a. Recalculate the budget for Luxury division to the end of the current year

Recalculating Luxury division’s budget for the year to reflect current conditions gives a more realistic target for the division managers. For the coming year, the effect of this is very significant and represents a much more challenging target for managers as it increases the expected total annual operating profit by 42% (5,660/4,000) over the original budget.

WORKINGS (C$000):

(W1) Revenue

(W2) Cost of sales

*6.67% = 1 –- (1.4/1.5), applied to 50% of COS.

(W3) Distribution costs

* 1.31% = 70% × (3/160)

(W4) Administration costs

Workings for savings in administration costs:

Q2 2,300.0 × 2.5% = 57.5

Q3 57.5 + (2,242.5 × 2.5%) = 113.6

Q4 113.6 + (2,186.40 × 2.5%) = 168.3

b. Incremental budgeting

Frendzee currently uses this type of budgeting, the starting point of which is usually the previous year’s actual performance or budget. This is then updated for any known changes in costs, or for inflation. The budget would normally remain unchanged for the remainder of the year.

Incremental budgeting is suitable for use in organisations which are stable and not undergoing significant changes. This is the case for Dairy division, which operates in a saturated market and has little opportunity to grow.

Production volumes in Dairy division have only increased by 0.5% over a full five years, so it is a very stable business. Dairy division has stability of both revenues and costs. It has long-term fixed cost and volume supply agreements with its supermarket customers. It also has similar fixed contracts with its suppliers of milk, the most significant raw material ingredient used in its products.

Though the third-party distribution company is able to pass on some increases in fuel costs to Dairy division, these are capped at only 0.5% per year. This is significantly less than the tax increases which will increase Luxury division’s fuel costs after the start of Q3. It appears that Dairy division has relatively little exposure to rising fuel prices.

Furthermore, these increases are agreed prior to the setting of the current year budget, so there is no need to update these costs on an ongoing basis throughout the year.

As the dairy foods market is saturated and stable, there is little opportunity for the division to incur discretionary costs such as research and development of new products.

Incremental budgeting is only suitable for business where costs are already well controlled. This is because a big disadvantage of incremental budgeting is that it perpetuates inefficient activities by often simply building inflation into previous year results or budgets. It appears that Dairy division, having been in existence for a relatively long time, does have good cost control as it has modern production plant and is recognised as having the most efficient production processes in the industry.

Incremental budgeting may, however, build in budget slack. Managers may spend up to their budgeted amounts in one year, so that their budget is not cut the next, which may affect their appraisal and reward in the future. It is unclear whether this is occurring at Dairy division, though for many years (while Dairy division was the only division at Frendzee), the budgets set following consultation with divisional managers have just been achieved. This may be consistent with the stability of the division, but could also indicate that budgets were not set at a challenging enough level, even though Dairy division had the best performance of the two divisions last year.

It is not therefore advisable that rolling budgets are introduced in Dairy division, as the current incremental process appears satisfactory. This is especially so since divisional managers have little experience of setting their own budgets, and the time and cost of using rolling budgets would exceed the value of them to the division.

Rolling budgets

Rolling budgets are continually updated to reflect current conditions and are usually extended by budgeting for an additional period after the current period, for example, a quarter, has elapsed. That way, the budget always reflects the most up to date trading conditions and best estimates of future costs and revenues, usually for the next four quarters.

Rolling budgets are suitable for businesses which change rapidly or where it is difficult to estimate future revenues and costs.

Luxury division was only set up two years ago, and is therefore a relatively new business. It also operates in quite a different sector of the industry to that in which Dairy division operates and where Frendzee has most experience. There is likely to be considerable uncertainty as to future costs and revenues as Frendzee has little direct experience on which to base its forecasts.

Whereas Dairy division operates in a saturated and stable market, Luxury division uses rare ingredients which are subject to variations in availability and cost, for example, as a result of poor harvests. There is no indication that Luxury division has fixed price and volume contracts with its customers or suppliers and is therefore likely to suffer from instability of supply as well as demand resulting from changes in consumer tastes.

The frequent changes in the product range are also likely to make forecasting for a year ahead difficult. The fact that a large proportion of ingredients are imported from Vee land, makes costs susceptible to changes in the C$:V$ exchange rates which can quickly make an annual budget out of date, though managers may use methods such as forward contracts to reduce these movements. If managers are appraised on a budget which is out of date or unrealistic, they are likely to give up trying to achieve the budget, which will negatively affect the performance of Frendzee.

Rolling budgets will provide a more accurate basis on which to appraise managers at Luxury division as they incorporate the best-known estimates of future costs and revenues. It can be seen by the recalculation following Q1 results that Luxury division’s revised budgeted operating profit for the year has increased significantly by 42% (5,660/4,000), most of which is due to exchange rate changes. Where costs and revenues are likely to change during the period, rolling budgets give a much more realistic basis on which to appraise divisional performance and appraise and reward divisional managers. Budgets are likely to be achievable, which will motivate managers to try and achieve them.

Though the regular updating of the budget required in rolling budgeting is costly, time consuming and possibly a distraction for divisional managers, it does seems that rolling budgets are more suitable for Luxury division than the current incremental approach, particularly as being realistic and achievable, they will increase managers’ motivation to achieve the budget and so improve the performance of the business.

Planning variances are those which arise due to inaccurate forecasts or standards in the original budget setting. Operational variances are then the remainder due to the decisions of operational managers. A planning variance is the difference between the original standard and a revised one set with the benefit of hindsight. An operational variance is the difference between this revised standard and actual performance.

The total variable cost variance considers all costs together and so it is unlikely that gains or problems can be attributed to one individual. It is of limited value and should be used to point to more detailed analysis to identify the specific source of the variance. Currently, at Mac, the standard costs have been set too high and it appears that the bulk of the cost improvements can be attributed to this. The operational managers have had limited impact in driving down costs overall in May 2014.

The sales price variance indicates how far sales prices were mis-estimated in the budget (planning) and how well the sales managers have done in negotiating high prices with customers (operational). It appears that the budget was overoptimistic in setting too high an initial price but the sales managers have done well in negotiations with customers. The best individual sales managers could be identified and their techniques communicated to the rest of the sales team. The initial price setting process should be examined as it may have been due to faulty market intelligence about the price setting of competitors or the commercial situation of the customers (supermarkets).

Purpose and benefits of budgeting

Budgeting is a key control tool for management and of particular importance in controlling costs in businesses such as Mac which is seeking to be a cost leader. At Mac, it is succeeding in this as total costs show a favourable variance. Budgets help to communicate and coordinate all the management activities within the company towards a single plan. The budget helps to attribute responsibility for performance, for example, the favourable material usage variance indicates that fewer raw materials are required than was planned and this reflects the work of the production manager in cutting waste and, possibly, the purchasing manager in buying good quality raw materials. The participatory nature of the budget process will help to motivate managers to achieve budget figures which they themselves have helped to set. It is important for this purpose that the budget is achievable or else it is demotivating.

Budgets assist the evaluation of performance by identifying variances and then point to areas for corrective action or future learning. At Mac, sales are clearly underperforming the plan both in terms of the quantity and price achieved. On the positive side, the managers in charge of labour and the workforce are working efficiently and cheaply.

There are several problems with budgeting at Mac:

1. The time-consuming nature of the process which is unusual as the business is mature and stable and so budget-setting should not be a complex process. The exasperation of the managers probably results from the fact that they see little benefit coming from work involved in forecasting. The operating variances given are relatively small.
2. The planning variances explain the bulk of the variances at Mac and so the operational managers have good reason to be concerned as their performance affects the operational variances only.
3. The operational and planning variance analysis is limited in scope. Performing more detailed operating and planning variance could also assist in addressing the complaint that operational managers are being asked to explain variances which are not their fault, for example, by doing this analysis for all the different cost headings in the operating statement and not just the total cost variance.
4. The use of standard costs in budgeting could discourage a system of continuous improvements which would help a cost leader in making efficiency gains. However, Mac’s senior management may view that it is unlikely that there will be a need to make such changes on a regular basis and that a review of the costs once a year is sufficient.

Zero based budgeting (ZBB) is a method of budgeting that requires each cost element to be specifically justified, as though the activities to which the budget relates were being undertaken for the first time. Without approval, the budget allowance is zero. There are four distinct stages in the implementation of ZBB:

1. Managers should specify for their responsibility centres those activities that can be individually evaluated.
2. Each of the individual activities is then described in a decision package. The decision package should state the costs and revenues expected from the given activity. It should be drawn up in such a way that the package can be evaluated and ranked against other packages.
3. Each decision package is evaluated and ranked usually using cost/benefit analysis.
4. The resources are then allocated to the various packages

The approach of ZBB is considered appropriate in industries where there are rapid changes in the business environment, new product developments and/or where there are very higher levels of overheads, especially discretionary costs such as research and development. This approach at Mac would appear to be inappropriate for a number of reasons:

1. There does not appear to be the need to have to justify every cost from scratch. There is little evidence of budget slack or excessive spending and the work generated in having to prepare decision packages may increase the complaints about time-consuming exercises from the operational managers.
2. The lower-level managers would now need to prepare their own decision packages and would require training in this. They do not appear to have the appetite for such development.
3. There is no indication that there are rapid changes in Mac’s business and little innovation, so the ZBB approach would not appear to yield many benefits.

Overall, then, there are insufficient benefits and many barriers to switching to ZBB at Mac and it is not recommended.

Annual costs of new system:

Benefit of new system (cost savings):

Net benefit $95,025

The BPR project will yield a net benefit of $95,025 p.a. and so the project is financially successful. However, there are other costs not included in this analysis such as redundancy/retraining of the staff whose workload has been reduced and the training costs for staff on the new system.

Tutorial note

An analysis using other methods such as payback or accounting rate of return would be equally acceptable.

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

It cuts across traditional departmental lines in order to achieve a more efficient delivery of the final product. At Barner, this is evident in the effect which the BPR project has had on both warehousing and purchasing departments.

This change to a process view will require a change towards process teams rather than functional departments. Employees will need to retrain in order to gain additional skills. The organisational hierarchy will flatten with the employees being given more responsibility to make decisions. This is often aided by the introduction of a unified corporate database accessed through an ERP system. These will represent major changes at Barner which appears to have become set in its ways. The change will require much communication and leadership from senior management as a result.

The implications for accounting at Barner are that performance measures must be redesigned around processes rather than departments. The aim is to identify where value is being added and eliminate where resources are employed to no valuable outcome. An activity-based approach might be used to model the processes in the business as part of the BPR restructuring and this could be carried on in the accounting systems. The ABC system of costing is a more detailed method of allocating overheads in order to achieve a more accurate product cost and, therefore, a more accurate idea of the profit each product generates. It is more timeconsuming and expensive to set up compared to traditional overhead absorption methods but in the context of the intended changes to processes at Barner due to BPR, it will fit well. Financial reports will have to be redesigned around process teams and any variances to budget used may need to be reconsidered in the light of the activity-based approach.

Appraisal is the process of collecting and reviewing data on an employee’s work which will provide an assessment of their capabilities and potential in order to improve performance, for example, by training. It also presents an opportunity to deal with other HR issues, such as discipline, career management, motivation and determining rewards.

There is a general need for some kind of performance assessment; however, appraisal systems are often criticised as irrelevant to the work of the organisation. Indeed, the current system at Barner has arguably become too informal, possibly as a result of neither side of the process taking it seriously. In order to make the process relevant, appraisal is seen as a means of control of staff and linking their activities to the overall organisational goals such as driving down costs. It will lead to improved development of appropriate skills and greater motivation on the part of the staff, especially if linked to a suitable reward system.

The balance between control and development within the appraisal process will link to the culture within the business. At Barner, there is a culture of craft appreciation which implies the importance of development of skills and thus it may be that there has been a loss of the sense of control and this has led to the increased costs which the CEO is trying to drive down.

The environmental goal of Francis is to reach the CO2 emission reduction target of 20% in five years while increasing capacity to cope with an expected rise of 10% in demand over that period.

The changes in mix of generating stations have the following effects:

Plan 1a

The new nuclear station will cost $6,000m. The total power output of Francis is maintained at 10,200 MW and the total CO2 emissions falls by 15.4% to 22.43 million tonnes. The operating cost of electricity will fall on average as a nuclear station is the cheapest one to operate. Therefore, Francis will have maintained its capacity and reduced CO2 emissions but it will not have covered the rise in demand nor met the government’s target for CO2 reduction. (Plan 1b will provide the same generating capacity as Plan 1a and it will be less expensive in capital terms but it will not reduce CO2 emissions.)

Plan 2

The addition of a second new nuclear station would cost a further $6,000m and would increase power-generating capacity by 11.8% to 11,400 MW. This would cover the expected rise of 10% in demand for electricity due in the next five years. It would increase the total CO2 emissions by only 1.1% (0.25/22.43, assuming it is done in combination with Plan 1a) and would, therefore, further reduce the average CO2 emitted in the operation of the stations.

We do not have the detailed figures for actual power output for each station but if we use maximum power capacity, then currently, Francis produces 0.0026 tonnes of CO2 per max MW (= 26.51/10,200).

If the company pursues plan 1a and plan 2 in combination, then it will produce 0.0020 tonnes of CO2 per max MW (= 22.68/11,400). This is a 23% reduction and indicates the government’s target may be achieved.

If the company pursues plan 1b and plan 2 in combination, then it will produce 0.0023 tonnes of CO2 per max MW (= 26.76/11,400). This is a 12% reduction and indicates the government’s target may not be achieved.

Management accounts provide us with an analysis of the performance of the business. However, traditional accounting systems are unable to deal adequately with environmental costs. As a result, managers are unaware of these costs and have no information with which to manage or reduce them.

Specific areas include the following:

• Conventional costs, such as energy costs will not be prioritised by management since they often hidden within overheads.
• Contingent costs such as future compliance costs or remediation costs when a power station is decommissioned are often incurred towards the end of a project so are ignored by managers who focus on short- term performance. This aspect is addressed within environmental lifecycle costing below.
• Relationship costs such as the cost of producing environmental information for public reporting are often ignored by operational managers who are unaware of their existence. It is likely that a separate PR department within Francis will deal with communications to the local community to reassure them about safety, for example.
• Reputational costs such as costs associated with failing to address environmental issues may be ignored by managers who are unaware of the risk of incurring them.

Lifecycle costing records the costs of a product ‘from cradle to grave’, taking into account the environmental consequences across the whole life of the product.

In order to appraise a project correctly, cost recording systems must capture all costs. In particular for a nuclear power station, these must include:

• those costs incurred prior to production such as costs of handling regulatory difficulties and design choices, and also
• those costs incurred after production ceases such as the clean-up costs of decommissioning and decontaminating the site and safely storing all waste.

It is important that these costs are identified and included in the initial project appraisal. In the case of Francis building a new nuclear power station, there are the uncertain costs up front associated with the regulatory process which could include the financing costs associated with delays in the project while regulatory approval is sought. There is the normal uncertainty over the building cost when a project costs $6bn and takes five years to complete. Finally, there is the estimated $1bn in decommissioning costs which again carry uncertainty. If Francis is to be able to claim to be financially and environmentally responsible, then it must have plans in place to cover these costs.

Government regulations relevant to SLT’s environmental strategy include requirements to recycle materials, limits on pollution and waste levels along with new taxes such as carbon levies to add additional costs. Performance indicators would be additional costs resulting from failure to recycle waste, fines paid for breaches and the level of environmental tax burdens.

The general economic climate is relevant to the strategy including factors such as interest, inflation and exchange rates. For SLT, the general economic environment is not good and cost savings from reductions in energy use would help to offset falling profits. Also, the difficulties indicated in raising capital could be monitored through the firm’s cost of capital. This would be especially relevant if the environmental initiatives lead to significant capital expenditure for SLT.

Trends and fashions among the general public appear to be relevant for SLT as the public will be end-users of its services and environmental action could improve the brand image of SLT. Suitable performance indicator would be based around a score in a customer attitude survey. Technological changes in the capabilities available to SLT and its competitors will affect its environmental strategy. New environmentally efficient technologies such as hybrid cars and solar recharging cells would be relevant to the cost and product sides of SLT. Performance indicators would involve measuring the impact of the use of new technology on existing emission data.

The company has a target of cutting emissions by 60% of their 2001 values by the year 2017. Overall, it has cut emissions by 38% in the first nine years of the 16-year programme. There was a reduction of 16% in the last year of measurement. If this rate of improvement is maintained then the company will reduce its emissions by 82% (62% × (84% ^ 7)) by 2017. However, it should be noted that it is unlikely that there will be a constant rate of reduction as it normally becomes more difficult to improve as the easy actions are taken in the early years of the programme.

The initial data are rather complex and so to summarise, three categories for the three types of transport were considered (Road, Rail and Air). The largest cut has been in rail related emissions (63%) while the contribution from road transport has only fallen by 38%. The road emissions are the dominant category overall and they are still falling within the programmed timetable to reach the target. However, it is clear that air travel is not falling at the same pace but this may be driven by factors such as increasing globalisation of the telecommunication industry which necessitates travel by managers abroad to visit multinational clients and suppliers.

One unusual feature noted is that the mix of transport methods appears to be changing. Rail travel appears to be declining. This is surprising as rail is widely believed to be the lowest emitting method from these forms of travel. However, caution must be exercised on this conclusion which may be due to a change in the emissions technology relating to each category of travel rather than the distance travelled using each method.

The major change that is apparent from the basic data is the move from petrol to diesel-powered motor vehicles which in the commercial fleet appears nearly complete. It will be more difficult to move company and private cars to diesel-power as there will be an element of choice on the part of the car user in the type of car driven.

Working:

Simplifying categories

Mix of travel method in each year

The analysis could be improved by collecting data on the total distances travelled so that employee behaviour can be tracked. This would allow measurement of the effect of switching away from physical meetings and using teleconferencing facilities. This may be particularly effective in cutting air travel which has been noted as a problem area.

It would also allow assessment of the homeworking scheme which should reduce total distance travelled. Although, the full environmental benefit will not be apparent as much of the travel would have been a regular commute to work which an employee will not be able to claim and so is unlikely to record.

Finally, the collection of distance travelled data will allow a measure of the effect of changing modes of transport by calculating an average emission per km travelled.

BCG analysis and evaluation of performance

Restaurants Division – This division has a low market share of a market sector with low growth, making it a dog in the BCG classification. The Restaurant Division therefore looks a likely candidate for divestment, unless it has any links with any of the other divisions in GST’s business.

Cafés Division – The Cafés Division also has a relatively low market share, but it is operating in a market sector with high growth. It should therefore be classified as a question mark.

The market sector is already showing good growth, but it currently seems quite fragmented. There could be additional opportunities for GST to grow by acquiring some rival businesses. Alternatively, if GST does not want to invest in this way, it might consider selling its Café Division to another business looking to consolidate in the sector.

Bars Division – The Bars Division is the market leader (high market share) in a market which has low (actually, negative) growth. This should be classified as a cash cow.

The Bars Division is currently GST’s largest division, and it contributed about 55% of the group’s total revenue in 20X0. The current decline in the bars market should therefore be a concern for GST, given the Bars Division’s role as a cash cow in the group. GST is likely to want to use the Bars Division to generate cash for the other businesses in its portfolio, but if the bars market starts declining in time this may limit the division’s ability to generate cash for the rest of the group.

The fact that the bars sector seems to be in the mature stage of its life cycle also highlights the importance of controlling costs. The degree of profit growth GST will be able to generate through increasing revenues seems limited, so instead it could look at reducing costs as a means of increasing profitability.

Dance clubs – The Dance Clubs Division has a moderately high market share (although still less than 1) in a market with reasonably high growth. This should currently be classified as a question mark as GST is not yet the market leader in the sector, but it has the potential to become a star if it can achieve market leadership.

Its market share is already relatively close to the market leader’s share, so with continued investment the division could grow to become the leader. The performance of this division is likely to be crucial to GST ‘s longer-term success, particularly if the performance of some of GST ‘s more mature businesses continues to decline.

Context for performance – The BCG provides a useful context in which to assess the performance of the different divisions. For example, it illustrates to management that they shouldn’t expect the Bars Division to grow at the same rate as the Clubs Division, due to the underlying differences in the growth rates of the two sectors.

Management approach – Equally, identifying the differences in the growth potential of the different divisions identifies that different styles of management will be appropriate for the different divisions. For example, the Clubs Division may require capital investments to enable it to sustain its rate of growth, but the focus in the Bars Division (in a more mature business sector) should be on cost control.

Help set performance metrics – By helping to set expectations and approach in this way, managers can then also tailor their performance management systems and metrics to reflect the different contexts of each of the divisions. So, the metrics for the high growth divisions (cafés and clubs) should be based on profit or return on investment, while the metrics for the low growth divisions (bars and restaurants) should be focused on maintaining margins, cash control and cash generation.

Limitations of BCG approach

Problems of definition – Although we have identified that the BCG matrix can be useful for providing a context for performance management, its usefulness is limited by its simplicity. For example, a business unit is only considered to have a high market share if its relative market share is greater than 1. By definition, however, this means that only the market leader can have a high market share, and therefore also there can only be one star or cash cow in each market sector.

Overlooks possible synergies – Another issue which arises from the simplicity of the model is that it treats business units in isolation, and in doing so can overlook possible synergies between them. For example, some of GST ‘s bars and restaurants may be linked to its clubs, such that customers may go for a drink or a meal and then go on to a club afterwards. However, if in time the restaurants and later some of the bars are divested then this link between the business units will be lost.

Defining the market sector – Another potential issue with using the BCG matrix comes from defining market sectors themselves. For example, the Bars Division has launched a new wine bar format which appears to have been successful. This suggests it has been growing, although the rest of the Bars Division has actually had negative growth. However, this raises an issue of whether the wine bar format should be treated as a separate sub-section (and as a ‘question mark’ which is given the support and investment needed to grow) or whether it should be subject to cost control in the same way that the rest of the Bars Division is.

Portfolio analysis, not performance management – It is also important to remember that the BCG matrix was designed for analysing a product portfolio, not as a performance management system. Therefore, while it can help to determine the appropriate performance management approach for a business, it is not in itself a performance management system.

i. 

Focus on cost budgets – The bonus element (50%) of the remuneration package is based on divisional performance against cost budget. As a result, divisional managers are likely to focus on controlling costs. Such an approach may be appropriate in the Bars and Restaurants Divisions, but is unlikely to be suitable for the faster-growing divisions (cafés and clubs).

In the Cafés and Clubs Divisions, GST should be looking to encourage growth, but the current remuneration package is unlikely to do this. As a result, there is likely to be a lack of goal congruence between the divisional managers and the GST overall.

Short-term performance – In a similar way, the focus on controlling costs may also lead to divisional managers taking a short-term view of performance. Again, it may actually be more beneficial for some of the divisions to spend now (for example, on marketing) in order to increase revenues and profits in the future.

Use of EVA^TM – There also appears to be an inconsistency between this focus on cost budgets and the use of EVA™ as the measure of divisional performance. The underlying logic behind EVA^TM will be to try to maximise the wealth of GST ‘s shareholder – which is the company’s objective – but this is not necessarily the same as controlling costs.

Importantly, EVA^TM specifically identifies that some costs which are treated as expenses in the financial statements (for example, advertising costs) should actually be considered as investments for the future.

Therefore, rather than basing the bonus element of the managers’ reward package on achieving cost budgets, GST may be better advised to base the bonus element on achieving target EVA^TM figures. In this way, the reward system at divisional level will reflect the company’s overall objective.

(6 mark)

ii. 

Context – The fact that some of GST ‘s divisions should be focusing on growth (cafés, clubs) while others (bars, restaurants) need to focus on cost control suggests that different management styles may be appropriate for the different divisions.

Budget-constrained style – Under a budget-constrained style, a manager’s performance is primarily assessed by their ability to meet the budget on a short-term basis, particularly in relation to ensuring that actual costs do not exceed budgeted costs. 50% of the bonus elements at GST are based on achieving the cost budget numbers set by the board, which suggests that GST may be using a budget-constrained style.

A budget-constrained style can be appropriate in a business where it is important to keep costs under control, which suggests that it may be appropriate to use this style in the Bars or Restaurants Divisions. However, it is less likely to be appropriate for the Cafés or Clubs Divisions.

Moreover, the budget-constrained style often leads to poor relationships between managers and subordinates, and also encourages the manipulation and misreporting of information, so GST needs to be aware of these potential problems.

Profit-conscious style – Under a profit-conscious style, a manager’s performance is evaluated more in terms of long-term performance, and the ability to generate future growth, rather than short-term performance and cost control.

This style is likely to be appropriate for the Cafés or Clubs Divisions at GST. However, the current bonus structure suggests that this style is not being used, which could suggest that not only do GST ‘s remuneration packages need revising but also that the management styles need reviewing too

(5 mark)

i. Purpose, potential benefits and potential problems of mission statements

Purpose

Mission describes the organisation’s basic function in society, in terms of the products and services it produces for its clients. Organisations often write down their mission in a mission statement. A mission statement should be brief, flexible and distinctive, placing an emphasis on serving the customers. It often refers to key stakeholder groups including employees and shareholders. The mission statement should make it clear to employees their contribution towards attaining the mission. It should also remain the same unless the mission changes.

Potential benefits of mission statements include the following:

• A written, public statement of the reason for the organisation’s existence
• Allied to this, communicate a clear image of what the organisation is to customers and other stakeholders
• Also help in resolving conflicts between stakeholder groups over what the organisation stands for
• Identify key cultural values to employees
• Aid strategy by helping businesses define their nature, services and products and competences
• Guide policies and standards of behaviour by managers and employees by stating business principles such as social responsibility and anti-discrimination
• State ways of competing, for instance on price or innovation

Potential problems of mission statements include:

• Vague statements which don’t explain what the business is for, or how it intends to achieve its aims
• Jargon which obscures what the meaning of the statement is
• Failure to be flexible and open ended as the mission will probably change over time as the business changes
• Being unrealistic in its aims
• Not taking account of external factors
• Inconsistency between the elements of the mission

(8 mark)

ii. Appropriateness of the mission statement for ED

A mission statement is meant to capture the purpose of an entity; that is, its reason for existence.

Value for money involves providing a service in a way which is economical, efficient and effective, and so ED’s mission statement would appear to have accorded with its overall mission (as it has operated on a profit-making basis).

Even so, the existing mission does not capture ED’s reason for existence, nor does it act as a guide to key stakeholders (such as employees). In order to do this, it would need to mention the organisation’s core aims and objectives (e.g., providing high quality care). In this sense, it is not appropriate.

In addition, when ED decided to open a homeless sanctuary for strays, as a free service, then providing value for money to clients is no longer the driving force, and so ceases to be an accurate reflection of its mission. Therefore, the mission statement as it currently stands will no longer be appropriate, if it ever was.

(4 mark)

i.

CSFs are the key factors and processes which enable an organisation to achieve its objectives and thereby achieve future success. In effect, CSFs highlight the areas in which it is crucial for an organisation to perform well in order for it to be successful.

CSFs and KPIs – However, once an organisation has identified its CSFs, it needs to know how well it is performing in relation to them. Simply identifying the areas where an organisation needs to perform well does not guarantee that it will do so. Therefore, it needs to measure how well it is performing in these areas. This is done by using KPIs.

KPIs – KPIs are the measures which indicate whether or not CSFs are being achieved, and how well the organisation is performing. This idea of measurement is vital for KPIs. KPIs must be measurable, because otherwise an organisation will not be able to measure whether or not its CSFs are being achieved.

(4 mark)

ii.

ED is a service business and so its CSFs are likely to relate to the services it offers, and in particular to the features of those services which are valued by its customers.

• Maintaining a high standard of cleanliness of accommodation for the dogs at ED.

If prospective clients come to visit ED’s kennels and they look dirty and untidy, it is unlikely that the owners will want their pets to stay at ED.

A KPI which could be used to measure cleanliness could be the number of cleans made per day or week of the dog kennels and common areas. However, this would not take into account the quality of the cleaning. So, customer assessment of cleanliness might be a better measure.

• Guaranteed safety of the dogs whilst in ED’s care.

Again, owners are not going to want to use ED to care for their dogs unless they feel confident their dogs will be well looked after.

This could be measured by the number of accidents over a given period. However, this would not take into account the severity of the accidents, so recording separately the number of major and minor accidents could be a better measure.

• An excellent health record.

This means no or minimal breakout of infections which would damage the reputation of the business.

This could become particularly important if CSF does start accommodating homeless dogs, because if any of the homeless dogs have got infections or diseases it will need to ensure that none of these get transmitted to the pets in its care. This could be measured by the number of dogs that fall ill during their time at ED.

(6 mark)

Three quantitative non-financial performance measures to assess quality of service

• Service availability. This may be measured by the number or percentage of owners able to book their dogs in on preferred dates and times.
• Care taken of the dogs and the quality of the service experience. This will be measured in return bookings and possibly word of mouth referral.
• Prompt and reliable collection and return of dogs to their owners. This is a key element of the service offered. This could be measured by logs of delivery and return of dogs safely and within the time promised.

SAM will need to identify existing and new cost information which is relevant to understanding the environmental impact its operations have.

Operating costs – SAM’s current management accounting system is already likely to record conventional costs such as raw material costs and energy costs. However, the costs of waste through inefficiency will not be recorded. If they were, however, this should encourage SAM’s management to reduce the amount of waste generated by the company’s processes.

Additionally, a number of environment-related costs (such as waste filtration) are currently classified within overheads, meaning that they are not very transparent to management. Similarly, the regulatory fines are also likely to be included within overheads. However, if all these environment-related costs were classified separately they would immediately be more visible to management.

Decommissioning costs – The profit forecast for Ruby highlights that SAM incurs a number of significant costs at the end of a project, for example the costs of decommissioning equipment, or cleaning industrial sites once they stop being used.

These costs (because they are large) can have a significant impact on the shareholder value generated by a project, and can also make significant demands on SAM’s cash resources. However, because they occur at the end of a project there is a danger that they will be given a lower priority if management focuses on short-term financial measures, such as annual profit.

Reporting on costs – As well as making the costs more visible to management, increasing the focus on environmental costs could also be beneficial to SAM from a public relations perspective. If SAM highlights these costs in its financial reports, and also highlights the actions it is taking to reduce to reduce its environmental impact, it can demonstrate to pressure groups and the regulator that it is taking its environmental responsibilities seriously.

Reputational costs – By contrast, if SAM is deemed not be taking its environmental responsibilities seriously, this could result in adverse publicity for the group, and ultimately could lead to consumer boycotts and lost revenues.

ABC

Traditional ABC allocates costs to cost centres or cost drivers on the basis of the activities that caused the costs.

Environmental ABC looks to distinguish between environment-related costs and environment-driven costs.

Environment-related costs are attributed specifically to an environmental cost centre, for example, waste filtration at SAM.

Environment-driven costs are not allocated to a specific environmental cost centre, but still relate to environmental drivers. For example, SAM may reduce the working life of some of the machinery in its refinery to reduce pollution levels in the later years of its working life. The increased annual depreciation charges that will result from this are environment-driven costs.

Applying ABC in this way will help SAM identify and control environmental costs.

Life cycle view Life cycle costing looks to record a product’s costs and revenues across the whole of its life, rather than for a single year, or for a specific phase of its life (such as the production phase).

This is important because it highlights the importance of costs incurred prior to production and those incurred after production ceases (for example, in SAM’s case, the costs of decommissioning plant and equipment). These costs can often be very large, and so could have a significant impact on the shareholder value generated by a project. As a result they may potentially influence the decision about whether or not to undertake a project.

Given the nature of SAM’s business, it is very important that any investment appraisals capture all the costs generated over the whole life cycle of a project – including decommissioning costs, which for the Ruby project are estimated at $18m.

Evaluation

Costs – One of the major issues SAM would face if it chooses to introduce environmental ABC is that it will need to collect significant additional amounts of information from the management accounting system, and there are likely to be costs involved in upgrading the system to be able to provide this.

Benefits – At the same time, while the techniques can help improve SAM’s economic and environmental efficiency, it may be difficult to quantify the benefits which will accrue from using the techniques. Therefore, it may be difficult to justify introducing the techniques on the basis of a financial cost/benefit analysis.

Strategic benefits – However, perhaps the stronger case for using the new techniques is a non-financial one. SAM believes it will be strategically important to be at the forefront of environmental developments, and using the new techniques will demonstrate its commitment to this.

By demonstrating its commitment to environmental issues, SAM could improve its public image, appease the pressure group (Green Kevland) and reassure the Government it is helping to improve its treatment of the environment.

Performance metrics – The focus of SAM’s current performance measures are predominantly financial, suggesting there are few, if any, environmental performance metrics.

However, the increasing focus on the environmental impact of SAM’s activities means that it should also identify some key environmental performance indicators, and measure its performance against them. Carbon dioxide emissions could be a particularly important metric, given the Government’s commitment to reducing it, and the threat of a tax on emissions being introduced in the future.

Unlike its current metrics, however, SAM will not be able to see how its environmental performance is directly contributing to its financial performance. For example, it will not be able to put monetary values on its CO2 emissions figures – although if the Government does introduce the proposed tax then SAM will be specifically able to identify the ‘cost’ of the emissions.

Information systems – Similarly, given that the focus of SAM’s information systems is currently on producing financial performance measures, the addition of environmental performance information could involve significant changes – for example, SAM may need to modify its existing database structure, or add additional records.

However, before it can monitor its CO2 emissions, SAM will have to start collecting data on the volume of emissions, which can then be recorded in its management information systems. As such, SAM will need to install measuring equipment to capture the relevant data, and then feed it back to the company’s management information systems.

The measuring equipment could capture real-time data which is uploaded automatically into the information systems. Having real-time environmental data could be particularly useful in detecting a potential problem in the refinery as early as possible (e.g. an unexpected increase in the level of CO2 emissions), and thereby helping to minimise the environmental damage the problem causes.

SAM’s traditional performance measure of product profit for Ruby suggests it will generate a profit of $41.5m over 5 years. However, this ignores the environmental costs (of waste filtration, and carbon dioxide exhaust extraction) as well as the cost of decommissioning at the end of the project.

By contrast, a life cycle analysis would include all of these costs:

When the environmental costs are all included, the forecast profit margin on the Ruby project is reduced from 27.8% to 6.8%, which makes it a much less attractive investment. Moreover, if the actual costs of decommissioning in 5 years’ time are higher than the forecast ($18.0m) – for example, due to changes in environmental legislation in the next 5 years – then the profit margin will be reduced even further.

Importantly, also, life cycle costing makes the post-production costs visible at the start of the project and in the design stage of the product. This should help SAM appreciate early in the project the need to minimise the costs of decommissioning. So, for example, it could investigate whether it could design any of the equipment to be used to produce Ruby in such a way that it could also be used to produce Ruby2.

Porter’s five forces and the option to enter the cardboard tube market

Porter’s five forces model assesses five competitive forces that affect a firm’s positioning in its market and ultimately its profitability.

BPC is considering whether it wants to enter the cardboard tube market. So, using the model to assess the option to enter this market:

i. Threat of new entrants. A new entrant such as BPC will bring more competition and extra capacity. The strength of this threat depends on the barriers to entry to the market such as high fixed costs or expertise in technology. It also depends on the response of the existing competition in the market. New machinery to make the tubes costs from $30,000 per machine, it only needs one operator and the expertise needed to operate it is fairly low as an operator only needs one day’s training. This appears to be a high threat. Another threat would be the foreign multinational company which has the machinery to manufacture cardboard tubes.

ii. Threat of substitutes. A substitute product is a good or service produced by another industry which satisfies the same customer needs. PTC has a range of plastic tubes that can be used to house small products. This use appears to be different from that of the manufacturers who use the tubing to wind products around. It is possible that the uses could be extended to satisfy some of the uses made of cardboard tubes. However, the plastic tubes are at present an average of 30% more expensive than the cardboard tubes on offer.

iii. The bargaining power of customers. Customers, who appear to be manufacturers, use the tubing for a variety of purposes and buy very large quantities. The customers seem to have some bargaining power in their purchasing as they buy in bulk, and may also be price sensitive as the tubing costs a tiny part of the total cost and they may wish it to remain so. The product is not likely to be specialised and so customers could switch suppliers readily. There are four main suppliers with similar ranges, so customers have some choice. This also appears to be a high threat.

iv. The bargaining power of suppliers. Suppliers can drive up prices for goods and services supplied to the industry. Obviously, a monopoly supplier with a differentiated product will have more influence than a range of small suppliers with a simple product. The tubes are made from a specialist paper that can be in short supply. So, suppliers do have some influence. Again, this is another high threat.

v. Rivalry amongst current industry competitors. The intensity of competition within an industry will affect overall profitability. The industry has four main manufacturers with 80% share in total and between 18% and 26% share each. So, the industry is fairly concentrated. There has been little market growth recently at 2% p.a. and the product is undifferentiated. Therefore, the competition is likely to be quite strong for a shrinking market and a homogenous product. This therefore poses yet another high threat.

In summary, there are some good reasons for entering the market, which include low entry barriers, as the manufacture of the product is unspecialised (though this could be a threat once BPC has established itself in the market and wishes to keep out other competition). There is also a small likelihood of substitution. However, the market is likely to be very competitive with a high concentration of entrenched competitors and customers who have considerable buying power.

On balance, the option to enter the market for cardboard tubes appears to be unattractive and BPC should consider alternative strategies for improving performance.

Limitations of the five forces model as a technique for assessing the attractiveness of an industry

Problem of market definition – The aim of Porter’s model is to identify the level of profits which can be sustained in an industry or market. However, it can sometimes be difficult to define exactly what the industry or market in question is – particularly for a large organisation, or one operating in a complex environment. Even in the BPC example, are cardboard tubes and plastic tubes in the same ‘tube’ market, or should they be distinguished on the basis of the different materials used?

This issue around market definition identifies a potential problem with Porter’s model. The model is best used for analysing simple market structures, but analysis of the different forces can get very difficult in more complex industries with lots of interrelated segments or product groups.

Environmental change – Moreover, the model assumes relatively static market structures. However, this is often not the case in today’s markets. For example, technological breakthroughs can change business models in relatively short timescales. Yet while the model can provide some useful analysis of the new market structure once it has emerged, it can only offer limited advice for any preventative measures.

The need for careful analysis is, perhaps, most important in the area of substitute products or services. It takes a particular alertness to discern potential substitutes in the early stages of their development.

Equally, while there may currently be strong barriers to entry into an industry, new technological developments could remove or severely reduce those barriers to entry.

Competition or co-operation? – It is also important to recognise that Porter’s model is based on the idea of competition between firms. It assumes that companies try to achieve competitive advantages over other players in the markets as well as over suppliers or customers. With this focus, it does not really reflect the dynamic of approaches such as strategic alliances, electronic linking of information systems of all companies along a value chain, or in a virtual organisation, in which the focus is primarily on collaboration rather than competition.

GILL Co and corporate failure

GILL Co had a market-leading share of 30% just 3 years ago. The current market share is 18% (see Working) so there has been a decline of 12% in 3 years. There are several performance indicators that could be used to flag up corporate failure. These are both financial and non-financial indicators and could include:

i. Declining profitability. GILL is losing market share in a slow growing market. It is very likely that profitability will be affected. If GILL starts to make losses it will become unviable to continue operating.

ii. Decreasing sales volume. GILL has lost market share in a near static market and therefore it has lost sales.

iii. An increase in gearing. GILL may well need to borrow if it is not earning sufficient revenue to fund operations and future growth. This is usually achieved through increasing its overdraft limit or long-term debt which can eventually lead to lenders refusing further borrowing. High levels of debt or financial gearing create financial risk affecting the company and its stakeholders.

iv. Poor financial controls. Organisations that lose control over costs and operations can fail spectacularly. Audit committees that do not exercise proper controls can fail to spot fraud or mismanagement.

v. Lack of planning. The remark by the MD suggests that GILL has not done anything to date to stem the decline in market share. This shows a lack of planning by the board having let things drift for three years.

vi. Frequent changes in senior executives. Mobility can be a sign of dissatisfaction with how the company is performing. The challenge of turning around a troubled company is outweighed by whether the company can be saved and the risk of being associated with a failed company.

Working: Market share

From Note (3) in the scenario: The four leading manufacturers have a market share of 80%. The market leader has a market share of 26%, so the other three (including GILL) together have a share of 54%. The three are equal in size, so each company has a share of 54/3 = 18%

BPR

BPR is the fundamental and radical redesign of business processes to achieve dramatic improvements in performance. For Jolt, the BPR proposal aims to meet the retailers’ demands for lower prices and the requirement to meet performance targets relating to lead times and quality.

Lower prices

To be able to sell swimwear at lower prices, Jolt proposes reducing costs by outsourcing production to an overseas supplier. The current average production cost of manufacturing is $5.00 per unit. The cost of purchasing from an external supplier is $4.00, which is $3.50 purchase cost, plus $0.50 ($5,000/10,000) shipping costs. This 20% ($1.00/$5.00) saving is a significant improvement in financial performance, but not a dramatic one, and may not fit the definition of BPR. Exchange rate movements could reduce the cost saving significantly. In the near future, expected changes to international trade tariffs will increase the unit cost to $4.35 ($4.00 + 10% of $3.50), and reduce the cost saving to just 13% ($0.65/$5.00).

Unless Jolt decides to outsource the remaining 50% of production and close its factory completely, factory overheads of $0.95 per unit may still be incurred and just be re-allocated to Jolt’s other sportswear products, possibly totally eliminating the cost saving.

Combining several jobs into one is a characteristic of a re-engineered process. As such, reorganising staff into multidisciplinary teams may create overhead savings, such as by reducing the number of staff employed by the automation of purchase invoice processing. These savings will be offset by additional costs, such as investment in new information systems, retraining staff to work in unfamiliar roles, or incentivising them to work overseas.

Re-engineered processes often allow workers more autonomy to make decisions. Giving teams more autonomy to set prices may allow Jolt to set prices reflecting the customers they serve and to prevailing market conditions.

Meeting performance targets

Lead times

Current lead times for customer orders are unknown. As the proposed supplier is 17,000 km away, goods will take several weeks to be transported by sea. This may increase lead times significantly, though may be offset by faster production times in larger factories. As Jolt’s sales are seasonal, retailers may pre-order in advance, reducing the importance of long lead times. To minimise shipping costs, shipping containers must be full, which may mean deliveries will be in larger quantities and which may increase the lead times.

Quality

Jolt is already known for producing high quality products. The quality of the new supplier’s products needs to be ensured. Any deterioration in the quality of Jolt products would undermine its reputation and reduce long-term business performance as fewer consumers would buy them. Monitoring of quality standards is more difficult when using external suppliers, especially at long distances, than when manufacturing in Jolt’s own factory. In re-engineered processes, work is performed where it makes most sense to do so. In this respect, having staff responsible for quality and supplier audits working close to the manufacturing site will help Jolt maintain performance in supplier relationship management.

Development of information systems

Functional departments currently have their own spreadsheet-based systems for planning and reporting. The data from these is unreliable and inconsistent. They are inadequate to provide the timely and accurate performance data, which Jolt needs to meet retailers’ performance targets.

Jolt must establish a shared database accessible by all parts of the multidisciplinary teams. This should be updated in real time, so workers in different time zones are using current data. The database should include financial data, such as cost information, and non-financial data relating to lead times and quality. Information systems must be able to provide teams with reports of performance data, and budgets, specifically for the accounts which they manage.

Fast and reliable internet services will be required, for example, so that team members can participate in online meetings, as they will be unable to meet in person.

Jolt may need to invest in specialised systems, such as the sophisticated software used by its competitors to minimise shipping costs by ensuring shipping containers are shipped fully loaded. Systems development may be required to integrate with suppliers’ bespoke systems so as to automate purchase invoice processing. Jolt must evaluate whether the benefits arising from all of these changes to its information systems are worth the cost and disruption of implementing them.

Impact on workers

Jolt is known for its high ethical standards towards workers. Following the BPR, at least 500 (50% of 1,000) manufacturing workers are likely to be left without jobs. As Jolt’s competitors have already closed their factories, these workers may be unable to find new jobs doing similar work, though jobs may be created in the new supplier’s factory.

Staff who remain in work may become demotivated if they think that BPR will be extended to all of Jolt’s products. This may reduce financial performance by reduced productivity, increased staff turnover or difficulties recruiting new staff.

Staff may also be demotivated if they are placed in unfamiliar roles, or may be unwilling to learn new skills. Other staff may welcome, and be motivated by, the opportunity to perform new types of work, learn new skills or work overseas. This will probably increase their individual performance.

Suppliers

Any association with unethical practices, for example, if the new supplier were found to be using unacceptable working practices, could seriously harm Jolt’s reputation for high ethical standards. This could reduce financial performance, as consumers may not buy Jolt’s products, or potential investors could be discouraged from providing capital. Part of the team located close to the manufacturing site is responsible for supplier audits, which may help to reduce this risk.

Environment

Jolt should consider the environmental impact of shipping goods long distances. The environmental credentials of the new supplier are unknown. As Jolt voluntarily publishes a corporate sustainability report, any deterioration in its performance on environmental issues will become widely known. This could lead to reduced financial performance if consumers switch to competing products.