Employees

Employees are cautious about the proposal to export to Kiviland, and are risk averse. They would use the maximin rule, which is the choice of product with the best of the lowest outcomes. In this case, this is Blue.

Directors

Directors are paid a high bonus dependent on profitability of the product chosen. As they have served on the board for many years, there appears to be little chance that they would be removed by making a poor choice. They are risk seekers, and will use the Maximax rule, that is, the choice of product with the best possible outcome. In this case, this is Green.

Shareholders

Shareholders are risk neutral. They will choose the product with the highest expected value; in this case this is also Blue, which has an expected value of D$82,728.

Total profit

Workings

W1 – Exchange rate

$D strengthens by 10% against $K: 2.00 + 10% = 2.20

$D weakens by 10% against $K: 2.00 – 10% = 1.80

W2 – Total profit at exchange rate of $D1.00 = $K2.20

Cost of imported materials (D$)

Total profit (D$)

W3 – Total profit at exchange rate of $D1.00 = $K1.80

Cost of imported materials (D$)

Total profit (D$)

W4 – Expected value

Berry’s three key stakeholder groups will use different criteria to make decisions on the Kiviland opportunity according to their attitude to risk and reward. The maximin and Maximax rules and the expected value can be used to determine the decisions which each group will make.

Maximin and Maximax rules

The maximin rule, the choice with the best of the lowest outcomes, which would be preferred by the employees, can be an excessively risk averse approach. As Berry’s products have short product lives, it must constantly develop new products, so some commercial risks will have to be taken.

The Maximax rule, which the risk-seeking directors prefer, has the problem that it may be overly optimistic. Product choices with the maximum reward or profits may also be riskier, and could mean that directors take risks which exceed the shareholders’ risk appetite so as to earn high bonuses.

A problem with both of the maximin and Maximax rules is that they both ignore the probability of the outcome actually occurring.

Expected value

The expected value approach is a long run average which can be applied to decisions which are repeated many times. The actual expected value is not a possible outcome and will never occur in practice. Though Berry may have developed many products, it has no experience of forecasting exchange rates and so the expected value approach may be inappropriate.

The expected value approach relies on estimates of probabilities, such as for average exchange rates. These may be subjective or difficult to make, which limits the value of this approach.

Identifies opportunities or threats

Analysing the external environment in Kiviland will allow Berry to identify opportunities and threats. It can maximise performance by taking actions to exploit opportunities, such as developing the new products to take advantage of growing income levels and the slower rate of technological obsolescence in Kiviland.

A draft PEST analysis has indicated that the exchange rate between D$ and K$ is a key economic factor affecting performance. By identifying this, Berry can act to maximise performance, such as by analysing the effect of exchange rates on profits of the new products or hedging against adverse exchange rate movements. A thorough analysis of safety regulations in Kiviland may prevent the problems which occurred with the failure of the previous product launch.

Identifies CSFs, KPIs and helps set targets

PEST analysis can help identify critical success factors (CSFs) and key performance indicators (KPIs). Having identified product safety as a legal factor affecting performance, a CSF may be to abide by safety regulations in Kiviland. The number of breaches of safety regulations would be a suitable KPI.

The PEST analysis can be used to set targets appropriate for the environment in Kiviland. A CSF for Berry is that it produces products for long enough to recover their development costs and make an acceptable profit. A target for the KPI of length of time in production could be 24 months in Kiviland, where technical obsolescence is slower, rather than the target of 18 months in Danyland.

Contribution per franchise = sales revenue – variable cost

= $20,000 – $6,000 = $14,000

Net operating cash flow each year before taxation

= ($14,000 × 300) – $600,000 = $3,600,000

Net operating cash flow each year after taxation

= $3,600,000 × 70% = $2,520,000

Net present value (NPV) at a discount rate of 11%

Net operating cash flow – initial investment – development costs

= (2,520,000 × 4.231) – (6,000,000) – (1,000,000 × 0.812) – (1,000,000 × 0.731) = $3,119,120

The positive NPV indicates that the proposal should be undertaken.

Tutorial note

A real discount rate of 11% has been used. It has been calculated as follows:

(1 + money cost of capital)/ (1 + rate of inflation) – 1 = (1 + 0.1544)/ (1 + 0.04) – 1 = 0.11 or 11%

There are barriers to the creation and revision of a performance measurement system. Key drivers are not easily measured. This applies specifically to the issue of intellectual capital.

Intellectual capital will include assets such as employee know-how, skills and creativity. Such assets cannot be measured using traditional financial measures. It is necessary to identify and value a number of alternative measures such as years of experience or service of key employees, or the proportion of employees generating new ideas for the development of the business.

The rise of intellectual capital statements has been driven by the decreasing information relevance of aspects of traditional financial statements.

There is a role for accountants (in particular management accountants) in classifying the intellectual (and intangible) assets in the organisation.

In F4U the development of new franchises will rely heavily on the intellectual capital input. This will require the ongoing development of existing employee knowledge and expertise and the recruitment of new expertise/knowledge as required by the trend in the franchise range.

There will be specific costs incurred in the retention and development of existing staff expertise and in the acquisition of new staff/expertise and its development within the ethos of F4U.

A Performance Measurement system (PMS) must be comprehensive for the following reasons:

• Financial is only one dimension of value – as such it is inadequate in evaluating strategic performance of an organisation in its entirety.
• Financial measures are traditionally backward looking – in today’s volatile markets, a poor predictor of future performance.
• Financial measures take no account of the intangible value drivers – especially important in knowledge intensive companies.
• Fixation with bottom line profit pushes for short-term decisions to boost earnings streams in short term.
• Alternative perspectives are needed to satisfy demands of providing a sustainable competitive environment.

The effectiveness of a PMS based solely on financial performance may be reduced due to key drivers not being easily measured such as, for example, the degree of innovation required for new franchises.

Also, there may be conflict between the PMS with the culture of an organisation. The culture will probably focus on innovation in franchise development. This will not be enhanced by a solely financial based PMS. It is important that a culture is developed which recognises and rewards the contribution of employees to achieving corporate goals and strategy fulfilment.

It is important to focus on sustaining competitive advantage through superior strategic management in all aspects of franchise development and implementation. There is a need for better business intelligence capability from both within the organisation and from external sources, in the assessment of likely demand for new franchise areas and how best to satisfy such demand. In this regard there is need for non-financial performance measures in order to enhance the effectiveness of the PMS.

The Maximax rule looks for the largest possible outcome. In this case F4U will choose a fee per franchise of $18,000 where there is a possibility of an NPV of $4,348,226. This may be seen as risk seeking since F4U has not been put off by the possibility of a lower NPV than if a $22,000 fee is charged and variable costs are $6,000 or $7,000.

The maximin rule looks for the fee per franchise which will maximise the minimum possible NPV. Hence maximin is a risk averse strategy. In this case F4U will choose a fee per franchise of $22,000 where the lowest NPV is $2,674,865.

This is better than the lowest figures applying where franchise fees of $18,000 or $20,000 apply. The minimax regret rule requires the choice of the fee per franchise which will minimise the regret from making the wrong decision.

Regret in this context is the opportunity lost through making the wrong decision. Using the calculation from the payoff matrix given in the question, a regret matrix may be created as follows:

This shows that the minimax regret rule leads to the choice of a fee per franchise of $22,000. This minimises the regret to an amount of $74,043.

Importance of incorporating risk and uncertainty in making long-term decisions

Risk relates to the variability of outcomes, the probabilities of which are known, or can be estimated. Uncertainty occurs where the outcomes and their probabilities are unknown. The variability of demand for SC’s chocolate bars is a risk, and the probabilities of different levels of demand can be estimated. The outbreak of conflict in a cocoa growing region affecting cocoa prices cannot be assigned a probability, and so is an uncertainty.

The market price of cocoa and the demand for chocolate bars are examples of exogenous variables which significantly affect the performance of SC. Exogenous variables arise from outside the business, but over which the business has no control. Climatic conditions, soil erosion, for example, all affect the price of cocoa, and therefore the performance of SC.

When investors evaluate businesses, they take into account prospective returns and the level of risk involved. Therefore, managers should consider risk and return when evaluating projects on their behalf. Long-term strategic planning requires forecasts to be made about future events, such as the price of cocoa. These future events are by definition unknown, and subject to risk and uncertainty. Risk and uncertainty must, therefore, be considered when making long-term plans, such as opening the new factory. The further into the future the plans project, the riskier, and more uncertain, events are likely to be, as it is harder to predict what conditions will be. This mean consideration of risk and uncertainty is even more important when making long-term decisions than for short-term decisions.

Use of PEST analysis

To incorporate risk and uncertainty into long-term strategic planning, SC must identify and monitor the most important exogenous variables, taking action to manage the risks they present. As a traded commodity, the risks of rising cocoa prices could be managed (hedged), for example, by using cocoa futures. The board member’s comments suggest planning for the cake business was poor, and did not adequately consider the importance of exogenous variables. Risks in the macro environment could be identified using a PEST analysis.

Political factors

The market price of cocoa is affected by conflicts and political uncertainty, so consideration of these external factors is needed to incorporate risk and uncertainty into long-term planning. By identifying factors such as political instability or conflict, SC can improve its long-term performance by sourcing cocoa from more stable regions. The political situation in a region can change rapidly, which might make it difficult to incorporate these risks into long-term planning, as there is a high degree of uncertainty.

The introduction of increased taxes on products containing sugar is a political factor affecting the long-term demand for SC’s products. Once introduced, this factor is likely to operate in the long term and be more predictable. Identifying this, SC could develop products containing less sugar and so reduce the amount of these additional taxes on its products.

Economic factors

Economic factors such as the variation in long-term interest rates can influence SC’s performance by affecting exchange rates or overall consumer demand. By identifying these factors, SC could hedge against currency exchange rates. In the longer term, SC could locate its operations in a country where the risks from exchange rate fluctuations are lower, or diversify geographically to spread the risk.

Social factors

Overall demand for chocolate products will be influenced by social factors such as consumer tastes or increased awareness of healthy eating. SC can improve its longterm performance by not investing in a chocolate factory at all, if it believes demand for its products will fall sufficiently to make the venture unprofitable.

Technological factors

The increased cocoa yields from genetically modified crops may reduce long-term cocoa prices and SC could incorporate this into the net present value calculations for the factory. There may be unpredictable consequences which are harder to plan for, such as the acceptance by consumers of genetically modified foods.

Tutorial note

Ensure you add enough depth to your answer in (a) rather than focusing too heavily on the calculations in (b) and (c).

Board

The board wants to minimise the opportunity cost of making the wrong decision about the size of the new chocolate factory, which means to minimise the regret of making the wrong decision. The minimax regret rule would be the appropriate method to use so they would choose the project with the lowest maximum regret.

The regret table is as follows:

the option preferred by the board according to their risk appetite. A drawback of using the minimax regret rule is that the probabilities of the outcomes are not considered.

New shareholders

The new shareholders are keen to increase the long-term performance of the business and are prepared to accept a high level of risk to achieve this. They will choose the option with the maximum possible outcome, which is option 3, with a maximum possible net present value of $17m. This is known as the Maximax rule. This also takes no account of the probabilities of the outcomes, and also tends to be over-optimistic. It also ignores the fact that even risk seekers have a risk–return trade off.

Expected values of each option

Option 1 – (0.3 x 3.0) + (0.4 x 0.5) + (0.3 x –2.0) = $0.5m

Option 2 – (0.3 x 5.0) + (0.4 x 2.0) + (0.3 x –1.0) = $2.0m

Option 3 – (0.3 x .7.0) + (0.4 x 1.5) + (0.5 x –2.0) = $2.1m

The risk neutral investor’s choice, for year 1 only, would be option 3, with an expected value of $2.1m.

Problems of using an expected value approach

A risk neutral investor would use the expected value approach to choose between the three options. The expected value is a long run average, and is only appropriate where a decision is repeated many times. This does not appear to be the case at SC which has made only one attempt at strategic expansion in the last several years. For the same reason, the expected value will not equal the actual outcome.

Determining the probabilities, of the market price of cocoa for example, is subjective. Even analysis of historical market prices is not necessarily a guide to what will happen in the future. The expected value approach is suitable for a risk neutral investor. This does not apply to the key stakeholders at SC, and hence this approach is inappropriate for use in the decision on the three options. Determining the payoffs is also difficult when demand is subject to uncertainty. SC should not make a decision on the factory based only on the first year’s operating profits, and should take a longer term view, for example, based on discounted cash flows.