QUESTION 07- FLINT GROUP
Company information and mission
Flint Group (Flint) is a listed company with two subsidiaries, both involved in food and drink retailing in the small country of Oscaland. Its mission is ‘to maximise shareholder value through supplying good value food and drink in appealing environments for our customers’.
Flint Cafés (Cafés) is the original operating company for the group and is a chain of 115 cafés specialising in different coffee drinks but also serving some simple food dishes. Cafés has been running successfully for 15 years and has reached the limit of its expansion as the café market is now considered to be saturated with competition. Further growth will occur only as the opportunity to obtain profitable, new sites is presented, although such opportunities are not expected to be significant over the next few years.
Flint Juicey (Juicey) was started by the Flint Group two years ago. Now, it is made up of 15 juice bars which serve a variety of blended fruit juice drinks and health snacks. The products served by Juicey have benefited from an increased awareness in Oscaland of the need to eat and drink healthily. Flint Group expects to increase the rate of property acquisition in order to feed the rapid growth of this business, intending to open 25 outlets per year for the next four years.
Flint Group organises its two subsidiaries in a similar way, as they are involved in similar areas of business. There is one exception to this, namely in the arrangements over the properties from which the subsidiaries operate. Cafés rent their properties on the open market on standard commercial terms with a five-year lease at a fixed rental payable quarterly in advance. Juicey, on the other hand, has made a single arrangement with a large commercial landlord for all of its properties. Juicey has agreed that the rent for its sites is a percentage of the revenue generated at each site. Juicey believes that it can continue its expansion by obtaining more sites from this landlord under the same terms.
Performance reporting systems
The board of Flint is reviewing the company’s performance reporting systems, and in relation to this the Chief Executive Officer (CEO) has asked for your thoughts on the current report, which you have been given a copy of (Appendix 1). This report contains information for both the subsidiaries and the group and is used by all three boards.
The CEO has asked you to evaluate the current report. However, the CEO has advised you that the board does not require an evaluation of Flint’s performance.
Cost structures
A second area the CEO wants you to consider is the cost structures at Flint, and the implications of the mix of fixed and variable elements in the key cost areas of staff and property for performance management.
The CEO has asked you to provide an assessment of the fixed and variable elements of these two key costs in each of the subsidiaries, and the impact which this may have on performance management of these costs. However, the CEO told you that detailed calculations are not required.
Value based management (VBM) and Economic value added (EVATM)
At a recent shareholder meeting of Flint, one of the large shareholders expressed concern that the group lacks focus and suggested the introduction of value-based management (VBM) using economic value added (EVATM) as the measure of value. Flint’s CEO has asked you, the group’s Strategic Management Accountant, to give the board more information on the implications of this suggestion. She has asked you to produce an example calculation of the EVATM for the Group using the current data (Appendices 1 and 2), justifying any assumptions made, and commenting briefly on how the shareholders might view the result.
The board also needs to have the VBM system explained and evaluated, to be able to make a decision about its use at Flint. To this end, the CEO has asked you explain how VBM could be implemented at Flint, and to evaluate its potential impact on the group.
Potential changes to mission statement
Finally, the board is considering amending the mission statement to include more information on the ethical values of the company. The area being considered for inclusion in the overall mission is the treatment of employees as it is felt that they should share in the progress and profitability of Flint since a happy working environment will help them to better serve the customers.
The proposed new mission statement would read:
‘To maximise shareholder value and to provide a fair deal to our employees by supplying good value food and drink in appealing environments for our customers.’
The CEO has asked you to consider how the Group’s performance in the area regarding employees could be measured using the current management information at Flint. You have been given additional information from the management information system to assist with this task (Appendix 3).
The CEO would like you to use this additional information, and the current performance report where appropriate, to provide justified recommendations for suitable performance measures to reflect the proposed change in the company’s mission statement.
Required
Write a report to the CEO of Flint to respond to her instructions for work on the following areas:
i. The current performance report
(15 marks)
ii. Fixed and variable elements in the key cost areas
(6 marks)
iii. The example calculation of economic value added (EVATM) for the Group
(9 marks)
iv. Implementing VBM at Flint
(10 marks)
v. Performance measures for the revised mission statement
(6 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer.
(4 marks)
(Total = 50 marks)
Appendix 1
Flint Group Year to 31 March
| |
Cafés
Budget Industry 20X4 $ |
Cafés
Actual
20X4 $ |
Juicey
Budget
20X4 $ |
Juicey
Actual
20X4 $ |
Group Budget
20X4 $ |
Group Actual
20X4 $ |
Group |
Costs and profit as a
% of revenue average |
| Revenue |
|
|
|
|
|
|
|
|
| Drink |
47,437,500 |
46,521,000 |
5,130,000 |
5,398,000 |
52,567,500 |
51,919,000 |
|
|
| Food |
15,812,500 |
15,913,000 |
570,000 |
582,000 |
16,382,500 |
16,495,000 |
|
|
| Total |
63,250,000 |
62,434,000 |
5,700,000 |
5,980,000 |
68,950,000 |
68,414,000 |
|
|
| Cost of sales |
|
|
|
|
|
|
|
|
| Drink |
12,808,125 |
12,560,670 |
1,385,100 |
1,457,460 |
14,193,225 |
14,018,130 |
|
|
| Food |
3,478,750 |
3,500,860 |
125,400 |
128,040 |
3,604,150 |
3,628,900 |
|
|
| Total |
16,286,875 |
16,061,530 |
1,510,500 |
1,585,500 |
17,797,375 |
17,647,030 |
25.8% |
|
| Gross profit |
46,963,125 |
46,372,470 |
4,189,500 |
4,394,500 |
51,152,625 |
50,766,970 |
74.2% |
72.8% |
| Staff costs |
16,128,750 |
15,920,670 |
1,453,500 |
1,524,900 |
20,082,250 |
21,345,000 |
31.2% |
30.9% |
| Other operating costs |
|
|
|
|
|
|
|
|
| Rent |
2,875,000 |
2,875,000 |
342,000 |
358,800 |
3,929,000 |
3,945,800 |
|
|
| Local property tax |
920,000 |
920,000 |
60,000 |
60,000 |
980,000 |
980,000 |
|
|
| Insurance |
276,000 |
282,000 |
18,000 |
18,400 |
294,000 |
300,400 |
|
|
| Utilities |
874,000 |
861,000 |
61,500 |
62,900 |
935,500 |
923,900 |
|
|
| Marketing |
6,957,500 |
6,888,000 |
627,000 |
750,000 |
7,584,500 |
7,638,000 |
11.2% |
10.0% |
| Depreciation |
4,427,500 |
4,427,500 |
353,400 |
353,400 |
4,780,900 |
4,780,900 |
|
|
| Total |
16,330,000 |
16,253,500 |
1,461,900 |
1,603,500 |
18,503,900 |
18,569,000 |
27.1% |
|
| Operating profit |
14,504,375 |
14,198,300 |
1,274,100 |
1,266,100 |
12,566,475 |
10,852,970 |
15.9% |
15.3% |
| Finance costs |
|
|
|
|
798,000 |
801,000 |
|
|
| Group profit before tax |
|
|
|
|
11,768,475 |
10,051,970 |
14.7% |
|
| Tax |
|
|
|
|
2,942,119 |
2,512,993 |
|
|
| Group profit after tax |
|
|
|
|
8,826,356 |
7,538,977 |
11.0% |
|
Appendix 2
Data about the group for the financial year:
- Debt/Equity 30.0%
- Cost of equity 15.7%
- Tax rate 25.0%
- Group ROCE 19.0%
- Group capital employed: $53,400,000 at period start and $58,500,000 at period end.
- Pre-tax cost of debt 6.5%
- There has been $2.1m of tax paid in the year.
- It is estimated that half of the marketing spend of $7.638m is on building the Flint brand long term.
- It is further estimated that there has been the same level of annual spending on long-term brand building in the years leading up to 20X4.
Appendix 3
Additional management information for 20X4
| |
Cafés |
Juicey |
Group |
| No. of employees |
|
|
|
| At year start |
1,495 |
96 |
1,611 |
| Leavers |
146 |
15 |
161 |
| Joiners |
152 |
35 |
187 |
| At year end |
1,501 |
116 |
1,637 |
Note. Group numbers include Cafés, Juicey and head office numbers.
Report
To: CEO
From: Strategic Management Accountant
Date: [today’s date]
Subject: Performance reporting and VBM at Flint
Introduction
This report evaluates the current performance reports at Flint, and the cost structures in the group. It then calculates Flint’s EVA™ (as an alternative measure of performance to the profit-based measures currently used in the performance reports) before evaluating the potential impact that VBM could have at the group.
Finally, the report recommends some new performance measures to reflect the change in Flint’s mission statement
i. Current performance report
We can use four basic criteria to evaluate Flint’s current performance report:
Purpose – What the purpose of the report is, and whether it provides information which is relevant to Flint’s performance against its mission
Audience – Whether the report is appropriate for its audience and their requirements
Information – Whether the report provides information which is relevant for decision making and control
Layout – Whether the report’s layout is clear for its readers, and identifies the most important information.
Purpose
Performance against overall goals and objectives
One of the overall aims of Flint’s performance reports should be to enable the Board to identify how well the company is fulfilling its mission, and achieving its goals and objectives. Flint’s mission statement identifies three key points:
- Maximising shareholder value
- Supplying good value food and drink
- Providing an appealing environment for customers
Shareholder value – The report currently only focuses on historic profits. It does not include any future cash flows, EVA™, share price or dividends – all of which could provide an indication of shareholder value.
As such, the report does not directly measure shareholder value. This point has also been highlighted by one of Flint’s large shareholders who has suggested the introduction of EVA™ as the company’s main measure of value. (We will return to this point later in this report.)
One of the dangers of using annual profit as the main performance measure is that it can lead to a focus on short-term performance. However, shareholders are likely to be interested in longer-term value creation as well as short-term performance.
Nonetheless, the comparison between budget and actual performance in the report is useful – both as a means of control and for giving some insight as to whether Flint is performing in line with strategic targets.
Good value food and drink – Comparing Flint’s gross profit against the gross profit for the industry as a whole can give some indication of whether Flint provides good value or not.
Flint’s gross profit margin is slightly higher than the industry average (74.2% vs 72.8%) which might suggest that the prices Flint charges its customers are slightly higher than the industry average. However, the gross profit margin by itself is not a good indicator of whether Flint is offering good value, because it doesn’t provide any insight into the reasons behind the relative margins (for example, Flint’s costs of sales might be lower than its competitors) or the quality of the food and drink it is offering might be higher, enabling it to charge higher prices.
Another limitation of the report is that it does not provide any historical comparisons, although these could potentially give some insight into how attractive Flint is to its customers. If Flint is consistently able to increase its revenues over time, this could be seen as an indicator that its customers feel it is providing them with good value.
Appealing environments for customers – It is difficult to measure the appeal of Flint’s cafés or juice bars from financial data alone (which is all the report provides). However, revenue growth gives some indication of customer satisfaction, because customers are unlikely to continue to use Flint’s premises if they are too unappealing.
Customer loyalty and price elasticity of demand could give a greater indication of the appeal Flint’s premises have for customers, but without surveying customers directly it will be difficult to assess the extent to which the environment has an impact on their purchasing decisions, compared, for example, to the price and quality of the food and drink provided in them.
Audience
The same performance report is used by Flint’s main group board, as well as the boards of the two subsidiaries. However, the information requirements of the subsidiary boards may be different to those of the group board.
Main board – The main board is less likely to be interested in detailed figures, and so a summary of key performance measures for each of the subsidiaries may be more useful to them than, for example, the detailed information about operating costs currently provided.
Subsidiaries’ boards – The report seems to treat the subsidiaries in the same way as the group, using profit and comparison to industry average margins and budgets as the main assessment tools. However, the different nature of Cafés’ and Juicey’s business may make comparison to an overall industry average less meaningful.
Moreover, as the subsidiary boards are likely to be interested in more detailed performance issues than the main group board, it doesn’t seem appropriate to only provide the subsidiary boards with the high-level overview which is produced for the group board.
For the subsidiaries, it would be useful to provide a more detailed breakdown of revenues and gross margins by product line, and by geographical region.
Similarly, it would be useful for the subsidiary boards to be provided with more detail about operating costs by geographical region so that they identify the profitability of different regions and, if necessary, they may then need to drill down further to look at the profitability of individual outlets if some appear to be underperforming.
It seems that the measure being used to assess subsidiary performance is operating profit, which is appropriate as it contains the elements of performance controllable by the subsidiaries’ managers. However, if the performance reports are only produced annually this would not appear appropriate for the needs of the subsidiary boards. They need more frequent information, to allow them to control their operations effectively.
Appropriate information for decision making
The annual reporting period also reduces the report’s usefulness as a basis of decision making for the subsidiaries’ boards.
In relation to operational/tactical decision making, the report would be more useful if it provided greater detail for individual products or sites to assist the managers of the subsidiaries in their planning and control activities.
Conversely, at a strategic level, the report is likely to be more useful if it provided some external information – for example, competitor information – rather than focusing on internal financial information. Currently, the only external benchmarks provided are the industry average figures, but these may be less useful than figures for competitors which compete directly with Flint in the same sectors of the market.
Also, for both boards, it would be useful to provide some historic information to help identify growth and trends. This is likely to be particularly important at Juicey, given the levels of growth it is currently enjoying.
Similarly, it would be useful, for both boards, if the report included some non-financial key performance indicators in relation to the three key areas of Flint’s mission: shareholder value, product value and customer satisfaction with Flint’s sites.
The current focus (on financial performance only) only provides the boards with ‘lagging’ information on how well Flint has performed, rather than providing them with any ‘leading’ indicators – and some insight into how well it will perform in future.
Layout
In terms of presentation, the data is clear and in a form which would be easily recognisable to those used to reading accounts. However, it could be useful to provide a short narrative commentary in conjunction with the report in order to highlight the key points highlighted by the figures – such as major deviations from the budget, or areas where Flint is performing significantly better or worse than industry norms. The report could also be made easier to read by rounding all figures to thousands and thus removing unnecessary detail.
(Max 15 marks)
ii. Cost structures
The costs in each of the two subsidiaries include a mixture of fixed and variable costs. In general terms, higher fixed costs will constitute a higher level of risk to Flint than variable costs. If Flint’s revenues fall, but level of fixed costs remains unchanged, then its operating gearing will increase.
In practice, however, it may not be possible to analyse costs simply into ‘fixed’ and ‘variable’ costs. Some will be partly fixed and partly variable.
Staff costs
Staff costs are likely to be part-fixed and part-variable. As these represent a significant part of the cost base, it will be necessary to establish what element is fixed (how many staff are the minimum required to run a site?) and what element is variable (how many staff can be used as needed when the sites are busy?).
This cost area will be managed through decisions over the balance of the numbers of permanent and casual staff, with casual staff being used to manage fluctuations in business. As such, this suggests that Juicey may need to use proportionately more casual staff than Cafés.
Property costs
The nature of the property costs is also different in the two subsidiaries:
Cafés – Rent is a fixed cost for Cafés, with fixed rental charges being payable quarterly in advance.
Juicey – Rent is a variable cost, being a percentage of revenue.
This structure appears appropriate to the nature of the different businesses. Cafés is a mature business whose revenues are likely to be relatively stable and predictable – meaning that there should be little risk of it not being able to cover its rental costs each month.
By contrast, Juicey is a relatively new business, but it is also rapidly growing, and therefore agreeing negotiating variable rental costs is more appropriate for it.
However, the percentage demanded will reflect the risk which the landlord is taking on the success of Juicey and so is likely to be higher than a fixed rent, such as that negotiated by Cafés. As Juicey becomes established, it may be worth considering beginning to move to negotiating fixed rental deals for Juicey in order to cut this cost.
This last point illustrates the dilemma which many businesses face in thinking about the balance of fixed and variable costs. Variable costs are more desirable as they do not threaten the survival of the business but they are often higher than a fixed cost deal.
(Max 6 marks)
iii. Economic value added
| |
$ |
Notes |
| Operating profit |
10,852,970 |
|
| Add back: |
|
|
| Brand building |
3,819,000 |
50% of marketing expenditure |
| Less: |
|
|
| Taxation |
(2,100,000) |
Tax paid in year |
| Lost tax relief on interest |
(200,250)
__________ |
Finance costs @ 25% |
| NOPAT |
12,371,720 |
|
| Capital employed |
53,400,000
__________ |
At start of 20X4 |
| Brand building expenditure capitalised |
3,819,000
|
Spending in previous years |
| Adjusted capital employed |
57,219,000 |
|
| Cost of capital employed
(@ 13.2%) |
(7,552,908)
___________ |
See Working for WACC calculation |
| EVA™ |
___________ |
employed |
| |
|
|
Working
| |
$ |
Notes |
| Equity: 100/130 × 15.7% |
12.1 |
|
| Debt: (30/130 × 6.5%) × (1-25%) |
1.1
____ |
Adjusted for tax at 25% WACC |
| |
13.2 |
|
The EVA™ calculation suggests that the group’s economic profits for the year (NOPAT) were significantly greater than its cost of capital – such that it was able to add $4.82 million to shareholder value over the year.
However, the EVA™ which has been calculated is only an example, and it has made several simplifying assumptions which would need to be investigated in more detail if we started to use EVA™ as one of our main performance measures.
- Depreciation – We have not made any adjustments to the depreciation charge, which assumes that economic depreciation is the same as accounting depreciation. However, this may not be the case, in which case the depreciation charge in NOPAT would need to be adjusted to reflect economic depreciation.
- Marketing and brand building – We have estimated that half of the marketing spend relates to brand building, but this figure may need to be investigated more closely.
More importantly, perhaps, although we have added back the brand-building expenditure in 20X3 to adjust the figure for capital employed at the start of 20X4, we have not made any further adjustments for previous years. However, to calculate EVA™ properly, the total amount of the brand-building expenditure in the years leading up to 20X4 should all be added back to capital employed.
Subsidiaries – As with the current profit measures in the performance report, if Flint decides to use EVA™, it may be useful to calculate EVA™ separately for the two subsidiaries as well as for the group. This will help to identify how much value each subsidiary is generating for the shareholders.
(Max 9 marks)
iv. VBM
The premise behind VBM is that the value of a company is measured by its discounted cash flows, and value is only created when the capital which companies invest generates returns which are greater than the cost of that capital.
Therefore, in contrast to Flint’s current approach to performance measurement which focuses on profits, VBM will encourage a focus on future cash flows, and the creation of value.
Importantly, given Flint’s mission, management decision making under VBM focuses on what activities (‘drivers’) increase the value of a company – and create value for its shareholders.
The VBM approach also aligns strategic, operational and management processes so that they all work together to create value.
Understanding value drivers
Implementing VBM at Flint will require that management understand the key value drivers which create value for the business.
Equally, VBM will also require management to establish processes which ensure that all business unit managers adopt value-based thinking when making decisions. For VBM to be effective, it will eventually have to involve every decision maker in the company.
Management processes and implementing VBM
There are four underlying management processes which govern the adoption of VBM (be it at group level, subsidiary level or operational level):
Step 1 – A strategy is developed to maximise value
Step 2 – Key value drivers are identified in relation to the strategy, and then performance targets (both short and long term) are defined for those value drivers
Step 3 – Action plans are drawn up to define the steps to be taken to achieve the performance targets
Step 4 – Performance measurement systems and incentive systems are set up to monitor performance against targets and to encourage employees to meet their goals
Strategy development
Corporate level – Using VBM, Flint’s management will need to devise a corporate strategy which focuses specifically on maximising the overall value of the company – including acquiring or disposing of business units if appropriate. Currently, Flint appears to be growing organically – with the growth of Juicey – but the board should consider whether this growth needs to be reinforced with external growth.
Subsidiary level – Similarly, the subsidiary boards will need to evaluate whether there are any alternative strategies for their businesses which could enable them to achieve competitive advantage and to create value.
Target setting
Once Flint has agreed its strategies for maximising value, this will need to be translated into specific targets which can be used to manage performance at both strategic and operational levels. The targets should be based on key value drivers, and should include both financial and non-financial aspects of performance – so, for example, customers’ rating of the appeal of Flint’s sites could be used as a target if this is a key factor in maintaining customer satisfaction levels.
Impact of VBM at Flint Implementing VBM would require Flint to introduce new performance measures based on the drivers, and the company’s reward and incentive systems will need to focus on value creation and performance against value-driven targets. Performance measures, targets and rewards will need to be developed at the group level, then at the subsidiary level and, finally, at the individual site level in order to ensure full co-ordination of the system across Flint. In order to align the interests of employees and management with shareholder value – particularly in the longer term – the new reward system may include a share-based payment scheme. The key benefits of VBM are the focus on value as opposed to profit, so reducing the tendency to make decisions which have positive short-term impact but may be detrimental in the long term. VBM thus will help to make Flint more forward looking. However, a danger of the VBM exercise is that it becomes an exercise in valuing everything but changing nothing. It is important that the detailed operational issues of the organisation are addressed through the new measures/targets. A further difficulty in implementation is that the measurement of the key value drivers can often involve non-financial indicators and these can represent a significant change for accounting-based management information systems.
(Max 10 marks)
v. Performance measures – fair deal for employees
The proposed change to the mission statement means that Flint will need to find a way of measuring whether it provides a ‘fair deal’ to its employees. This will be inherently difficult to measure, due to the subjective nature of determining how Flint treats its employees.
Staff turnover
However, the information about staff numbers and staff turnover given in Appendix 3 of Flint’s current performance report can provide some indication of employee satisfaction.
The figures indicate that the staff turnover rate for the group as a whole was 9.9% for the last year, with staff turnover being significantly higher in Juicey (14.2%) than in Cafés (9.7%). Some of this difference may be due to the fact that Juicey is a much newer and more dynamic operation, and that it may have been employing staff on short-term or temporary contracts. However, the variation in rates should still be investigated, and Flint’s staff turnover rates should also be compared against competitors if possible. If Flint’s staff turnover rates are higher than its competitors, this could be an indication that employee satisfaction at Flint is lower.
Staff turnover rates
| |
Cafés |
Juicey |
Group |
| Average number of employees in 20X4 |
1,498 |
106 |
1,624 |
| Number of leavers |
146 |
15 |
161 |
| Staff turnover rate (%) |
9.7% |
14.2% |
9.9% |
Tutorial note.
We have used the average number of employees across 20X4 to calculate staff turnover rates, but ACCA’s marking guidance indicated that it was also acceptable to use year-end figures.
Average pay
The figures in Appendix 3 can also be used in conjunction with the staff from Appendix 1 to calculate the average wages Flint pays to its staff:
| |
Cafés |
Juicey |
Head Office |
Group |
| Average number of employees in 20X4 |
1,498 |
106 |
20 |
1,624 |
| Staff costs ($’000) |
15,921 |
1,525 |
3,899 |
21,345 |
| Average pay per employee |
10,628 |
14,387 |
194,950 |
13,143 |
These figures could again be compared to competitors to indicate whether Flint is offering its staff fair – or competitive – rates of pay. Benchmark information is not currently provided in the performance reports, although the fact that Flint’s staff costs as a proportion of revenue are slightly higher than the industry average (31.2% vs 30.9%) suggests Flint offers its employees a reasonably fair deal.
However, the overall Group figures appear to be distorted by the salaries paid to Flint’s head office staff, and the average wages earned by staff in the Cafés subsidiary are significantly lower than the group average of $13,143.
Conclusion
Tutorial note. ACCA’s marking guidance indicated that you did not need to provide a conclusion for your report in order to score the professional marks available, although you would have earned additional credit if you did so.
Flint’s current performance report has a number of weaknesses – in particular that it does not provide an indication of how well the group is performing against the three aspects of its current mission. The report focuses on Flint’s profitability rather than shareholder value, but moving to a VBM approach and introducing EVA™ as a performance measure could help to address this issue.
It would also be useful to produce separate reports for the main board and for the subsidiaries’ boards, due to the differing information requirements.
(Max 6 marks)
(Professional presentation 4 marks)
