Test of professional competence in management accounting [6th ed] 9781856177818, 1865843830, 1856177815

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CIMA Official Learning System

T4 — Test of Professional Competence in Management Accounting Nick Best Edited by Heather Barnwell

CIMA Publishing is an imprint of Elsevier Linacre House, Jordan Hill, Oxford OX2 8DP, UK 30 Corporate Drive, Suite 400, Burlington, MA 01803, USA First edition 2008 Copyright © 2009 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (⫹44) (0) 1865 843830; fax (⫹44) (0) 1865 853333; e-mail: [email protected]. Alternatively you can visit the Science and Technology Books website at www.elsevierdirect.com/rights for further information Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data A catalogue record for this book is available from the Library of Congress 978-1-85617-781-8 For information on all CIMA publications visit our website at www.elsevierdirect.com Typeset by Macmillan Publishing Solutions (www.macmillansolutions.com) Printed and bound in Italy 09

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Contents Guide to the Icons used within this Text The Full Syllabus − Professional Competence Level

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TOPCIMA and the Skills Needed to Pass

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Learning Outcomes 1.1 Introduction to the TOPCIMA exam 1.2 Aims of the TOPCIMA exam 1.3 The pre-seen material 1.4 The unseen material 1.5 The requirement 1.6 Lessons from the examiner’s Post Exam Guidance 1.7 So what do you need to do to pass TOPCIMA? 1.8 Two part TOPCIMA – practical experience 1.9 Changes to the TOPCIMA exam from 2010 1.10 Four TOPCIMA exams each year 1.11 How this Learning System will help you prepare

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Earning Marks in the Exam – The TOPCIMA Marking Criteria

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Learning Outcomes 2.1 The TOPCIMA assessment criteria 2.2 History of the marketing grid 2.3 Technical 2.4 Application 2.5 Diversity 2.6 Focus 2.7 Prioritisation 2.8 Judgement 2.8.1 Analyse the issues 2.8.2 Evaluation of alternative solutions 2.9 Integration 2.10 Logic 2.11 Ethics 2.11.1 Personal and professional ethics 2.11.2 Business ethics and corporate social responsibility 2.11.3 Corporate governance 2.12 Writing to the marking criteria

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The First 30 Minutes – Planning and Prioritisation

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3.1 3.2

Learning Outcomes The first 30 minutes! Prioritisation

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CONTENTS

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3.3

3.4

3.5 3.6 3.7

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Practicing your prioritisation 3.3.1 September/November 2006 – Kadgee clothing case pre-seen 3.3.2 SWOT analysis based on pre-seen 3.3.3 Prioritisation 3.3.4 My prioritisation matrix for the revised Kadgee unseen Prioritising your first full unseen 3.4.1 November 2006 unseen 3.4.2 The examiner’s prioritisation order Planning your solution Writing your prioritisation section Prioritising in the real exam

Time Management and Report Writing 4.1 4.2

4.3 4.4

4.5

4.6

4.7

4.8

Learning Outcomes Report writing Time management 4.2.1 Timetable for written exams 4.2.2 Timetable for PC-based exams Report format Calculation appendices 4.4.1 Exercise 4.4.2 Solution 4.4.3 A pragmatic view of the solutions Theory appendices 4.5.1 Exercise 4.5.2 Solution 4.5.3 Exercise 4.5.4 Solution Contents, Introduction and Terms of reference 4.6.1 Contents page 4.6.2 Introduction 4.6.3 Terms of reference Prioritisation section 4.7.1 Example prioritisation 4.7.2 Exercise 4.7.3 Analysing your answer 4.7.4 Solution Analysing the issues 4.8.1 Explanation of the issue 4.8.2 Analyse the issues 4.8.3 Examine the alternative solutions 4.8.4 Include an industry example 4.8.5 Example section 4.8.6 Exercise 4.8.7 Analysing your solution 4.8.8 Solution

39 39 40 40 42 43 44 49 50 52 53 55 57 57 58 59 59 60 61 61 63 63 63 64 65 65 66 66 67 68 68 69 69 70 70 71 71 71 72 72 73 75 75 76

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Practise Exam

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5.1 5.2 5.3 5.4 5.5 5.6 5.7

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Learning Outcomes The full mock The Merbatty pre-seen Set up for taking your first unseen November 2007 unseen Reviewing your answer Solution Post Exam Guidance report for November 2007 unseen

How to Analyse the Pre-seen Material and Research the Industry Setting 6.1 Introduction 6.2 Why you need to conduct industry research 6.3 How to conduct industry research and sources of information 6.3.1 Personal networks 6.3.2 Visiting similar firms 6.3.3 Trade media and news media 6.3.4 Using the Internet 6.3.5 Professionally produced industry analysis 6.3.6 What should you produce? 6.4 Analysing the pre-seen material 6.5 Making effective notes on the pre-seen material 6.5.1 Speed read the pre-seen material 6.5.2 Page summaries 6.5.3 Spider diagrams 6.5.4 Timelines 6.5.5 Organisation charts 6.5.6 Biodata files 6.5.7 Post-it-notes 6.5.8 Colours

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141 143 143 144 144 144 145 146 147 147 148 148 149 149 150 151 152 153 155 155

CONTENTS

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4.9 Ethics 4.9.1 Analysing the ethical issues 4.9.2 Recommendations 4.9.3 Exercise 4.9.4 Solution 4.10 Recommendations and conclusion 4.10.1 Aims for the ethics section 4.10.2 Example 4.10.3 Exercise 4.10.4 Analysing your solution 4.10.5 Conclusion 4.11 Formatting your report 4.12 I can’t do it in the time!

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CONTENTS

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6.5.9 Cut and paste analysis 6.5.10 Pictures 6.6 Detailed analysis of the pre-seen material 6.6.1 Merbatty, September/November pre-seen information in full 6.6.2 Précis of main points of each page 6.6.3 Four elements of strategy 6.6.4 Financial analysis 6.6.5 Business portfolio 6.6.6 Industry analysis 6.6.7 Conducting a corporate appraisal or SWOT analysis 6.6.8 Critical success factors 6.6.9 Information systems strategy 6.6.10 Risk 6.6.11 Business valuations 6.6.12 Strategic options

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Getting Ready for the Exam

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7.1 7.2

7.3 7.4 7.5 7.6 7.7

Learning Outcomes Introduction Use of past papers 7.2.1 Exercise 1 – Read through a number of the Post Exam Guides 7.2.2 Exercise 2 – Undertake a range of prioritisation exercises on past exams Mock exams on your unseen Time management Writing to the assessment criteria Preparation checklist Create a plan and work hard

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Appendix A: Technical Knowledge Appendix B: May 2008 – Solberri Appendix C: Practise Exam Review Checklist

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Exam Q & As

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Index

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Guide to the Icons used within this Text

Key term definition Equation to learn Exam tip to topic likely to appear in the exam Exercise Question Solution Comment or Note

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The Full Syllabus – Professional Competence Level

T4 – TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING Overview The Test of Professional Competence in Management Accounting comprises two component parts that must both be achieved in order to complete the test. Credits are used to measure success, rather than marks. To pass the Test of Professional Competence in Management Accounting, students must achieve an aggregated minimum of 75 credits – comprising a minimum of 50 credits for Part A (maximum 50 credits) and a minimum of 25 credits for Part B (maximum of 50 credits). Students are advised to undertake Part A and Part B concurrently, although either can be taken in any order once all Strategic level examinations have been completed. The overall result for the Test of Professional Competence in Management Accounting can only be given when both component parts have been completed.

T4 Part A Initial Professional Development – Work-Based Practical Experience Overview Students must gain a minimum of 3 years’ relevant work-based practical experience. Experience may be drawn from any of the following three areas, but a minimum of 18 months must be gained within the ‘Core’ area.

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Area 2 – Core Experience

Area 3 – Supplementary Experience

1a Preparing and maintaining accounting records

2a Preparation of management accounts

3a Financial strategy

1b Statutory and regulatory reporting

2b Planning, budgeting and forecasting

3b Corporate finance

1c IT desktop skills

2c Management reporting for decision-making

3c Treasury management

1d Systems and procedure development

2d Product and service costing

3d Taxation

2e Information management

3e Business evaluation and appraisal

2f Project appraisal

3f Business strategy

2g Project management

3g External relationships

2h Working capital control 2i Risk management and business assurance Note: Some or all of the required experience may have been gained before registering as a CIMA student.

Practical experience must be recorded by students within a Career Profile and submitted to CIMA for assessment. An approved Career Profile is awarded 50 credits – the amount needed to meet the requirements for Part A of the Test of Professional Competence in Management Accounting. Full details of the practical experience requirements and how to complete the CIMA Career Profile can be found on the CIMA website and within a separate publication entitled ‘Practical Experience Requirements’. Employers and their students are advised to refer to these documents.

T4 Part B Case Study Examination (maximum 50 credits) Overview The examination is based upon a case study that is set within a simulated business context relating to one or more fictionalised organisations. However, the context described in the case material is based on a real business or industry. The examination comprises a 3-hour assessment of competence, completed within a supervised examination environment. It provides an integrated test of syllabus content that is mainly included within the three Strategic level papers – E3, P3 and F3. However, it will also draw upon content covered within the Management and Operational level papers. The Case Study examination therefore has no specific syllabus content of its own. The Case Study examination primarily involves the application of strategic management accounting techniques to analyse, recommend and support decisions. Students will be required to deal with material in a less structured situation than those encountered in

THE FULL SYLLABUS – PROFESSIONAL COMPETENCE LEVEL

Area 1 – Basic Experience

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THE FULL SYLLABUS – PROFESSIONAL COMPETENCE LEVEL

previous Strategic level papers, and to integrate a variety of skills to arrive at a recommended solution. It is unlikely that there will be a single right answer to such a complex business problem, and students will be expected to recognise the possible alternatives in dealing with a problem. The emphasis will be on assessing the student’s capabilities and competence in the application of appropriate, relevant knowledge, the ability to demonstrate the higher level skills of synthesis, analysis and evaluation, and skill in effectively presenting and communicating information to users.

Assessment aims The purpose of the Case Study examination is to test the capabilities and competence of students, to ensure that they: ● ● ●

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have a sound technical knowledge of the specific subjects within the curriculum; can apply technical knowledge in an analytical and practical manner; can extract, from various subjects, the knowledge required to solve many-sided or complex problems; can solve a particular problem by distinguishing the relevant information from the irrelevant, in a given body of data; can, in multi-problem situations, identify the problems and prioritise them in the order in which they need to be addressed; appreciate that there can be alternative solutions and understand the role of judgement in dealing with them; can integrate diverse areas of knowledge and skills; can communicate effectively with users, including formulating realistic recommendations in a concise and logical fashion; can identify, advise on and/or resolve ethical dilemmas.

Assessment strategy There will be a written examination paper of 3 hours, plus 20 minutes of pre-examination question paper reading time. This paper will have a limited number of questions (requirements). They will normally be answered using a report and/or presentation, with further supporting documents, to a variety of users. The questions will be based upon: (a) a case study (pre-seen material), which will be published on the CIMA website at least 6 weeks in advance of the examination. This will provide an opportunity, before the examination, to undertake preparatory analysis based upon the pre-seen material. The volume of pre-seen material is likely to be between 15 10 and 20 sides of A4 paper; (b) further information regarding the case (unseen material), which will be added as part of the examination paper. This will allow further developments to be explained and additional issues to be raised. The volume of unseen material is likely to be between 3 and 6 sides of A4 paper; Questions will test the student’s capabilities and competence in the application of appropriate knowledge, and the processes undertaken in dealing with the problems identified in the examination, together with the ability to present and communicate information in a variety of formats. A ‘Case Study Assessment Matrix’ will be published on the CIMA website,

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with the pre-seen case material. The matrix will identify the assessment criteria and scoring system to be used when assessing the capabilities and competence of candidates.

THE FULL SYLLABUS – PROFESSIONAL COMPETENCE LEVEL

To successfully pass Part B of the Test of Professional Competence in Management Accounting – Case Study examination, students must score a minimum of 25 credits (out of a possible maximum of 50 credits).

Learning outcomes Students will be required to go through the following stages to prepare for, and to answer, the requirements of the Case Study examination: A – Preparatory to the exam: ● ● ●

analyse the context within which the case is set; analyse the current position of the organisation; identify and analyse the issues facing the organisation.

Note: These activities will be undertaken using the published pre-seen case study material. B – During the exam: ● ● ● ● ●

analyse the current position of the organisation; identify, analyse and prioritise the issues facing the organisation; identify, evaluate and discuss possible feasible options/courses of action available; recommend a course of action; prepare and present information in a format and to a standard suitable for presentation to senior management.

Note: These activities will be undertaken using the pre-seen and unseen case study materials.

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1 TOPCIMA and the Skills Needed to Pass

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TOPCIMA and the Skills Needed to Pass

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LEARNING OUTCOMES By the end of this introductory chapter you should 䉴

understand the aims of the TOPCIMA exam;

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understand the nature of the exam, and how it differs from all other CIMA exams;

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be clear about the nature of the pre-seen and unseen material in the exam;

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understand the keys to passing TOPCIMA, and problems often faced by students in this exam;

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understand how this Learning System can improve your skills and prepare you for your TOPCIMA exam.

1.1

Introduction to the TOPCIMA exam

The TOPCIMA exam is different from all the earlier CIMA exams. Unlike previous papers there is no new theory to learn. Instead, you are expected to draw on the knowledge you have gained throughout your CIMA studies, particularly the three strategic papers, and apply this to a specific company. ‘Pre-seen’ information about this company is made available on the CIMA website in advance of the exam day, which enables you to analyse its strategic position and undertake industry analysis, so you have a good understanding of the issues it faces. On the day of the exam you are given a single requirement, and about 4–5 pages of new ‘unseen’ information, about which, you are expected to prepare your answer. As well as the format of the exam being completely different, TOPCIMA is marked in a totally different way too. You’re probably familiar with the old rules of mark allocation where you earned one mark for each good point raised, or for each calculation done correctly. TOPCIMA is different. It is marked using a marking grid of nine assessment criteria, such as Judgement, Integration and Focus. Your answer needs to be sensible and commercially realistic, draw upon your knowledge of real-life experience and industry 3

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TOPCIMA AND THE SKILLS NEEDED TO PASS

analysis, and, needs to be written to gain a breadth of marks across all the nine assessment criteria. Since the exam is totally different, your preparation needs to be totally different too. No longer can you learn theory, practise past questions and expect to pass on exam day. For subjects up to TOPCIMA, many students arrive in the exam without ever having practised a full mock exam to time. You will be extremely unlikely to pass if you attempt to do that this time. In fact, the majority of your preparation time should be spent taking full mock exams to time. It is only through doing this that you will gain feedback on how well your report scores against the marking grid criteria, how good your analysis is, and most crucially of all, you master your time management in the exam. This Learning System is designed to take you through the initial stages of your TOPCIMA exam preparation. In it, you will find a step-by-step guide through the TOPCIMA maze, including practical exercises and worked examples based on past TOPCIMA exams, which will enable you to confidently understand the expectations of the report you must prepare and the assessment matrix on which you will marked. You will also find 2 full past papers, with solutions and exam guides, which will enable to you to practise, and develop the skills you need to pass the exam. You will also be shown how to examine your specific pre-seen with the confidence that you are doing the right thing, and sets you up ready to practise unseens on that specific scenario. The key to passing TOPCIMA is good preparation. This learning system will enable you to develop your analysis and report writing skills, as well as showing you how to analyse your own ‘pre-seen’ scenario.

1.2

Aims of the TOPCIMA exam

The aim of the TOPCIMA exam is to test higher level skills of candidates as a final gateway to CIMA membership. The TOPCIMA exam can only be sat by candidates who have passed all three Strategic Level exams and is taken as a stand-alone exam. The TOPCIMA exam aims to test the candidate’s ability to: ●

apply strategic management accounting techniques and technical knowledge to the organisation given in the case material and to prepare appropriate strategic recommendations.

The TOPCIMA exam aims to test the capabilities and competence of candidates, to ensure that they: 1 have a sound technical knowledge of the specific subjects within the curriculum; 2 can apply technical knowledge in an analytical and practical manner; 3 can extract, from various subjects, the knowledge required to solve many-sided or complex problems; 4 can solve a particular problem by distinguishing the relevant information from the irrelevant, in a given body of data; 5 can, in multi-problem situations, identify the problems and rank them in the order in which they need to be addressed; 6 appreciate that there can be alternative solutions and understand the role of judgement in dealing with them;

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7 can integrate diverse areas of knowledge and skills; 8 can communicate effectively with users, by formulating realistic recommendations, in a concise and logical fashion; 9 can identify and advise on resolving ethical dilemmas.

TOPCIMA AND THE SKILLS NEEDED TO PASS

These aims can seem a bit formal and hard to really know what this means that you have to do in the exam to achieve them. In a more practical sense, the above aims require you to: ● ●

● ● ● ● ●

analyse and identify the current position of the organisation (position audit or SWOT); analyse and identify the relevant problems facing the organisation in the pre-seen material (including ethical issues); appraise possible feasible courses of action; evaluate and then choose specific proposals (using the unseen material on the exam day); identify and evaluate priorities related to the proposals; recommend a course of action, with reasoned arguments for each course of action; prepare and present information in a format suitable for presentation to senior management.

Preparing your answer in the exam hall is difficult, due to pressure of time and exam conditions, but the report should be presented in a logical fashion, covering all of the above requirements and should conclude with clear well-reasoned recommendations. The report should be able to be read by a senior manager who could act on each of the recommendations made. A jumbled, confused or repetitive report would not be well received by a senior manager in any organisation – or by the TOPCIMA examiner!

1.3

The pre-seen material

The pre-seen material, typically around 16 pages long in total (including appendices), sets the scene for the industry and gives details of a company operating within that industry. The pre-seen material usually provides organisational structures, with short biographies of key personnel, financial data (historical as well as future forecasts and plans) and also text discussing how the company is operating. This can include details of past and current successes and problems, as well as discussion of future plans. You have several weeks to thoroughly read and understand this pre-seen material and to research the industry in which it is set. You will need to undertake a full strategic analysis on this company, so that you fully understand where the company stands now, so that you can correctly assess alternative future strategies. Research can be undertaken in several ways, perhaps using the Internet, reviewing financial statements of real-life companies or reading the financial pages in newspapers to pick up current industry data and problems being experienced in the real world. Additionally, articles are published on the CIMA website and in student magazines. Commercially available pre-seen analysis is also available from a range of tuition providers and online companies. Whichever method you choose, it is vital that you understand both the industry and also the issues facing the company in the pre-seen material. It is also vital that you have learnt 20–30 real-life examples which you can use as examples to support arguments you make in your report. You are not allowed to take any pre-prepared notes into the exam hall, so you must learn anything you want to have available to use.

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TOPCIMA AND THE SKILLS NEEDED TO PASS

In Chapter 6, you will learn the techniques that you should use to analyse the pre-seen material.

1.4

The unseen material

In addition to the pre-seen information, on the day of the exam, you will also be given additional material relevant to the scenario. This is usually about a further 6 pages in length. The unseen material usually gives details of changes in the company since the preseen material, and alternative strategic options. These should be carefully considered and incorporated into your answer. The report you produce in the exam is expected to deal, almost exclusively, with the issues from the unseen analysis. You should use your knowledge and information from the pre-seen to add to your analysis of those unseen issues, but do not need to discuss issues which are not referred to in the unseen. Candidates who fail to incorporate data given in the unseen material into their answer, or do not discuss all of the new strategic options, but simply write out a pre-prepared answer, will not earn good marks, so do ensure that all new data given to you is analysed, discussed and that your recommendations incorporate all of the new relevant information One of the main reasons for candidates failing is lack of appreciation or use of several of the new facts given in the unseen material. As with other CIMA exams you are given 20 minutes of reading time, in which time you are only able to write on your exam script, along with 3 hours of writing/typing time to complete your report. Since each TOPCIMA exam has two exam sittings for each set of pre-seen material, there are two different sets of unseen material and two different requirements – one for the March (or September) sitting and the second for the May (or November) sitting. Each of these unseen’s are independent of each other, so that those sitting the later exam should not consider any of the earlier unseen issues in their answer.

1.5

The requirement

Unlike all of the other CIMA exams, the TOPCIMA exam includes a single 100-mark requirement. Over most recent exams the requirement has been of the following form: ‘Prepare a report that prioritises, analyses and evaluates the issues facing [the company’s name], and makes appropriate recommendations’. Although your requirement is likely to be of a similar form, it is vital that you do review it to check that it is as you expect it to be. In the September 2008 exam, for instance, a specific note was added to the requirement asking the student to address cultural change issues. Students who overlooked this part of the requirement would have been unlikely to pass. Examining this requirement in more depth, you need to: (1) Prioritise the issues This means that you must consider the issues presented in the unseen and present them in order of importance to the company and its stakeholders. Typically you will be looking to prioritise issues based on the impact, they have on the company, the likelihood of the events happening and the urgency of those issues. In Chapter 2, you will learn a specific method of prioritisation.

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In your report, you should include a section showing the priorities of your issues, along with your justification of those priorities. As a general guide it is the top 5 issues which will form the basis for both this and later sections of your report. (2) Analyse the issues The official CIMA definition of analyse is to ‘Examine in detail the structure of ’. To achieve this aim, for each of the key issues you should: ● outline the key stakeholders who will be affected and what the impact for them is or could be; ● examine the financial implications of the issue, including financial or numerical analysis of the numbers presented to you; ● relate the issue to the company’s current market position and strategy. A common error is to focus too narrowly in the analysis, considering just the financial implications or the impact on one key stakeholder. Breadth, as well as depth of analysis is important here. In your report, you should include an analysis section showing your analysis of this situation. (3) Evaluate the issues The official CIMA definition of evaluate is to ‘Appraise or assess the value of ’. In this exam you are expected to examine a range of possible solutions to issues. For some issues the examining team will outline the key solutions that the company are considering. For others, you will be expected to generate issues of your own. In both cases you will need to evaluate each alternative, as a way to work towards the solution you will recommend later in your report. Evaluation of possible solutions, should include financial evaluation, where you are given financial information, often done in appendices, or can be carried out by doing an analysis of Advantages and Disadvantages or through use of a formal model such as the Johnston and Scholes, Suitability, Acceptability, Feasibility model that you learnt in the E3 Enterprise Strategy paper.

TOPCIMA AND THE SKILLS NEEDED TO PASS

It is vital that financial analysis is undertaken on any issue where financial information is presented to you in the unseen. Remember that you are studying for an accountancy qualification, and so preparing financial analysis is a core skill you must demonstrate to have.

(4) Make appropriate recommendations On many occasions, the examining team have stated that the most important part of your answer is the recommendations. If you have undertaken a good quality analysis and evaluation, then this should be easy, since these recommendations should follow on naturally from that evaluation. You must make clear recommendations on what actions should be taken along with the justification of why you have selected this course of action. A timescale of when actions should take place, who should do them and how they should be undertaken will also earn higher marks. (5) Prepare a report All of the elements of the requirement must be brought together in a stand-alone report which reads well, covers all of the key issues, makes well-reasoned and justified

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STUDY MATERIAL T4

recommendations and is supported by appropriate calculations. It should be the sort of report a non-financial manager or director could clearly understand and act upon. In summary, the suggested report format, which is not compulsory, but is recommended by the examination team, is summarised below: ● Contents page ● Introduction – A brief background on the company of around 8–10 lines. ● Terms of reference – A brief 5–10 lines to set the scene of who you are – e.g. a management accountant or consultant, and to state who the report was commissioned by, and who it is aimed at. ● Prioritisation section – Identify and prioritise the main issues facing the company, showing the top five issues in priority order together with justification for the ranking of these issues. ● Issues analysis – This is the main body of your report and should be divided up into sections which should include an analysis of each of the issues that you have prioritised. – For each issue facing the company, you should discuss the impact this issue has on the company and its stakeholders and discuss a range of strategic alternatives to overcome these issues. – Your discussion of each issue should be supported by analyses, both theories, such as Porter’s five forces or supporting calculations showing an evaluation of the alternative solutions (which should be shown in appendices). ● Ethical issues – Ideally you should cover three ethical issues, explaining the issue and offering clear recommendations on how the issues should be handled. ● Recommendations – This is the most important part of the report and should pick up on each of the issues discussed earlier. – Each recommendation should be clear and well justified as to why you are recommending a particular course of action. – As a general rule, be bold and try to avoid recommending that more information needs to be collected before a recommendation can be made. ● Conclusion – A brief 5–8 lines for closing comments. ● Appendices – These should include some strategic models, such as a SWOT analysis, PEST analysis and Stakeholder Map, as well as detailed calculations. – The appendices must be referred to within your report. Note that an executive summary is NOT required. In Chapter 4, there is a more detailed analysis of this report format, along with an explanation of how you should prepare and structure your answer.

1.6

Lessons from the examiner’s Post Exam Guidance

At the end of each exam the examination team produce Post Exam Guidance (PEG). This provides an analysis of the exam, and guidance on what candidates did well and less well.

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Over a range of sittings, a range of common problems are highlighted in these PEGs, and by understanding these and ensuring that you do not repeat the same errors that many other students have in the past, you can improve your chances of passing the exam. With this in mind, here is a list of key problems often highlighted in these PEGs. Students have:

TOPCIMA AND THE SKILLS NEEDED TO PASS

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● ● ● ● ● ●

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not prepared a position audit (SWOT) or review and prioritisation of the issues facing the company; not related their answer based on the new material and the requirement set but have simply written out their pre-prepared answer; not prepared clear and well-reasoned recommendations; stated that they are unable to make recommendations without further material – you must make clear recommendations, even if you state that these are subject to satisfying the Board on whatever outstanding matters more information is wanted; not demonstrated use of technical knowledge or applied it to the company; not demonstrated industry knowledge in their answer; laid out the report poorly; not explained or commented upon their calculations; not provided and evaluated a range of solutions to each issue; not stated why they consider an issue to have an ethical side to it, and clearly explained what that ethical issue is; not made clear recommendations for each ethical issue presented; not finished the paper (most likely due to poor time management).

You will find example PEGs of the exams used in this learning system in later chapters. You should also consider reviewing other PEGs, available on the CIMA website, to improve your awareness of the common problems faced by students in the exam.

1.7

So what do you need to do to pass TOPCIMA?

Considering these common student problems, the aims of the paper set out in Section 1.2, the requirement, and range of information given to you both before and in the exam, what exactly do you have to do to achieve those aims, and pass TOPCIMA? Here is my summary: (1) Ensure you have sufficient technical knowledge You must have a good background awareness of the technical areas from throughout your studies. For most students, particularly those who have recently passed strategic level, little further work will be required by them to relearn technical theory. A good, broad knowledge of the main strategic level theories is usually enough. You will find a brief revision section on the main theories in Appendix A. (2) Understand the pre-seen material You must have analysed the pre-seen material in depth, so you are aware of the key issues facing the organisation. This will enable you to view the unseen issues in the context of a good understanding of the business, just as a managing director of a business is able to deal with new issues with a deep understanding of their own company. In Chapter 6, you will be shown how to undertake an industry analysis.

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STUDY MATERIAL T4

(3) Generate a good, broad business and industry understanding This exam requires good, practical, logical analysis and business recommendations. Your solution can be judged overall, by how good your advice to the company’s directors is. Good, solid practical advice will score high marks. Illogical and immature advice will mean you will be likely to fail. For many people, this general understanding will have come from a number of years spent dealing with real-life workplace issues at work, alongside their studies to this point. You can also bolster experience you have by examining current business issues in the media, and in particular through doing research into the real-life issues facing your pre-seen industry. (4) Be able to prioritise and analyse business issues presented in the unseen One of the keys to being able to prioritise issues is having a clear, systematic approach to your prioritisation. In Chapter 3, you will be shown a method to prioritise your unseen issues, which, with practise applying this to past exam unseens and mock unseens based on your pre-seen, should enable you to generate the skill needed to quickly and easily prioritise issues faced in your exam. Each issue will also need to be analysed in depth, and Chapter 4 will show you how to do this. (5) Gain a strong understanding of the marking grid and how to earn marks on that grid Marks are awarded based on the marking grid provided. Your solution should earn marks across each criteria on the marking grid. To do that you must understand how each element of the grid is marked, and write a report designed to earn marks on that grid. Chapter 4 will talk you through an approach to writing your report based on the marking grid. (6) Master your time management Most students I meet taking TOPCIMA would usually agree that TOPCIMA is even more time pressured than strategic level exams, and so good time management here is vital to success. The key to good time management is to have a pre-set plan of the time you will take on each section of the exam and your report, and diligently stick to that. You will find a suggested time plan in Chapter 4, which you will need to adjust to suit yourself and your own strengths and weaknesses. (7) Practise, practise, practise! Few students pass their first mock TOPCIMA exam. The time management is so difficult, the format is so different and marking approach so unique, that only with the feedback of a few failed/or marginally passed attempts, are they able to truly understand how to do well in this exam. It is therefore imperative that you sit a range of past exam paper questions and mocks based on your pre-seen scenario prior to taking the real exam. As a minimum, I would suggest five full papers, but know that many students I teach sit nearer to eight or nine by the time they sit their final paper. This is difficult to do for the March and September sittings since preparation time is limited and the exam tuition providers produce fewer mock exams to practise, but is certainly an appropriate goal for those sitting in June or November.

1.8

Two part TOPCIMA – practical experience

Our discussion to date, and the focus of this book, has been on the TOPCIMA exam. From 2010 the TOPCIMA exam became one of two parts (known as Part B) of TOPCIMA (The Test of Professional Competence in Management Accounting). Credits are used to measure

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Part A – Experience Overview Students must gain a minimum of three years’ relevant work-based practical experience. Experience may be drawn from any of the following three areas, but a minimum of 18 months must be gained within the ‘Core’ area. Area 1 – Basic Experience

Area 2 – Core Experience

Area 3 – Supplementary Experience

1a

Preparing and maintaining accounting records

2a

Preparation of management accounts

3a

Financial strategy

1b

Statutory and regulatory reporting

2b

Planning, budgeting and forecasting

3b

Corporate finance

1c

IT desktop skills

2c

Management reporting for decision-making

3c Treasury management

1d

Systems and procedure development

2d

Product and service costing

3d Taxation

2e Information management

3e Business evaluation and appraisal

2f

Project appraisal

3f

Business strategy

2g

Project management

3g

External relationships

2h Working capital control Note: Some or all of the required experience may have been gained before registering as a CIMA.

Practical experience must be recorded by students within a Career Profile and submitted to CIMA for assessment. An approved Career Profile is awarded 50 credits – the amount needed to meet the requirements for Part A of the Test of Professional Competence in Management Accounting. Full details of the practical experience requirements and how to complete the CIMA Career Profile can be found on the CIMA website and within a separate publication entitled ‘Practical Experience Requirements’.

1.9

Changes to the TOPCIMA exam from 2010

While the exam format is likely to remain largely the same as prior exams, most exams up until 2010 have asked students to take on the role of an external consultant. However, indications are that for exams from 2010, that there will be a shift towards you being asked to take the role of an employee of the business. This is more representative of the role most management accountants take in real life. The content of any report produced is likely to be very similar, although it may be that it is less formal in nature, and you may be asked to prepare a memo, for instance, instead of a report. This change will also require writing from the perspective of an employee, who is less independent, and perhaps more considerate

TOPCIMA AND THE SKILLS NEEDED TO PASS

success, rather than marks. Part A of the exam consists of work-based practical experience. To pass the Test of Professional Competence in Management Accounting, students must achieve an aggregated minimum of 75 credits – comprising a minimum of 50 credits for Part A (maximum 50 credits) and a minimum of 25 credits for Part B (maximum of 50 credits).

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STUDY MATERIAL T4

of their position in the hierarchy, the perspective of their role (e.g. a management account is likely to provide a financial perspective on the issue) and internal politics (they are less likely to be critical than an independent consultant). It is important that as new exams are produced during 2010, that you review them, and adapt your approach accordingly. While current expectations are that few major changes will be seen, the proof will be in the actual exams themselves.

1.10

Four TOPCIMA exams each year

There are four TOPCIMA exams each year, in March, June, September and November. These exams are based on two different sets of pre-seen materials, with the March and June sittings, based on one scenario, and September and November being based on another. The March and September exams are computer-based exams, and can only be sat by candidates using CIMA’s learning partners, who provide the computer facilities for these exams. For these exams, candidates complete their answer on a PC using ‘Word’ and ‘Excel’, to write their report and prepare supporting calculations. In all other respects the exam is the same as a ‘normal’ paper-based exam. The June and November exams can be sat in one of two ways. Some learning partners enable these also to be sat using a PC on their premises. Alternatively you can also take a standard written-based exam at an exam hall much in the same way as you have sat your professional and strategic level papers.

1.11 How this Learning System will help you prepare As you work through this CIMA Learning System you will be taken through the steps required to pass this exam. Chapter 2 will examine the marking criteria, so you can understand how the exam is marked, and you will be guided through a range of exercises to gain a solid understanding of this. Chapter 3 shows you how to plan and prioritise in the exam, while Chapter 4, covers the report format required, and how to generate marks in your report, against the marking grid criteria. In Chapter 5, you will get the chance to undertake your first full mock paper, and be given a systematic method to analyse your own performance, so you can learn and improve on subsequent sittings. In Chapter 6, you will be shown how to deal with the pre-seen material, and be guided through an analysis of a past pre-seen to demonstrate what you should be looking to do for your pre-seen. This will leave you in the position ready to take mock unseens on your own pre-seen paper, and subsequently take the real exam. Details of exam dates and availability of pre-seen material is available using the CIMA website (www.cimaglobal.com).

2 Earning Marks in the Exam – The TOPCIMA Marking Criteria

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2

Earning Marks in the Exam – The TOPCIMA Marking Criteria LEARNING OUTCOMES By the end of this chapter you should 䉴

understand the criteria on which the TOPCIMA exam is marked;

䉴

be clear about what you need to do in the exam to earn marks against each of the 9 assessment criteria.

2.1

The TOPCIMA assessment criteria

TOPCIMA is marked in very different way from other CIMA exams. In TOPCIMA, scripts are assessed against nine different criteria. This means that to pass the TOPCIMA exam, you need to produce a script which is good in a range of ways. It is vital, then, that you understand what the assessment criteria are, and that you write your script in a way which will earn marks against each of these criteria. In this chapter, I examine each criteria in depth, examining the marks typically available in each, and how you score marks against those criteria. In Chapter 4, you will learn a report format that, if followed, will help you to produce a balanced answer, which should score highly right across the marking grid. Marks are awarded for fulfilling each of three stages of dealing with the exam, analysing the issues, strategic choice and making recommendations. Within these three headings, marks are awarded using the nine criteria as shown below. The typical mark allocation is shown, although this can change on an exam-by-exam basis, so it is important that you check to ensure that it has not changed for your exam. Analysis of Issues

Typical Marks

Technical

Use relevant theoretical techniques and frameworks and perform relevant calculations to help to analyse the case material and support arguments made.

5

Application

Use the techniques, frameworks and calculations you have produced to support your analysis of the issues and your choices of actions.

15

Diversity

Display knowledge of relevant real-life situations within the same or a similar context as that

5 (Continued)

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16

STUDY MATERIAL T4

Analysis of Issues

Typical Marks in which the case is set. Additionally, display knowledge of real-life commercial or organisational issues relevant to the situation in the case. These may occur in the industry or organisational setting in which the case is set or in different industries or settings. 25

Strategic Choices Focus

Select the issues you feel to be the most important and make sure that you properly address these issues in the report you produce.

5

Prioritisation

Rank the key issues, stating clearly and concisely 10 your rationale to justify your ranking. Issues should be given high priority primarily because of their impact on the organisation in the case. Their urgency may also be a factor. Also, state the issues that you feel deserve a lower priority ranking and give your reasons.

Judgement

Exercise commercial and professional judgement to discuss the key issues. Discuss the impact of the priority issues have on the organisation. Discuss alternative courses of action, with reasons, that the organisation could take to resolve these issues. Your analysis should include relevant supporting financial analysis.

Ethics

Using your judgement, highlight and analyse 5 the ethical issues in the case and state why you consider these issues to have ethical implications. Discuss alternative courses of action that the organisation could take to resolve the issues.

20

40 Recommendations Logic

Make clear, well-justified recommendations for each of the prioritised issues and ensure the reasoning for the recommended courses of action is clearly stated. The recommendations should follow on logically from the weight of the arguments and choices of actions given earlier in the report.

20

Ethics

Make clear, well-justified recommendations for each of the ethical issues and ensure the reasoning for the recommended courses of action is clearly stated. The recommendations should follow on logically from the weight of the arguments you make in your report.

5

Integration

Produce a well-structured report in an appropriate format and linguistic style. (3) These marks are awarded holistically according to the overall quality and functionality of your report. (7)

10

35 100

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

2.2

History of the marking grid

The International Federation of Accountants (IFAC) has an International Education Statement (IES) called IES 6 on the ‘Assessment of Professional Capabilities and Competence’, which became effective in January 2005. It is the responsibility of IFAC member bodies (of which CIMA is one of the many member bodies) to have in place assessment procedures that ensure that candidates admitted to membership are appropriately qualified. In IES 6, IFAC have set out that candidates need to be able to demonstrate that they have the necessary skills under nine headings. Since 2005, these nine headings have formed the basis for TOPCIMA assessment. Until September 2008, these headings were presented in the form of a marking matrix, which aimed to set out what capability was required to score a range of marks under each criteria. As the marking scheme evolved, the matrix criteria were applied less and less, and so from September 2008, the matrix was abandoned, although the criteria and total marks under each heading have remained largely the same. As you look back through past exam papers, you may therefore see the criteria presented in a matrix format. That format can now be ignored.

2.3

Technical Use relevant theoretical techniques and frameworks and perform relevant calculations to help you to analyse the case material and support your arguments.

The technical section usually accounts for 5 marks and rewards students for demonstrating their technical knowledge from all subjects throughout the CIMA curriculum. Any theory from across any paper can be relevant for the technical section, although in practise, most students tend to focus on those used at the strategic level. Typical theories used are: ● ●

SWOT analysis PEST analysis

EARNING MARKS IN THE EXAM – THE TOPCIMA MARKING CRITERIA

Although the ‘Ethics’ criterion is shown under both the ‘Strategic Choices’ and ‘Recommendations’ section, it is not necessary for your discussion of ethical issues to be split in this way within your report. If you choose to do so, it is quite acceptable for the ethical issues contained in the case to be discussed within a single section of your report, and this is the approach taken by most students, and what I would recommend. You should take into account, when you discuss ethical issues. The weightings of marks available by each of the nine assessment criteria can change between cases and you should ensure that you are familiar with the availability of marks for the exam that you are planning to take. As in any CIMA exam, you need to achieve a minimum of 50 marks in order to pass the TOPCIMA exam. This will earn you the 25 ‘credits’ you need to achieve to pass Part B of TOPCIMA. As with other exams, there are a number of ways to achieve 50 marks. It is not necessary to pass every criterion, so a poor mark in one may be offset by a good mark on another. However, you should aim to produce a balanced script which passes each criterion.

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18

STUDY MATERIAL T4 ●

● ● ● ● ● ● ● ● ● ● ● ● ● ●

The use of the Johnson and Scholes’ suitability, acceptability and feasibility framework model to evaluate possible strategic options Porter’s Generic Strategies Porter’s five forces Ansoff ’s Product/Market matrix Porter’s value chain Mendelow’s stakeholder analysis BCG matrix and life cycle analysis Motivational theories put forward by Herzberg and Maslow Risk assessment/profiling Net Present Value analysis Business valuations Ratio analysis Lewin’s forcefield analysis Lewin’s Unfreeze, Move, Refreeze model McFarlan’s strategic grid/Earl’s Grid (information systems)

Use of each of these theories earns one mark per theory, meaning that you should aim to use 5 throughout your exam in order to earn the 5 marks available in this category. The most common approach to gaining these technical marks is to demonstrate their use in the appendices, doing one appendix for each model used. You must then cross-reference these models in the main body of your report, to demonstrate that you have indeed used them. Not referring to models in appendices is a very common mistake that students make. The point of the use of theories is to support arguments made elsewhere in your answer, not to stand alone at the end as appendices. You can also gain theory marks by discussing theories as part of your main discussion. To gain a mark you must do more than simply mention a theory or theorist’s name, you must briefly explain that theory and how it is applicable to the issue you are considering. In the exam you have to decide which theories are most appropriate for your answer. Some of the theories are more commonly used than others, while other theories are useful in certain circumstances. In the section below, you will find my overview of the importance and use of each of the main theories for TOPCIMA. SWOT analysis The SWOT analysis gives a simple overview of the company’s current position, and as such it is a very useful tool to use in TOPCIMA. In fact it is safe to say that you MUST do a SWOT analysis in your exam, since the examiner has specifically stated this in the past. Most people do this as their first appendix. PEST analysis The PEST analysis outlines the broad industry environment the organisation is operating within. This is very commonly used in TOPCIMA, since it is applicable to most companies at most times, and elements of the PEST analysis can be referred to as you discuss issues in the main body of your report. It is also particularly relevant when applied to an overseas expansion strategy, to analyse the PEST issues related to the new market. Johnston and Scholes – suitability, acceptability, feasibility This model is used to evaluate strategic options. Since this is one of the key features of the requirement, it is a model you can, and should, always use in the exam. It should be used

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Porter’s Generic Strategies Michael Porter’s Generic strategies, suggests that all companies should either be a cost leader or differentiate their product if they are to succeed. In addition, they should either focus on a broad market (selling to the mass market) or focus on a specific market segment. Many past cases have offered opportunities to use this model, since it is often clear from the pre-seen information, the basis on which the company competes. You can refer to this model as you discuss strategic options as justification of whether a specific strategic option supports or contradicts the company’s generic strategy. In the November 2007 Merbatty scenario, in which the company differentiated based on quality, you could, for example, have used generic strategies as justification for any option which would further enhance the quality of their offering, increase staff training for instance. You might also include an appendix showing the company’s competitive position alongside competitors mentioned in the case or real-life companies. Ansoff ’s product/market matrix Ansoff ’s matrix is a useful way to generate strategic options. It is always easy to put an Ansoff ’s matrix in the appendix of the report where different strategic options from the unseen or pre-seen are shown in the matrix, and can be relevant to demonstrate the range of options available to the business. Many students who use this model often simply refer to the appendix without making reference to the relevance of the model though, so if you do use it, make sure you say why it is relevant. Porter’s five forces Porter’s five forces enables the analysis of the industry the company operates in, using the following five forces: threat of new entrants, buyer power, supplier power, threats of substitutes and threats of competitors. Most students do not include a five forces analysis in their report, although, in fact, it can effectively be used in a many situations. Examples might include: ● ● ●

Supplier issues (particularly where a supplier has high power, due to patents for instance) Customer issues (particularly where there are a small number of large, powerful customers) New companies are entering the market (where a discussion of the barriers to entry might be appropriate)

You should undertake a five forces analysis as part of your pre-seen analysis, and watch out for changes in the force caused by unseen issues. Porter’s Value chain This business strategy model is commonly used for examining the value added through a range of business activities such as inbound logistics, operations and outbound logistics. This model is very rarely used in TOPCIMA, and can usually be avoided, unless there some specific indication that a review value added is required. Mendelow’s stakeholder analysis This is an extremely useful model to help analyse the power and interest of stakeholders, and what this means for the way the company deals with the stakeholder. It is very common for students to use this in the TOPCIMA exam, since there are always a range of important

EARNING MARKS IN THE EXAM – THE TOPCIMA MARKING CRITERIA

in the main body of your report, as three headings which you use to consider a strategic option the organisation are considering undertaking.

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STUDY MATERIAL T4

stakeholders, and each individual issue usually affects one of these stakeholders in some significant way. In the exam, look out for these changes in power or interest which may result from an issue as an opportunity to use this framework, or use it to justify your recommended course of action by commenting on the importance of the stakeholder affected. BCG matrix and life cycle analysis These two models enable product analysis. While they are perfectly acceptable to use, it has been rare in recent pre-seen analysis to have companies with many different products or specific product life cycle issues. These are ones to consider on a case-by-case basis. Motivational theories put forward by Herzberg and Maslow These motivational theories can commonly be used in a TOPCIMA exam, simply because it is so common to have to consider staff motivational impacts of decisions made. Having said that, in my experience, few students do use these models, perhaps because they were learnt much earlier in people’s studies than some of the others. These theories are not good ones to use in an appendix, but are better as part of the main discussion. Look out for staff/director motivation/satisfaction issues and where you see them, include a paragraph explaining how the issue relates to these models. Risk assessment/profiling This risk assessment model, rarely has good application in the exam, and in my experience is one to avoid unless specifically requested. Net Present Value (NPV) analysis NPV calculations are common in the exam, and are definitely something which should be revised and practised. Look out for statements about, or even a table, of future cashflows, as a clue that an NPV is necessary. Another good indicator that an NPV is required is the inclusion of a cost of capital figure in the unseen information. It is unlikely that you will be required to calculate a cost of capital theory using your financial strategy knowledge. Ratio analysis Ratio analysis (e.g. liquidity ratios such as the current ratio), can be a useful way to analyse the businesses current position. It is very rare for you to be specifically asked to do ratio analysis in the exam, but you can include some in an appendix as part of your business evaluation. Occasionally this can be useful, particularly where the business has cashflow or gearing issues, but as a general rule, few students do ratio analysis and it is probably not something to prioritise unless you have a specific reason to do so. Business valuations This is another common examination area. You should revise, and be able to undertake the following valuation approaches: ● ● ● ●

Discounting future cashflows P/E ratio based valuations Net asset values Share price valuations

In the scenario, look out for details of a take-over bid, or shareholders looking to sell the business, or, alternatively where the business are looking to buy another business, as an

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Lewin’s Forcefield analysis, and Unfreeze, Move, Refreeze model These models of change management are appropriate for any issue involving cultural change. These were particularly appropriate for the September 2008 exam where commenting on cultural change was included as a specific requirement, but by and large are not commonly used models in the exam. McFarlan’s strategic grid/Earl’s Grid (information systems) These information system models could always be used where the organisation has significant IT issues, but in practise students do not tend to do so, and there are probably other models which ought to be prioritised. An overview of the main theories can be found in Appendix A, which should be used as a reference source for information on the theories.

2.4

Application Use the techniques, frameworks and calculations you have produced to support your analysis of the issues and your choices of actions.

This area of the assessment matrix rewards the application of technical knowledge to the information in the case. In the technical section you are marked on your knowledge of a technical theory, while in this section you earn marks for applying that theory to the circumstances of each particular case and whether the calculations and theories are relevant to that case. Some of the marks are available for correctly applied numerical skills. For example, if the data given in the case suggested that NPV calculations are relevant, marks will be awarded for correctly applying discounting techniques to the numbers given in the unseen material. Marks are only awarded for the use of technical knowledge where they are ‘relevant’ to the specific material in the case. Similarly for calculations, they must be relevant to the case material and not calculations prepared on pre-seen material. An example of how marks were awarded in Application, using the November 2006 Kadgee clothing case, is as follows: ● ● ●

SWOT analysis PEST analysis for the proposed move of some manufacturing to China Applying any other relevant technique to the case material

Plus a range of any of the following calculations: ● ●

● ●

Preparation of financing statement for the sale of land Calculation of alternative financing methods, such as a new loan or funds that could be raised by debt factoring An NPV calculation Calculation of the revenues required for an IT proposal to break even

EARNING MARKS IN THE EXAM – THE TOPCIMA MARKING CRITERIA

indication that a valuation is needed. You can find specific examples of valuations in the May 2006 Zubino coffee shops case and the November 2007 Merbatty boat case.

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STUDY MATERIAL T4 ●

●

Any relevant calculations of what Kadgee could be valued at for either a trade sale or if it chose to go into voluntary liquidation Relevant ratios for Kadgee on working capital management and inventory turnover

As a general guide, about 8 marks are available in this section for calculations, while the remaining 7 are for application of models. There are usually 3 marks available for application of your SWOT analysis, and roughly a mark for appropriate application of other theories. You should therefore spend longer on your SWOT than other theories, and must also make sure you go into enough depth on points made in your SWOT. As a general guide to the mark allocation for your SWOT in the application section you might consider the following: 1 mark – Brief SWOT, updated for some unseen issues. A 1 mark SWOT would include points in the following format: ● Strong asset base 2 marks – Some analysis of points in SWOT, with all key unseen issues updated. 3 marks – Detailed analysis of points in SWOT, clearly indicating the relevance to the company, including updates for all key unseen issues. A 3 marks SWOT would discuss points like this: ● Strong asset base which will provide security for raising future finance, necessary for new expansion plans. It is common in solutions to mock exams done by the main tuition providers to see SWOT points in the 1 mark rather than 3 marks category, so don’t see this and be fooled into thinking that this is sufficient for all the full marks available. On the other hand, you also have to be practical, and to do a very detailed SWOT does take time, which is in very short supply, and a quickly updated 1–2 mark SWOT may be a better use of your time. You need to decide which approach is best for you. In terms of your preparation for the exam, you must learn a SWOT analysis of the preseen before you enter the exam, and you should have practised writing this out many times, so you can do it very quickly. This will enable you to gain time to spend elsewhere in your answer. You should also make sure you do update it for unseen issues, particularly in the opportunities and threats section, which is often made up primarily of unseen issues.

2.5

Diversity

Display knowledge of relevant real-life situations within the same or a similar context as that in which the case is set. Additionally, display knowledge of reallife commercial or organisational issues relevant to the situation in the case. These may occur in the industry or organisational setting in which the case is set or in different industries or settings. The TOPCIMA assessment grid rewards students for their ability to give real-life business examples which are relevant to the case. This may be companies who operate in the industry setting of that case or real-life companies in different industries who have faced similar problems. Marks will also be awarded for an understanding of the business environment in which the company is set. Therefore, a good general business awareness is useful in addition

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Typical student example In recent years, Tesco’s have expanded out of the UK into European and wider markets as a way to expand out of its current markets. Problem: Too brief, no detail, not related to company Better example Tesco expanded into Central Europe in 1994 when it bought a 51% stake in Global of Hungary. A year later it paid £8 m for Savia in Poland and in 1996 a further £77 m for 13 stores operated by K Mart of the US in the Czech Republic and Slovakia. These expansion plans have been very successful for Tesco, and demonstrate the success that supermarkets can have when expanding into new growing markets. This new opportunity for Asdabury’s to expand into the Indian market would appear to offer similar benefits. Why is this better? Full paragraph of information, detailed (including statistics), meaning for Asdabury’s made clear. In Chapter 6, you will find more detail on exactly what you should do in your industry analysis, and how you should go about doing it.

2.6

Focus Select the issues you feel to be the most important and make sure that you properly address these issues in the report you produce.

This criterion rewards students for their ability to solve a particular problem by distinguishing the relevant information from the irrelevant. It relates to a student’s ability to sift through all of the data given (in both the pre-seen and the unseen) and to select which data is relevant to the question asked in the requirement.

EARNING MARKS IN THE EXAM – THE TOPCIMA MARKING CRITERIA

to specifically researched industry knowledge. This will also help you make valid, commercial decisions elsewhere in your report. As a guide, 1 mark is scored for each good example given, so you should aim for a total of 5 throughout your report. In order to be able to use 5 appropriate examples you should aim to collate about 20–30 real-life examples as part of your industry research. Aim to get a range of examples which cover many different key issues that real-life companies are currently having, and which could be faced by the company in the pre-seen. Do remember only to use 5 in the exam though, many students waste time quoting a lot more, and time is not something you have a lot of! You can also include non-industry related real-life examples too. As an example, if the company is facing an issue with its Managing Director leaving, you could relate to the consequences of another MD or CEO leaving in any company, in any industry. The key is to show that you have some good, broad business awareness and that you are using this to support the advice you give to the company. A problem I often find in student scripts, in relation to industry examples, is that people simply add a real-life example into their script without giving enough detail or saying what this means to the business in question. As an example, let’s say the pre-seen is on the supermarket industry for a company named Asdabury’s.

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STUDY MATERIAL T4

This criterion is particularly important as there is a plethora of data given in the preseen and unseen material and it is important to be able to discuss the most important, key information as a priority for senior management. For example, your line manager will not want a report on a departmental budget covering all of the many assumptions made, but would require a report which highlighted the most important or most sensitive of the assumptions. Your answer should be able to demonstrate that you have correctly identified the key issues, made appropriate recommendations, and have sorted and dealt with the relevant data, out of the wealth of information presented to you. The main focus of your report should be the top five issues that you have prioritised as important to the company. For each key issue identified and discussed fully in your report, you should earn 1 mark. Past Post Exam Guidance reports have highlighted that it is common for people to score full marks in this section, and that’s exactly what you should be aiming for too – it is one of the easiest sections on which to score marks. The main reason for candidates loosing marks here is for not discussing all of the key issues or for not discussing them in depth.

2.7

Prioritisation

Rank the key issues, stating clearly and concisely your rationale to justify your ranking. Issues should be given high priority primarily because of their impact on the organisation in the case. Their urgency may also be a factor. Also, state the issues that you feel deserve a lower priority ranking and give your reasons. Each case study will give students a very wide range of small and large problems, and marks in this criterion are awarded based on a student’s ability to rank the problems in the order in which they need to be addressed. In order to earn the full 10 marks available, it is necessary to identify and place in priority order at least the top five issues facing the company in the question, taking account of the events given in the unseen material on the exam day. These should be fully justified and also the top priority, in the examiner’s view, should have appeared in the top three priorities given by the candidate. As an example, in the Merbatty case in November 2007, the company faced a hostile take-over bid, and, as an issue affecting virtually every stakeholder in a significant way, this issue should have appeared within the top two priorities in order to gain high marks in prioritisation. For those people who failed to do this, for instance placing it only as fifth priority, they would have been awarded fail marks in Prioritisation, although they could still have passed the overall TOPCIMA exam if the discussion and recommendations on this and other issues had been good. Not only is prioritisation vitally important to success in the exam, it is also a skill you have yet to develop in your studies to date. For this reason the whole of Chapter 3 has been devoted to the prioritisation and planning of issues. You will find there, a step-bystep methodology for prioritising your issues in the exam, to make the process both quick and logical, along with practise exercises to help you to develop this skill.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Judgement

Exercise commercial and professional judgement to discuss the key issues. Discuss the impact the priority issues have on the organisation. Discuss alternative courses of action, with reasons, that the organisation could take to resolve these issues. Your analysis should include relevant supporting financial analysis. Along with logic, this assessment criterion usually carries the most marks. This makes it very important, and indeed, this in criterion which assesses the main section of your report. It rewards students for: (1) analysing the issues (2) identifying and discussing the alternative actions that could be taken to address each issue. In terms of weighting of marks, typically the second element of these two is prioritised highest, and it so the majority of your writing should be addressing the alternative actions. There is no clear-cut answer to any case, although CIMA do publish the case writer’s suggested answer, so you are able to pass this criterion even if your answer differs from the case writer’s recommendations, as long as you analyse your issues and strategies appropriately and in detail. You need to be able to demonstrate that you can choose between alternative courses of action and that your decisions have been made after consideration of all of the appropriate factors. In the next sections, I’ll examine each of the two elements of the judgement criteria and assess exactly what you need to do to achieve each for each:

2.8.1

Analyse the issues

To achieve this aim, for each of the key issues you should consider the following: Key stakeholders Each issue will probably impact a number of stakeholders. It is important that you consider the key stakeholders affected and what their likely reactions and views of this issue will be. Key stakeholders to consider could be: (1) Large shareholders: Consider the impact on their future dividend streams and company value, while considering their significant voting power on issues which affect this. (2) Small shareholders: They will have concerns about future dividend streams and value, but will have less power, so while their views must be considered their views are less important than large shareholders. (3) Key suppliers: They are likely to want continued custom, and payment of balances owed. They may have power if they are a monopoly provider. The more alternative suppliers there are, the less relevant it is to consider their views in your analysis and recommendations. (4) Key customers: It is vital for most organisation’s success to keep customers happy by providing good service. Where there are a small number of key customers, who represent a large proportion of sales, their buyer power is high, and the impact of decision on them must always be considered.

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2.8

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(5) Employees: Their interests typically relate to job security, pay and working conditions. Their power tends to be limited unless there is group action in the form of a union – not an uncommon situation in past scenarios. (6) Directors: They have similar needs to the employees, but are also likely to be concerned with internal politics and power as part of their decisions. A loss of power caused by outsourcing significant elements of the business, might be an example. They also have much more power in the decision-making process, particularly the CEO/MD and Chairman, and it is common in the exam for you to have to take these particularly powerful individual’s views into consideration as part of your analysis. (7) Government: They are very powerful, but, most of the time, have little interest in the business. It is important that laws are abided by and tax paid on time. Your aim should be to consider one or two key stakeholders for each issue, although I suggest no more than a paragraph on this in total, simply to help you manage time overall. The financial implications of the issue Key financial considerations can include: (1) (2) (3) (4) (5)

The impact on profit Business valuations Cashflow and liquidity implications Investment appraisal results (e.g. NPV calculation results, payback period) How any cash required will be raised (e.g. debt, equity, including relationships with banks, shareholders and so on)

Impact on the company to the current position of the company It is also important to relate the issue to the company’s position. This may mean commenting on how this issue relates to the strengths and weaknesses identified in your SWOT analysis, or alternatively how it creates a new strength or weakness. You can also consider the impact on the company’s competitive position, relationships with suppliers, customers and employees, brand impact and any other marketing related issues, production issues and so on.

2.8.2 Evaluation of alternative solutions In this exam you are expected to examine a range of possible solutions to issues. For some issues, the unseen will contain possible solutions that the company are considering. For others, you will be expected to generate issues of your own. In both cases you will need to evaluate each alternative, as a way to work towards the solution you will recommend later in your report. Evaluation of possible solutions, can simply be carried out by doing an analysis of Advantages and Disadvantages or through use of a formal model such as the Johnston and Scholes, Suitability, Acceptability, Feasibility (SAF) model. Your aim should be to use the SAF model at least once in your answer, since this will gain you marks in the technical and application section as well as here in the judgement section. Although this is one of the key Business Strategy models I often find that it is only partially understood by people doing TOPCIMA. With this in mind use the following guide when you use SAF in the exam.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

● ● ● ● ● ●

Human resources (e.g. skills of staff ) Marketing (e.g. impact on brand) Financial position (e.g. need for funding which may be limited) Supply issues (e.g. loss of a key supplier) IT (e.g. suitable given current IT infrastructure) Competitive position (e.g. relation to current generic strategy such as cost leadership)

Acceptability Acceptability concerns the stakeholders and the views they have about the issue concerned. The impact of the option on each of the key stakeholders shown in Section 2.8.1 should be undertaken. In this section, you should also consider financial acceptability to stakeholders, in the form of the results of your NPV analysis, or other investment appraisal. Ethics issues are also important, although be wary of discussing these too much here, since you are likely to cover these in depth in the later section of your report. Feasibility Feasibility concerns the likelihood that the option will be a success, or indeed whether it is even practical to proceed with this option. It might include: ● ● ● ●

Availability of finance Technical feasibility (e.g. if some new technology was involved) Availability of resources (e.g. staff ) Timescales – are they practical and realistic

Remember, marks will only be awarded in the criterion of Judgement for comments and recommendations that are commercially viable, realistic and sensible. In the exam, you do not have time to do an extremely detailed SAF analysis, so aim to keep your commentary of each of the three areas down to around two paragraphs.

2.9

Integration

Produce a well-structured report in an appropriate format and linguistic style. (3) These marks are awarded holistically according to the overall quality and functionality of your report. (7) This criterion rewards candidates for their ability to write a cohesive, comprehensive report that ‘flows’ well and reaches well-justified recommendations for each of the key issues. The report needs to be read like a professionally prepared business report that shows

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Suitability The suitability section is a commentary on how the option relates to the Strengths and Weaknesses of the company (as shown in the SWOT analysis). You should overview whether the issue compliments the strengths, overcomes the weaknesses or is limited by the weaknesses. This should be referenced to the SWOT in your appendix. It might include suitability of the issue in relation to:

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understanding all of the key issues affecting the business and their context in the industry in which the company is operating. Low marks are awarded in this section if: ●

●

it is considered that a company, in receipt of a report of this standard would be dissatisfied due to a lack of sensible recommendations; a report that contained recommendations which were inappropriate or could even be detrimental to the company.

Most importantly, the entire report must read well, be comprehensive, and have clear, convincing, well-reasoned and justified recommendations on the key issues in the case. 7 marks are available in total for markers to assess how well the script addressed these key issues, so a script that has good recommendations on priority 4 and 5 but is ‘poor’ or has not discussed the 2 key issues will get low marks in Integration. Put yourself in the position of the Board you are writing to – and imagine they are paying a large fee for your report! Would they be satisfied with what you wrote and will it tell them what actions they should take and why on the key issues facing the company. The integration section also covers the production of a report using suitable report formats (see Chapter 4) and how well you communicate your points. Language used must be professional, the presentation of a high standard and the points made communicated well. This criterion is a general one, which is often the last on which marks are awarded when scripts are marked. As such, markers use this section to assess whether scripts which are near the pass mark should pass or fail the exam, depending on whether they feel the report is of sufficiently high enough quality to pass.

2.10

Logic

Make clear, well-justified recommendations for each of the prioritised issues and ensure the reasoning for the recommended courses of action is clearly stated. The recommendations should follow on logically from the weight of the arguments and choices of actions given earlier in the report. Logic relates to the recommendations section of the report. This is the most important area of the report, and, it is important that you allocate sufficient time to this section. There will usually be around 20 marks for logic, and it is very important that exam time is managed effectively so that clear, well-justified recommendations are prepared. A rushed recommendations paragraph at the end of your report that just lists recommendations, without detailed explanation or the underlying reasoning, will earn very low marks in the assessment grid for logic. One of the most common problems in student scripts is that they write either very short or, indeed, no recommendations. The reason is that this is the last section of the report to be completed and many people do not manage their time well, leaving inadequate time to do this section. In Chapter 4, I will discuss time management, and give you a suggested time plan. If you keep to this time plan you will have adequate time for recommendations.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) Make 2–3 clearly stated recommendations, which support each other, and/or flow well over time Often recommendations can be stated as a flow of recommendations over time. Lets say that a bid to takeover the company was on the table and you had decided that it was in the company’s best interest to accept it. It is very tempting to simply recommend acceptance of the bid and leave it as that. The real world is never quite as simple as that though. Rarely does the first bid put in get accepted, and it is more likely that a negotiation will take place. Discussions with key shareholders are also likely to take place too, to ensure that they agree with the recommended course of action. Other stakeholders, such as employees, might also be affected, and consideration of what this means for them might also be considered. A high quality recommendations section, might therefore show the recommendations as follows: (a) Meet with shareholders to discuss their view of the bid and bid price, with a view to recommending acceptance of the bid to them, after negotiations aimed to get a higher price. (b) Enter into negotiations with the bidder, with an aim to maximise the price and terms, and to ensure that a good redundancy package is agreed for those employees who will lose their job as a result of the move. (c) Assuming a bid is agreed, appoint a project leader and team to manage the due diligence process and the smooth transition of the company to the bidder. (2) Justify each recommendation made You must justify each of the recommendations you make. This will inevitably mean repeating some element of earlier discussions, which you must not be afraid to do. These justifications are a summary of the key arguments you made in your earlier section explaining why you have chosen to recommend this course of action. The main recommendations that are key to the business should be presented first, with lesser or less urgent recommendations following. (3) Explain each recommendation made Recommendations should be explained in detail including: ● ● ●

●

The timing of the action. Who should be responsible and follow through on this. The responsibility of the person to who the report is address (often the Board of Directors) (e.g. the Finance Director takes the action while the Board reviews progress periodically at board meetings). How the action should be undertaken (e.g. using a consultancy, with tact, specific steps, in consultation with unions).

2.11

Ethics

Using your judgement, highlight and analyse the ethical issues in the case and state why you consider these issues to have ethical implications. Discuss alternative courses of action that the organisation could take to resolve the issues.

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The next consideration is what you need to do for each issue. My suggestion to you is that for each of the five key issues you discuss in the exam you should aim to:

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It is important that company’s and directors operate in the ‘right’ way, and as such it is vital that these rights and wrongs of behaviour are considered as part of your report. As such, the TOPCIMA grid has 10 marks available in total for the discussion of ethical dilemmas given in the case material, and recommendations on how to deal with these. Although it is not compulsory, most students complete a separate section in their report to deal exclusively with ethical issues. This criterion includes personal and professional ethics, business ethics, corporate governance and social responsibility.

2.11.1 Personal and professional ethics These are the ethical principles, or standards of behaviour, which individual applies, as to what is right or wrong. A member of a profession, such as an accountant, will also be expected to apply the set of ethical principles adopted by their professional body as standards of professional behaviour that its members are expected to adhere to. CIMA’s ethical principles have been adopted based on those suggested by the International Federation of Accountants (IFAC), and are a good guide to the standards of behaviour which can be applied to any professional, and indeed, any director or senior manager in the scenario in the exam. Summarised below are the five fundamental principles that form the basis of the code, which are: integrity, objectivity, professional competence and due care and professional behaviour: (1) Integrity means being straightforward, honest and truthful in all professional and business relationships. People should not be associated with any information that they believe contains a materially false or misleading statement, or which is misleading because it omits or obscures the facts. (2) Objectivity means not allowing bias, conflict of interest or the influence of other people, to override professional judgement. To protect your objectivity, you should avoid relationships that could bias or overly influence your professional opinion. (3) Professional competence and due care is an ongoing commitment to maintain a level of professional knowledge and skill. Each individual should ensure that their employer or customer/client should receive a competent and professional service. Updates should be undertaken on current developments in the individual’s area of work, legislation and regulation. Directors and managers must also make sure that those working under them have the appropriate training and supervision. Work should be completed carefully, thoroughly and diligently, in accordance with relevant technical and professional standards. (4) Confidentiality means respecting the confidential nature of information acquired through professional relationships such as past or current employment. Information should not be disclosed unless the individual has specific permission or a legal or professional duty to do so. Confidential information should never be used for the individual’s or another person’s advantage. (5) Professional behaviour requires individuals to comply with relevant laws and regulations. Professionals, such as accountants, must also avoid any action that could negatively affect the reputation of their profession. For the issues in your exam you should show how each of the five fundamental principles shown above have, or have not, been put in place by individuals in the company,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

2.11.2 Business ethics and corporate social responsibility Each business will have their own set of ethical principles. In many organisations, these principles will be set out in an ethical code, which states a range of acceptable and unacceptable behaviour for staff to adhere to. An organisation may also consider its role in relation to wider stakeholder interests, as part of its operations. This idea is that of corporate social responsibility, and can include consideration in decisions of the well-being of staff, customers, suppliers, the general public and the environment. For your pre-seen, you need to ascertain the general approach the organisation plans to take in relation to ethics and social responsibility and ensure that any decisions taken uphold their rules and regulations. In some TOPCIMA scenarios this is explicitly stated, so for example, in the Solberri case from the first half of 2008, a full page was provided as an appendix outlining the company’s social responsibility objectives. If no explicit policies are presented, you should assume that the company would want to hold themselves up to high standards of ethical behaviour and this should be reflected in your answers.

2.11.3

Corporate governance

Corporate governance is the management of the business to ensure that the organisation is run on behalf of all stakeholders, rather than in the interests of a small number of people, notably the directors themselves. Corporate governance regulation has increased over recent years due to a range of corporate scandals such as Enron, Worldcom, Gerome Kerviel at Societe Generale, and Polly Peck. In response to this regulation has been developed around the world, including Sarbannes Oxley in the US and the UK’s combined code on corporate governance. For your exam, it is important that you ensure that corporate governance is appropriately addressed. A good, general guide for what to look for can be gained by analysing your pre-seen against the UK’s combined code, which you studied at strategic level. In summary this states that: Remuneration of directors Remuneration of directors should be: ● ● ●

Fair, and linked to performance; Disclosed in the accounts; Decided by a remuneration committee of non-executive directors.

Directors ● Directors should be selected on merit, using a formal process, led by the nomination committee or non-executive directors; ● The roles of Chairman and CEO should be held by different individuals;

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and where changes and improvements need to be made. You should also recommend what changes and improvements should be made and in what timescale (e.g. immediately or within 6 months).

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The Board should be balanced, containing, ideally, at least a half non-executive directors to support shareholder needs and provide independent advice on board decisions; Directors should be re-elected every 3 years.

Relations with shareholders ● Dialogue with institutional shareholders should be regularly undertaken; ● Constructive use should be made of the Annual General Meeting. Accountability and audit ● Appropriate financial reporting; ● Maintenance of a system of internal control, based around a regular risk assessments; ● There should be an audit committee of non-execs, responsible for scrutinising the accounts, risk management processes, the work of internal audit and selection of and liaison with the external auditors. In the exam, it is crucial that you both examine the ethical issue, explaining the issue in depth, and then you recommend a solution or solutions to that issue. In Chapter 4, you will find a suggested approach to this, and you will have the opportunity to work through examples of ethical dilemmas faced in a past exam.

2.12

Writing to the marking criteria

This chapter has given you an understanding if the criteria on which the TOPCIMA exam is assessed, and what you need to do to earn marks under each criterion. It is vital that as you practise papers that aim to write solutions which score marks against all these criteria. I suggest that as you progress through the remainder of your studies, you continually refer back to this chapter, and the criteria and ask yourself whether you are writing reports which get marks under each heading. In Chapter 3, I will take you through how to read and analyse the unseen material on the exam day and how to select the 5 issues that you will discuss and how to rank them in a priority order. This is so important in order to gain high marks in the criterion of Prioritisation and also to ensure that you identify and discuss all of the key issues in the unseen material.

3 The First 30 Minutes – Planning and Prioritisation

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The First 30 Minutes – Planning and Prioritisation

3

LEARNING OUTCOMES By the end of this chapter you should 䉴

be clear about how you will spend the first 30 minutes of your time in the exam;

䉴

have learnt and practised a system for prioritising issues presented to you in the unseen on exam day;

䉴

know how to plan your report, and the contents of that plan.

3.1

The first 30 minutes!

The first 30 minutes of your exam are arguably the most important of the whole exam. In that time, you will review the requirement, read the unseen, prioritise the issues in the unseen and make a plan for your report. Your output from those first 30 minutes makes the difference between what will be a high quality script which passes and a script which fails. This is particularly important for the prioritisation of points in the unseen, in which you must do well if you are going to pass the exam. To avoid confusion, let me be clear straight away what I mean by those first 30 minutes. This first 30 minutes includes your 20 minutes of ‘reading time’ plus the first 10 minutes of your ‘exam time’. With time so pressured in this exam, it is vital that you use your reading time in the most productive way, by actively making notes on the key issues as you read them, and in this section, I will show you how to do this so within 10 minutes of the exam starting you will have prioritised your issues accurately and planned your report in a way that will help you when writing the key sections.

3.2

Prioritisation

The prioritisation criterion offers 10 marks in the exam, and rewards students for their ability to identify the issues facing the company and to place those issues in priority order. Marks are awarded based on a student’s ability to: (1) rank the problems in the order in which they need to be addressed, (2) justify that ranking order. 35

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As we saw in Chapter 2, getting this right is critical to success. An incorrect prioritisation will not just lose marks under the prioritisation section, but under other headings too. Minor points do not carry as much weight for the Focus, Judgement and Logic sections, so if you fail to find one the examiner’s top 2–3 issues in your top 5 issues, it is very difficult to pass, however good your report. One key problem people often face is that of making broad, general assessments of priorities, based on feelings rather than fully evaluating the issue. Gut feel and intuition can be useful at times, but it is fraught with danger in this instance, since what ‘feels’ like a major issue, on further inspection can often turn out not to be. Intuition can help you make your decision, but must not be the basis of your decision-making. Instead, it is vital that have a clear method to help you make your decision. Another issue I commonly find with some of my students is that they can take too long to prioritise, possibly because of the importance of prioritisation in the exam. You simply do not have the luxury of lots of spare time, so you must have a system in place to prioritise quickly and correctly. Although there are many appropriate methods of prioritisation, in the paragraphs that follow you will find the one I use with my students. I have adapted and perfected this over many years of teaching TOPCIMA, and from the feedback students give me, they find it both easy to use, and it saves them time in the exam. Broadly speaking, from the evidence of marking their mock exams, they also tend to prioritise accurately using this system too. The system is based on comments made in one of the past Post Exam Guidance reports in which it stated that:

The basis used to prioritise issues might be: (1) Timescale (short to long-term) (2) Scale of impact (most significant to least) (3) Degree of risk (highest to lowest)

Using these, as the basis of prioritisation, the following steps of prioritisation can be used. Step 1 – Set up a prioritisation page The first step is to set out, on a blank page, ideally in landscape format, the proforma in Figure 3.1. Note that this proforma includes columns to assess impact and timing or each issue, as to whether they are high, medium or low, as suggested by the PEG, alongside likelihood of the event happening (which is substituted for risk for the reasons noted later). Based on these three areas of assessment, a score out of ten can then be applied to each issue (10 being high priority and 1 low), and finally, once all issues have been analysed, the top five issues chosen and the order noted in the final column. A purely practical question arises in the exam of where you layout this proforma, since you are likely to start doing this in the first few minutes before you are allowed to write in your answer booklet. In recent papers, the requirement page, has been a tear-out page, with a blank page at the back, so this is an excellent place to start your prioritisation. If this is not available, you will probably need to find another blank page elsewhere in your question booklet (of which there is usually one available somewhere). If you are unlucky

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Impact (H/M/L)

Likelihood (H/M/L)

Timing (ST/MT/LT)

Prioritisation (i) Score/10 (ii) Order

1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Figure 3.1 Issues prioritisation proforma

enough not to have any free pages in the booklet (which one student did complain to me happened in her exam some years ago), you can use the same steps we are going to go through on the script, alongside each unseen issue. Step 2 – Read the first issue in the unseen Read the first issue presented to you in the unseen, and note the issue down in the lefthand column of the page. Step 3 – Grade impact Next, grade the impact it will have on a scale of High, Medium or Low. Here, you are looking at the impact on: (1) Key stakeholders (2) Financial position of the business (e.g. profits, cashflow, survival of the business) (3) Points in the SWOT (e.g. capitalising on a strength or making a key weakness even worse) As a guide, high impact issues tend to have a large impact on financial performance (e.g. revenue or profits), and/or are of major importance to many or the most important stakeholders. A takeover bid, for example, will impact the income and ownership of shareholders, affect directors and staff, many of whom may find themselves out of a job or with different working arrangements, customers, who may experience changes in service or quality. Many stakeholders are affected, and in a significant way. Medium-sized issues, will have some impact. Financially, the issue is not significant enough to cause the company to go bankrupt, but it might make a sizeable dent in profits. Alternatively, it could just affect a small group of stakeholders. A redundancy programme, for instance, would have a major affect on some staff, and a more minor ongoing affect on staff morale amongst existing staff. As such it is likely to be a medium-sized issue. This could, of course, change based on the circumstances in the exam. If, as a result, the union were planning strike action, the impact would be far more wide reaching, both financially and on a wider group of stakeholders and the issue would rise to high in importance.

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Issue

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Issues of low importance affect few people in a minor way, and tend not to have significant financial implications. Loss of a minor customer is likely to have relatively minor impact on anyone (a major customer could be quite different of course). Step 4 – Grade the likelihood of the event happening The PEG suggests prioritising based on the level of risk. However, you may remember from your risk management studies that risk can be categorised on a graph using 2 criteria, impact and likelihood. Since we have already dealt with impact in Step 3, the only element of risk remaining is the likelihood of the event happening. From a prioritisation perspective, even if the impact would be high (so for example, a takeover bid would have a big impact on most stakeholders), if there is a low chance that this will occur (the takeover has been rumoured but seems unlikely) then it should be prioritised lower than if the event definitely will occur (the bid is already on the table). The likelihood of an event happening, in my experience, is the least important of the three prioritisation criteria, but is useful as a way to prioritise between two issues which are similar in both impact and timing. Step 5 – Timing The more imminent the issue, the higher it should be prioritised. A key staff member leaving in the next week is far more important than the same person leaving in a year’s time, since that gives time to find a replacement and create a handover plan. As a general guide use the following prioritisation approach: Short term (ST) – Next 3 months Medium term (MT) – More than 3 months but less than a year Long term (LT) – A year or more in the future. A key mistake made by some students is to prioritise key strategic issues (e.g. a major expansion plan) when there are no plans or need to proceed with them for some while. This kind of issue, might make it into your number four or five issue, but it is unlikely to be in the top 2. Top 2 issues are, almost always, both short term and high impact. Step 6 – Prioritisation score In the next column, give each issue a score out of 10. Issues which are H/H/ST will be 8, 9 or 10s, while L/L/LT, will score below 3. Some of my students, have tried to work out a formal scoring system at this stage (e.g. High and Short term are 3 points each, so add up the 3 to get a score between 9 and 3). This kind of system is easy and quite scientific in approach, but loses some of the personal judgement that you should be putting into your assessment, so I prefer students to take the assessments of impact, likelihood and timing as a general guide, and using this use their own judgement as to what they feel is a fair score. As you progress to later issues you can also start comparing with scores for earlier issues too. If two issues were both H/H/ST, and for the earlier issue you have scored it an 8, you might use your personal judgement to score this issue higher or lower. Step 7 – Prioritisation order Complete Steps 2–5 for each issue, and, once complete, note down your top 5 issues in order in the final column. As a starting point, this should be as easy as ordering them

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

3.3

Practising your prioritisation

Using this prioritisation system, gives you a clear systematic approach to prioritisation which should speed up your approach, and enable you to accurate prioritise your issues. Each individual is different though, and your judgement and view, may differ from that of the examiner. It is important then, that you practise this approach on many different scenarios, so that you learn how certain types of issues are typically prioritised. With practise, you will also get quicker at prioritising, and if you can save 5 minutes at this stage, you will get more time to do more analysis, and score more marks, later on. So, now is your chance to do some practise. Our first prioritisation exercise is based on the exam from the latter 6 months of 2007, on a company called Kadgee. At this stage, you don’t want to waste time, preparing the whole pre-seen material, so you are going to do this exercise based on a cut down version of the pre-seen, which follows. Read this through, mentally taking note of the key points.

3.3.1 September/November 2006 – Kadgee clothing case pre-seen Kadgee is a European clothing manufacturing company which is suffering declining sales and declining profitability following the pressure by other global clothing manufacturing companies, especially those in China. It is a family-run, unlisted company which is using more cash than it is generating in its operations. The company had a large (and growing) overdraft of €1.5 million at the end of 2005 and with its declining fortunes appears to be sliding towards liquidation. The key questions that needed to be considered by directors were: ●

●

Can Kadgee survive, and if so, what changes would need to be make in order to secure its survival? Should the company be sold now as a way to generate a higher returns for the private shareholders than if it were forced to cease trading?

If it is to survive, and continue trading, Kadgee is likely to need to lower its manufacturing cost base in order to compete effectively on the world stage. Kadgee has suffered loss making periods before and had recovered from them by improving quality and becoming more efficient through the use of TQM. Kadgee cannot easily cut its costs further as most of its costs are staff costs and wage levels. Moreover, wage levels in China are a fraction (about 3%) of European wage levels, making it very hard to compete with items sourced there. Kadgee has a very limited customer base which it is heavily dependent on. It has only 6 main customers, with the 2 largest customers accounting for almost 55% of its sales revenue in 2005. It has recently lost one of these key customers, Forum, which generated €16.8 million of revenues in 2005 which was 22.6% of Kadgee’s total sales.

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

based on their score, although, again some judgement must be applied too, and you may want to change the order of some based on your overall assessment of the issues. Once you have made your decision on planning order, by and large I do not recommend changing it later in the exam. I’ve known many students do this, and by and large they were right initially. Not only that, but changing order mid-way through the exam can cause great problems in formatting your report, and also can make people divert from their time plan, which is a grave error. My advice then is take the time you need to decide on your prioritisation order during Step 7, and then stick to this for the rest of your report.

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From these details we can see that Kadgee’s customers wield immense power over the company and Forum’s departure leaves Kadgee with significant extra capacity. The company owns and operates 6 factories at full capacity and therefore with the loss of over one-fifth of its sales, at least one factory will have to close and further job losses at other factories are inevitable unless Kadgee can win new business quickly. The company has only secured two new contracts in the last 10 years. So, to win 1 new contract to fill part of the hole caused by the loss of Forum will be difficult to achieve. Kadgee is a net cash burner of €0.592 million which it funds by increasing its overdraft. Poor cash flow is still the single most important reason for companies going into liquidation – and Kadgee is heading in that direction. The problems facing Kadgee, as well as other European manufacturers, are the substantially lower cost base in China and the increase in imports that were over 70% higher in 2006 than 2005, forcing even more European companies to cease trading. Chinese manufacturers are also improving the quality of their products, which is a threat to Kadgee’s basis of success over recent years.

3.3.2

SWOT analysis based on pre-seen

Strengths ● ● ●

●

●

● ●

Weaknesses

Long standing, stable family-run company Loyal and hard working employees Regular customers who have procured clothing from Kadgee for many years Unlisted family company, not under any pressure from investors Bankers have provided long-term finance and overdraft facilities High-quality production Increased productivity through the use of TQM

Opportunities ● ● ● ●

Overseas production Further cost cutting exercises Develop design Diversification into new products

3.3.3

● ● ● ● ●

● ●

Loss of recent major customer (Forum) Lack of innovation Operating in a very price competitive market Narrow product range Aged machinery that is prone to regular breakdowns and need to invest in improved machinery and more maintenance Falling operating profits Deterioration in working capital cycle with an increase in inventories of almost €1.9 million in 2005

Threats ● ●

Loss of further customers Globalisation has increased competition, making it harder for Kadgee to retain long-standing customers

Prioritisation

The first scenario for you to practise is based on the September 2006 exam, but has been significantly shortened and simplified in order to make easier as for a first attempt. Work through the steps of the prioritisation process outlined in Section 3.2, doing a prioritisation for each of the issues in the scenario that follows. Shortened September 2006 unseen Meeting with Kadgee’s bankers Kadgee’s existing loans of €4,500,000 are secured against the property owned by Kadgee. There is the capacity to borrow an additional €3,000,000 against Kadgee’s assets. PGB (Kadgee’s Bank) has also provided Kadgee with an overdraft facility. The overdraft is

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Loss of another customer In addition to the loss of Forum, another of Kadgee’s customers, Zeeb, notified Kadgee in August 2006 that it would not be procuring any further clothing from Kadgee after its current contract for the 2006/07 winter season finishes. Sales to Zeeb amounted to 6.9% of Kadgee’s sales revenue in 2005. New contract won by Kadgee In May 2006, Kadgee recruited a new designer who has established a reputation for designing ranges of clothes using recycled textiles. The recycled textiles are procured at a very low cost from an international charity. Each new manufactured garment is different and requires a higher input from skilled manpower, especially cutters. Following discussions, a contract for a 3-month trial period was signed in late June 2006 between Kadgee and a new customer, GREN, for deliveries in July, August and September 2006. This was successful and a contract has been proposed by GREN for the whole of 2007. This would utilise over 9% of Kadgee’s manufacturing capacity of 10.9 million garments. The proposed manufacture of 1 million garments using recycled textiles will be undertaken at two of its factories which have spare capacity following the loss of the Forum and Zeeb contracts. GREN has insisted on an answer within the week, so it can plan its future requirements. Proposal to move some manufacturing to China Kadgee has been approached by a Chinese manufacturing company called LIN. It has proposed a joint venture with Kadgee. It proposes that Kadgee should concentrate on what it does best, which is designing and distributing to the European market. It proposes that Kadgee should continue to work with its current customers and agree designs, which could then be electronically transferred to a factory in China to manufacture. Kadgee would then continue to supply existing customers, but with clothes manufactured in China. This would necessitate closure of all six of Kadgee’s European factories. The proposal is for the joint venture to be LIN 60% and Kadgee 40% for investment and all financial aspects of the proposed joint venture. The proposed joint venture with LIN would require the construction of a large purpose built factory with a manufacturing capacity of over 20 million garments per year. If Kadgee chose to invest in the joint venture, the investment cost is forecast to be €22.5 million, of which Kadgee’s share at 40% would be €9 million. The directors are seriously considering this option, as one of the few long-term solutions to turn around the company’s flagging profits. Proposed new product line Kadgee has, to date, only manufactured fashion clothing and has not made any outerwear such as jackets and coats. Following extensive market research, it has been identified that there is a substantial gap in the number of high-quality coats manufactured for the North American market, including Canada. Capital expenditure of €8 million will be required for the new product line.

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

currently standing at €1,750,000 at the end of August 2006. This overdraft has increased from €1,520,000 at the end of December 2005. The agreed overdraft limit is €2,500,000. PGB stated that Kadgee will not be allowed to exceed the agreed limit, whatever the circumstances. PGB stated that if Kadgee were to exceed the limit, then the bank would call in the overdraft entirely. A new cashflow forecast suggests that this does not appear to be of immediate concern, but it may have an impact either in the long term, if profitability cannot be turned around, or if new funding is required for other projects.

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STUDY MATERIAL T4

Legal case against Kadgee Kadgee is facing a major legal case for allegedly copying designs by a major fashion designer, SM. Several of Kadgee’s designs from its latest range bear a remarkable similarity to SM’s designs, but Kadgee’s designs were drawn up before the famous designer’s clothes were launched. Kadgee has so far refused to back down and the publicity has boosted sales of Kadgee’s designs to many of its customers. Lawyers have advised it is likely to be many months, if not years, before this goes to court. Fire at one of Kadgee’s factories At the very end of August 2006, a fire broke out during the night at one of its factories. The fire has destroyed the entire inventory of finished goods held there awaiting transportation to customers, as well as a large amount of work-in-progress and raw materials. The factory was one of Kadgee’s larger factories, which manufactured 2.4 million garments each year. In addition to the total loss of all inventories, there was several days loss of data from the computer systems at that factory. In accordance with usual routines, the IT systems had been backed up each night, but the back up files had not been stored in a fire-proof cabinet or off site, as required by Kadgee’s IT instructions. Therefore, the factory manager has not been able to ascertain what deliveries have been made to customers over the preceding 4 days before the fire. Many of Kadgee’s customers are still chasing Kadgee for deliveries in the confusion following the fire less than a week ago. Kadgee’s management has been busy transferring orders to its other factories, and some orders may have been repeated. Accidents at several Kadgee factories There have been a number of minor accidents during July and August at all six factories. Maintenance has been reduced and machine breakdown is common. The general feeling in the factories is that a major accident will occur before the management team either replaces the faulty and aged machinery, or improves the level of maintenance. Other human resource issues Kadgee’s employees are very concerned for their future employment, having seen many other clothing manufacturers in the same towns in which they work cease trading. Kadgee employs a high proportion of skilled female employees and many are unhappy and have complained that they are paid a lower pay rate than their male colleagues who are doing the same work.

3.3.4 My prioritisation matrix for the revised Kadgee unseen Issue

Impact H/M/L

Likelihood

Timing

Score/10

Order

1

Funding

H

M

LT

5

2

Customer loss

M/H

H

MT

6

4

3

GREN contract

M/H

H

ST

7

3

4

LIN Joint venture

H

M

MT

8

2

5

New product line

M

L/M

MT/LT

4

6

Legal case

M

M

MT/LT

5 (Continued)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Impact H/M/L

Likelihood

Timing

Score/10

Order

7

Fire

H

H

ST

9

1

8

Accidents

M

L/M

ST/MT

5

5

9

HR issues

L

L

MT

2

The fire is my number one issue. With customers having already been lost elsewhere, Kadgee cannot afford to lose customers given the fire, loss of capacity and stock and resulting confusion over orders. Quick, decisive action must be taken to resolve this. The impact of the acceptance of the LIN joint venture proposal is huge, much greater than the fire in my opinion, since it would result in the closure of the factories, and subsequent job losses, and may secure the possible long-term survival of the business. It is a medium-term issue, however, since an immediate decision is not required, and for this reason I have prioritised it after the fire. In addition, it is only a proposal, while the fire is an issue which must be dealt with (i.e. likelihood is high). The GREN contract gives an opportunity to replace the lost customer, which is a serious threat to the business following the loss of the Forum and Zeeb contracts. In addition significant investment is required. Although I have shown GREN as number 3 and the Zeeb loss as number 4, these issues are highly linked, and in the exam I would have been tempted to combine the customer loss and GREN contract issues into a combined number 3 issue, something which is acceptable to do in the exam. I had a number of issues which scored 5, and any of them could have been my number 5 issue here. I chose the accident issue since the implications of a serious accident are high for PR, employees, the business (possible legal fees) as well as it being an ethical issue. It also needs to be dealt with quickly. As a general rule, based on my experience of many similar exams, possible accidents are often prioritised quite highly due to the high possible impact, even though the likelihood is low. The funding issue could have been very important, but the caveat at the end of the section saying that a new cashflow forecast showed it was not of immediate concern convinced me leave it out. Of course, if I had dealt with GREN and Zeeb together, it would have given me the opportunity to include the funding issue as my number 5, which would have been a good, low-risk option to take. It is worth noting that the order obtained from this exercise does differ slightly from the examiner’s formal solution to this question due to changes that have been made to simplify it for the exercise. Please keep your prioritisation sheet for these issues, since we’ll be using this again in Section 3.5.

3.4

Prioritising your first full unseen

Having done a shortened and simplified unseen, it is now time for you to attempt a prioritisation for a full unseen. Over the next few pages you will find the unseen of the November 2006 exam. This was also based on the Kadgee case scenario. Using a piece of paper in landscape format, write the headings for the prioritisation matrix at the top of the page and then, work through the steps of the prioritisation process outlined in Section 3.2, doing a prioritisation for each of the issues. This time you can review your top 5 with the examiner’s actual top 5 to see how you got on.

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

Issue

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STUDY MATERIAL T4

3.4.1

November 2006 unseen

New Managing Director joins Kadgee Following the loss of the contract with Forum in May 2006, the Kadgee Board agreed that some serious changes were required for it to remain competitive and for it to retain its existing contracts. Andrin Burnak (Chairman and historic Managing Director) fully appreciated that he did not possess the skills required for Kadgee to compete in the challenging world markets now facing the company. Andrin Burnak recruited Birgit Zeim as the new Managing Director, with the full backing of the Kadgee Board. She had established her reputation when she managed to turn around another fashion manufacturer. She was reluctant to join Kadgee at first, and it proved necessary to offer an attractive package including share options. Birgit Zeim joined Kadgee in July 2006 on a salary of €400,000 per year, making her the company’s highest paid director. She also has share options to purchase 100,000 shares in Kadgee, within the next 5 years at a price of €3.00. Birgit Zeim has not yet invested any of her personal finance in Kadgee. She would only wish to exercise her share options to purchase 100,000 shares at a total cost of €300,000 if Kadgee were to become significantly more profitable. By joining Kadgee, she has her professional reputation at risk if she is unsuccessful. She is confident that the company could become a leading global force in the manufacture of high quality clothing with a far greater level of sales and far higher profitability levels than currently being achieved. Changes announced by the new Managing Director Within a month of joining Kadgee and meeting all of the management team and visiting each of Kadgee’s six factories, Birgit Zeim prepared a proposal for the Kadgee Board which met in early August 2006. Birgit Zeim stated to the Board that Kadgee could only survive in the long-term and become more successful financially if it were to undergo a transformational change. In order to allow the Kadgee Board time to agree on what direction it should aim for, Birgit Zeim has introduced some short-term measures to cut costs. The Board discussed and reluctantly agreed to each of the proposals. The following changes were announced in August 2006: ● ●

● ●

An immediate wage cut of 5% for all operational staff working within Kadgee’s factories. Changes to the contracts of employment for operational staff working within the factories, which include a reduction of paid leave and other entitlements. Immediate closure of one factory with compulsory redundancies of 54 employees. Closer scrutiny of sick leave, which Birgit Zeim considers to be very high. She has stated that she would not hesitate to terminate the employment contract of any employee who she considers to be exploiting the company’s generosity. Two employees with high sickness records have been dismissed as a result of this policy.

Birgit Zeim is fully aware that employee morale is already low, and that these measures would have a detrimental effect. To counter this, she wants all employees to have a share of up to 20% of the total profits achieved each year. However, the profit-related pay would only be paid if all departments achieved agreed targets. She plans to introduce a range of financial and non-financial performance-related targets during 2007.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

November 2006 Kadgee Board meeting At the November 2006 Kadgee Board meeting, Birgit Zeim announced that the company simply could not carry on as at present as it is very vulnerable to losing further orders from its regular customers. Birgit Zeim stated that she is looking at various ways in which Kadgee can undergo a transformational change, which would start within the next 6 months and that some of the changes will not be easy for the management or the employees to accept. The possibilities that she explained to the Board in November 2006 were as follows: ●

● ● ●

Manufacturing in China on its own by setting up a large factory to manufacture clothing for the European and other markets. Manufacturing in China in a joint venture with a Chinese manufacturer. Moving all or part of Kadgee’s manufacturing base to elsewhere in Asia. Further investment in IT solutions to sell its clothing to a much wider market than it currently does.

Proposal to manufacture in China Birgit Zeim stated to the Kadgee Board that no international manufacturer can afford to ignore China and that the company needs to have a strategy to deal with China. Birgit Zeim reported that already almost 25% of the clothing sold in the EU has ‘Made in China’ labels and that this growth is continuing to accelerate. She continued by reporting that to date Kadgee has not lost much of its business because it has managed to maintain a high quality output which has achieved premium prices aimed at the top end of the price range for women’s and children’s clothing. However, she insisted that the high quality of clothing produced in China made competition from that source highly likely in the very near future. Birgit Zeim further stated that Kadgee cannot attempt to manufacture in China without the full support of the Kadgee Board and that it should not be considered as an additional manufacturing factory as well as Kadgee’s European factories. She stated that an investment in China would necessitate some of Kadgee’s senior management to be based in China to manage the investment and that all of its European factories should close. However, many members of the Kadgee Board were not convinced on the proposed relocation of its manufacturing base to China. Proposal to set up in China on its own Andrin Burnak (Chairman and historic Managing Director) wants Kadgee to remain independent and is not enthusiastic about the possibility of a joint venture (see later). However,

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

Kadgee’s bankers The proceeds from the sale of the land at the factory that was closed in August 2006 are expected to cover the redundancy costs of the 54 employees and other closure costs. However, following the closure and imminent sale of this site, Kadgee’s bankers, PGB, have stated that they would now only allow a maximum of any further loans of €2,000,000 due to Kadgee’s reduced asset base. Kadgee’s existing loan from PGB of €4,500,000 is secured on Kadgee’s assets. Additionally, Kadgee’s current overdraft, standing at €1,604,000 at the end of October 2006, must not exceed the agreed overdraft limit of €2,500,000. PGB has informed Andre Schnaffer (the Finance Director) that if Kadgee were to exceed this limit, then the bank would call in the overdraft entirely.

45

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STUDY MATERIAL T4

he recognises that the possibility of Kadgee expanding into China on its own needs to be explored very carefully. Proposal to set up in China in a joint venture Birgit Zeim proposes that Kadgee should enter into a joint venture with a Chinese manufacturer, so enabling it to reach a much larger global market and also to achieve cost reduction on a scale that would not be possible in Europe. Birgit Zeim has been in contact with several Chinese manufacturing companies for over a year, even before she agreed to join Kadgee, and she has selected Xina as a proposed joint venture partner. Xina has been manufacturing low cost clothing for the last 3 years and now wants to enter the higher quality clothing market and is keen to work with a European company. If Kadgee does not choose Xina, then Xina has made it clear that it will select another company to work with. The joint venture proposal is to establish a manufacturing base that would replace four of the five European factories that Kadgee currently has operational. Kadgee would retain one small European factory. The manufacturing and distribution centre in China would be a 60 /40 joint venture, with Xina having a 60% stake. If the joint venture is agreed then it would be established as a separate legal company. The forecast total investment is the equivalent of €20 million, of which Kadgee’s share of the investment would be €8 million. This will include a state of the art design centre, manufacturing facilities capable of producing up to 20 million garments annually, as well as warehousing and distribution facilities. The manufacturing capacity of this proposed new factory is almost twice that of Kadgee’s current capacity. The proposal is to invest in early 2007, if this proposal was chosen, and for the factory in China to be operational later in 2007. The table below shows the cash inflows for Kadgee’s 40% share of the post-tax cash inflows only and the figures are shown in Euros using forecast exchange rates. Kadgee’s share of the capital expenditure of €8 million is not included in these cash inflows. Kadgee’s share of the forecast post-tax cash inflows

Probability

2007 € million

2008 € million

2009 € million

2010 € million

2011 € million

High

70%

2

8

10

12

14

Low

30%

1

5

6

7

8

As the project carries a higher risk than an investment in Europe, Andre Schnaffer recommends that a suitable risk adjusted discount rate is 14% post-tax and considers that this investment should be appraised over a 5-year period. Kadgee’s post-tax cash inflows between 2007 and 2011 shown in the table above could be overstated by as much as 15% across the entire 5-year forecast if the Chinese currency changes further against the Euro than assumed in the above forecast. Birgit Zeim also commented that additional payments (not included above) may need to be made to ensure that the joint venture is approved. She also stated that there is the potential problem of employees of the joint venture, or Xina itself, establishing ‘shadow’ operations to compete directly with the proposed joint venture.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

NPVs (post-tax) of 2 alternative locations elsewhere in Asia (including capital expenditure)

High sales (70% probability) € million

Low sales (30% probability) € million

NPV of Location 1

9.3

4.8

NPV of Location 2

9.9

3.4

Proposal to close Kadgee’s European factories If Kadgee did invest in China or undertake the strategy to move to an operating base elsewhere in Asia, it would involve closing some or all of the five European factories currently operating. The factory that was recently closed had a low resale value, but this is expected to cover the redundancy costs and closure costs associated with closing that site. Of the five factories that are operational, which are all owned by Kadgee, only two of the sites have land that has a resale value, for possible residential use. The land at these two sites was valued in Kadgee’s Balance Sheet at the end of 2005 at €6 million, but it has been recently revalued, for possible sale, at €12 million in total. The other three factories are located in run down industrial sites and have no resale value. It is expected that the closure costs of all five factories to return the sites to a clean and safe condition is a total of €1.5 million. However, Kadgee is not legally obliged to clean up each of the sites. Andre Schnaffer has forecast that site closure costs could be reduced to a minimum of €0.3 million if the three factory sites that would not be sold, are simply closed and left derelict. It is forecast that redundancy costs could be around €3.0 million, minimum. If Kadgee were to pay redundancy to many of the part-time workers, who are not legally obliged to receive redundancy payments, but many of whom have been employed for many years by Kadgee, the cost could increase to €4.0 million. Investment in IT This option could enable Kadgee to remain in Europe, or could be undertaken alongside any of the proposed relocations of Kadgee’s manufacturing base. Birgit Zeim has been persuaded by Jan Berzin (the IT Director) of the importance of investing in IT in order to win new business. The proposal is to enhance Kadgee’s existing IT systems to provide a secure ‘extra-net’ system, which would be totally interactive, allowing existing, as well as new customers, to browse through all of the available designs that Kadgee is offering to manufacture and would facilitate ordering online. The system would also allow customers to personalise their orders as they would be able to choose the colours, the materials and the designs they wanted. In this way Jan Berzin is confident that much new business could be secured. He is also confident that a price premium could be

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

Investment in a new factory elsewhere in Asia (not China) A further alternative strategy is to move some, or all, of Kadgee’s manufacturing to a location elsewhere in Asia, but not into China. The two alternative locations in Asia (not China) would have a similar manufacturing capacity as Kadgee had at all six European factories, of around 11 million garments per year. The proposed NPVs (post-tax) of two alternative proposals, evaluated over the next 5 years, each of which includes an investment cost of €7 million, and discounted at a suitable risk-adjusted discount rate, are forecast as follows:

47

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STUDY MATERIAL T4

charged for clothes that are ‘custom made’ to customers’ requirements, therefore enhancing the margins that could be achieved. The proposal is forecast to cost €0.5 million for IT hardware and software plus additional IT staff costs of €0.2 million per year. The marketing budget would also need to be increased by €0.6 million per year for the first 2 years, resulting in a total additional spend of €0.8 million per year for 2 years, in addition to the IT investment costs of €0.5 million. Sam Skala (the Marketing Director) and Jan Berzin have already almost secured its first customer, BBZ, if the system is agreed to be implemented. BBZ is a medium-sized retailer in Europe and has not previously bought any clothing from Kadgee. It is forecast that the operating profit (pre-tax) from BBZ’s first order could be worth €0.2 million in the first year, and a second order for the next year could generate in total an operating profit of €0.4 million. However, until the system is operational, BBZ does not wish to place any orders with Kadgee. It wants to remain free to procure from other manufacturers globally who do have an interactive ordering system. Other issues affecting Kadgee’s operational performance at present Quality of production As could be expected the employees’ morale is low and the quality of the output has fallen. Despite all of his best efforts, Peter Coletta (Factory Operations Director) is unable to improve the general feeling of discontent and fear that Kadgee will close the remaining five European factories before long. With the ongoing concerns over possible future closures, a few key employees have recently left Kadgee, and Peter Coletta is concerned over the quality of the current output, and possible loss of further orders. Machine breakdowns In order to achieve agreed budget cuts, Peter Coletta has reduced training and much of the routine preventative maintenance has stopped. Engineers are only called in to attend to machinery when it breaks down, which it often does, when employees are unable to fix it themselves. When a packaging machine recently broke down, two employees were badly injured when they attempted to fix the problem themselves. The two injured employees had worked full time for Kadgee for 3 years but had received little training on the machines, and they did not understand the health and safety issues surrounding machine repairs despite requests for additional training. They were trying to be conscientious in keeping production flowing, but instead caused a major delay in production due to this accident. It is considered that a major investment programme in new machines would be required to overcome these problems and Birgit Zeim is very reluctant to invest more in Europe. Dismissal of Rita Scree Another factor that has caused much concern amongst employees at the factories was the dismissal of Rita Scree in September 2006 by Peter Coletta for a poor attendance record. She had worked for Kadgee for over 35 years. She is a skilled sewing machine operative who had been hard-working and loyal to the company. Her current poor attendance record is entirely due to a family member being critically ill. Her fellow employees feel that she has been badly treated and have asked for her to be re-instated and to be given paid special leave.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Appointment of a consultant At the Kadgee Board meeting held in November 2006, the strategic issues shown above were discussed and it was agreed that a consultant would be appointed to advise the Board on the issues facing Kadgee.

3.4.2

The examiner’s prioritisation order

The examiner considered the top 5 priorities in this case were as follows: Top priority – resolving the dismissal of Rita Scree The top priority is to re-appoint Rita Scree and give her paid special leave to attend to family matters. She is obviously a long-term employee, who is highly respected by her fellow employees. Kadgee cannot risk the threat of strike action, a slow down in production or any further reductions in the quality of its output. The risk of not re-appointing her is therefore too great for Kadgee to bear. Strike action is both high impact and the issue must be dealt with immediately so it is of high urgency also. Second priority – decision on the proposed joint venture with Xina in China The second priority is the decision whether to set up a joint venture with Xina or not. The impact of this decision is very high, since it would result in the closure of factories, with subsequent job losses, and may secure the possible long-term survival of the business. Xina will not wait long (high urgency) or it will seek out another company if Kadgee does not make a swift decision. The joint venture will require an investment of €8 million which Kadgee does not have unless the two sites with a resale value are sold and closure costs are minimised and further loans (with PGB, or another source of funding) are agreed. The longer the decision is put off to reduce its manufacturing cost base and in what form, the harder it will be for Kadgee to compete. Third priority – decision to re-locate some, or all, of its manufacturing base to elsewhere in Asia (not China) The third priority is the proposed move of Kadgee’s manufacturing base to Asia. This decision needs to be evaluated and compared to the China options, and if the China alternative proposal is not agreed, then the Asia proposals need to be seriously considered. It comes after issue 2 since any decision on this must follow that issue which is higher urgency. However, the impact of any such move, as with issue 2 would be huge, in terms of costs, staff and the future direction of the company.

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

Birgit Zeim has stated to fellow directors that she would not allow the re-instatement of Rita Scree and has refused to discuss this matter further. She has instructed Lars Veel, the HR Director, to ensure that Rita Scree is not re-appointed as she considers this to be a point of principle. Birgit Zeim has informed her fellow directors that she needs their confidence in her ability to turn Kadgee around and that she would consider resigning from Kadgee if she is not supported by fellow Board members on this Human Resource matter. The employees across three of the five factories have approached Peter Coletta and asked for him to re-appoint Rita Scree. They are threatening strike action if Rita Scree is not re-appointed.

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THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

50

STUDY MATERIAL T4

Fourth priority – management of Kadgee’s cash flows Kadgee has an overdraft of €1,604,000 at the end of October and the overdraft limit is €2,500,000. The bank has stated that this limit must not be exceeded. There is a need to ensure that detailed cash flow plans are put in place to ensure that the overdraft is not exceeded, as the company could go into liquidation if the bank, PGB, called in the overdraft facility, making the impact high. The issue is less important than earlier ones since the threat is not immediate (probably medium term), and also since it only has a medium likelihood of occurring. Fifth priority – investment in IT solutions The fifth priority is to decide whether Kadgee should invest in enhancing its IT systems and to increase its marketing spend to attract new customers, who could browse and order online. This would allow customers globally to purchase from Kadgee, and would change the way it currently operates. This IT proposal could be undertaken if Kadgee continued to manufacture in Europe or moved to China or to elsewhere in Asia. However, it would allow Kadgee to enhance and increase its range of customers without changing its manufacturing base. There will always be some discussion about exactly what the prioritisation order should be. Small differences such as reversing the order of the number one and two issues, are not important. Large divergences are important though, and in this case higher marks were awarded for having the potential strike in the top 3 issues as this was considered to have an over-riding importance, as a strike could result in Kadgee to cease trading. Do keep your prioritisation sheet for these issues, since we’ll be using this again in Section 3.5 and Chapter 4.

3.5

Planning your solution

In addition to undertaking a prioritisation of the issues, you must also prepare a plan for your answers, and this can be done very efficiently on the same page as you used for your prioritisation analysis. The aim when you plan your solution is to know the main crux of what you are going to write about in your prioritisation and analysis sections. This means being clear about: (1) Impact: Stakeholders, financial, link to the current strengths, weaknesses and current position (2) Possible alternative actions (3) Ethical issues (4) Links with other unseen issues A plan should include just a brief 2–3 word outline of key issues under these headings. Remember that your plan, will not be marked, so do it in enough detail to help produce your answer, while keeping it as brief as possible so you do not waste time. Exercise For the September 2006 practise exam that we did earlier, add another column to the prioritisation sheet you used for that, and for each of your top 5 issues, consider the impact, alternative solutions, as well as any ethical issues.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Issue

Impact H/M/L

Likelihood

Timing

Score/10

Order

Notes

1

Funding

H

M

LT

5

2

Customer loss

M/H

H

MT

6

4

Impact: S: Shareholders, staff F: Future revenues SW: If continues, cash flows/survival Linked: GREN, New product line Actions: Accept Reject Depends on LIN JV

3

GREN contract

M/H

H

ST

7

3

Impact: S: Shareholders F: Future revenues SW: Overcome lost contract Linked: Customer loss Actions: Accept Reject Depends on LIN JV Ethics – sustainable materials

4

LIN Joint venture

H

M

MT

8

2

Impact: S: Staff, shareholders F: Future survival, funding SW: High cost base Linked: Customer loss, funding Actions: Accept Reject Negotiate terms Propose cut down version of agreement

5

New M product line

L/M

MT/LT

4

6

Legal case

M

M

MT/LT

5

7

Fire

H

H

ST

9

Ethics – copyright 1

Impact: S: Staff, customers F: Lost revenues, insurance SW: Customer losses Linked: Funding for rebuild (Continued)

THE FIRST 30 MINUTES – PLANNING AND PRIORITISATION

Solution

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STUDY MATERIAL T4

Issue

Impact H/M/L

Likelihood

Timing

Score/10

Order

Notes Actions: Rectify order probs Insurance claim Shut factory Rebuild factory

8

Accidents

M

L/M

ST/MT

5

9

HR issues

L

L

MT

2

5

Impact: S: Staff F: Maintenance costs, legal costs SW: Too little investment Linked: HR issues, funding Actions: Accept Reject Depends on LIN JV Ethics – Concern for staff

Planning in this way means that writing the prioritisation section is easy, since the key points of impact are clearly noted. The key points for the issues analysis are already identified, ready for further analysis, as are the alternative solutions. Although you could consider recommendations at this stage, my feeling is that it is better to write your full analysis, and seeing where that leads you, prior to making a final decision. Now that you have practised doing one of these, you may also like to go back to your November 2006 prioritisation schedule and create a plan based on that too.

3.6

Writing your prioritisation section

In the exam you should have a separate section in your report (for most people it is Section 3), which deals with your prioritisation. In this section you should: (1) Introduce the section explaining that you are dealing with issues in priority order throughout the report. (2) Include a subsection (3.1, 3.2, etc.) for each of your top issues. (3) Justify your order of each issue by covering the three elements in your plan, explaining why that issue is prioritised where it is in relation to other issues. It might, for example, be just as high impact, but less urgent than an earlier issue. Remember the three issues to consider are: (a) Impact (most important) (b) Urgency (c) Likelihood (least important) You will find an example of this in Chapter 4.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Prioritising in the real exam

Even after using this prioritisation approach many times, when it comes to the real exam, you will still feel nervous when deciding on your prioritisation order. Over a number of years of teaching TOPCIMA, I’ve noticed that after the real exam, I have complaints from many of my students that that exam was much harder to prioritise than the ones we practised in class. Almost invariably, when I take a look at it, it doesn’t seem any harder than the others at all. My conclusion is that the difference is exam nerves, and a desire to ‘get it right on the day’. By following the process outlined in this chapter you can quickly, easily and accurately prioritise your issues. If you trust in the system on exam day, you will, most likely, prioritise your points well. Having learnt how to prioritise and plan your answer, you now need to be able to write a report which addresses these points in a way which scores marks against the marking criteria. This is the focus of Chapter 4.

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3.7

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4 Time Management and Report Writing

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Time Management and Report Writing

4

LEARNING OUTCOMES By the end of this chapter you should 䉴

be clear how you will manage your time in the exam;

䉴

have learned a report format to use for the exam;

䉴

have practised writing sections of the report, and so be familiar with the requirements of each section.

4.1

Report writing

On my TOPCIMA courses, I usually spend a whole day with my class practising time management and the writing of each section of the report. This is probably the most important day of the course, since, it is only on this day, that people start to realise just how much is required in the exam to pass, and just how difficult it is to do this in the time allocated. After this day, students are usually bought into the fact that they must work hard, practising past exam papers or mock exams of their own pre-seen if they are going to do well in the exam. In this chapter, I will take you through the same process that I do on my courses. We will start by looking at how you manage your time in the exam, move on to the format in which you are required to produce your report and then run through a series of exercises to help you understand how to approach the main sections of the report in the exam. These exercises will also take you along the first steps to mastering time management.

4.2

Time management

Over a number of sittings I had a student attend my TOPCIMA courses, who simply couldn’t pass. His problem was that he worked too slowly. By the end of the exam he would have written an excellent first half of the paper, but he completely lacked the second half. Given another hour he would have produced an excellent script and, I’m sure, would have done very well in the exam, but his speed of working was his downfall. There is no doubt about it, 57

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that the TOPCIMA exam requires you work at a high pace, while also producing the quality of report that a Board of Directors would be happy with, and this is not an easy task. In addition to working at a high pace throughout, it is critical that you have a clear plan for the use of your time in the exam, since this will guide how long you spend in each key section to ensure you produce a balanced script which gains marks against all the marking criteria.

4.2.1 Timetable for written exams The time plan below, is designed to be both manageable, while also enabling your answer to balance the key report sections, and therefore score marks across all the marking criteria. This timetable, which is the one I use with my students on courses, reflects two things. First, it is based on many years of experience working with students. I have refined it over the last few years to reflect feedback I’ve had from students about the way they apply it in real exams. Secondly, it reflects a long debate between myself and Heather Barnwell, the examiner of over 15 different TOPCIMA papers, and consultant editor of this Learning System. This debate hinged on the practicality of writing sections in the time available versus the relative importance of the different sections, most notably the recommendations section, in the mark allocation. As a result of this, significant time has been allocated to the recommendations section to reflect the importance of this section, and the fact that so many scripts are weak in this area. While the volume of material produced in this section will probably be lower than in the main analysis section, it is absolutely critical that the recommendations are of a high quality, and this time allocation provides for a little thinking time, in addition to writing time, so students ensure their recommendations are of the highest quality. This does make earlier sections of the report very time pressured, but ultimately it will result in a script which is more likely to pass. For these reasons, while you may want to amend it slightly to fit your own approach and style, I would suggest not making significant changes. Importantly, not only must you learn these timings, but also you must learn how to write your answers within these time boundaries. This is not easy, and significant practise is a must. Time

What you should be doing?

20 minutes Reading Time ⫹10 minutes of Exam Time

Read case and prioritise Notes on key points of impact and alternative solutions

15 minutes

Do calculations (in the appendix) Reconsider priorities given the calculations

15 minutes

Appendices: SWOT analysis and at least 2 other models of your own choice

5 minutes

Report format, Introduction and Terms of Reference

15 minutes 3 minutes on each key issue

Prioritisation section

55 minutes 13 minutes on top 3 issues 8 minutes on issues 4 and 5

Main body of report. For each major issue: summarise, then analyse, give alternative solutions and provide an industry example

15 minutes

Ethics: Identify and explain 3 ethical issues, and make recommendations

50 minutes 12 minutes on top 3 issues 7 minutes on issues 4 and 5

Recommendations, including answering why, how, when and who Conclusion

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.2.2 Timetable for PC-based exams For those of you taking PC-based exams, you have more flexibility in the order in which you write out your answers since you are not restricted to writing in the order of the answer booklet. This flexibility means that most students I teach prefer to change their time plan from that shown in Section 4.2.1, and certainly that would be my recommendation. In this case, I suggest you deal with the recommendations for each issue immediately you have completed the analysis of this issue, while your analysis is still clear in your mind. Doing the paper this way, leaves you with the following plan for your time. Time

What you should be doing?

20 minutes Reading Time ⫹10 minutes of Exam Time

Read case and prioritise Notes on key points of impact and alternative solutions

15 minutes

Do calculations (in the appendix) Reconsider priorities given the calculations

15 minutes

Appendices: SWOT analysis and at least 2 other models of your own choice

5 minutes

Report format, Introduction and Terms of Reference

15 minutes 4 minutes on each key issue

Prioritisation section

1 hour and 45 minutes Top 3 issues: 13 minutes analysis, 12 minutes recs Issues 4 and 5: 8 minutes analysis, 7 minutes recs

Main body of report. For each major issue: summarise, then analyse, give alternative solutions and provide an industry example Recommendations, including answering why, how, when and who

15 minutes

Ethics: Identify and explain 3 ethical issues, and make recommendations Conclusion

Another quick word of warning based on my experience of students using this alternative timetable. Students who use this, rather than that in Section 4.2.1 often tend to finish only 4 issues and not 5, and often do their first issue in far too much depth. It is acceptable to spend a couple of additional minutes on your top 2 issues, as the expense of later, less important issues, but no more – stay disciplined to the time plan.

4.3

Report format

Using the correct format in the exam is essential. Although you do have flexibility in the report format you use, in practise by far the majority of students use the same report format, since a number of years ago the examination team provided a suggested format. Not only does this ensure you prepare a report which addresses each area of the assessment criteria, but it also helps markers when they are marking your script. They will develop a marking approach based around the suggested format and by using exactly the same approach you will make it easier for them to allocate marks to your script, than if they are

TIME MANAGEMENT AND REPORT WRITING

For simply practical purposes, you should write your Appendices in one answer booklet, and the main body of the report in the second. This enables you to do the Appendices first, as indicated in this plan.

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searching around an usual format to decide how that relates to each of the marking criterion. The suggested report format is summarised below: ● ●

●

●

●

●

●

●

●

Contents page Introduction – A brief background on the company of around 8–10 lines. Terms of reference – A brief 5–10 lines to set the scene of who you are – e.g. a management accountant or consultant, and to state who the report was commissioned by, and who it is aimed at. Prioritisation section – Identify and prioritise the main issues facing the company, showing the top five issues in priority order together with justification for the ranking of these issues. Issues analysis – This is the main body of your report and should be divided up into sections which should include an analysis of each of the issues that you have prioritised. – For each issue facing the company you should discuss the impact this issue has on the company and its stakeholders and discuss a range of alternative actions to overcome these issues. – Your discussion of each issue should be supported by analyses, both theories, such as Porter’s five forces or supporting calculations showing an evaluation of the alternative actions (which should be shown in appendices). Ethical issues – Ideally you should cover at least three ethical issues, explaining the issue and offering clear recommendations on how the issues should be handled. Recommendations – This is the most important part of the report and should pick up on each of the issues discussed earlier. – Each recommendation should be clear and well-justified as to why you are recommending a particular course of action. – As a general rule, be bold and try to avoid recommending that more information needs to be collected before a recommendation can be made. Conclusion – A brief 5–8 lines for closing comments. Appendices – These should include some strategic models, such as a SWOT analysis, PEST analysis, and Stakeholder Map, as well as detailed calculations. – The appendices must be referred to within your report.

It is important that you practise the use of the formatting, and learn how that relates to the time plans from Section 4.2, so in the next few sections we will work through each of these sections using the November 2006 unseen, which we worked on in Chapter 3. You will be shown how each section should be presented, and be given exercises to help you practise producing answers in this format, and within the required timeframe.

4.4

Calculation appendices Start this section 10 minutes into exam time (i.e. 10 minutes after the reading time ends) Duration: 15 minutes

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.4.1

Exercise

Using the unseen information about the November 2006 exam in the previous chapter, undertake some numerical analysis on the following issues, and note them in the following appendices: Appendix 3 Appendix 4 Appendix 5

Financial evaluation of the proposed joint venture in China with Xina Financial evaluation of the proposed re-location to Asia (not China) and comparison to the joint venture in China proposal Summary of funds available for moving Kadgee’s manufacturing base to China or elsewhere in Asia

Allocate just 20 minutes for the exercise, and be disciplined in your use of time for the exercise. Remember, you are not aiming to produce a perfect answer (as you will find in the solutions below), but one that will score 5–6 marks, so that you will have passed this element of the exam.

4.4.2

Solution

Appendix 3

Evaluation of the proposed joint venture with Xina in China

All figures in € million

2006

High sales alternative: Investment (Kadgee’s 40% share) Net post-tax cash flows Net cash flows Discount rate at 14% Discounted cash flows Cumulated DCF

(8.0) 0 (8.0) 1.000 (8.0) (8.0)

NPV Total discounted cash flows 2007 to 2011 With further possible currency changes of 15%

2007 – 2.0 2.0 0.877 1.8 (6.2)

2008

2009

2010 2011

– – – 8.0 10.0 12.0 8.0 10.0 12.0 0.769 0.675 0.592 6.2 6.8 7.1 0 6.8 13.9

– 14.0 14.0 0.519 7.3 21.2

21.2 29.2 24.8 (Continued)

TIME MANAGEMENT AND REPORT WRITING

The first main sections of your report which you will complete are the calculation appendices. Having spent the first 30 minutes undertaking your prioritisation and planning, doing the calculations straight away enables you to more fully assess the importance of each issue. Indeed, you may find that an issue which appeared to be significant in financial terms actually turns out to be less important once the calculation is undertaken. In fact, it may be the case that you change your priority order once you have done this calculation, although, in my experience this is rare. You have 20 minutes to do your calculations. Often there can be a temptation in the exam to spend longer, but you must remember that there are probably no more than 10 marks (and possibly fewer) for calculations in the exam, so it is simply not worth while spending longer on them. If you do, you may find yourself running out of time later on in the exam, which means you risk having less time for your recommendations section (the last you do) which is the most important in the exam. If you do find yourself running out of time on your calculations, be pragmatic. Make simplifying assumptions, or do brief calculations which will enable you to have some numbers which you can discuss in your report. Compared with previous exams, it is less important that you complete all possible calculations in a standard way.

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STUDY MATERIAL T4

All figures in € million

2006

2007

2008

2009

2010

Less investment Revised NPV with further possible currency changes

8.0 16.8

Low sales alternative: Investment (Kadgee’s 40% share) Net post-tax cash flows Net cash flows Discount rate at 14% Discounted cash flows Cumulated DCF

(8.0) 0 (8.0) 1.000 (8.0) (8.0)

– 1.0 1.0 0.877 0.9 (7.1)

– 5.0 5.0 0.769 3.8 (3.3)

– 6.0 6.0 0.675 4.1 0.8

– 7.0 7.0 0.592 4.1 4.9

NPV Total discounted cash flows for 2007 to 2011 With further possible currency changes of 15% Less investment Revised NPV with further possible currency changes

Expected NPV calculations High Low Expected

2011

– 8.0 8.0 4.2 9.1 9.1 17.1 14.5 8.0 6.5

Probability

Forecast NPV

70% 30% 100%

21.2 9.1 17.5

Forecast NPV after further possible currency changes of 15% 16.8 6.5 13.7

Appendix 4 Evaluation of the proposed re-location to Asia (not China) and comparison to the joint venture in China proposal

Probabilities Location 1 NPV Location 2 NPV Comparison to Kadgee’s share of proposed joint venture with Xina in China

NPV High

NPV Low

NPV Expected

70% 9.3 9.9 21.2

30% 4.8 3.4 9.1

100% 8.0 8.0 17.5

Investment

PI

7.0 7.0 8.0

1.14 1.14 2.19

Discounted cash flows over 5 years (excluding investment)

Discounted cash flows per year on average

15.0 15.0 25.5

3.0 3.0 5.1

Appendix 5 Summary of funds available for moving Kadgee’s manufacturing base to China or elsewhere in Asia Land available to sell if all 5 factories were closed Less: Closure costs Redundancy costs

Full costs € million

Reduced costs € million

12.0

12.0

(1.5) (4.0)

(0.3) (3.0) (Continued)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Reduced costs € million

(4.5)

(4.5)

2.0

4.2

8.0 7.0 (6.0) (5.0)

8.0 7.0 (3.8) (2.8)

Repayment of PGB bank loan secured against European factories Net funds available for moving Kadgee’s manufacturing base Funds required for joint venture with Xina Funds required for re-location to Asia (not China) Shortfall for investment in joint venture with Xina Shortfall for investment in Asia (not China)

Therefore, investment in the joint venture with Xina in China or the investment elsewhere in Asia (not China) could only be made if new loan finance were to be secured with either PGB or an international bank located in China or elsewhere in Asia. The new loans would need to be for €6.0 or €3.8 million for the joint venture with Xina. The new loans would need to be for €5.0 or €2.8 million for the investment in Asia (not China).

4.4.3

A pragmatic view of the solutions

On a pragmatic note, it is unlikely that you would be able to do the full solutions outlined above in 20 minutes allotted in the exam. Two of these three appendices would have been sufficient. Always remember the general rule that it is more important that you stop after 20 minutes than provide a fully complete answer.

4.5

Theory appendices Start this section 25 minutes into exam time Duration: 15 minutes

It is typical to do between 2 and 4 theory-based appendices. As a general rule, aim for 3 appendices. These are crucial to gain Technical and Application marks in the exam. In Chapter 2, you will find an overview of the importance of the various models to the exam and in what situations you are likely to be able to use them. In summary, you must do a SWOT analysis as your first appendix, and then need to choose other appropriate models from others. Those most commonly used are PEST analysis, Generic strategies analysis, Porter’s five forces and Mendelow’s stakeholder matrix. Also remember that all models used, must be updated for unseen issues, so that your end result is an overview of both that and the pre-seen. It is VITAL that ALL of your top 5 issues from your report have been considered in your SWOT analysis.

4.5.1

Exercise

In Section 3.3.2, you will find a SWOT analysis based on the pre-seen material for the Kadgee case. Using the unseen information for the November 2006 exam in Section 3.4.1, update the SWOT analysis for the unseen issues.

TIME MANAGEMENT AND REPORT WRITING

Full costs € million

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4.5.2

Solution

SWOT analysis Strengths ● ● ●

●

●

● ● ●

Long standing, stable family-run company Loyal and hard-working employees Regular customers who have procured clothing from Kadgee for many years Unlisted family company, not under any pressure from investors Bankers have provided long-term finance and overdraft facilities High-quality production Increased productivity through the use of TQM New Managing Director with determination to transform Kadgee into a much more profitable company

Weaknesses ● ● ● ● ●

● ●

●

●

●

● ● ●

Opportunities ● ●

● ● ●

●

●

Joint venture proposal with Xina in China Proposal to re-locate manufacturing base to Asia (2 alternative locations) in order to achieve lower operating costs Proposal to invest in IT to attract new customers Possible first order from BBZ Higher employee motivation if 20% of profits paid to staff as proposed by Birgit Zeim Sale of land of European factories if Kadgee re-located to China or Asia If Kadgee re-locates to China or to elsewhere in Asia it will use new high technology machinery with few breakdowns

Loss of recent major customer (Forum) Lack of innovation Operating in a very price competitive market Narrow product range Aged machinery that is prone to regular breakdowns and need to invest in improved machinery and more maintenance Falling operating profits Deterioration in working capital cycle with an increase in inventories of almost €1.9 million in 2005 Staff motivation falling following changes announced by new Managing Director Restriction to the amount of loan finance following closure and imminent sale of one factory Falling quality of production. Quality is Kadgee’s key differentiator and this issue is very important Accidents due to machine breakdowns Poor staff training on machine maintenance Loss of control by the founding Burnak family if Birgit Zeim exercises all of her share options

Threats ●

●

● ●

●

●

●

●

●

●

●

Threat of strike action following the dismissal of Rita Scree Birgit Zeim is trying to change Kadgee very fast and her dictatorial style may not suit this familyrun business Loss of further customers Possible loss of intellectual property (designs, etc.) if Kadgee entered into a joint venture with Xina, Low cost imports from China as well as other countries Globalisation has increased competition, making it harder for Kadgee to retain long-standing customers Much of Kadgee’s machinery is reaching the end of its useful life and there is the threat of a major accident occurring Cash flow issues and need to remain inside overdraft limit of €2,500,000 PGB removing, or changing, Kadgee’s financing arrangements Closure of European factories if Kadgee re-locates to China or Asia and disruption to production that this could cause Need to re-finance if Kadgee re-locates, as current loans are secured on European factories

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.5.3

Exercise

For your second appendix, complete a PEST analysis based on the proposed joint venture in China with Xina.

4.5.4

Solution

Appendix 2 PEST analysis for the proposed joint venture in China with Xina Political/Legal ● Problems with enforcing intellectual property rights in China ● Unfamiliar legal system ● Unfamiliar work practices ● Cultural and language difficulties ● Setting up joint venture arrangements to ensure that Kadgee is not dominated by Xina Economic ● Competitive market ● Ability of joint venture to achieve much higher levels of profitability ● Possible trade barriers in future if China continues to dominate world markets in textiles and clothing ● Economic downturn in Europe reducing demand for high quality premium priced clothing would adversely affect sales by joint venture Social ● Redundancies of employees in European factories ● Closure of some of Kadgee’s factories resulting in further decline of the industry in Europe and economic decline of the towns in which Kadgee is a key employer ● Possible adverse publicity if the joint venture is tainted with child labour publicity ● Long hours worked for low pay for Chinese workers ● Safety standards are lower than those imposed on factories operating in Europe ● Employee welfare is much more the responsibility of employers in China as many employees live away from home and work long hours at the factories and reside in accommodation provided by factory owners

TIME MANAGEMENT AND REPORT WRITING

The issues in bold are those which have been added based on the unseen. Note how virtually all the opportunities and threats come from the unseen. That is what you would normally expect in your exam. A SWOT analysis like the one above would be worth around 3 marks in the exam. Again, taking a pragmatic viewpoint, you may wish to have fewer points in order to save time, but remember that you will then score fewer marks in your SWOT. Most students DO NOT do SWOTs in as much detail as that shown above for this reason. Just as this solution shows updated points in bold, it can also be useful to highlight your unseen points in the exam. In PC-based exams, you can also show these in bold. In written exams you can underline them. This makes it very easy for the marker to pick up updated points from your script.

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Technological ● The new joint venture factory can utilise the latest high technology machinery that will enable faster throughput of garments and better quality of manufacture (from cutting, pressing, sewing and finishing) ● Improved latest designs can be transmitted direct from Kadgee’s design centre in Europe to the new factory in China electronically and this will reduce machine set up time and result in improved production planning ● High technology links can be established with customers globally in order to grow the level of sales ● Use of sophisticated machinery will enable a higher production standard to be achieved with less dependency on employees’ commitment and motivation, and should lead to continued high quality production with fewer faults.

4.6

Contents, Introduction and Terms of reference Start this section, 40 minutes into exam time Duration: 5 minutes

These are the first sections of the report, and you have about 5 minutes to complete them. They are largely standardised sections which you can pre-learn before you enter the exam, and to which you will need to make only slight changes.

4.6.1

Contents page

Over the page, you will find below a suggested contents page for the report. It should include a title, an indication of who the report is to and from, an outline of the key sections and the titles of the appendices. You should use the whole of your first page of your report for the contents.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

To: Kadgee Board From: Consultant Date: 23 November 2006

Analysis and Evaluation of Current Position at Kadgee Contents 1 Introduction 2 Terms of reference 3 Prioritisation of issues 4 Discussion of the issues 5 Ethical issues and recommendations on ethical issues 6 Recommendations 7 Conclusions Appendices Appendix 1 Appendix 2 Appendix 3 Appendix 4

SWOT analysis PEST analysis for the proposed joint venture in China with Xina Financial Evaluation of the proposed joint venture in China with Xina Financial Evaluation of the proposed re-location to Asia (not China) and comparison to the joint venture in China proposal Appendix 5 Summary of funds available for moving Kadgee’s manufacturing base to China or elsewhere in Asia Appendix 6 Potential change in Kadgee’s shareholdings

4.6.2

Introduction

Your introduction should provide an overview of the company’s current position. I suggest including some of the key elements of the SWOT analysis in this section, and that you refer to that SWOT as part of your introduction. It is advisable that you pre-learn an introduction, which you then make some minor amendments based on the unseen information. The introduction can also be a good place to obtain your first diversity mark, and I suggest you include a good industry example or some industry statistics, ideally related to the unseen information, as part of your introduction, to earn a diversity mark here. Overall, it is important that the introduction is kept brief, and is a maximum of half a page in length. I have seen many student’s introductions which are over a page in length that is far too long. The introduction is a necessity as part of your report, but does not earn significant marks across the marking criteria, so keep it short and simple. Here is an example introduction. 1 Introduction Kadgee is an unlisted family-run company which had been highly profitable for most of the last 50 years but is now struggling to maintain profitability due to increased competition, especially from China. Kadgee has a small customer base which is able to exert great

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REPORT

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STUDY MATERIAL T4

buying power over Kadgee and the company has recently lost a major customer, resulting in a loss of around 23% of its revenues. Urgent steps are needed to either grow revenues or to reduce Kadgee’s operating cost base, or both. Kadgee has appointed a new Managing Director, Birgit Zeim, and she has already started to downsize the company by closing one of Kadgee’s six factories. In order for Kadgee to survive in the long term, it needs to change and react to globalisation and become much more competitive, rather than relying on the loyalty of long-term customers. The difficulties faced by Kadgee have also been reflected in the industry as a whole, and many similar organisations have withdrawn from the UK market over recent years. One example of this was SR Gent who used to be a key supplier of Marks and Spencer who ceased trading at the end of 2005. The company has a number of strategic alternatives to evaluate in order to determine its future strategic direction. A full summary of the businesses current position can be found in the SWOT analysis in Appendix 1.

4.6.3

Terms of reference

The aim of the terms of reference is to set out the purpose of the report. In most exams, this will be pre-learnt, and, like the introduction, should be brief since it does not earn marks in its own right, beyond the need to have this section as part of your formal report. The terms of reference should reflect the actual requirement, so if, like in September 2008, the standard requirement does change, then your terms of reference should reflect those changes. Here is an example. 2 Terms of reference As a consultant, I have been appointed by the Kadgee Board to prioritise and discuss the issues facing Kadgee and to make appropriate recommendations. This report will discuss a wide range of alternative strategic choices and make recommendations on the future direction for Kadgee to enable it to survive, grow, remain profitable and increase the value for its shareholders.

4.7

Prioritisation section Start this section, 45 minutes into exam time Duration: 15 minutes

Chapter 3 examined in depth how to approach prioritisation in the exam. This section of the report should come out of the work done in that crucial first 30 minutes of the exam. In this section you should: (1) Introduce the section explaining that you are dealing with issues in priority order throughout the report. (2) Include a subsection (3.1, 3.2, etc.) for each of your top issues.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

You only have 3 minutes for each section, so this must be brief. My suggestion to you is that you keep each section down to one paragraph of 2–3 sentences.

4.7.1

Example prioritisation

You will find below, example prioritisation sections for the first 2 issues from the Kadgee November 2006 exam: 3 Prioritisation of the issues facing Kadgee Throughout this report, issues will be dealt with in order of highest to lowest priority. In this section, the key issues facing Kadgee are presented along with the justification for the prioritisation order used. 3.1 Top priority – resolving the dismissal of Rita Scree The top priority is the dismissal of Rita Scree. She is a long-term employee, who is highly respected by her fellow employees. Kadgee cannot risk strike action, which at this stage could cause further loss of customers, and ultimately cause the failure of the firm. Even a slow down in production, or any further reductions in the quality of its output, could also be catastrophic. Therefore, the risk of not re-appointing her is too great for Kadgee to bear. This must be dealt with straight away to avoid any strike action and as such it is the number 1 issue. 3.2 Second priority – decision on the proposed joint venture with Xina in China The second priority is the decision whether to set up a joint venture with Xina. This will have an impact on a range of stakeholders, not the least the employees, many of whom will lose their jobs, although it may also secure the survival of the firm through reducing costs and making it more competitive. The Joint Venture will require an investment of €8 million, which Kadgee does not have unless the two sites with a resale value are sold, closure costs are minimised, and further loans (with PGB, or another source of funding) agreed. This issue is quite urgent since, having made the proposal, it is unlikely that Xina will wait long before it seeks out another company, although not as urgent as the Rita Scree issue, and, for this reasons, it is shown as the second priority.

4.7.2

Exercise

These are good examples of what you should be looking to produce in the exam. It is now time for you to attempt this yourself. It is important that you do time yourself as you do this, just to find out how time pressured this section is, and also important that you do indeed have a go at this exercise, so start to familiarise yourself in a practical way of the requirements of this section. With 20 minutes available for the whole of this section, that gives you 4 minutes per section. Since I am going to ask you to do three sections, you should allow yourself only 12 minutes.

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(3) Justify your order of each issue by covering the three elements in your plan, explaining why that issue is prioritised where it is in relation to other issues. It might, for example, be just as high impact, but less urgent than an earlier issue. Remember the three issues to consider are: (a) Impact (most important) (b) Urgency (c) Likelihood (least important)

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Your task: Take a moment to familiarise yourself with the prioritisation you did in Chapter 3 on the Kadgee November 2006 exam, and the justification for prioritisation order given by the examiner in Section 3.4.2. Once ready, give yourself 12 minutes to complete the prioritisation of the following 3 issues: (1) Relocation elsewhere in Asia (2) Management of Kadgee’s cash flows (3) Investment in IT

4.7.3

Analysing your answer

Before we look at a formal solution to the remaining issues, review your own answer by asking the following questions: (1) Did you complete all 3 issues in the 12 minutes available? If not, what will you do next time to speed up? (2) Did you keep the total amount written on each issue to less than half a side? If not, you probably wrote too much, and had time management issues. (2) Does each of your sections clearly indicate at least one point of impact for each issue? (3) Is the urgency (and if relevant likelihood) explained for each issue? (4) Have you compared each issue to earlier issues explaining the relative importance of each?

4.7.4

Solution

3.3

Third priority – decision to re-locate some, or all, of its manufacturing base to elsewhere in Asia (not China) The third priority is the proposed move of Kadgee’s manufacturing base to Asia. Like issue 2, this would cause a huge impact on the company’s employees, directors and whole future strategy. This decision needs to be evaluated and compared to the China options, and if the China alternative proposal is not agreed, then the Asia proposals need to be decided on. For this reason, it is prioritised after the China alternative. 3.4 Fourth priority – management of Kadgee’s cash flows Kadgee has an overdraft of €1,604,000 at the end of October and the overdraft limit is €2,500,000. PGB has stated that this limit must not be exceeded. There is a need to ensure that detailed cash-flow plans are put in place to ensure that the overdraft is not exceeded, as the company could go into liquidation if the bank, PGB, called in the overdraft facility. Although the impact of the cash position is very large, this is less urgent than the earlier issues and so is prioritised as the number 4 issue. 3.5 Fifth priority – investment in IT solutions The fifth priority is to decide whether Kadgee should invest in enhancing its IT systems and to increase its marketing spend to attract new customers, who could browse and order online. This would support good customer service, which is key to Kadgee due to the recent loss of the Forum contract.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

It is worth noting that each element of these solutions deals with impact, urgency and prioritisation order. Also note that each issue is dealt with relatively briefly. Being concise is key, not just in this section, but throughout your report.

4.8

Analysing the issues Start this section, 1 hour into exam time Duration: 55 minutes

The next section of your report is the main section. In this section, you are aiming to: ● ● ● ●

briefly (2–3 lines only) explain the issue analyse each of the issues consider the alternative solutions include a relevant industry example related to each issue

Your aim is that each issue should be examined in sufficient detail that a logical conclusion can be made about the best way forward for the company. You will present that conclusion in your recommendations section later on.

4.8.1 Explanation of the issue Your initial explanation of the issue only needs to be brief. You are simply setting out the issue as it stands. Few extra marks are awarded for this brief introduction but, scripts that do not include it are often difficult to follow, and do not flow well. It is important that somewhere in your answer that you include a brief introduction to this issue and, in my view, this is the best place for it.

4.8.2

Analyse the issues

Your analysis of the issues is the next element to consider. Your aim should be to consider the following: (a) Impact on stakeholders Each issue will probably impact a number of stakeholders. It is important that you consider the key stakeholders affected and what their likely reactions and views of this issue will be. Ideally, you will consider one or two key stakeholders for each issue, although I suggest no more than a paragraph on this in total, simply to help you manage time overall. (b) The financial implications of the issue For some issues you will be presented with detailed financial implications, and will be able to undertake detailed calculations, for instance of the: impact on profit, value of

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This IT proposal could be undertaken if Kadgee continued to manufacture in Europe or moved to China or to elsewhere in Asia. However, it would allow Kadgee to enhance and increase its range of customers without changing its manufacturing base. Although important, its impact is not as wide ranging or crucial as earlier issues, and hence it is prioritised fifth.

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the business, cash flow and liquidity implications, investment appraisal results (e.g. NPV calculation results, payback period) or impact on cash flow. These calculations should appear as an appendix in the back of your report, and the implications of the numbers described in this section of your report. Some issues in the unseen do not actually provide you with any financial details. With these, you should estimate the total overall financial implications and discuss these in general terms. You might, for example, note that new IT systems are likely to be very expensive and time consuming to develop and require the use of external consultants, even though no specifics are actually mentioned in the scenario. (c) Impact on the company/relationship to the current position of the company It can also be useful to relate the issue to the company’s position. This may mean commenting on how this issues relates to the strengths and weaknesses identified in your SWOT analysis, or alternatively it might create a new strength or weakness. In Kadgee, for example, the joint venture opportunity might be linked to a lack of experience in overseas manufacture to explain why a joint venture is an attractive option. You can also consider the impact on the company’s competitive position, relationships with suppliers, customers and employees, brand impact and any other marketing related issues, production issues and so on. (d) Relationship with other issues in the unseen Finally, it is important you link the issues the company currently faces. This is a sign of an excellent script. Where two different issues are competing for limited funding, you might note that only one of these is possible. Where staff motivation issues are considered in another issue, the impact of the current issue on staff motivation becomes particularly important.

4.8.3 Examine the alternative solutions For each of your key issues you should examine a range of possible solutions. For some issues, the unseen will contain possible solutions that the company are considering, while for others, you will be expected to generate issues of your own. In both cases, you will need to evaluate each alternative, and can do so by doing an analysis of advantages and disadvantages or through use of a formal model such as the Johnston and Scholes, Suitability, Acceptability, Feasibility (SAF) model. It is useful to include the SAF model at least once in the exam, since this will help you gain both technical and application marks, but beware, a SAF analysis can be time consuming to undertake, and it is my experience that students that try to use it too many times, while they do produce well-analysed solutions, tend to go over on their time allocation and as a result do not spend enough time on later sections. Unless the option is particularly important, keep your analysis of each solution down to maximum of 2 paragraphs (simply due to the lack of time available to do anything more), and aim for about 2 alternative solutions. Again, while more would be good, practically, most people do not have time to do more.

4.8.4 Include an industry example You may remember from Chapter 2, that you are aiming to include five industry examples as you progress through your report in order to gain the five available diversity

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Remember my warning to you in Chapter 2, to avoid simply quoting an example without relating it to the company or scenario. This is very important, or your example becomes meaningless, and is obviously just something thrown into the report to gain marks, which, while true, is not how it should appear! Do aim to make it flow naturally into your script. Also remember that while, specific industry-related examples are best, non-industry related real-world examples can also be used.

4.8.5

Example section

In the sections which follow, you will find examples for the first two issues of the Kadgee 2006 scenario. 4

Discussion of the issues facing Kadgee

4.1 Resolving the dismissal of Rita Scree The employees of the three factories who are threatening strike action if Rita Scree is not re-appointed, must be placated and this urgent HR issue needs to be addressed by Kadgee’s management team, as the consequences of a disruption to production or a further fall in the quality of production could lead to loss of sales. Kadgee simply would not have a long-term future if it does not address this short-term problem. Once a customer is lost then it is difficult for Kadgee to win new business as it is not price competitive. Therefore, it must retain its existing customers. It cannot do this with an unhappy, and frustrated, workforce, who are threatening strike action. Therefore in summary, the future of Kadgee, and all of the employees’ jobs rest with how this issue is dealt with. Three possible alternatives for Kadgee’s management are: (1) Call the employees’ bluff on the threatened strike action. This is a very risky alternative, since, as discussed, the negative consequences could be so significant. (2) Re-appoint Rita Scree as requested by the employees against Birgit Zeim’s wishes, which could lead to Birgit Zeim resigning over a point of principle, as she sees this as an issue that her fellow Board members should support her on. Given the other significant issues currently facing Kadgee, this would leave the company without a leader at a crucial time, and could seriously affect their decision-making ability. (3) Negotiate with Birgit Zeim and ask her to back down over this point of principle and to allow Lars Veel to re-appoint Rita Scree. The only way that Kadgee can move forward and continue to satisfy its customers’ requirements is to keep the employees satisfied. The employees must realise that Kadgee’s management is considering closing further factories (one has already been closed after Birgit Zeim’s appointment as Managing Director) and they must consider that they have very little to lose as their jobs may go anyway.

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marks. These can be in any section of your report, but one easy way to structure your answers is to plan to include an industry example in the analysis of each section. This, together with the example you included in your introduction, should enable you to generate good marks in the diversity category.

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Therefore, the threatened strike action should be avoided at all costs. The negative publicity over this issue could also anger its customers and the rest of the employees in other Kadgee factories. 4.2 Proposed joint venture with Xina in China The competition from China is a great threat to the European clothing industry and competition is growing fast and can no longer be ignored. Xina have proposed a joint venture with Kadgee to manufacture in China, and this is an option which must be seriously considered by Kadgee, particularly given Kadgee’s weaknesses of a high cost based and the fact that it is losing customers due to a lack of competitiveness on price. The accepted way to enter the Chinese market is to establish good business connections. Birgit Zeim had already established contacts with Chinese manufacturers and has introduced Xina to Kadgee as a possible joint venture partner. On the other hand, closing factories in the UK would mean laying off UK-based staff to whom the directors owe a duty of care, and would totally transform the nature and operations of the business. 4.2.1 Joint venture with Xina Considering the joint venture proposal to enter the Chinese market, a PEST analysis for the proposed joint venture in China is shown in Appendix 2. The evaluation of the proposed joint venture with Xina in China is shown in Appendix 3 and is summarised below. Kadgee’s share of the proposed joint venture with Xina post-tax NPV figures Probability NPV after 5 years Reduced NPVs with a further change of the Chinese currency against the Euro

High

Low

Expected

70% € million 21.2 16.8

30% € million 9.1 6.5

100% € million 17.5 13.7

As can be seen from the above table, the proposed joint venture with Xina generates strong positive NPVs when evaluated over a 5-year period. Even if the Chinese currency were to further change against the Euro, then the NPVs still remain positive even under the low sales level. Clearly, Xina is keen to enter into a joint venture with a European company, and if Kadgee were to decline this proposal, then it is highly probable that Xina will enter into a joint venture with a different European company which would create yet more competition for Kadgee. Therefore, this joint venture proposal is highly attractive. If Kadgee were to enter the joint venture with Xina, then it would need €8 million to invest in the new factory. It would also need to close all, or perhaps all but one, of its European factories. So, how could it raise €8 million when it already has existing loans of €4.5 million and an overdraft of over €1.6 million? The loans are secured on the company’s assets and if it were to close the European factories and sell the land then the existing loans would need to be repaid. The discussion on finance for the proposed new joint venture factory is analysed in paragraph 4.8 below.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

When Tesco’s wanted to enter the Chinese market, they did so through a joint venture with Ting Hsin, owner of the Hymall chain of 44 stores. It began with a small stake in the company, as its way of generating knowledge and gaining an interest in this new market. Over time it gradually increased its stake before finally building Tesco branded stores. The joint venture was crucial to its success, and as a proven model, is one that Kadgee should also consider. 4.2.2 Entering China alone An alternative solution would be for the company to set up in China on its own, it is considered that this is simply not feasible. The Chinese government does not welcome Western companies without the involvement of a Chinese partner and there are a number of ways in which the start of the business could be delayed by bureaucracy. Due to the relatively immature Chinese legal system, together with the bureaucratic nature of local and state government, it would be virtually impossible for Kadgee to establish a manufacturing base in China on its own. In summary, the longer the decision is put off to enter the Chinese manufacturing industry, or not, or in what form, the harder it will be to compete.

4.8.6

Exercise

Now you have seen the type of answers that might be expected of you, it’s your turn! In the exam you have 11 minutes available explaining each issue, so in this case, your task is to write the remaining 3 issues in a total time of 33 minutes. As a reminder, the other 3 issues are the alternative Asian manufacturing option, cash-flow management and the IT investment. Please do not be tempted to skip actually writing out these solutions, since the key here is to start practising the process, which is harder than it might initially appear, and to begin to develop your time-management skills. You obviously won’t have researched industry examples for this scenario, but it is important that you start the process of including an industry example for each issue. My suggestion to you is that you simply make up examples in this case using fictitious companies. While this may feel false, it is very good practise, and builds your knowledge of the process.

4.8.7

Analysing your solution

For each of your issues complete the following checklist: 4.3 Another Asian country

4.4 Cash-flow management

4.5 IT investment

Stakeholder impact considered Financial implications Related to some point in SWOT? (Continued)

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Additionally, there would be a period of around a year when the European factories would be operational before the new joint venture factory in China became operational, and the finance for the new factory would need to be invested at the commencement of the joint venture arrangement. Therefore, it could not rely on the proceeds from the sale of the existing sites to fund the new joint venture. Some ‘bridging’ finance would be required, which could be secured against the joint venture assets (i.e. the new factory).

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4.3 Another Asian country Linked to other unseen issues Briefly examined at least 2 alternative solutions?

4.4 Cash-flow management

4.5 IT investment

Not necessary here as dealt with in issue 2

Included an industry example? Did you finish this issue in the allotted time (11 minutes)?

Where you have answered ‘No’ in these boxes, it is important that you start to consider how you will change this for next time. In some cases, ‘No’ might be completely relevant, as in the case of alternative solutions in issue 3, but in most cases it won’t be. Finally then, in each box where you have written ‘No’ note what you will do differently next time to ensure you improve for next time.

4.8.8

Solution

4.3

Proposed re-location of some or all of Kadgee’s manufacturing base to elsewhere in Asia (not China) In order to survive beyond the next few years and to remain competitive, Kadgee’s management must reduce its manufacturing cost base. Manufacturing in Europe is far more expensive than manufacturing in China or elsewhere in Asia. Therefore, if Kadgee decides not to enter the joint venture with Xina, then it should plan to re-locate to either of the two identified locations in Asia (not China). The NPVs for the two alternative locations in Asia (not China) are given in the case material as follows: Kadgee’s post-tax NPV figures Probability Location 1 Location 2

High

Low

Expected

70% € million 9.3 9.9

30% € million 4.8 3.4

100% € million 8.0 8.0

Appendix 4 shows a comparison of these NPVs to the joint venture proposal with Xina in China. The main differences are: ●

●

●

●

The China joint venture could manufacture around 20 million garments and the locations in Asia (not China) only around 11 million garments The China expected NPV for Kadgee’s 40% share is €17.5 million, whereas the NPV of the two alternative locations in Asia (not China) are both only €8.0 million. The Profitability Index for the Asia investment is only 1.14 (NPV of €8.0 million divided by the capital investment of €7.0 million) compared to a much higher PI for the China joint venture of 2.19. The discounted cash flows per year (on average) from the two proposals are €3.0 million for either location in Asia (not China), but are much higher at €5.1 million for Kadgee’s share only of the proposed joint venture in China.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Overall, both investments in Asia are financially viable, and if Kadgee’s management chooses not to enter into a joint venture with Xina in China, then the question is which of the two locations in Asia should be chosen, assuming Kadgee did choose to re-locate from Europe. Both locations produce an expected NPV of €8.0 million on an investment of €7.0 million. Location 2 is the riskier option, as the low case scenario produces a much lower NPV of only €3.4 million (almost 30% lower than Location 1 in the low sales scenario). However, it produces a higher NPV in the high sales scenario, which has a 70% probability. Therefore, on financial factors alone, there is not much to choose between either location. Therefore, if Kadgee chose to re-locate to Asia (not China) then other non-financial factors should play the determining role, such as political stability, shipping links, transportation costs and quality of potential employees. 4.4 Management of Kadgee’s cash flows It is imperative that Andre Schnaffer, Kadgee’s Finance Director, manages Kadgee’s cash flows more carefully over the coming year. Andre Schnaffer has allowed Kadgee’s overdraft to creep up to its present level of €1.6 million. Its agreed overdraft limit with its bankers, PGB, is €2.5 million which it must not exceed. If it were to exceed this limit, the bankers have stated that it would recall the entire overdraft, which would force Kadgee to cease trading as it would not have sufficient cash to trade. This would impact all stakeholders, from shareholders, to suppliers, banks employees and so on and so it is vital that this is managed well. It is common in industry for even profitable companies to fail due to poor cash flows. Roughly, 70% of all business failures amongst start up companies, are due to a lack of cash flow, and while Kadgee has a longer history, the position it finds itself in it must take this issue very seriously. With the company continuing to have net cash outflows, there is a danger that the overdraft will soon be reached and given difficult trading conditions, other finance will be hard to raise. It is also important to consider the effects of any Chinese or Asian operation on the cash-flow position also. This is a further reason why the proposed strike action should be averted as this would delay deliveries, and therefore cash receipts. Therefore, the delay in receiving cash could force Kadgee into liquidation. One option to consider is improved cash-flow planning and monitoring. Cash-flow forecasts could be produced to demonstrate the position over the next few months and years, and facilitate cash management. This is both quick and easy to do, and would facilitate better control, and ensure that the future cash-flow problems are identified early so action can be taken. Management of cash, not profits, should be given a far higher profile, with rolling weekly cash forecasts and better monitoring and authorisation of all payments. Ultimately, cash flow will only be able to be managed better with improved business performance, and consideration of options such as the Chinese joint venture, so practical steps in the business to reduce costs or increase revenues, may be the only long-term solution.

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In summary, therefore, the China joint venture investment generates a much higher NPV and PI.

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4.5 Investment in IT solutions Kadgee also has the opportunity to invest in IT solutions in order to attract new customers in today’s global markets. The proposal is to invest €0.5 million in hardware and software to provide an ‘extra-net’ system for customers, and potential new customers, to browse through designs and materials and prices and to place orders online. Jan Berzin has managed to persuade the new Managing Director, Birgit Zeim, of the importance of IT in winning new business and this is an area that Kadgee has neglected to date (it is a key weakness in the SWOT analysis in Appendix A). It has not won new customers for many years and has instead relied on existing customers to grow the volume of orders. With the recent loss of one major customer, Forum, and the increasing competition from Chinese manufacturers, this is an area that Kadgee should concentrate on to remain competitive. The use of innovative IT solutions that allows it to work closely with its customers should be encouraged and developed. As well as the capital cost of €0.5 million, annual running costs for the first 2 years are forecast to be €0.8 million. However, Kadgee has already had interest from one potential customer, BBZ, which would generate a contribution of €0.2 million in the first year and a further €0.4 million in the second year, i.e. a total of €0.6 million against total running costs of €1.6 million in the first 2 years with just this one new customer. Whether Kadgee chooses to invest will depend on market research demonstrating that other customers are willing to place orders with Kadgee if this new IT facility were to be available. Therefore, further research and a sound NPV proposal is recommended before a final decision is made as Kadgee cannot invest a total of €2.1 million over 2 years (€0.5 million investment costs and €0.8 million for 2 years) without a firm belief that this investment will generate sufficient sales and cash flows. This is particularly relevant given the cash-flow issues highlighted in issue 4, given that a further €0.5 million will immediately cause Kadgee to be near its overdraft limit unless other finance is raised. BBZ has stated that it would not place orders with Kadgee unless this system was available and would deal with other manufacturers which offer this IT facility. Therefore, this IT solution is not a new feature as it is widely available from other manufacturers. It again demonstrates how far behind the competition Kadgee has slipped and how much it needs to improve if it is to again be seen to be competitive in the world’s markets. Alternatively, the investment could be postponed or avoided totally. Given the need to impress customers, and recent losses, no investment seems unlikely. However, a postponement of investment until after China joint venture may enable the system to be designed with the needs of the revised global group in mind.

4.9

Ethics Start this section 1 hour and 55 minutes into exam time Duration: 15 minutes

Ethics is the next section of the report. In total there are 10 marks available for dealing with ethical issues, of which half are for analysing the ethical issues and the remainder for recommendations on how to deal with these.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) Personal and professional ethics (2) Business ethics (3) Corporate governance If these are not fresh in your mind, now would be a good time to review this section of Chapter 2, so you can use them effectively as you analyse the ethical issues in Kadgee.

4.9.1 Analysing the ethical issues In my experience, students are good at identifying ethical issues from the scenario, but less good at actually describing or analysing those issues. If we use as an example a common ethical issue which many companies are currently toying with of the environment and climate change. A typical student answer will say something like: An environmental group has recently criticised ABC plc for its higher than industry average levels of emissions of greenhouse gasses. It is important that ABC plc consider environmental issues. I therefore recommend that more research be undertaken into the emissions from the factories, and if it is confirmed that these are high that measures be put in place to keep them low. Lets take a look at this statement line by line. Line 1: An environmental group has recently criticised ABC plc for its higher than industry average levels of emissions of greenhouse gases. This line is a statement of fact which presumably comes out of the unseen, and this should always be your starting point for your answer. Few marks will be scored for this though, since, as yet no analysis has been undertaken. Line 2: It is important that ABC plc consider environmental issues. This sentence is the key weakness in this answer. The question is, why is it important that ABC consider environmental issues, not simply that it is important. Line 3: I therefore recommend that more research be undertaken into the emissions from the factories, and if it is confirmed that these are high that measures be put in place to keep them low. These recommendations are far too brief and simple. They lack the specifics that you would expect in a good answer. What research should be undertaken? Who should undertake it? How will it be assessed whether it emissions are high or low? Can the company afford to put measures in place to combat the emissions, and what will be the consequences of not doing so? What types of measures could they implement? When analysing ethical issues, here is a checklist of items to consider: (1) Who is a duty of care held to? In this case, there is a duty of care to society generally, both now and for future generations of people. Note that there are usually conflicting duties. The company also has a duty to shareholders to keep costs down, and additional measures which reduce emissions may reduce their returns. These conflicting objectives do need to be considered, since emissions cannot be reduced at any cost. Balance must be achieved.

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In this exam, you will be looking to identify about 3 ethical issues to discuss. These ethical issues can come from any or all of the categories that were discussed in Chapter 2 of:

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(2) What are the values inherent in the ethical issue? ABC plc should hold values of integrity and fairness, and as such should ‘do the right thing’ on behalf of all stakeholders, which includes society as a whole. (3) What are laws or other norms in society? The norms in society, in this case, could mean, abiding by emissions legislation, which is the minimum which should be expected of the company, or looking beyond this, to the way most similar organisations are responding to the issue. In this case, many organisations, now have strict environmental policies and targets. In addition, there is an increasing expectation in society that companies will consider environmental issues in their approach to business. (4) How does this compare with the company’s own ethical code or any relevant professional codes of conduct? An analysis of this issue, should, therefore look like this: An environmental group have recently criticised ABC plc’s record on emissions. While ABC plc have always kept their emissions levels within legal standards, many organisations in their industry are now setting emissions targets which go beyond legal minimum requirements, and indeed there is now an increasing concern in society generally about environmental issues. Companies are a key part of society and its functioning, and many companies now see themselves as owing a duty of care to society generally. Indeed, the issue of climate change, steps beyond current society to future societies, to whom our current generation owe a debt to ensure their standard of living is retained, and not affected by our current lifestyles. It is always important to balance this duty of care to society to that owed to shareholders and other stakeholders, so if low cost methods of reducing emissions can be found then I would recommend further action be taken.

4.9.2

Recommendations

Having analysed the issue, it is now important that well-considered recommendations are made. For a detailed analysis of how to make recommendations, you can apply the same rules as used for the main recommendations section (see Section 4.9). As a general guide, aim to make a flow of recommendations over time, with clear justification of each one. Each recommendation should make clear who should do it, how it should be done and when it should take place. If we take the example above, a good quality recommendation might look like this: I recommend that ABC plc bring themselves up to industry standard norms in relation to greenhouse gas emissions, because of the duty of care they owe society as whole in relation to climate change. ABC plc should begin by benchmarking other organisations in its industry to understand the emissions levels which have been attainable by other similar organisations, along with the ways in which they have achieved this. I recommend a project team be set up, led by the operations director, to undertake this exercise. Support from independent consultants, may also help to ensure appropriate expertise is obtained, and independent views included in the analysis. Based on the findings of this exercise suitable emissions targets can then be set, which are both consistent with industry norms and attainable. Any such targets will also need to be accompanied by appropriate change programmes internally, which would need to be appraised, planned and organised.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Exercise

For the Kadgee November 2006 unseen, review the ethical issues which you noted when you were creating your plan, and ensure that you have identified three good ethical issues. Next, write out a full answer to these in 20 minutes, the time allotted to ethics in the timetable in Section 4.2.

4.9.4 5

Solution

Ethical issues

5.1 Dismissal of Rita Scree The over-riding ethical problem is the dismissal of Rita Scree, for poor attendance records due to a family member of Rita Scree being critically ill. She has worked for Kadgee for over 35 years, and as a long-standing member of staff who has given much of her life to the company, it is fair that Kadgee give her some flexibility in this difficult time. Other staff, obviously, also consider that the company’s actions are unfair, and are a good gauge of what might be expected in society more generally. It is recommended that Birgit Zeim backs down from her threat over her re-employment. Her dismissal has enraged her fellow employees who are threatening strike action. This could have a severe effect on Kadgee’s production and reputation and could lead to the loss of further orders. She should be re-employed immediately and be given paid special leave. This would cost the company very little, against the huge possible loss of production if this debacle was allowed to escalate further, and would be seen to be ethically the right thing to do in the circumstances. This would also help staff morale, in that others would also be more confident that they will be treated fairly in the future. 5.2 The wage cut and changes to contracts of employment The wage cut and changes to the contracts of employment for operational staff working in Kadgee’s factories that were imposed by Birgit Zeim shortly after she was appointed as new Managing Director, only applies to operational staff. It was not an across the board wage cut for all staff, and as such could be seen to be unfairly discriminating against this set of employees in these difficult times.. The employees who have worked hard to keep the quantity and quality of production going and as such have a right for their efforts to be rewarded by fair and equal treatment with other employees. This was not an equitable or ethical solution to reduce the wage bill, particularly when it has been accompanied by the appointment of Birgit Zeim herself who has a very substantial package. The decision on this issue has now been made, and it would be embarrassing to backtrack at this stage. However in future, similar decisions should be made with consideration of choice of the most equitable solution. In this case, an alternative solution would have been to reduce the number of hours worked, particularly by some of the female employees who did not want to work full time, rather then the imposed wage cut for the same number of working hours. Kadgee’s skilled employees working in the factories have little choice of alternative employment as many European clothing manufacturers have already ceased trading and they fully understand that their jobs are under threat. 5.3 Redundancies and closure costs In the last few months, Birgit Zeim has already closed one factory, made 54 employees redundant and she has insisted on the dismissal of Rita Scree. Many of the employees will

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4.9.3

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realise that a mass closure of the factories in Europe could happen and that the company may re-locate to China or elsewhere in Asia. As a socially responsible company, Kadgee owes a duty of care to those employees to ensure they minimise the volume of redundancies where this is possible given the difficult trading conditions, and where it is not possible that they provide fair redundancy packages to support these, mostly longstanding and loyal staff. This should, of course, be balanced against the company’s duty of care to its shareholders to ensure the survival of the company. It is recommended that Kadgee should pay more than the legal minimum redundancy payments to all employees who face redundancy and, in addition, assist the employees to find new employment or retrain in another field. Kadgee could, for example, help finance any training or college courses for employees being made redundant. As there are so few clothing manufacturers still operating in Europe, it is unlikely that they will find a similar job in another clothing manufacturing company. If the decision is made to re-locate to China or elsewhere in Asia, the mass closure and redundancies will need to be very carefully handled as staff morale will be low, but there will be a period of time, perhaps up to 1 year, when Kadgee will still need its employees to manufacture clothing to the required high standard before the new factory in China is operational. This will be a difficult time and staff motivation and management of the redundancy programme will need to be carefully and diplomatically handled. It is recommended that good channels of communication are established with all staff and decisions are communicated accurately and promptly to stop rumours spreading.

4.10

Recommendations and conclusion Start this section 2 hours and 10 minutes into exam time Duration: 50 minutes (to the end of the exam)

The final section of your report is to make your recommendations, and follow this up with a brief summary conclusion. This is the most important element of the report, and it must flow well and be logical.

4.10.1

Aims for the ethics section

For each issue you present you should aim to: (1) Make 2–3 clearly stated recommendations, which support each other, and/or flow well over time Many students have run out of time by this part of the exam, and often only make one simple recommendation with no depth or detail added. Often, although not always, recommendations can be stated as a flow of recommendations over time, or as one overriding recommendation with a number of sub-parts. By providing that extra level of detail you significantly improve the quality of your report. Lets take the examples

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.10.2

Example

Here are example recommendation sections for the first two issues being considered for the Kadgee November 2006 unseen. 6

Recommendations

6.1 Resolving the dismissal of Rita Scree It is recommended that Rita Scree is re-appointed and that Birgit Zeim backs down on this point of principle. The disruption to production and possible effects on customers of strike action should be avoided as a priority, since the impacts of this could be catastrophic to Kadgee’s future position through causing a further loss of custom. Ethically, Kadgee owes a duty of care to support such a long-standing member of staff and this should come above any specific ‘point of principle’. With this in mind, it is also recommended Rita Scree is given special leave to sort out her family problems, and that HR policies are updated to allow flexibility to staff in a similar position in the future. These actions should have a positive effect on employee morale generally. If Birgit Zeim refuses to back down and not re-appoint Rita Scree, then it is recommended that the Kadgee Board should terminate Birgit Zeim’s contract of employment. 6.2 Proposed move to China It would not be possible for Kadgee to set up a factory on its own in China as this would be blocked by the Chinese local government. This option is not feasible and should be ignored.

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of a planned redundancy programme. Rather than simply stating that a company should undertake the programme, this might be shown as follows: (a) Meet with the unions to discuss planned redundancy programme, explain the reasons for it and negotiate mutually acceptable terms. This will reduce resistance to change and avoid possible industrial action. (b) Offer voluntary redundancy in the first instance, so that the effect is limited to those staff who are happy to leave, and staff morale can be maintained as high as possible. (c) Offer full support to staff who are made redundant to facilitate them finding new positions elsewhere (e.g. retraining, time off for interviews). (d) Progress with the programme swiftly, to minimise the negative effect on morale that will inevitably follow. (2) Justify each recommendation made You must justify each of the recommendations you make. This will inevitably mean repeating some element of earlier discussions, which you must not be afraid to do. These justifications should simply be a summary of the key arguments you made in your earlier section. A redundancy programme might be justified by reason of a need to cut costs to ensure the firms survival or falling sales reducing capacity requirements on a permanent basis. It might also be justified in comparison with the other alternatives, so for example, redundancy might be considered better than cutting the wages of all existing employees as an alternative way to cut costs for motivational reasons.

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The Xina joint venture proposal in China should be considered carefully. However, this would require some drastic changes in Kadgee’s operations including: ● ● ● ● ●

Closing and selling all or most of the European factories Refinancing, possibly with an international bank Repayment of loans with PGB which is secured on the European factories Re-location of Kadgee’s senior staff to China to manage the joint venture Concerns over possible loss of intellectual property

Overall, it is recommended that Kadgee is not ready for such a drastic change. Kadgee is a family-run company with long-standing loyal employees. Can the management team, aside from Birgit Zeim, cope with manufacturing in a different environment such as China and working as part of a Joint Venture? It is considered that apart from Birgit Zeim, who is enthusiastic for Kadgee to re-locate, the rest of the Directors may not stay with Kadgee, and this opens up more risks. Therefore, it is recommended that Kadgee does NOT re-locate to China in a joint venture with Xina despite the strong positive NPV which the proposal is forecast to produce.

4.10.3

Exercise

Complete a recommendations section for the remaining three issues from the November 2006 Kadgee case. With 35 minutes in total for the recommendations section, that means just 7 minutes for each, giving you a total of 21 minutes.

4.10.4

Analysing your solution

For each of the issues considered, complete the following analysis table. 4.3 Another Asian country

4.4 Cash-flow management

4.5 IT investment

Have you given more than one recommendation, either flowing in time, or as sub-parts of one overall recommendation? Is it clear, how this recommendation will be undertaken? Have you stated who will undertake the recommendations? Is timing of the recommendations stated? Have you stated why you have made this recommendation? Is it clear why this recommendation is superior to other options available to the company?

Solution 6.3

Proposed re-location of some or all of Kadgee’s manufacturing base to elsewhere in Asia (not China) If the joint venture in China with Xina is rejected then Kadgee has four remaining alternatives: ● ● ● ●

Re-locate to elsewhere in Asia Stay in Europe Voluntary liquidation of Kadgee Trade sale

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

It is therefore recommended that Kadgee re-locates to either of the two locations elsewhere in Asia that have been identified. This would enable it to reduce its cost base considerably, but still to be able to have 100% control over the manufacturing operations. Also by operating in Asia (but not China) the risk of loss of intellectual property is reduced. It is recommended that Location 2 with an expected NPV of €8.0 million (and a high sales scenario NPV of €9.9 million) is selected as the location for Kadgee’s new low-cost manufacturing base, although the final choice will depend on other non-financial factors such as political stability, shipping links, transportation costs and quality of potential employees. It is further recommended that four of the remaining five factories in Europe are closed and that one remains open. These closures will need to be led by the board as a whole and undertaken on completion of the new facility in roughly a years time. The factory that remains open should be one of the three factory sites which have land with a no resale value, as Kadgee would need to sell the two sites for €12.0 million to help finance the new factory in Asia. This factory can be used for orders that have short delivery times, or highly specific requirements where long-standing experienced staff would be required. This decision will have significant impact on staff, so I recommend that the board undertake discussions immediately with union representatives, with a view to agreeing the terms of redundancy packages and ensure the terms are fair, while also aiming to continue buy-in of staff during, what could be a lengthy period, until the new Asian facility opens. 6.4 Management of Kadgee’s cash flows An updated cash-flow forecast should be prepared in detail, by week, for a rolling 3-month period and a less detailed cash-flow forecast prepared for a rolling annual period. It is imperative that the agreed overdraft limit is not exceeded. It is recommended that the working capital cycle is reduced and that more innovative methods of reducing debtor levels are initiated. There may be a way to ask customers to pay in shorter time period by linking payment and invoicing directly to delivery data, and all exchanges of data to be done electronically. This should be pursued, although customers will be unwilling to pay quicker without receiving discounts. These should be assessed against the cost of Kadgee’s current overdraft cost. It is recommended that Kadgee should sell some of its high level of inventories (at a loss if necessary) to generate much needed cash. All supplier payments must be carefully controlled by the FD to ensure that the agreed overdraft limit of €2.5 million is NOT exceeded in any circumstances at all. Andre Schnaffer needs to report to the Kadgee Board on the cash situation regularly and the importance of cash, rather than profitability, needs to be emphasised. 6.5 Investment in it solutions It is also recommended that Kadgee does not yet invest in the proposed IT solutions proposed by Jan Berzin as it does not have the necessary cash resources and at present the NPV is negative as only one potential customer has been identified.

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It is not feasible to stay in Europe and continue what it is doing as there are no long-term signs that the business will become more profitable, and it would simply delay the time until the company were to cease trading, as it would become more and more uncompetitive on price.

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When the company has undergone the selection of its re-location of its manufacturing base, and it can be more price competitive (due to lower production costs), it is recommended that this IT solution could enable Kadgee to win more orders. However, until then it is recommended that it is not approved. If Kadgee were to open a large factory in Asia, equivalent to the capacity of all six European factories, and still retained one factory in Europe, this IT solution could help to generate additional business and allow the company to expand the business.

4.10.5

Conclusion

The conclusion should provide a brief round up and summary of everything that has gone on before. Few additional marks are gained for this section, beyond those for using the correct formatting, so you must do this, but you should keep it brief. For the unseen we have been using in this chapter a suitable conclusion might look like this. 7 Conclusion Kadgee needs to become much more innovative in order to survive. China cannot be ignored, but the proposed joint venture with Xina is not recommended at this time. Instead a move to re-locate most of its manufacturing base to elsewhere in Asia where Kadgee would have 100% control is recommended. However, Kadgee should retain one of its European factories in order to fulfil some customers’ orders. Kadgee is only likely to survive in the long term if it changes what it currently does, and this will inevitably involve moving most of its manufacturing base outside of Europe.

4.11

Formatting your report

Formatting of the report is important, since 3 marks are available for format and overall presentation in the exam. I suggest that you number each of your main sections and subsections in the same way as used in the example above, giving each heading an overall number (1–7) and each sub-heading numbered with a point (e.g. 4.1, 4.2, 4.3 and so on). I would also recommend starting each new section on a new page, so that your report is well spaced out, and, for the same reasons, each new sub-section of the main body of your report (Section 4) on a new page too. Headings should be underlined (with a ruler) or, in the PC exam, done in bold, and I would suggest leaving a line after each heading, and between each paragraph, as is the norm in most business reports, and again ensure the report looks smart and earns those presentation marks. If you do run out of time, try avoiding, leaving headings in your report for sections which you have not completed, as I often see some students do. I think these students like setting out all their headings at the start of the exam, and then fill in the gaps as they progress. While this may help this with the overall structure, a report with clearly missing sections does not look professional, and it is better to make it look like you simply never intended to cover more so that the whole document looks complete than make it look like your document is incomplete in some areas.

4.12

I can’t do it in the time!

Probably the most common statement I hear from my students, in relation to TOPCIMA, is that they have difficulty completing the whole report in the time allocated. Having practised a variety of sections so far, you may now have some sympathy with them! If you

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) Practise as many exams as you can The more you practise, the more the whole process will become second nature to you and the quicker you will get. As I have suggested before, aiming to complete about 8–9 full practise exams should certainly be the goal for most students, particularly those doing the June and November sittings when there is more time to prepare. (2) Work at a high pace When I look around the room at students sitting their mock exams, I see people working at a great variety of speeds. Some people are beavering away, writing very quickly, reading quickly, really getting on with the job of getting the report finished. Other people look like they’re on holiday! Everything is slow, considered, relaxed and easy. If that is you, then aim to work at a higher overall pace, remembering the key to success is not just quality, quantity is important too. (3) Keep to the time plan, and learn your own limits Learn the limits of what you personally can practically do in the time. If, despite trying to speed up, you are still struggling for time, then work within the limits of what you can do. If you can only manage to write 2 paragraphs for each ethics issue in the time, then do just that. If the most you feel you write in the main body of your report in 11 minutes, is one side for each issue, then work out how to cover everything you need to in that amount of space. Do what you can, rather aiming for the perfect answer. (4) Only do 4 issues If you are really struggling for time, in my view it is better to do 4 issues and do those well, rather than aim for 5 and then leave your report incomplete in the recommendation section. Another option, is to ensure you leave space for the fifth issue, but do this at the end, only when you’re sure you’ve got time to do it. You may need to adjust your timings from those in Section 4.2 to take this approach, but it is a consideration if you are struggling for time. (5) Spend less time on your appendices While the appendices do gain some very good marks, it may be better to spend less time on calculations, do one fewer theory appendix, or do your points in your SWOT more briefly, to gain some time later on to ensure you complete your report. I have known a number students who passed having decided that since calculations were not their strength that they would leave them out and use the time to gain marks elsewhere in the report. While that wouldn’t be my recommendation to you, since the examiner has stated that marginal failure scripts with no calculations will not get ‘promoted’ to a pass, it does demonstrate the range of options you have to save time if you really need to. (6) Only do two ethical issues By only doing two ethical issues, you will sacrifice the 2–3 marks you will have gained for the third issue, but, if this gains you time to ensure you complete your main recommendations section this is preferable. You could always return to this section at the end if you find you have a few minutes left. Do remember that suggestions 3–6 above are last resort options, to be used only when you’ve tried everything else and still you’re struggling to finish. Time management is tough, but with practise, you can find a way that you can make work for you. In this Chapter you have learnt and practised all the sections in the report. You should now be well prepared to take a full exam, and that is exactly what you will be doing in Chapter 5.

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find yourself as one of those students who is struggling to complete your report in the time, how do you overcome this key issue? Here are my suggestions:

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5 Practise Exam

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5

Practise Exam

LEARNING OUTCOMES By the end of this chapter you should 䉴

have practised a full mock exam;

䉴

have analysed your answer to gain feedback on what you did well, and on what areas you need to improve.

5.1

The full mock

Hopefully by now, you’ve come to realise the importance of exam practise as preparation for TOPCIMA, and assuming you have read through the previous chapters, and attempted the exercises in them, then you are ready to attempt your first full mock exam. This is the part that everyone hates, but as I mentioned back in Chapter 1, this needs to be the first of up to 8 or 9 full mock exams that you should be aiming to practise as you work towards the exam. Now is the time to put it all together in one full exam.

5.2

The Merbatty pre-seen

The exam you will be doing is November 2007 paper. There is little to be gained by you preparing old pre-seens in depth, so, much like we did in Chapter 3, for practical purposes, I suggest you prepare for the exam using a summary of pre-seen information. If you would like to see the full pre-seen information for this scenario it can be found in Chapter 6, but I would not recommend spending more than a few minutes reading this. At this stage, what is important is building the skills to be able to write a good answer, not the analysis of an old case on which you will not be examined. Take a few minutes then to read and examine the following summary of this pre-seen.

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Summary of the November 2007 Merbatty case pre-seen The Merbatty boat case sets the scene in the luxury boat building industry. This newly listed European company has very ambitious growth plans. Merbatty operates three boat building facilities in three different parts of the world – in Europe, in the USA and its soon to be opened facility in Surania in the Middle East. Merbatty became a listed company only 1 year ago, and the finance raised from the flotation is being used to finance expansion of the business, including the new boat building facilities. In 2006, Merbatty built 280 boats from a product range of 15 different boats. These ranged in sales price from €0.4 million to over €4.4 million each. By 2011, its 5-year plan is to build 500 boats and to double its sales revenue to €1,000 million. Many investors have very recently bought shares in Merbatty on the basis of the 5-year plan, and they expect this plan to be delivered, even though it is very challenging plan. They are trusting the Merbatty Board to manage the operational problems and to put plans in place to achieve the agreed strategic plan. The two most visible targets for investors will be: (1) The number of boats built compared to plan. (2) The profit after tax compare to plan. As part of the flotation, a new investor, JKL has purchased 50.4 million shares, which represents a 28% shareholding and has a seat on the Board. Merbatty’s shares were issued at €2.80 per share and by the end of June 2007 the share price had risen to €3.65, a rise of 30% in less than 8 months. Clearly the Stock Market is impressed with Merbatty’s profitability and its ability to grow. The other main shareholder is Alberto Blanc, the Chairman, who owns 30% of the company. Key facts to be aware of. Merbatty: ●

● ● ●

● ●

●

make most of its sales through independent sales agents, and pay 4% commission on the sales price for each boat sold; employ 2167 employees; currently make 280 boats per annum; compete by building boats of the highest quality and luxury, and selling these to wealthy clients; achieve this using a highly skilled workforce. currently make boats in Europe in 2 boat building facilities, but are soon to open a new facility in the Middle East in a fictitious country of Surania. Have close relationships with a small number of suppliers – MNE, their only engines supplier, Topcrest, who supply hulls, Marinatron, who supply all radar and navigation equipment and Aqua designs who supply all interior fittings.

Merbatty is a global company operating in three different continents and selling boats to customers all around the world. There is scope for lots of new opportunities – and there is scope for lots of things to go wrong!

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Strengths

Weaknesses

●

Listed company with experienced Board of Directors

●

Dependant on its suppliers for many bought in components

●

Growing demand for new boats

●

Speed of innovation

●

Approved 5-year plan with high growth prospects

●

New technologies improving at a fast pace

●

Good market reputation for quality

●

Can Merbatty maintain quality as sales increase

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Good range of boat models with new models being introduced each year (innovative)

●

Can Merbatty recruit the required level of skilled employees to meet the growth in boat building

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New boat building facility in the Middle East which gives Merbatty spare boat building capacity to meet demand

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Strong asset backed balance sheet

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High market profile with 2 sponsorship contracts

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Experienced employees, many of whom own shares in Merbatty

Opportunities

Threats

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New markets in Asia

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Costs higher than current 5-year plan

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Expansion in range of boat models

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Overstretching management resources due to high growth

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High growth 5-year plan

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Retaining management expertise

●

New boat designs

●

Retaining and motivating employees

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Improved production efficiency

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Highly competitive

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Improved use of high technology in boat building to save costs

PEST analysis for Merbatty – using pre-seen material only Political/Legal ●

●

●

Possible operational problems at the new Middle East boat building facility – will it open on time in September 2007? If boat building facilities are moved to Asia in 2011, there could be problems with culture, language and work practices Potential problems with enforcing IPR’s if boat building facilities in Asia lead to loss of Merbatty’s commercial knowledge and designs

Economic ●

If there were another global recession, there would be a downturn in demand for these luxury goods

PRACTISE EXAM

SWOT analysis for Merbatty based on pre-seen material only

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Social ● ● ●

Changes in customers’ behaviour and tastes, resulting in higher (or lower) level of boat sales Safety standards for employees and customers Environmental issues concerning these luxury boats

Technological ●

● ●

●

The need to continue to be innovative in production to generate better standards for customers and to reduce boat construction costs The need to be innovative in boat designs in order to stay competitive The use of improved technology to make to save costs, make boats safer and improve quality Threat of competitor innovations

5.3

Set up for taking your first unseen

I suggest you quickly review the report formats from Chapter 4, along with the key elements required in each section. This will ensure the requirements for each section are fresh in your mind, and will enable you to attempt this assessment within the allotted time. Reproduced below, is the standard timetable for written exams. You will undoubtedly find the timing tough, but you must have the discipline to keep to these timings, so that you do get through the report in the time. On a practical basis, I usually suggest that my students aim for just 4 issues (as opposed to the ideal number of 5), in their first mock exam, in order to make the report manageable. At this stage you are still learning about formats, timetables, prioritisation approaches and so on, and so it can be tough to expect yourself to do a full answer straight off.

Time

What you should be doing?

20 minutes Reading Time

Read case and prioritise

ⴙ10 minutes of Exam Time

Notes on key points of impact and alternative solutions

15 minutes

Do calculations (in the appendix) Reconsider priorities given the calculations

15 minutes

Appendices: SWOT analysis and at least 2 other models of your own choice

5 minutes

Report format, Introduction and Terms of Reference

15 minutes

Prioritisation section

3 minutes on each key issue 55 minutes 13 minutes on top 3 issues 8 minutes on issues 4 and 5

Main body of report. For each major issue: summarise, then analyse, give alternative solutions, and provide an industry example

15 minutes

Ethics: Identify and explain 3 ethical issues, and make recommendations

50 minutes 12 minutes on top 3 issues 7 minutes on issues 4 and 5

Recommendations, including answering why, how, when and who Conclusion

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

5.4

November 2007 Unseen

The requirement You are the consultant appointed by the Merbatty Board. Prepare a report that prioritises, analyses and evaluates the issues facing Merbatty, and make appropriate recommendations. The unseen Merbatty Boat Case – Unseen material provided on examination day. Read this information before you answer the question. Adverse weather conditions resulting in reduced stock market confidence As a result of increasingly unusual weather and harsh sea conditions linked to global warming, there have been a growing number of boats ‘lost at sea’. In fact, 30 boats sunk last year. After the required investigations, none of the boat models were found to have any design faults. In October 2007, following a severe storm, a further 4 boats, including a Merbattybuilt boat, were ‘lost at sea’. These boat losses attracted much adverse press speculation. The stock market has reacted to the current loss in confidence and all companies in this sector have seen a fall in share prices by around 7%. Merbatty’s share price at the end of June 2007 was €3.65 but since the end of October 2007 the shares have been trading at around €3.40. Most manufacturers worldwide have seen a reduction in advance orders. As a result of the downturn in sales, some competitors have reacted by reducing their selling prices in order to stimulate sales. Updated navigation software As a result of this recent adverse publicity, Marinatron (Merbatty’s supplier of on-board systems) has updated its latest satellite navigation software to include an enhanced early warning weather system. Marinatron has identified a strong demand for this enhanced early warning feature. The new navigation software system costs €70,000 per system, whereas the previous navigation software system was only €10,000. Marinatron is advising

PRACTISE EXAM

Given the limited research done into this company and industry, for this mock I also suggest you do just 2 theory appendices, a SWOT analysis and PEST analysis, and that you use those outlined as part of the pre-seen summary as the basis for your answer, remembering to update these for new unseen information. Remember that ideally you will do 3 or 4 in the real exam, but practically, for your first attempt with an unfamiliar pre-seen, 2 is a manageable number. You are unlikely to have good business examples to use for this scenario, so, just for the purpose of the exercise, you should make up some industry examples using fake companies. While this sounds false, it is crucial that you get into the routine of adding industry examples into each issue as you write it. Remember that your main goal here is not to get the answer right, it is to practise the full process from the beginning to the end, to familiarise yourself with that process and practise your time management. Find yourself a quiet place where you won’t be disturbed for the next 3 hours and 20 minutes, get yourself ready and best of luck.

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all boat manufacturers that they should install this latest navigation software system to all newly manufactured boats. Marinatron has requested boat manufacturers to inform all of their previous customers of the availability of this new enhanced navigation software system, so that customers can decide for themselves whether they want to have it installed at an additional cost. Alain Mina, Technical Director – Systems and IT, does not believe that this new navigation software system is worth the extra cost and has made a decision not to procure this new system for boats currently in production. He also considers that the extra cost that Merbatty would incur, could not be passed onto customers, as the customers have already signed contracts for their boats. Additionally, Alain Mina has advised the Board that, in his opinion, this new navigation software system is not necessary and that if Merbatty’s existing customers were to be asked if they wanted a new system, they may feel disappointed with the existing IT systems installed. The Merbatty Board agreed not to inform existing customers of the updated navigation software system. Merbatty’s boat building facilities Merbatty’s new boat building facility in Surania opened, as planned, in September 2007 and Merbatty has selected this facility to construct all boats for customers based in the Middle East as well as to specialise in the construction of all large boats for customers worldwide. The Suranian boat building facility has already commenced work on a number of large boats. As a result of strong competition in the USA, Merbatty has seen its boat sales from the USA fall significantly from the planned levels in 2007 and beyond. The original 5-year plan (shown in Appendix 5 to the pre-seen material) predicted that by 2011 24% of total sales revenue would be from customers based in the USA. However, it is now predicted that sales revenue from the USA customers will be far lower. Bernie Ritzol, Merbatty’s Global Market Development Director, has prepared a proposal to the Merbatty Board to close the USA boat building facility during 2009 and to develop an additional boat building facility in Asia (originally planned for 2011), as much of Merbatty’s recent growth has been in the Asia and Australasia regions. This proposal highlights that a boat building facility in Asia would result in a significantly lower cost base, due to lower staff costs. The differential between the two locations is forecast to be increased post-tax profits of €10 million per year. If this proposal were to be agreed by Merbatty’s board, then additional loan finance would be required in order to finance the required capital expenditure, as the USA boat facility would need to remain operational until the proposed new facility opened in Asia. The USA boat building facility could then be closed and the land sold to repay debt. An alternative strategic proposal is to expand Merbatty’s boat building facilities in Europe. A large plot of river-side land next to Merbatty’s European boat building facility has been put up for sale which would allow Merbatty to extend its facilities, which would replace the need to expand to Asia. If Merbatty were to expand its operations in its home country, then this site would be invaluable. Tobias Houllier, the Operations Director, considers that Merbatty’s expertise should be retained in Europe and he has prepared a proposal to acquire this European land for future strategic purposes. Tobias Houllier has highlighted that if Merbatty did not acquire it on this occasion, then it is unlikely that it would be able to get such a prime river frontage site in the locality again. The land (only) is forecast to cost €40 million including legal and surveying costs. This cost excludes the construction of the boat building facility itself. A decision

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Effect on Merbatty’s profitability due to currency fluctuations Merbatty has its cost base in Euros, US Dollars and the Middle East currency of Dinars. However, Merbatty is a European company and its profits are accounted and reported in Euros. Its revenues are generated in only Euros or US Dollars. Merbatty is a European company, listed on a European stock exchange, and its group profits are reported in Euros. The majority of its costs are currently denominated in Euros, as all of the engines it procures for all boat models are from MNE, which is European based. However, over 60% of its sales revenues have historically been contracted for in US Dollars, as customers in the USA, Middle East and other areas prefer to pay in US Dollars rather than Euros. The company has a policy of hedging all currency transactions at the point of signing a sales contract so that the value of future sales receipts is known for certainty in Euros, its base currency. Merbatty is also able to net its payments and receipts in US Dollars including its agency fees and staff costs. Therefore, transaction exposure is minimised as much as possible. Due to the current exchange rate between Euros and US dollars, Merbatty has identified that over 90% of its customers in the last 6 months have chosen to contract for new boats in US dollars. If the trend in sales denominated in US dollars were to continue, which has allowed customers to purchase their boats at a lower price, then this would have an adverse effect on Merbatty’s profits. The adverse effect is forecast to be around €6 million on posttax profitability in 2008, unless action is taken by Merbatty. Andreas Acosta, the Finance Director, has asked Stefan Gil, Sales Director, what actions could be taken to secure more sales in Euros or alternatively whether Merbatty should have its price list denominated only in Euros. Higher operating costs than planned Andreas Acosta has prepared an updated plan for the period 2007 to 2012. The updated plans are due to be discussed at a Board meeting in early December 2007. They show lower levels of profitability than the agreed 5-year plan (shown in Appendix 5 to the preseen material). However, the latest full year forecast for 2007, shows post-tax profits of €45 million, as planned, due to slightly higher sales earlier in the year, offset by higher operating costs. The updated plan shows that post-tax profits could be €12 million lower than planned, at €39 million for 2008, rather than the original approved planned post-tax profit of €51 million. The post-tax forecast profit for 2008 of €39 million includes the forecast adverse effect of currency changes of €6 million post-tax, as detailed above and also the lower forecast sales in the USA (as detailed above). However, it does not include the impact of Stefan Gil’s resignation (see later) and also does not include the impact of the proposed new sales agency in the USA (see later). Future years’ post-tax profits are also forecast to be lower than planned. Proposals to reduce operating costs Henri Gaston, Merbatty’s Chief Executive, has stated that actions need to be taken in order for the agreed profitability in the 5-year plan to be delivered. Henri Gaston has suggested that one possible area for cost reduction is to change the supplier of the engines for Merbatty’s boats. The cost of engines represents the single largest bought in component in the boat building process. The cost of engines from Merbatty’s

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as to whether Merbatty should acquire this European land, or not, needs to be made by the middle of December 2007. This is to ensure that it is not acquired by another buyer.

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sole engine supplier, MNE, amounted to €38 million in 2006. MNE increased its prices in May 2007. The price rise was slightly higher than Merbatty had incorporated in its plans. Another engine manufacturer, ENG (which is based in the USA) could supply Merbatty with engines for around half of its boat models at a lower cost, with no necessary redesigning of the engine space in the boat. Merbatty has considered using ENG in the past. Lukas Dian, Merbatty’s Technical Director – Design, states that these alternative engines would not generate the same power, and could have an adverse effect on Merbatty’s high reputation. It is estimated that if Merbatty were to select engines from ENG for half of its boat models, this could result in post-tax savings of around €4 million in 2008. Henri Gaston has asked his fellow Directors to re-examine areas where additional revenues could be generated or reduced costs could be identified. He considers that it may be possible to increase the selling price on Merbatty’s top priced boat, which is the model P3000, which currently retails at €4.7 million each, excluding revenues from additional features. The latest plan is that the number of boat sales of this model in 2008 will be 50% higher than the number sold in 2006. Henri Gaston has asked whether Merbatty could reduce the specifications for some new boats by using cheaper, lower technology equipment. Henri Gaston has also asked whether Merbatty could reduce the expenditure on the development of new boat models, which is forecast to be around €8 million post-tax each year. Henri Gaston has suggested that Jesper Blanc, Marketing Director, should immediately terminate both of the sponsorship contracts, which could save Merbatty a total of €6.5 million post-tax each year (the sponsorship contracts costs Merbatty €5 million each before tax). Merbatty’s Sales Director resigns In early November 2007, Stefan Gil announced his resignation and stated that he was moving to CCL, a rival boat building company based in Europe. His contract of employment with Merbatty did not prevent him from taking up this position. It was agreed that it would be in Merbatty’s best interests if he did not remain with the company during his 3 month notice period. He therefore left Merbatty on 9 November 2007. Stefan Gil still owns 5.4 million shares (3.0%) in Merbatty. At the November 2007 Board meeting it was agreed that Stefan Gil’s deputy was too inexperienced to be promoted to Sales Director and in the meantime, Jesper Blanc has been asked to take on the Sales Director’s responsibilities in addition to his role as Marketing Director. Merbatty’s sales agents in the USA The majority of Merbatty’s sales to end customers are made through agents. The commission cost of operating an agency service is 4% of sales revenue. In early October 2007, one of Merbatty’s USA sales agents, LABS (which sold only Merbatty boats) gave 3 months’ notice of the termination of its agency for Merbatty. With effect from January 2008, LABS will sell boats for a major competitor. In the previous 5 years LABS sold approximately 60% of Merbatty’s boats in the USA market. In November 2007, after Stefan Gil’s resignation, Jesper Blanc approached another experienced boat sales agency, SFBS, and invited it to switch from selling boats built by one of Merbatty’s competitors. SFBS has a very good reputation. SFBS has officially responded to confirm that it would agree to exclusively sell Merbatty boats, but only if Merbatty were to agree to a higher agency fee of 8%. However, Andreas Acosta is concerned that other Merbatty agents around the world will learn of SFBS’s proposed agency arrangements.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Computer test program results showing possible faults Merbatty has very recently upgraded its computer test program for a number of its larger boat designs. The test program was purchased from a leading software company, which developed this specialised software. It has proved to be very reliable in identifying small faults in boats under construction. During October 2007, the test program indicated a number of errors and potential faults on four large boats. However, Alain Mina, Merbatty’s Technical Director for Systems and IT, has told the test team to ignore these error reports, as he considers that they are likely to be computer systems errors, and not real faults with the boats. The customers for these boats are very influential individuals and Alain Mina is keen not to delay delivery of the boats to them. Appointment of a consultant At the Merbatty Board meeting held on 19 November 2007, it was agreed that a consultant would be appointed to advise the Board on the issues facing Merbatty.

5.5

Reviewing your answer

Before you look at the formal solution, let’s do the most important thing, which is to learn lessons from what went well and less well in that exam. You will find below a checklist of

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Takeover bid by CCL One of Merbatty’s boat building competitors is CCL. CCL is a listed company with sales revenue at around the same level as Merbatty, although its net profit margin is lower. CCL’s share price has not grown as its investors had expected and the Board of CCL is under pressure to deliver higher earnings per share (EPS). CCL’s Business Planning Director has been monitoring Merbatty’s impressive growth in sales, and its recent listing. He has convinced the CCL Board that if it were to acquire Merbatty, it would help to improve CCL’s EPS. CCL is the same company that has recently recruited Stefan Gil, Merbatty’s ex-Sales Director. On 16 November 2007, CCL announced its intention to offer the equivalent of €4.20 per share, in a share for share exchange offer. CCL stated that it would require a majority shareholding if the acquisition is to proceed. Prior to the announcement of CCL’s takeover bid, Merbatty’s shares had been trading at around €3.40. After the takeover bid was announced Merbatty’s share price rose, due to speculation, and on 19 November 2007 was €3.74. Both companies had a P/E ratio around the market average of 15 before the bid was announced. At the scheduled Merbatty Board meeting on Monday 19 November 2007, the takeover bid by CCL was discussed. Together with its corporate advisers, Merbatty made a press statement advising shareholders to reject the bid. Alberto Blanc was quoted as saying ‘Merbatty is confident that its long-term growth prospects would be higher if Merbatty were to remain independent’. Merbatty’s main external investor, JKL, stated that it needed to be convinced as to whether it should accept, or reject, CCL’s bid. Jesper Blanc considers that the CCL bid could be an opportunity for him to give up his responsibilities to Merbatty. He has spoken to his father, Alberto Blanc, the Chairman, about his plans to sell his shares. Alberto Blanc is very disappointed at his son’s plans to sell his shares, as he had always wanted Jesper Blanc to be the Chairman of Merbatty one day. Alberto Blanc has promised that Merbatty will pay Jesper Blanc a loyalty bonus of €3 million during 2008 if Jesper Blanc agrees not to sell his shares to CCL.

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questions to ask yourself to review your script. This checklist is based on what you need to do for the real exam, and can be used both here and in future mock exams you undertake. For this reason it assumes that you have not taken the shortcuts I suggested in Section 5.3. You will find another copy of this to use in future exams in Appendix 3. ✔

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What will you do differently next time to improve?

Time management Did you finish in the required time? Did you keep to the timetable throughout? Report formats Contents page, clear with correct formats Introduction: completed, including an industry example Terms of reference completed Numbered headings for each section and sub-section Script is legible and well laid out Planning and prioritisation Did you complete this section within 30 minutes? Had you made a clear decision on your prioritisation order at the end of this time? Had you planned some key discussion points and alternative solutions for each of your 5 top issues? Were the examiner’s top 2 issues within your top 3 issues? Is your overall top 5 approximately in agreement with the examiner’s? Analysis of the issues Did you complete this section in the allotted time? Issue 1 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 2 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses (Continued )

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

✘

What will you do differently next time to improve?

– Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 3 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 4 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 5 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Ethics Did you finish this section within 15 minutes? (Continued )

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✔

✘

What will you do differently next time to improve?

Issue 1 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Issue 2 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Issue 3 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Recommendations Did you complete the recommendation section of your report within the full time of the exam (remembering it is the most important section)? Issue 1 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 2 Have you made a range of recommendations for this issue? (Continued )

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✘

What will you do differently next time to improve?

Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 3 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 4 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 5 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Are the recommendations on all five issues consistent with each other? If this were a real-world company, and this report was given to a real world Board of Directors, would they be happy taking these recommendations? Are they logical, well-thought through, justified, and ultimately would they leave the company in a stronger position going forward? (Continued )

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✘

What will you do differently next time to improve?

Conclusion Have you done a suitable conclusion? Appendices A SWOT analysis was undertaken The SWOT analysis was updated for unseen issues The SWOT includes all of the top 5 issues in the report Have you done at least 2 further theory appendices? Have these additional appendices been updated? Have you done 2–3 calculation appendices? Are calculations clearly laid out? Have you cross-referenced every one of your appendices in the main body of your script at least once? Overall As you review your script as a whole, what are the key areas you need to improve for next time?

5.6

Solution

The solution which follows is that provided by the examiner. As such, it has not been written precisely to the formats and process laid out in this book, although you will see that most elements are addressed somewhere in the answer, as you would expect of a high quality solution. It is important to realise that you are unlikely to have produced an answer of this length and complexity, and you would not be expected to, you will notice, for example, that the report covers more than 5 issues, which your report should not. It does, however, give you a high quality report to review, and, most importantly the views on the unseen of the examiner, in particular, the examiner’s prioritisation order, although it is also important to realise that you do not have to have reached the same conclusions as the examiner. What is important is that your recommendations are logical, flow through from detailed analysis, and would put the company in a strong position going forward.

TOPCIMA – Merbatty boat case – November 2007 exam REPORT To: Merbatty Board From: Consultant Date: 22 November 2007

Review of Merbatty Contents 1.0 Introduction 2.0 Terms of reference 3.0 Prioritisation of the issues facing Merbatty

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Discussion of the issues facing Merbatty Ethical issues and recommendations on ethical issues Recommendations Conclusions

Appendices Appendix 1 SWOT analysis Appendix 2 PEST analysis Appendix 3 Summary of key ratios Appendix 4 Valuation of CCL bid for Merbatty and comparison to future values Appendix 5 Summary of changes required to achieve planned post-tax profits for 2008

1.0

Introduction

Merbatty is a newly listed company, which has grown steadily over the last few years and has an ambitious 5-year plan, which investors will want to be achieved. Since becoming a listed company, Merbatty is experiencing some difficult times with higher costs in some areas and there is the need to manage the process to put the company back on plan to meet the agreed profitability targets. Additionally, there has been a fall in the boat sector’s stock market share prices due to low confidence caused by bad weather and some loss of boats at sea.

2.0

Terms of reference

I am a consultant appointed by the Merbatty Board to prioritise and discuss the issues facing Merbatty and to make appropriate recommendations. This report will discuss a wide range of alternative strategic choices and make recommendations on strategic issues in order for the company to achieve its 5-year plan and to generate an increase in shareholder value.

3.0

Prioritisation of the issues facing Merbatty

3.1 Top priority – CCL takeover bid There can be no greater threat to a listed company than a hostile takeover bid. Merbatty has seen the value of its shares fall by 7% in 2007, due to a lack of market confidence following the loss of a number of boats at sea in adverse weather conditions. This has affected the whole market segment including other listed boat manufacturers, including CCL. The offer, at €4.20, is over 23% higher than Merbatty’s shares were trading at prior to the bid. It is usual for the share price of the target company to rise following a bid, due to speculation. What is the key issue here is which company’s management are best placed to achieve the planned growth in earnings over the next few years, and whether Merbatty can persuade its investors, particularly JKL, to stay loyal to Merbatty’s management. The directors of the company are in a difficult situation, as they are also all shareholders of Merbatty. They need to act in the best long-term interest of its shareholders, which is to maximise shareholder value, even if this were to mean recommending acceptance of the CCL bid. The issue to be debated and analysed below is whether Merbatty’s management have greater skills than CCL’s management to achieve the planned growth in EPS and share prices in the next few years.

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4.0 5.0 6.0 7.0

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It is also unlikely that JKL and other investors will stay loyal to Merbatty unless the planned level of post-tax profits for 2008 can be delivered. 3.2 Second priority – the need to achieve the planned level of profits, especially for 2008 The updated plan prepared by Andreas Acosta for the next Board meeting shows a lower level of profits than the agreed 5-year plan. For 2008, the planned post-tax profit is €39 million, which is substantially lower than the original plan which was €51 million. In order to retain investors’ confidence and also to ensure that the key investors, including JKL, do not accept the CCL bid, the Board of Merbatty would need to convince its shareholders of its ability to deliver the profits in the original agreed plan. 3.3 Third priority – to appoint a new Sales Director Following Stefan Gil’s resignation, to join CCL, the company trying to acquire Merbatty, this key position needs to be filled. However, it is unlikely that Merbatty will be able to attract and appoint anyone externally for this key role whilst the CCL bid process is happening. However, there is an urgent need to fill this post either internally or with a temporary external appointment. The Board’s temporary appointment of Jesper Blanc, the Chairman’s son, to this key role was not a good decision. It is apparent that Jesper Blanc does not possess the skills required, or the experience and seniority, for the Sales Director role. This is due to several reasons, including that Jesper Blanc already holds the role of Marketing Director and also that he is too inexperienced to take on the Sales Director role at this difficult and competitive time. A different internal candidate should be appointed or a temporary external appointment should be made. 3.4 Fourth priority – to change Merbatty price list to minimise currency fluctuations Merbatty is a listed company reporting its accounts in Euros and it needs to deliver the forecast level of profitability in Euros, irrespective of any fluctuations in any of the currencies that it incurs costs in, or charges its customers in. The forecast effect of currency fluctuations, as a result of more customers paying in US Dollars is forecast to be €6 million in 2008, which represents nearly 12% of planned posttax profits. Clearly, it is within the power of Merbatty’s management to reverse the recent trend of customers choosing to contract and pay for their boats in US Dollars, as this is reducing the value of sales revenue in Euros. Merbatty could do a range of actions from changing its price list to Euros only or charging a currency surcharge for any difference in changes to exchange rates, or by increasing its list prices to take account of the cost of the currency fluctuations. Whilst this is currently causing an adverse currency variance, it may well be that in future this could have a favourable effect. Changes need to be made to protect Merbatty’s profitability in the short term to meet the demands of its shareholders. 3.5 Fifth priority – need to appoint a new sales agent in the USA As stated above, it is important that Merbatty achieves its ambitious sales targets. One of its USA agents has left Merbatty and Merbatty now needs to appoint a new agent. Alternatively, it could open its own sales office. Whichever action it decides, it cannot afford to double the agents’ costs, which is what SFBS has requested. In 2006, sales were €502 million and

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Therefore, Merbatty urgently needs to appoint a new agent, but at the current fee level. 3.6 Sixth priority – whether to change the locations globally of Merbatty’s boat building facilities Merbatty currently has three boat building facilities open, in its home country in Europe, the facility that became operational in the USA in 2004 and the new boat building facility that opened only 2 months ago (in September 2007) in the Middle East. It has a total capacity to build a maximum of 500 boats (depending on size of boats built). Merbatty has two opportunities to change the locations of its boat building facilities which are: (1) To acquire some land which is adjacent to its boat building facility in its home European country which is available for purchase at a cost of €40 million plus the cost of building the facilities. (2) To move some of its boat building operations to Asia to reduce its operating costs, as labour and some materials are available at a lower cost. 3.7 Other priority issues Other priorities, in priority order, are as follows: ●

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Ways in which Merbatty could raise the positive profile and safety of its boats to improve investors’ and the stock market’s confidence which could lead to an increase in share prices in the sector. Computer test results. Merbatty’s Technical Director for Systems and IT is putting employees under pressure to ignore test faults so that boats are delivered on time to customers. It is important that any faults highlighted by tests are correctly followed through to eliminate any possible faults on the boat before delivery to the customer. Commercial pressures should not take priority over safety issues. Ways in which Merbatty can lower its manufacturing costs without compromising on quality or damaging its high reputation, so that the 5-year plan is achieved.

A SWOT analysis summarising the strengths, weaknesses, opportunities and threats is shown in Appendix 1. The greatest threat facing Merbatty at this time is the hostile takeover bid by CCL. This report will discuss the weaknesses and how to overcome them, so that Merbatty can build upon its strengths and defeat the takeover bid and achieve the agreed 5-year plan. A PEST analysis for Merbatty is shown in Appendix 2. Examiner’s note: It was not necessary to have the issues prioritised exactly as shown above. The full 10 marks for Prioritisation would have been awarded provided that the CCL takeover bid was in the top two priorities and also the need to achieve the planned level of profit anywhere else in the top 5 priorities and the justification for the ranking was well explained.

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agency costs at 4% were around €20 million. Merbatty’s post-tax profits were €40 million and therefore this is a significant cost item. If Merbatty were to double the agency fees for one agent it would be unfair to other agents. This could lead to either a loss of other agents or could lead to other agents worldwide also demanding an 8% agency fee. Therefore, if agency fees were to double, this would have a significant effect on Merbatty’s profits.

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4.0

Discussion of the issues facing Merbatty

4.1 Overview Merbatty has only been a listed company for around 1 year and is already facing a hostile takeover bid. The company has an ambitious 5-year plan which investors will want to see achieved, so that the planned level of dividends and capital growth can be delivered, which is why they invested in Merbatty in 2006. The company has a high level of sales and profits and is a cash generating business. Its sales grew by nearly 13% in 2006, and profit after tax grew by 29%. The 5-year plan is for profit after tax to grow to €80 million by 2011, which is a 100% increase from the actual profits in 2006. See Appendix 3 for full details of key ratios for Merbatty. Merbatty operates in a truly global industry with many companies competing for market share in this elite industry which caters for the wealthy individual. In the UK, a leading international company is Sunseeker Ltd., which manufactured over 200 boats during 2006. It is recognised as a leading brand worldwide and 99% of its boats are exported. Merbatty is a manufacturer of high quality boats for customers worldwide and has manufacturing facilities in three countries. It is a global company which needs to manage its currency exposures in a professional way so as to maximise profit and minimise risk. The company needs to demonstrate how it can achieve the agreed 5-year plan so as to convince investors to stay loyal to Merbatty and not to sell their shares to CCL. From the shareholders’ perspective, the company should be owned and run by the management team in which the shareholders believe would have the greater ability to deliver to the agreed 5-year plan. This is likely to be Merbatty’s current management team and not CCL. 4.2 CCL takeover bid For Merbatty to be able to reject the takeover bid from CCL, it will need to convince at least 51% of the shareholders. Alberto Blanc holds 30% and JKL holds 28%, so aside from these two key shareholders the decision will lie with the remaining shareholders. The crucial question that will decide whether CCL is successful in the takeover of Merbatty is which company, CCL or Merbatty, is best placed to achieve the best financial results over the coming years. JKL has a seat on Merbatty’s Board and will be aware that the current financial plan for Merbatty is showing post-tax profits of only €39 million, compared to plan of €51 million. If JKL, and also the institutional investors, are to stay loyal to Merbatty’s management then they need to be assured that planned profitability levels will be achieved. If Merbatty can achieve the €51 million profits in 2008 that was planned, at a P/E ratio of 15, this would generate a higher share price than the CCL bid price, at €4.25 per share, as shown in the table (see later). Therefore, it will be a matter of confidence in which company can grow the post-tax profits the fastest. The case material stated that CCL’s share price has not grown as its investors had expected and that it is under pressure to deliver higher EPS. The share exchange proposal to acquire Merbatty will only deliver higher EPS for CCL if the profits grow in accordance with Merbatty’s plans. If CCL pays €4.20 per share, shareholder value for CCL will only be created when the share price would be greater than this value, based on P/E values. According to the agreed planned profits, shown in Appendix 4, this share price will be exceeded from the end of 2008 onwards, if the planned level of profits is achieved.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

The proposed hostile takeover bid by CCL is not uncommon in this industry (or in other industries). For example, Trinity Yachts, which is a very large US-based yacht building company, has developed many of its designs through acquiring competitors. In May 2007, Trinity Yachts announced its proposed acquisition of International Yacht Collection (IYC), which will enable Trinity to expand its capabilities and to offer its clients the entire range of yachting services, including new construction, repairs, brokerage, charter management, retail charter, yacht management and crew placement. Many boat building companies have expanded by acquiring rivals, and so this hostile takeover bid is not entirely unexpected. It is up to the Board to act in the best interests of shareholders, of which the Directors hold a significant proportion of the shares. Stefan Gil owns 3% and will now vote in favour of his new employer CCL. Furthermore, Alberto Blanc, the Chairman, has proposed to pay Jesper Blanc a ‘loyalty’ bonus (using Merbatty funds) to entice him not to sell his shares to CCL. This is also an ethical consideration and is discussed further in Paragraph 5.0. Jesper Blanc owns 8% of Merbatty’s shares. Therefore, if Jesper Blanc decides to sell to CCL, then CCL could gain a 51% backing if it can gain the support from JKL and the institutional investors. It is not known what percentage of shares CCL may have already bought on the open market. Those shareholders who could vote in favour of the CCL bid are summarised as follows: Stefan Gil

3%

Jesper Blanc

8%

JKL

28%

Corporate fund investors

12%

Total possible shareholding to accept the CCL bid

51%

JKL and the corporate investors will be looking ONLY at which company can provide the highest financial returns in the future. All investors will consider the longer-term growth prospects of Merbatty and future growth in share price, as all investors will consider the longer-term gains to be made. Appendix 4 shows that the value of Merbatty shares, based on a P/E ratio of 15, would be €4.25 a share at the end of 2008 and possibly over €6.60 by 2011. These values are significantly higher than the current bid price of €4.20, which appears to undervalue Merbatty, due to its planned high growth over the next few years, assuming that this can be achieved. A summary of the bid price compared to the forecast value of Merbatty’s shares based on a P/E value of 15, using the 5-year plan post-tax profits are shown in Appendix 4 and summarised below: CCL bid price

2008

2009

2010

2011

Post-tax profits according to agreed 5-year plan € million

51

60

69

80

Share price based on P/E of 15 € per share

4.25

5.00

5.75

6.67

CCL bid price € per share

4.20

PRACTISE EXAM

It is recommended that Merbatty should try to re-assure its key shareholders, particularly JKL and the corporate fund investors, so that they stay loyal to Merbatty, as they could see a much higher growth in the value of the Merbatty shares over the coming years if the 5-year plan can be achieved.

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The case material stated that CCL has a lower net margin than Merbatty on the same level of sales. Therefore, it is a less profitable company with lower margins. This may be due to a different mix of sales (more smaller boats, which have lower margins) or perhaps Merbatty is more efficient than CCL, or Merbatty achieves greater economies of scale than CCL. Additionally, the case material states that CCL’s share price has not grown as its investors had expected and has not achieved the growth in EPS expected. The takeover bid for Merbatty may be a distraction from its own troubles. Clearly, CCL has not got a good track record for delivering what its investors expected. This is another reason that Merbatty could use to try to persuade JKL and the corporate fund investors to stay loyal and not to sell their shares to CCL. Therefore, Paragraph 4.3 concerning how the planned profits could be achieved is very relevant to whether the bid could succeed, and whether Merbatty’s management team can convince its investors, particularly JKL, that it can deliver planned post-tax profits, particularly for 2008 but also for future years. If it cannot deliver the planned profits for 2008, it is highly likely that there would be a further takeover bid, from CCL or another company, and it may be that investors will not have confidence in Merbatty’s Board. Therefore, it is imperative that Merbatty’s Board finds ways to achieve the planned profits for 2008, particularly so soon after floatation. 4.3

The need to achieve the planned level of post-tax profits for 2008 It is essential that Merbatty finds acceptable ways to deliver the agreed 5-year plan financial results. Appendix 5 shows that the forecast profit gap identified for 2008 of €12 million must be closed and suggests ways in which the planned level of post-tax profits of €51 million could be achieved, without compromising too much on Merbatty’s high reputation. There are a number of proposals to increase profits and these include: ● ● ● ● ● ●

Changing the engine supplier to ENG for half of the boat models Changes to the selling prices charged to take account of currency fluctuations Increasing the selling price of the P3000 Reducing the specifications for boats Reducing the development costs of new boat models Cutting both sponsorship contracts.

The currency variance of €6 million will be discussed in Paragraph 4.5. It is important that Merbatty increases its post-tax profits to the planned level of €51 million, but it is also important that the changes that are agreed do not impact negatively for Merbatty’s future. Merbatty needs to make a number of changes to increase its forecast post-tax profits for 2008 but it needs to find ways to do this without damaging its longterm reputation. Appendix 5 outlines the suggested ways in which this could be achieved and all of the proposals shown above are discussed below. The suggestion to change the engine supplier to ENG for half of the boat models is a realistic proposal. It would enable Merbatty to match some of its US Dollar revenues with more US Dollar costs, as ENG is a US-based manufacturer. Furthermore, the engines would fit into Merbatty boats with no re-designing of the engine space. Perhaps the customer could be given the choice of which engine would be preferred, with engines from MNE charged at a premium. The proposal to switch engine supplier for around half of

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

It is always a dangerous position for a company to have a single supplier for a key component, as it is heavily dependent on it. This could have an adverse effect on Merbatty if MNE were to have any production delays or quality issues. The case material stated that it had increased its prices in May 2007 higher than Merbatty had included in its plans for 2007. Therefore, Merbatty appears not to have any significant negotiating power over this supplier. Lukas Dian, Merbatty’s Technical Director – Design, is concerned that the alternative engines from ENG would not generate the same power, and that this could have an adverse effect on Merbatty’s high reputation. Merbatty faces a conflict between cost savings and its high reputation. However, if Merbatty can be re-assured by ENG on the power aspects of its engines, then it would appear to be a commercial decision to move some of its engine purchases to ENG. Furthermore, for boat models that require a powerful engine, Merbatty should not change to ENG engines and should stay with MNE engines. Additionally, customers purchasing other boat models could be given the choice of engines, with MNE engines being charged as an additional extra. Many customers only moor their boats and do not take them out to sea much, and a less powerful ENG engine may be suitable for their requirements. Perhaps if Paul Lavie were to contact MNE and state that Merbatty is seriously considering switching half of its engine purchases to ENG, this would put MNE under pressure to re-negotiate a better price with Merbatty to retain 100% of its supply. Merbatty spent €38 million with MNE in 2006 on 280 boats. Therefore, at 2006 prices, if Merbatty builds the planned 500 boats by 2011, the forecast spent with MNE would be around €68 million. Therefore, if MNE wants to retain Merbatty’s business for all engines, it needs to review its prices, or risk losing half of the volume of business. The concern that Andreas Acosta has over orders placed and paid in US Dollars and the adverse effect that this is forecast to have on 2008 profits of €6 million is a very important issue and one which needs management action to address. The customers of Merbatty are wealthy financially astute individuals who probably have bank accounts in a variety of currencies. They will identify from Merbatty’s price list which currency to place their order in which will minimise the cost of their new boat. Merbatty gives its customers a choice to contract and pay for their boat in Euros or US Dollars. When Merbatty’s price was last reviewed, if the prices were set in Euros and converted to US Dollars at that point in time, if the exchange rate between the US Dollar and the Euro has moved, then this would result in US Dollar revenues being worth more, or less, in Euros, which is Merbatty’s base currency. This cannot be allowed to continue and there are many ways to address this problem. This is discussed further in Paragraph 4.5. The comment that it may be possible to increase the price for the top model, the P3000 is also a very valid suggestion. The price is currently €4.7 million and the forecast number of boats of this top model to be sold in 2008 is 15 (50% higher than 2006 sales of 10 boats). The big dilemma is whether Merbatty would not secure 15 sales if the price were to be increased. At the top end of the boat specification, it should be assumed that customers are not as price sensitive as at the lower end of the luxury boat range, although there is strong competition to secure sales from customers. It is more likely that the features and design of these top of the range boats will have more of an impact on customers’ decisions than just price. If Merbatty considers that any increase in price of the P3000 will not affect sales, then it should increase the price. The suggested increase is 8%, bringing the selling price

PRACTISE EXAM

the boats in production would generate a post-tax saving of €4 million in 2008, and subsequently larger savings in future years as the number of boats built increases, according to plan. Therefore, this could generate even larger savings.

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to €5.1 million. This would generate additional post-tax profits of €3.7 million. Even a more modest 5% would generate an additional €2.3 million post-tax. In respect of reduced specifications for new boats or reducing development spend, neither of these two areas are recommended for cost cutting. It is important for Merbatty to continue to be innovative and produce new boat models, so again cutting boat development costs would have an adverse effect on the medium to longer term. Therefore, it is not recommended that Merbatty should cut costs in this important area which is required in order to achieve the longer-term plan. Merbatty has an ambitious sales growth planned over the next few years and cutting of promotional spend on sponsorship could have a significant adverse effect on Merbatty’s ability to secure sales. It is therefore recommended that the sponsorship contracts are not terminated. Furthermore, sponsorship contracts cannot be simply terminated at short notice without penalties being payable. It is not advised that sponsorship contracts are cancelled as this would generate negative publicity for Merbatty and even perhaps signal that the company is in trouble. This could have an adverse effect on new sales orders. This should be avoided at all costs. It is recommended that the Merbatty Board re-assure all shareholders of its confidence and ability to deliver the planned level of post-tax profits and dividends. This should help to give Merbatty’s shareholders the re-assurance that the plan could be achieved, which may persuade them to reject the CCL bid. 4.4 To appoint a new Sales Director Following Stefan Gil’s resignation a new Sales Director needs to be appointed. A temporary appointment of Jesper Blanc, who is currently also the Marketing Director, has been made, but Jesper Blanc is inexperienced for this important role and has other main Board responsibilities. It is disappointing that Merbatty did not have a succession plan in place for this key role, as it is stated that Stefan Gil’s deputy is too inexperienced. Since the CCL takeover bid has happened it would be very difficult to find and appoint a permanent replacement for this key role whilst the bid is going on. Therefore, a different temporary appointment should be made and steps taken to head-hunt or find a suitable experienced long-term replacement, assuming the CCL bid is not successful. Merbatty needs a high profile experienced Sales Director who will be able to achieve the planned 100% increase in sales from 2006 to 2011. The new Sales Director also will need to oversee the changes in Merbatty’s price list to overcome the currency problems. There is also the difficult task of appointing a new sales agent in the USA (see below for details on the SFBS proposal) and the need for Merbatty to win more sales in the competitive USA market. The Sales Director needs to identify innovative methods to retain the loyalty of Merbatty’s sales agents. Merbatty has recently lost one sales agent in the USA and does not want to lose further agents to competitors. It is also important for the Sales Director to manage the sales agencies and to minimise agents’ costs. No agent should be paid more that the currently accepted level of 4% of sales revenue. In a competitive and high profile industry such as the boat industry, a very experienced and well-respected person is required to fill this key role. Even if Merbatty is able to control its costs and build boats on time, if the sales forecasts are not achieved then financial targets will be missed. Now that Merbatty is listed there will be much greater emphasis and

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.5 Currency fluctuations As discussed above in Paragraph 4.3, under the need to achieve the planned level of posttax profits for 2008, Merbatty has a number of alternatives to overcome the adverse effect of currency fluctuations between the Euro and the US Dollar. This problem must be tackled so that profits are not adversely affected, due to a ‘loophole’ in Merbatty’s price lists. As Merbatty is a European-based company and prepares its accounts in Euros, it needs to maximise its revenues in Euros and not accept payment from European customers in US Dollars, based on a cheaper list price in US Dollars. The adverse profit variance caused by the recent currency fluctuations is forecast to be €6 million in 2008. This represents almost 12% of Merbatty’s post-tax profits for 2008. Management action needs to be taken to minimise or avoid this currency variance entirely. Merbatty could change its price list in various ways. It could increase its list prices (in US Dollars and Euros), although this could make it uncompetitive and this could lead to reduced levels of boats sales. Merbatty could insist on contracts and payments in Euros from all customers worldwide except those based in the USA. This would reverse the current trend of over 90% of customers paying in US Dollars. It could choose to have its US Dollar prices ‘pegged’ to changes in exchange rates, but again this would make Merbatty uncompetitive in the USA. It is further advised that the US Dollar price list is revised to reflect the current exchange rate between the Euro and the US Dollar so that there is no major difference in what currency the new boat sales are in. An alternative is to have the price list limited to sales in Euros for all sales worldwide, except to customers based in the USA, where Merbatty is finding competition tougher. This passes on the currency exchange difference onto the customer. Sales to customers in the USA represent 29% of total sales in 2006, falling to 24% by 2011. Therefore, sales in US Dollars should be limited to sales to customers in the USA only. With the change to all sales in Euros, except customers based in the USA, and a revised price list for US Dollar sales, it is therefore anticipated that Merbatty should be able to reduce the forecast adverse effect of €6 million. Depending on what date these changes can be made effective from, the majority of this could be saved. Merbatty should have regular published dates for price increases. It is not known when its price list was last changed. Sometimes the pressure of an imminent price increase will help to speed up securing sales contracts. It is recommended that Merbatty should review its prices each year, with possible price reductions on certain boat models if it helps that model to become more competitive. 4.6 Need to appoint a new sales agent in the USA A new sales agent in the USA is required to replace LABS which gave notice to Merbatty to sell boats for a competitor. It will not sell Merbatty boats after the end of December 2007, and it is possible that boat sales up to this date could be lower than planned.

PRACTISE EXAM

visibility on achieving targets. The sales targets of growing Merbatty’s sales revenue from €502 million to €1,000 million in 5 years will be difficult to achieve. Hence the importance attached to recruiting a very good Sales Director with a good track record as soon as possible after the issue of the CCL bid has elapsed. In the meantime a temporary person, not Jesper Blanc, should be appointed. There must be a suitably experienced senior manager, or another Director, who could manage this role temporarily.

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It is NOT recommended that Merbatty appoint SFBS, as SFBS is insisting on an 8% agency fee. This is double what Merbatty pays to all other agents. Andreas Acosta is correct to be concerned that other agents around the world will find out about this higher agency fee and then Merbatty could be ‘held to ransom’ if all other agents demanded such a large increase in the agency fee. The total agents costs at 4% of revenue was around €20 million in 2006 and Merbatty cannot afford to have this cost item doubled. If Merbatty cannot find a suitable experienced agent to sell Merbatty boats in this competitive USA market at the usual fee of 4% of revenues, then Merbatty should open its own sales office with Merbatty employees. If it does this, it would need to incentivise its employees to secure sales and to have challenging but realistic sales targets. In summary, Merbatty should not consider increasing the agency fee to 8%, as this would have a disastrous effect on profits if / when Merbatty’s other agents found out and insisted on higher fees also. Therefore, SFBS should not be appointed unless it agrees to the usual fee of 4% of sales revenue. 4.7 Whether to change the locations globally of Merbatty’s boat building facilities Merbatty has recently opened its third boat building facility in the Middle East and operates two other facilities, the original boat building facility in Europe and the USA facility that became operational in 2004. Merbatty has a choice of three strategic choices for its boat building facilities: (1) It could bring forward the planned construction of a new boat building facility in Asia, which was originally scheduled to open in 2011. This could achieve reduced operating costs and then Merbatty could close the USA facility. (2) It could acquire the land in Europe at a cost of €40 million (plus the cost of constructing the boat building facility) to extend its European-based boat facility. (3) It could choose neither of these options and follow the approved 5-year plan. Merbatty has a number of strategic options here. The company was listed only a year ago and shareholders invested based on the agreed 5-year plan. With three boat building facilities open, Merbatty has no operational needs to change the number or location of its boat building facilities. Furthermore, the construction of purpose built boat building facilities is a huge distraction for the management team, which should be focused on achieving the planned sales volumes, planned number of new boat models and most importantly delivering the planned level of profits. Therefore, why change the global locations of Merbatty’s boat building facilities now? There are a number of factors to consider in respect of the USA boat building facility. This allows Merbatty to match some of its US Dollar revenues with US Dollar cost base. Furthermore, it would probably be harder to sell boats in the competitive USA market which are not built there. Another factor affecting sales is that many USA customers (particularly for smaller boats) would be unwilling to travel to a location outside of the USA to inspect their boat, and would order form a different boat builder. Furthermore, as the USA boat building facility is operating well, why change location now? This is particularly important since Merbatty’s management team have so many other strategic and operational issues to be managed at this time.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Another consideration in the proposal to move to Asia is that additional loan finance would be required to expand to Asia earlier and the costs of servicing the additional loan would impact on profits, until the USA facility was subsequently closed and sold. The proposal to acquire the land in Europe is also a viable proposal but would increase the level of Merbatty’s Euro cost base. It would also detract from its global presence if it were to expand in its home country. However, this could generate cost savings as it may enjoy economies of scale in Europe. Against the proposal to acquire the European land is that this would be a speculative purchase and Merbatty should not speculate with shareholders’ funds. It would be sensible to build a fourth boat building facility in a different location, when demand dictates the need to expand, as Merbatty is serving a global market and should be seen to be operating on all continents, not just expanding in Europe. Therefore, it is considered that Merbatty should not acquire the European land. 4.8

Other issues

4.8.1 Computer test results Merbatty’s Technical Director is putting employees under pressure to ignore test faults so that boats are delivered on time to customers. It is important that any faults highlighted by tests are correctly followed through to eliminate any possible faults on the boat before delivery to the customer. 4.8.2 Safety issues Following the poor level of investor confidence, following the boats lost at sea and the adverse effect this had on industry share prices, Merbatty should investigate ways in which it could raise the positive profile and safety of its boats. This could then lead to improved stock market confidence which could lead to an increase in its share price. It could also help to boost sales. 4.8.3 Reduction in boat building costs Merbatty’s management team should investigate ways in which it could lower its boat building costs without compromising on quality or damaging its high reputation, so that the profit levels in the 5-year plan can be achieved. It needs to look at new technology and innovative ways of reducing the time and manpower involved, without compromising on quality. This may be achieved with a different mix of skill or by investing in training so it has more skilled employees, enabling stages of boat building to be achieved in a shorter time, or with fewer faults. Merbatty could look at using teams of boat builders, which could add to the motivation of employees, together with realistic, but challenging targets both for quality and speed of production.

PRACTISE EXAM

A concern of opening a boat building facility in Asia is that this is an entirely new operational area of the world for Merbatty and it has no experience here. It must also be questioned whether the proposed Asian facility could achieve the same high standards achieved in other Merbatty facilities, as well as how to manage this new location. As the standards of manufacturing are very high in Asia, it could be assumed that quality standards could be met. Also as the wage levels are low, it is quite feasible that costs could be reduced, and an additional €10 million in post-tax profits is a substantial amount and would be welcomed by shareholders. So the decision to move to Asia at some time makes commercial sense, but when. It is considered that it is too soon to consider opening a further boat building facility now.

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It should encourage employee participation in all aspects of boat building as it is the actual employees building each boat that have the detailed knowledge of what areas could be improved, and where areas of difficulty lie.

5.0 Ethical issues and recommendations on ethical issues 5.1 Range of ethical issues facing Merbatty There are a number of ethical dilemmas facing Merbatty, as discussed below, but the overriding ethical problem is Alberto Blanc’s promise of a “loyalty” bonus of €3 million that has been promised to his son Jesper Blanc to entice him NOT to sell his shares to CCL. There is a range of other ethical issues in this case which will be discussed below and recommendations made, including the following: ●

●

●

●

Merbatty has not given its customers a choice as to whether they would like the newly enhanced navigation software, costing €70,000 per system, to be installed on new boats. Merbatty has also not given its existing customers the choice concerning this new software as Merbatty’s Director of Systems and IT does not consider the enhanced system to be worth the extra cost. However, this is a decision that customers should be allowed to make. Proposed termination of agreed sponsorship with immediate effect, in order to cut costs to achieve planned profit levels. Potential faults showing on the specialised software test program that Alain Mina is choosing to ignore.

5.2 Loyalty payment Alberto Blanc is the Chairman of a listed company and can no longer treat the company as his own. He may be the founder, but now he is merely a shareholder, albeit with the largest single shareholding of 54 million shares which represents a shareholding of 30%. This ‘loyalty’ bonus is not being offered to other directors and is not ethically correct, nor is it good business practice. Whilst Jesper Blanc is the Chairman’s son, any financial arrangements made between the two shareholders to try to ensure that Jesper Blanc does not sell his 8% shareholding to CCL, is a private matter between them and should not involve payments to be made from Merbatty. It is also unethical that Jesper Blanc who is a Director of Merbatty, particularly the Chairman’s son, should wish to sell his crucial 8% shareholding to a competitor and not to offer it to other Directors or to sell it on the traded market. 5.3 New navigation software The ethical issue here is not about the increased price that Marinatron is charging for its recently enhanced navigations systems but that Merbatty has made the decision not to install the latest navigation systems and that it has not given its customers a choice. There may be some customers that are willing to pay a premium for this latest navigation system if they perceive there to be a benefit to them. The other ethical aspect of this issue is that Merbatty has not advised its existing customers of this new navigation system, as Alain Mina ‘does not consider the system to be worth the extra cost’ and does not want the quality of the IT systems installed to be questioned or for customers to feel disappointed that the latest systems have not been installed, and has therefore not kept the customers informed of the new software. This is not a professional or courteous way to deal with customers.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Therefore, it is recommended that Merbatty should immediately contact all existing customers who have bought boats from Merbatty over the last 5 years and advise them of the availability and cost of the new Marinatron navigation system. Merbatty could also offer to install this new system, and advise installation costs. In respect of new boats under construction, Merbatty should contact all customers and offer them the alternative to upgrade the navigation system at an extra cost and advise them of the differences between the standard system that was planned to be installed and the new system, together with the additional costs and let customers decide. It is further recommended that all new boat sales should have the option to upgrade to the new navigation system as a separate optional extra, at an additional cost to the customer. This would give the customer the choice, without increasing the building costs of new boats. 5.4 Proposed termination of sponsorship contracts It is unethical for Merbatty to consider the immediate termination of one or both sponsorship contracts without offering a notice period or compensation for cancelling the contracts. Organisations which Merbatty sponsor are very dependent on sponsorship funding for their activities. The recipients of sponsorship look towards large companies such as Merbatty to support them in their chosen field or sport and are heavily dependent on their sponsorship. In turn, they generate much favourable publicity for Merbatty. It is recommended that neither sponsorship contract is cancelled. If a sponsorship contract were to be cancelled, then Merbatty should be prepared to act ethically and responsibly and pay the agreed fees or penalties in accordance with the contractual notice period. However, as this could cost a large sum of money and potentially generate adverse publicity, it is recommended that no changes are made to either of the existing sponsorship contracts. 5.5 Faults showing on test programs Alain Mina is choosing to ignore the faults showing on test programs in order to meet customer delivery dates. He is stating that these are software errors and not real faults. They may be, but Merbatty should not be ignoring the faults in case they are real faults. This could have an adverse effect on Merbatty’s reputation. Safety must be seen to be of key importance within Merbatty, which may need a change in Board responsibilities. Which Director is responsible for safety? It is recommended that Alain Mina should be reprimanded or dismissed for ignoring these potential faults. It is recommended that boats should not be delivered to customers until all potential faults have been resolved. It is recommended that a main Board Director should have overall responsibility for safety. This could be incorporated into Tobias Houllier’s responsibilities as he is the most experienced Director, although this could raise the concern over commercial pressures to deliver boats to customers versus the safety aspects of newly built boats. Perhaps a non-executive Director of Merbatty would be better placed to be more independent to take on the role of safety for all new boat building.

PRACTISE EXAM

Some customers may have heard of the new navigation software through the press or marine journals and would then feel especially badly treated that their supplier, Merbatty, had not contacted them with the choice of upgrading their navigation systems.

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6.0 Recommendations on business issues Note: All of the recommendations on the ethical issues have been included in the Ethics section above and this section of the report deals with recommendations on the business issues only. 6.1 The CCL takeover bid It is recommended that Merbatty would need to convince at least 51% of shareholders not to sell in order to defeat the CCL bid. The bid could be defeated if Merbatty’s Board could convince JKL, which owns 28% of shares, not to sell its shares. The Board needs to persuade JKL that it has steps in place to deliver on its 5-year plan. The share price at the end of 2008 is forecast to be higher than the bid price if the planned profits of €51 million are delivered in 2008. All efforts should be put into achieving the planed results. This assumes that CCL does not subsequently offer a higher bid price if the initial bid at €4.20 is unsuccessful. If a subsequent higher bid is offered, then bid defences will need to be re-visited by the Merbatty Board. The 5-year plan shows profitability rising to €80 million by 2011, and at a P/E of 15, this would result in a share price of €6.67. This is far higher than CCL is offering now. The question is whether CCL will best be able to achieve the planned for growth or whether Merbatty’s management would. CCL does not have a good record for growth in EPS and Merbatty has a good record of high margins and growth in profits. The CCL bid is lower than it would have had to offer due to low market confidence following adverse weather and loss of boats. The plan showed that Merbatty’s share price would be worth €3.75 at a P/E of 15, if the post-tax profits of €45 million are achieved in 2007. However, Merbatty’s share price prior to the bid was only €3.40 due to low market confidence. It is recommended that Alberto Blanc meets with JKL and the other corporate investors and tries to convince them of Merbatty’s ability to deliver to plan and explain how this could be achieved as detailed below in Paragraph 6.2. It is also recommended that Alberto Blanc explains that Merbatty has grown rapidly and has a high reputation and that CCL has not got a good track record of keeping its investors happy. The Board should do everything that it can do, to defeat the bid. The other Directors would not be able to exercise their share options any time up to 2012 if the takeover is successful, so it is in the Directors’ financial interests also for the bid to be defeated. If the bid were to be successful, they also may lose their jobs, depending on who CCL would wish to retain. It is recommended that Alberto Blanc does everything in his power to ensure that his son Jesper Blanc does not sell his 8% of shares to CCL. This proposed act of disloyalty should be reprimanded and further demonstrates that he is too inexperienced and not fully committed to be a Director of a listed company. It is recommended that Jesper Blanc is replaced after the bid is defeated. 6.2 Ways to achieve the planned levels of profits Merbatty needs to take action to bring the forecast profits back to planned levels in order to keep its investors happy. This can be achieved in the following ways. It is not recommended that Merbatty reduces its selling prices in order to stimulate sales, as a response to loss of confidence in the market due to adverse weather conditions and

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

The recommended actions to bring the latest forecast profits for 2008 up to the planned post-tax profit of €51 million are summarised as follows: Post-tax profits for 2008 € million Latest forecast for 2008

39.0

Change in list price to limit contracts in US Dollars

⫹4.3

Change engine supplier to ENG for some boat models

⫹4.0

Increase selling price for model P3000 by 9%

⫹3.7

Revised post-tax profits (agrees to plan)

51.0

It is recommended that changes should be made to Merbatty’s price list limiting sales in US Dollars and that the US Dollar price list is revised as soon as possible to reflect current exchange rates between the Euro and the US Dollar. This should save around €4.3 million in 2008 and have longer run benefits to Merbatty. This recommendation is further explained in Paragraph 6.4. It is recommended that no change in development costs or boat specifications are made so as not to negatively affect future sales and could put Merbatty’s high reputation at risk. It is recommended that no changes to sponsorship contracts are made as Merbatty needs this PR to help generate sales. It is recommended that Merbatty does switch to ENG to procure engines for half of its boat models so that it is not totally reliant on MNE, which has recently increased its prices. The switch to ENG is forecast to save €4.0 million in 2008 and generate greater savings in future years as more boats are built. It is recommended that the selling price of the top of the range model, the P3000 is increased by 8% as buyers at this price are probably not very price sensitive. Assuming that a price increase would not negatively affect sales volumes, this price increase could generate additional post-tax profits of €3.7 million. Merbatty should work with its key supplier Marinatron to promote the new navigation system and it should advise all of its existing customers of this new software. It should also offer new customers the choice to upgrade the navigation system, but at an additional cost to the customer. 6.3 To appoint a new Sales Director Stefan Gil has left Merbatty but still holds shares in Merbatty. It is urgent that an experienced Sales Director is appointed to this key post that the Board has the confidence in to deliver the required level of sales. The temporary appointment of Jesper Blanc is rather short-sighted, as he has no history in sales and has other responsibilities in Marketing. It is recommended that Merbatty should seek to locate and appoint a new Sales Director externally, but this could only be done once the CCL bid has been defeated. In the meantime, it is recommended that the temporary appointment of Jesper Blanc is changed as he is too inexperienced and is acting disloyally to the company by suggesting that he sell his shares to CCL.

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boats lost at sea. Instead it is recommended that Merbatty emphasises the safety features on its boats and also enhances the features (including the new software from Marinatron) to enable it to achieve the planned level of sales.

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It is recommended that this key role is managed by another experienced main Board Director, working closely with the deputy sales manager. The main Board Director recommended to take on this key role temporarily is Lukas Dian. It is further recommended that all Board Directors and other senior managers have their contracts amended to stop them moving to a competitor without a time lapse of over 6 months and also their contracts should ensure that they are on competitive terms. Merbatty cannot afford to lose any more of its key personnel. 6.4 Management of currency fluctuations As Merbatty is a European company which reports its profits in Euros, it should change its terms of business and price lists, where possible, so that revenues from customers are contracted and invoiced and paid in Euros and not US Dollars for all non US-based customers. Despite hedging all US Dollar sales at point of sale, there will always be currency exposure when invoicing in a different currency to the company’s base currency of Euros. It is understandable that all US sales, in this competitive market are priced and invoiced in US Dollars, but as sales to USA customers only represent 29% of sales in 2006 (falling to 24% by 2011), there is plenty of scope to minimise its currency exposure to its customers based in other parts of the world, including customers in the Middle East. If customers in the Middle East still want to pay in US Dollars, then the US Dollar price should reflect the latest exchange rate, at the point of contract, to the Euro. It is further recommended that Merbatty should revise its US Dollar price list to reflect current exchange rates between the Euro and US Dollar. 6.5 Recommendations on new sales agent in the USA It is NOT recommended that Merbatty appoint SFBS as it is insisting on an 8% agency fee. This is double what Merbatty pays to all other agents and this could severely affect Merbatty profitability if other agents insisted on a similar fee level. It is recommended that Merbatty should try to locate another agent in this area at the usual fee of 4% of revenues. Alternatively, it is recommended that Merbatty could open its own sales office with Merbatty employees. If it does this, it would need to incentivise its employees to secure sales and to have challenging but realistic sales targets. 6.6 Recommendations on the global locations of Merbatty boat building facilities There is not a convincing enough reason to undertake such a drastic move to construct another new facility in Asia at this point and close the USA facility in order to achieve operational cost savings. Merbatty’s management have only just got the Middle East facility operational. Merbatty does not need extra capacity until 2011 and therefore this proposal should be rejected at this time, but perhaps be brought forward. The upheaval and potential problems this could cause could detract from the Merbatty management’s need to manage the business during this growth period and more importantly to achieve the agreed 5-year planned level of profitability. The proposal to purchase land in Europe should also be rejected. There is no need at present for this land and Merbatty should not be investing shareholders’ funds in a speculative

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6.7

Recommendations on other issues

6.7.1 Computer test results It is recommended that the Board stop the delivery of boats to customers, due to the computer test faults that have been discovered, until it is satisfied that the faults have been rectified, or whether there really are software faults in the test program. It is strongly recommended that Alain Mina should not put delivery schedules ahead of customers’ safety, as this could have a long-lasting effect of Merbatty’s reputation. It is recommended that Alain Mina be reprimanded or dismissed for this unethical and bad business behaviour. 6.7.2 Safety issues It is recommended that Merbatty should have a PR campaign to emphasise the safety issues included in all of its boats and also to promote the new navigation system that Marinatron has developed, which Merbatty should offer to all new, and existing, customers. 6.7.3 Reduction in boat building costs Merbatty needs to continue to be innovative with new technology and continue to seek ways in which the cost of boat building can be reduced, without affecting the specifications or the quality of the boats. It is recommended that Merbatty should further investigate the proposal to open a boat building facility in Asia, which is planned for 2011. Perhaps this date could be brought forward to generate additional operational costs savings.

7.0

Conclusions

Merbatty is a recently listed highly profitable company. If it can re-assure its shareholders to stay loyal and to reject the CCL takeover bid, it must deliver the planned level of profitability. This will be a challenge to Merbatty’s management but it could see the volume of boat sales and its share price double over the next 5 years if the plan can be achieved.

Appendix 1 SWOT analysis for Merbatty Strengths

Weaknesses

●

Listed company with experienced Board of Directors

●

Loss of Stefan Gil as Sales Director

●

Growing demand for new boats

●

Loss of experienced sales agency in the USA

●

Approved 5-year plan with high growth prospects

●

Operating in a competitive market

●

Good market reputation for quality

●

Exposed to global changes in currencies

●

Good range of boat models with new models being introduced each year (innovative)

●

Dependent on its suppliers for many bought in components (Continued)

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way. Already Bernie Ritzol is proposing that Merbatty’s fourth boat building facility should be in Asia, in order to meet the demands of this growing market and to achieve cost savings. Merbatty would have no need for the land adjacent to its European boat building facility. Therefore, it is recommended that this land is not purchased.

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Strengths

Weaknesses

●

New boat building facility in the Middle East which gives Merbatty spare boat building capacity to meet demand

●

Higher than planned cost of engines

●

Strong asset backed balance sheet

●

Adverse publicity over weather conditions and loss of boats at sea

●

High market profile with two sponsorship contracts

●

Experienced employees, many of whom own shares in Merbatty

Opportunities

Threats

●

Change in location of future boat building facilities to reduce operating costs

●

CCL takeover bid

●

Acquisition of land in Europe next to Merbatty’s existing European boat building facility

●

Possible loss of repeat orders and new boat sales following Stephan Gil’s move to CCL

●

Change in Merbatty’s price list to reduce currency exposure

●

Falling share price due to low market confidence following loss of boats at sea

●

Appointment of new sales agents in the USA

●

Reduction in profitability due to movement of exchange rates against the Euro

●

Opportunities to cut costs to meet 5-year plan targets

●

Loss of sales in the USA compared to plan, due to strong competition

●

Purchase lower cost engines from ENG

●

New price list in Euros could make Merbatty uncompetitive in some markets

●

Appointment of a new Sales Director

●

Higher sales agency costs in the USA which could lead to higher agency costs elsewhere in the world

●

To reject the CCL bid and persuade shareholders to have confidence in Merbatty’s management to deliver the 5-year plan results

●

Costs higher than current 5-year plan and need to cut costs which may impact on long-term objectives

●

New markets in Asia

●

Fault indicators found on computer test program could result in faulty boats being delivered to customers, if no investigation takes place

●

Expansion in range of boat models

●

Overstretching management resources due to high growth

Appendix 2 PEST analysis Political/Legal ● ●

●

● ●

Possible operational problems at the new Middle East boat building facility If boat building facilities are moved to Asia, there could be problems with culture, language and work practices Problems with enforcing IPR’s if boat building facilities in Asia lead to loss of Merbatty’s commercial knowledge and designs Unfamiliar legal system in Asia, if Merbatty moves there Political unrest in some of Merbatty’s export markets

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● ●

● ●

●

Merbatty is offering luxury goods and is subject to global changes in demand If there were another global recession, there would be a downturn in demand for these luxury goods Merbatty is operating in a competitive market Merbatty has to ensure that its prices are competitive (against similar models to competitors) and it needs to offer its products in a competitive way, which may expose it to loss of revenue due to currency changes Currency changes have resulted in more customers paying in US Dollars, which has resulted in a lower level of revenues in Euros

Social ●

●

● ● ● ●

●

Changes in customers’ behaviour and tastes, resulting in higher (or lower) level of boat sales Global changes in weather conditions which may result in loss of confidence and result in lower demand for luxury boats Employee welfare and the pressure on employees to meet challenging delivery targets Safety standards for employees Safety standards expected by customers Reluctance of Merbatty to fit better satellite navigations systems as standard to its boats on cost grounds Environmental issues concerning these luxury boats

Technological ●

● ● ● ●

●

● ●

The need to continue to be innovative in production to generate better standards for customers and to reduce boat construction costs The need to be innovative in boat designs in order to stay competitive The use of improved technology to make boats safer and improve market confidence Improved use of high technology equipment in order to save staff costs Improved use of high technology components in a boat to act as a differentiator to achieve higher sales The use of technology in order to improve quality and safety testing of a boat prior to delivery to customers Competitor innovations Use of new materials in boat building

Appendix 3 Summary of key ratios 2006 actual

Change from 2005

2011 plan Planned change from 2006

Average revenue per boat (€ million)

1.79

N/A

2.0

⫹11.7%

Average operating costs per boat (€ million)

1.52

N/A

1.73

⫹13.8% (Continued )

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Economic

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2006 actual

Change from 2005

2011 plan Planned change from 2006

Average operating margin per boat (€ million)

0.27

N/A

0.27

0

Total revenue and growth in revenue (€ million)

502

⫹12.8%

1,000

⫹99.2%

Gearing (Defined as loans and overdraft as a percentage of equity plus loans and overdraft)

24.4%

Reduction of (32.7)%

20.6%

Reduction of (3.8)%

Market capitalisation (using P/E ratio of 15) (€ million)

600

⫹29%

1,200

⫹100%

Number of new boats commenced in year

280

N/A

500

⫹78.6%

Operating margin

15.1%

⫹0.5%

13.7%

(1.4)%

Note: N/A is data not available

Appendix 4 Valuation of CCL bid for Merbatty and comparison to future values Share price (€)

Number of shares (million)

Market capitalisation (€ million)

Comments

Bid price

4.20

180

756

22% higher than Net Assets value as at end 2006

Previous trading price

3.40

180

612

1% lower than Net Assets value as at end 2006

Bid premium

24% 621

Assets newly revalued for listing in 2006

Valuation of Net Assets as at end 2006

Note: Comparison to Net Assets as at the end of 2006 is for information only. Accurate figures for Net Assets as at end 2007 is not available, but is estimated to be around €643 million (€621 million plus 2007 planned profit of €45 million less planned dividends of €23 million). The bid at €4.20 is still almost 18% higher than the planned Net Assets at the end of 2007.

Valuation of Merbatty using agreed 5-year plan post-tax profits at P/E of 15: 2007

2008

2009

2010

2011

Post-tax profit (from agreed 5-year plan) (€ million)

45

51

60

69

80

Market capitalisation at P/E of 15 (€ million)

675

765

900

1035

1200

Forecast future value per share (based on 180 million shares) 3.75 (€ per share)

4.25

5.00

5.75

6.67

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Summary of changes required to achieve planned post-tax profits for 2008 Revenue/cost item

Effect on post-tax profits (€ million)

Latest forecast for 2008

39.0

Changes recommended: Switch to a different engine supplier, ENG, for engines for half of the boat models

4.0

Change in price list limiting contracts in US Dollars, to minimise adverse currency changes: 90% of customers (assuming even mix of boat sales) pay in US Dollars ⫽ adverse cost of €6 million. The forecast sales to USA in 2008 ⫽ 26%

4.3

Therefore, potential saving by having prices in Euros ⫽ 100% sales less 26% USA sales ⫽ 74% sales to be paid in Euros. Only 10% is currently paid in Euros. Therefore, saving is on 64% of sales only ⫽ 64/90 ⫻ €6 million ⫽ saving achieved ⫽ €4.3) Increased revenues by a price increase on top priced boat: P3000 model:

3.7

2006 sales ⫽ 10 boats. 50% increase ⫽ 15 boats 15 boats at €4.7 million each ⫽ €70.5 million An 8% sales price increase on just this one model ⫽ €5.6 million, which post-tax ⫽ €3.7 million Reduced specifications to boats – not recommended

0

No changes to development in new boats – the new designs will be required for the 0 planned growth in boats sales and revenues No changes in sponsorship as this would adversely affect Merbatty’s profile and marketing

0

Total updated 2008 forecast profit

51.0

Total original planned post-tax profit for 2008

51.0

Examiner’s note: It was possible for candidate’s to earn the full marks available in the assessment criterion of Application for any choice of the many ways in which the profit gap of €12 million could be closed. The above is an example only, and alternative ways were valid.

5.7

Post Exam Guidance report for November 2007 Unseen

Shown below is the Post Exam Guidance report for this exam. As you read it, take notes of what you did right and what you did wrong. Also learn from what you omitted to do at all. This report contains valuable advice from the examiner – so learn from this so that you do not make these mistakes yourself in your REAL exam. General overview The purpose of this report is to give help and advice to candidates who were not successful in the November 2007 sitting of the Merbatty TOPCIMA exam. This report explains

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Appendix 5

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what the examiner was looking for in candidates’ answers and details the most common mistakes made by candidates sitting this exam. This report will also be useful to candidates planning to sit a future TOPCIMA exam, as the advice given is not necessarily specific to the November 2007 TOPCIMA case, but can be taken and used to improve candidates’ understanding of the higher level analysis skills required to pass this final CIMA exam. As always in CIMA exams, it is quality, not quantity, which is important. It is often the recommendations at the end of your report and the judgement displayed throughout the report that will determine whether your report will pass or fail. So good time management is crucial in order to allow adequate time to prepare detailed, fully justified recommendations. TOPCIMA is a case study based exam, with the pre-seen material to set the scene, being published over 8 weeks before the exam sitting. This case was about a luxury boat building company called Merbatty. The requirement was similar to previous TOPCIMA exams. Candidates were asked to write a report to the Board of Merbatty, which: ● ●

●

Prioritises the issues facing Merbatty. Analyses and evaluates the issues and provides a choice of alternative actions to address them. Makes appropriate recommendations on what actions should be taken, together with the rationale for why each particular course of action has been selected (from the choices provided earlier in your report).

The assessment matrix has 9 criteria, each of which carries between 5 and 20 marks. It is stressed that it is important to earn high marks in Judgement (for analysis of the issues) and Logic (for recommendations), as each carries 20 marks. Merbatty, the luxury boat building company featured in the case, has been a listed company for less than 1 year and has an ambitious 5-year plan, which investors will want to see achieved as this is why they invested in Merbatty in 2006. The two main issues in the unseen material concerned: (1) A hostile takeover bid by CCL, at a bid price equivalent to €4.20 per share. (2) A gap in the planned profit for 2008, which was planned at €51 million, but is currently only forecast to be €39 million. The unseen material also included 5 issues of secondary importance: (1) Currency fluctuations which are having an adverse effect on profits. (2) Sales Director had resigned (and moved to CCL, who have announced the takeover bid against Merbatty). (3) A sales agent in the USA has resigned and a possible new agent is requesting substantially increased agent’s commission. (4) The locations of Merbatty’s boat building facilities and whether the plans to expand in Asia should be brought forward, or whether land in Europe should be acquired for future expansion there. (5) Test results on boats in production showing possible faults. These faults could lead to delays in a market where there is commercial pressure to deliver boats on time. Prioritisation is very important, with the need to identify and subsequently analyse around 5 issues. Therefore, it is NOT necessary to discuss ALL 7 issues in this case. However, the 2 main issues, which are inter-related, are the takeover bid and the need to

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Areas that were well attempted by candidates The format of candidates’ reports remains very good. Technical knowledge was also good. Around 90% of candidates earned pass marks in prioritisation. The examiner considered that the hostile takeover bid by CCL should be within the top 2 priorities and that the issue of achieving the planned profit for 2008 should appear anywhere within the top 5 priorities. Recommendations were good in some candidates’ reports, as they showed clear reasoning as to how they had reached each recommendation. It is this justification behind the recommendation that earns higher marks rather than the recommendation itself. Also,

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achieve the planned level of profits. Without discussing either of these 2 important issues, it would be difficult to earn sufficient marks to pass. However, almost every candidate did discuss one or both of these 2 important issues. Many candidates who failed this sitting of TOPCIMA did so because they did not recognise the future potential value of Merbatty or the importance of achieving the planned profit level and did not recognise the inter-relationship between these two key issues. Only about a third of candidates prepared relevant calculations to identify that the bid undervalued the company’s future earnings potential. Even without any calculations, many candidates who identified that Merbatty was growing fast, did not understand that the Merbatty Board did not have the power to reject the bid, and that the rejection of the bid would be dependent on a few key shareholders including JKL, who own 28%. The unseen material even included a sentence reminding candidates that ‘JKL need to be convinced’. However, many candidates did not discuss JKL at all or even how JKL could be convinced to stay loyal. This demonstrated a poor understanding of this very fundamental strategic issue. The second issue in the case concerned how Merbatty could achieve its planned profit target of €51 million in 2008. The unseen material stated that 2007 planned profits had been achieved but that plans had identified a profit gap of €12 million in 2008. As in real life, this issue is inter-related to the hostile takeover bid. If the Merbatty Board are to be able to convince JKL to stay loyal and that a higher share price will be achieved in the future if Merbatty achieves the 5-year plan (which they invested in Merbatty on the basis of ), then it is extremely important that the 5-year plan is achieved. Therefore, it was extremely naïve for some candidates to recommend that the bid should be rejected and that JKL must be convinced to stay loyal, and then to state that they could not make any recommendations as to how Merbatty could ensure that the planned profits are achieved. Many candidates discussed all of the individual ways to reduce costs (change engines, cut down specifications, cut sponsorship, manage currency differently) but then did not recommend any changes. If the profit gap of €12 million was not closed, and a substantially lower profit subsequently achieved in 2008, then Merbatty would lose the confidence of its investors and any future hostile takeover bid (probably at a lower bid price) would no doubt be successful. It is unrealistic that candidates should recommend JKL to ‘stay loyal and Merbatty will achieve plan – but, sorry Merbatty will not achieve plan in 2008’ as they failed to recommend any changes so that the planned profit can be achieved. There is a need for more consideration of the impact of the key issues on the company in the case, rather than repeating theoretical strategies, with little understanding of their relevance to the strategic decision-making process. Candidates are reminded that all of the analysis given in the appendices should be relevant to the case and should be referred to and discussed in the body of their report. They should not be simply used as ‘stand alone’ appendices which are then not used to analyse the issues in the main body of the report.

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many candidates correctly prepared recommendations for all of the issues they had identified, prioritised and discussed earlier in their report. Ethical issues were generally well answered, although advice tended to be weak. Areas that were not well attempted by candidates There are 20 marks for Judgement and 20 marks for Logic. Therefore, these two criteria have a significant impact on the total marks awarded. It is in these two criteria that unsuccessful candidates often did not achieve high marks, resulting in marginal fail marks overall. Therefore, it is important to learn the skills required in order to earn pass marks in these two criteria in particular. Within these two criteria there were 5 main areas of weakness: (1) Many candidates simply stated that the takeover bid price at €4.20 was ‘very attractive’ as it was 24% higher than the share price before the takeover was announced. This did not recognise what future potential value of Merbatty or its stated growth plans. For example, if the 2008 profits are delivered at €51 million, this would result in a higher price of €4.25 (€51 million/180 million shares ⫻ P/E of 15). Furthermore, if the planned profit of €80 million were to be achieved in 2011, the share price could be €6.67, based on a P/E ratio of 15. (2) Many candidates did not recognise that the Board of Merbatty cannot reject the bid as they do not own overall control of the shares. They can make a recommendation to shareholders not to accept the bid, but ultimately it is the shareholders decision. JKL, with a 28% shareholding, is a crucial shareholder to convince. Therefore, recommendations that stated ‘the bid should be rejected’ earned lower marks that a more detailed recommendation such as ‘the Merbatty Board should try to convince JKL of its ability to deliver the planned level of profits, which will see the Merbatty share price rise far beyond the bid price to around €6.67 by 2011’. (3) The need to achieve planned profits was clearly not recognised by many candidates. The unseen material gave a few ideas as to where costs could be saved but most candidates simply stated that none of these costs should be cut, as the cuts could affect Merbatty brand reputation. Neither did candidate suggest any other ways to achieve the planned profit of €51 million. Many candidates simply recommended rejecting each of the suggested cost reduction methods. The candidates did not recognise the important link between the need to convince JKL to reject the bid – which it would only do if it could be assured of the 2008 planned profit being delivered. It was rather commercially naïve to expect JKL (who have a seat on the Board) to reject €4.20 per share now and then to only achieve 2008 profits of €39 million, which represents only €3.25 per share. It is the role of a management accountant to identify profit gaps as part of the planning process and to work with management to identify ways of closing the profit gap. (4) Currency. This was an area that many candidates chose not to discuss, despite the currency movement that was forecast to cause an adverse variance of €6 million, half of the profit gap in 2008. Many candidates earned no marks for simply stating that Merbatty should hedge it currency exposure, which the case material stated it already undertook. What was required here was a discussion on whether Merbatty should try to procure more supplies in US Dollars to match revenues or to change its price list to be denominated in only Euros. A better understanding of currency management is recommended. (5) Agent’s fees. A disappointing large number of candidates did not recognise that if Merbatty appointed a new sales agent at 8% commission (double what Merbatty

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Furthermore, many candidates earned low marks in Application. High marks were often awarded in the criterion of Technical for a wide display of technical knowledge, but unfortunately much had not been ‘applied’ to the case material, resulting in lower marks in Application. Also many candidates prepared very few relevant calculations, such as valuations for Merbatty or how costs could be saved to close the forecast profit gap. Assessment matrix and areas for improvement Overview of the TOPCIMA Assessment matrix The examiner was pleased with the format of candidates’ reports although the discussion was often ‘thin’ and lacked depth of analysis and many of the supporting theoretical frameworks were not referred to in the reports. The analysis of alternative strategies and the recommendations (marked in Judgement and Logic respectively) were generally weak. In addition to the top 2 priorities of the takeover and the need to achieve the 2008 profits, there were 5 other issues in this case. The other 5 issues in the case included the choice of location for Merbatty’s boat building locations, the need to appoint a new Sales Director, how to manage the loss of a key sales agent, currency fluctuations and the test results. These issues gave candidates ample opportunity for analysis and to make a range of commercially sensible recommendation to earn marks. It was NOT necessary to discuss all of these 5 additional issues but perhaps just 3 of them (in addition to the takeover and the need to reduce costs). Therefore, whilst reasonable marks were awarded in the other 7 criteria, the criteria of Judgement and Logic (which carry 40% of the total marks) were often poorly answered. It is important to display a good degree of professional and commercial judgement throughout the report and to make sensible, commercially realistic recommendations. Technical There are 5 marks available for Technical. Many candidates earned very high marks for a good display of relevant technical knowledge. Indeed many candidates produced at least 3 or 4 relevant theories or analyses, including a SWOT, a PEST analysis, references to Porter, Ansoff, Mendelow, etc. as well as financial ratios and valuation techniques. There was ample opportunity to earn marks in this criterion for the display of any of the following techniques: ● ● ●

●

●

SWOT analysis PEST analysis for the proposed move to Asia The Johnson and Scholes model to structure the answer by using the suitability, acceptability and feasibility framework for the proposals to cut costs or for evaluating the takeover bid Porter’s Generic Strategies to demonstrate that Merbatty differentiates itself on quality and excellence in design and customer satisfaction Porters five forces to demonstrate that barriers to entry in the industry are high and that suppliers’ power is also high

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is paying to all other agents), this could result in far larger fees being demanded by other agents and that this could have a significant impact on Merbatty’s profits. It was expected that candidates would identify that an alternative agent should be found and paid the same 4% fee. Alternatively, existing agents in another part of the USA could be asked if they wanted to expand their sales territory. Another option is that Merbatty could open its own sales office.

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● ●

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Mendelow’s stakeholder analysis which should analyse Merbatty’s many stakeholders, including its shareholders. This was particularly relevant in terms of sales agents for delivering sales and JKL as a key shareholder in respect of the takeover bid Motivational theories put forward by Herzberg and Maslow Other applied models such as Ansoff ’s growth matrix, the BCG matrix and the Balanced Scorecard Valuation techniques such as Dividend Valuation Model (DVM) or valuations based on P/E ratios Relevant ratios

However, many candidates spend too much time preparing detailed appendices that are then not referred to or discussed within the body of the report. It is a fine balance on how to spend the 3-hour exam time. The 2 criteria of Technical and Application are together worth 20 marks – and therefore should not have more than 20% of exam time spent on them. This equates to 36 minutes maximum. However, it is suggested that with exam planning time and time spent prioritising issues, no more than 30 minutes should be spent on appendices. Exam time would be better used to prepare a more in depth analysis to earn higher marks in Judgement and Logic. The recommended study text is Elsevier’s TOPCIMA Learning System, which has a whole chapter on techniques that should be revised for use in this exam. Application The Application criterion carries 15 marks and is used to reward candidates for applying technical knowledge (both theories and calculations) to the case material. In order to earn high marks for the SWOT, candidates should have identified the CCL takeover bid as a Threat and also the threat of reduced share price if the planned profit is not achieved. It is necessary to incorporate all of the new information given in the unseen material in order to earn high marks. A pre-prepared SWOT based on the pre-seen is insufficient. Candidates are also reminded that all of the issues prioritised should be included in the relevant section of the SWOT. It is surprising how many candidates omitted the top priority of the take over as a Threat. There is no greater threat to any company than a takeover, which will cause the company to not exist in its current form. Additionally, many candidates listed the take over as an Opportunity for Merbatty. Whilst this is partially correct (as it may enjoy economies of scale, etc.), Merbatty would cease to exist in its current form – therefore it really is an Opportunity for CCL and a Threat for Merbatty. A good range of theoretical knowledge was prepared and applied to the case material and many candidates earned high marks for the theories applied. However, within the available 15 marks, roughly half of the marks were available for applying theoretical knowledge and the other half for relevant accurate supporting calculations. TOPCIMA is not a ‘numbers’ exam and there are limited marks in the assessment criteria of ‘Application’ for relevant calculations. Therefore, it is recommended that candidates do not spend too much time (perhaps 20 minutes maximum) on preparing supporting calculations. However, in this November 2007 exam concerning a hostile takeover bid, it was particularly relevant for candidates to prepare some calculations to value Merbatty, both now and its future value (based on profits in the 5-year plan) as this would support their analysis of the bid. Unfortunately, in this case the accuracy and range of supporting calculations was not very good. Only about a third of candidates prepared any valuations for Merbatty at all.

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Merbatty’s market capitalisation and the bid premium Valuations for Merbatty based on 2007 profits and the 5-year plan profits for 2008– 2011 using P/E ratio method or DVM method Calculation of ways in which the profit gap of €12 million could be closed, by saving costs such as changing engine supplier, increasing prices and reducing the currency losses Calculations concerning the possible impact of higher agents fees Calculations for providing the enhanced Marinatron navigation systems Relevant ratios for Merbatty on gearing and profitability

Diversity Diversity carries 5 marks. Many candidates earned good marks for industry awareness and relevant comments on international boat building companies and other companies that have been taken over. Many candidates appeared to have some understanding of the boating industry and had obviously undertaken research or been taught about the sector prior to the examination. Relevant companies included Sunseeker (location in Poole, UK), Riviera (strong brand and established reputation in the Australian market), Ferretti (innovation, level of expenditure on research and development activities, and development of products with companies such as Mitsubishi), Ferretti (currency issues), Sunseeker (Alliances with other companies), Ferretti and Azimut-Benetti (growth by acquisition), Princess and Riviera (sales agents) and Sunseeker (use of own sales teams). There were also references to boat shows, the development of marinas in China and other countries, and the increasing number of high wealth individuals around the world. Many candidates also commented on the American economy and the recent ‘credit crunch’, and made reference to how this might affect Merbatty’s operations in the USA. In summary, high marks were awarded in Diversity to many candidates. However, the information about the real-life companies was often not considered when preparing the rest of the report. Focus There are 5 marks available for the Focus criterion. These are awarded for discussing the issues raised in the case. There was the opportunity to earn marks in Focus for the discussion of any of the 7 issues. These included the takeover bid, the need to achieve the planned profit in 2008, the currency issue, the need for a new Sales Director, the need to replace the USA sales agent, the choice of location for Merbatty’s boat building facilities and the problem with the test results for some boats in production. Most candidates earned the full 5 marks available for their discussion of 5 relevant issues. Prioritisation Almost all candidates clearly prioritised 5 issues at the start of their reports, and did attempt to justify the rationale behind their ranking. This resulted in high marks for prioritisation for many candidates in the important criteria. The most crucial of all issues affecting a company is maintaining its very existence. A hostile takeover threatens Merbatty’s very existence and no other decisions affecting

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Those who did usually calculated the correct 2011 share price projection of €6.67 per share. This helped them to identify that the bid significantly undervalued the future earnings potential of Merbatty. Calculations that could have been prepared, to earn marks include:

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Merbatty’s future could be decided before this issue. Therefore, the examiner considers that the CCL proposed takeover bid should be ranked as the top priority. However, given exam conditions and all of the other important issues in the unseen material, the examiner awarded high marks (8–10 marks) if the takeover bid was placed either as the top or the second priority. If the takeover was placed as a lower priority, marginal fail marks in the criterion of prioritisation were awarded. Therefore, whilst a candidate could still pass, low marks would be awarded if the takeover was not recognised as one of the 2 highest priorities. Furthermore, the related issue concerning the need to achieve the planned level of profit for 2008 was considered by the examiner as being important. This issue needed to be placed anywhere within the top 5 priorities. The title and discussion concerning achieving the planned profit could take various formats, as it was unimportant whether it was described as ‘reducing costs’, or ‘achieving plan’ or whether ‘the engines and other cost savings’ were given separate priorities. However, what was important here was recognition of the need to take action to ensure that a higher profit than the latest forecast of €39 million must be achieved. There continues to be a lack of understanding by some candidates of the nature of prioritisation. It is not about urgency but about impact on the company. A minor issue that requires a decision next week is less important than a major strategic issue that will affect the future success or very existence of the company. To summarise, in order to earn the full 10 marks available, it was necessary to identify and place within the top 2 priority issues the takeover bid and also to prioritise the need to achieve the planned level of profits for 2008 anywhere within the top 5 priorities. Judgement This is a very important criterion, which carries 20 marks. Marks are awarded for analysing each of the issues and for discussing a variety of alternative solutions. The Judgement criterion is a clear discriminator between well-prepared candidates and weaker candidates. Where low marks are awarded in Judgement, it is unlikely that the candidate will have earned enough marks in other criteria in order to pass TOPCIMA. Therefore, it was this criterion that often determines the difference between pass and fail in a script and is an important criterion which future candidates should concentrate on, to ensure that their analysis skills have been developed and practised. Candidates who analysed and discussed several of the issues well and showed good commercial judgement on several issues earned pass marks of over 10. However, candidates who demonstrated poor commercial and professional judgement earned between 3 and 8 marks. Therefore, it must be stressed that this criterion is an area that unsuccessful candidates need to improve in. Marks are only awarded in Judgement for comments and choices of action that are commercially viable, realistic and sensible. Common sense and general business awareness were often not displayed. For example, many candidates stated that it is important that Merbatty do not lose any further sales in the USA and that the proposed new sales agent SFBS should be appointed, even though the requested sales commission is double the existing sales commission. Some candidates even stated that a confidentially agreement should be signed. Furthermore, there was no recognition that if Merbatty’s other sales agents worldwide were to hear of the 8% commission arrangements, this could have a material effect on Merbatty’s profits. Agents costs at 4% of revenues equate to around €22 million (2007 revenues of €555 million ⫻ 4%). If all sales agents were to insist on 8%, this would result in operating costs increasing by a further €22 million – which is half of

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(1) The CCL takeover bid The CCL bid at €4.20 represents a 24% premium on Merbatty’s pre-bid share price of €3.40. Usually a bid premium exceeds 25% and is often around 30%. So the bid price was not generous. Some candidates incorrectly stated that the bid price was ‘attractive as it exceeded the share price’. This was incorrect as a hostile takeover bid would always be at a price higher that the current share price – otherwise it would not be attractive to the shareholders! What many candidates did not recognise was the value Merbatty as a company could be worth. This should have included valuations of what Merbatty is worth now and what could be its worth in a few years if it were able to deliver the planned profits. Merbatty was only listed a year before, in November 2006. When shareholders invested in Merbatty (at €2.80 per share) they invested on the basis of the published 5-year plan. They are not investing to make a ‘quick profit’ – they are investing for the medium to longer term. While the Merbatty Board continues to deliver the planned level of profits, they will be content. The unseen material stated that the 2007 planned profit of €45 is likely to be achieved. On the basis of this profit, at a P/E of 15, the company is worth €3.75 per share (€45 million ⫻ P/E 15/180 million shares). Therefore, the current market price reflects Merbatty’s current earnings, despite the loss of market confidence in this market sector. Candidates could also have prepared an analysis of who could vote for and against the bid and this should have identified that JKL are a key player (Mendelow’s matrix) with 28% of the shares – so much would depend on whether JKL considered the future value of Merbatty would be greater under the current Merbatty’s Board control or under CCL. Given CCL’s track record of lower EPS and lower net profit margin, there is evidence available to persuade JKL that CCL would not deliver Merbatty’s current 5-year plan. The key to gaining high marks in Judgement in respect of the takeover bid was the recognition of the importance of JKL and the need for the Merbatty Board to come up with reasons as to why the bid should be rejected and also the recognition of Merbatty’s much higher future value. If the planned level of profits were to be achieved, the Merbatty share price would be over €6.67 in 2011. Many candidates earned low marks as they did not recognise that the Merbatty Board do not have the ability to reject the bid – this is for the Board to advise its shareholders (i.e. JKL in particular). Also few candidates recognised Merbatty’s future potential higher value or prepared calculations to substantiate its future share values. A further disappointing theme in some weaker candidate’s answers was that the take over (which was a share exchange) would result in cash flowing into Merbatty. This was totally incorrect. (2) The need to achieve the planned profit of €51 million in 2008. If JKL are to be persuaded to reject the bid, then it is important that plans are made so that the 2008 planned profit of €51 million is achieved. It would not be acceptable to ask JKL to stay loyal and then to state, ‘sorry, but we are going to issue a profits warning

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the post-tax profits for 2007. This would be a significant impact on profitability. The alternatives would be to find other sales agents who would accept the 4% commission fee, or to ask Merbatty’s existing sales agents in the USA to expand by opening further sales offices. Alternatively, Merbatty could open its own sales office staffed by employees and incentivise them for achieving sales. In the November 2007 case, there were 7 issues for which marks were available in Judgement. Marks were awarded for reasoned analysis of the following 7 issues:

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as 2008 profits will €12 million lower at €39 million, and we are taking no action to close this profit gap’! This is unrealistic. Commercially, it is important that Merbatty continues to hit planned profit targets. It is the role of a management accountant to identify profit gaps and to work with management to develop ways in which the profit gap could be closed. It is never easy and some tough decisions will have to be made. In the case material on exam day, some suggestions as to how costs could be saved were included. It is the role of the consultant to advise on some of these suggestions and to explain the consequences of the cost cutting. However, it is not acceptable to state that Merbatty should not change engines, should not reduce specs, should not increase prices, and should not cancel sponsorship, etc., as some of these decisions will need to be made – unless other more innovative ways can be found to save the €12 million profit gap. It was surprising, and disappointing, that so few candidates produced any summary of how the 2008 profits could be improved, as this was fundamental to the case. It was expected that candidates would recognise that the dual sourcing of engines made good commercial sense, particularly at the bottom end of Merbatty’s range of boats. Merbatty boats are pleasure boats not speedboats. The customer could be given the choice. Therefore, Merbatty could have a price list with an extra charge if the more powerful MNE engines were requested by a customer. Additionally, ENG engines procured in the USA would provide a good match for US Dollar revenues, therefore reducing Merbatty’s currency exposure as this would provide a natural hedge. The proposal to increase the price of the P3000 model was generally rejected by candidates, despite the fact that Merbatty plans to sell only 15 in 2008. Many candidates stated that any price increase could affect volumes of sales without recognising the small number of boat sales. Sales volumes may be reduced, but enhanced specifications, possibly incorporating the new Marinatron navigation system could justify a price increase in this one model. This proposal was generally rejected. With TOPCIMA it is not the answer that is right or wrong generally, but the arguments put forward to justify the suggested courses of action. Generally this was not well handled. In respect of the other cost savings suggested, it was expected that candidates would reject the suggestion to install cheaper, lower technology equipment as this was totally contrary to Merbatty’s policy of differentiation on quality and could damage the brand image. Similarly, it was expected that candidates would reject the proposals to reduce development expenditure and to cancel the sponsorship contracts. There were two reasons for not cutting sponsorship: first, both of the sponsorship contracts have several years to run and probably could not be cancelled without a penalty. Secondly, the cancellation would generate adverse publicity and cause potential customers to lose confidence in Merbatty if such a visible sponsorship contract were cancelled. It would be better to suggest that Merbatty should consider not renewing one or both when the contracts came up for renewal in 2009 and 2011. Many candidates suggested that Merbatty should install the new Marinatron navigation software in all boats, but were often unclear as to whether they were suggesting that Merbatty bear the cost or whether customers would pay for this additional extra. If Merbatty were to bear the cost, this would increase the 2008 profit gap. It could be suggested that Merbatty should offer this enhanced navigation system as an extra, or as a way to justify a higher sales price. Merbatty was only listed in November 2006 – only 1 year before, and it is important that Merbatty tries its best to deliver to the plan that was promised its investors. At this first hurdle, ways need to be found, such as JIT, lean manufacturing techniques,

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TQM and so on, to enable Merbatty to achieve its financial plans. What earned marks here was not just a discussion of ways to cut costs, but the recognition of the need to deliver its planned profits to keep its investors content. If Merbatty were to fail to achieve the planned profit of €51 million in 2008, CCL or another bidder would come along with another hostile takeover bid and perhaps Merbatty’s investors would not be loyal if Merbatty had failed to deliver the planned profit. In the business section of national newspapers, there are usually reports on take overs and on whether shareholders will accept or reject the bid and about historical and future profit projections. These would help candidates to understand what the examiner wishes to elicit in their answers in TOPCIMA. (3) Currency fluctuations It was expected that candidates would recognise that what was being described here was exactly what has happened in real life. The US Dollar was very weak and was around $2 to £1 in November 2007 when this exam was sat. Candidates at this level of their studies should be aware of the importance of currency movements in today’s global markets. This goes deeper than treasury management and external hedging techniques. Many candidates earned no marks for simply stating that Merbatty should hedge it currency exposure. A discussion on natural hedging methods such as procuring more supplies in US Dollars to match revenues or to change its price list to be denominated in only Euros was required. An alternative would be to change Merbatty’s reporting currency to US Dollars. This is typical of the challenges facing many international companies today, and this issue was noticeably either avoided by candidates or handled badly. It is important that candidates should gain a good understanding of currency management. It was expected that candidates would discuss a range of ways to ensure that the potential €6 million currency loss (half of the total profit gap of €12 million) does not occur by pricing in Euros only or Euros only for non-USA sales and by ensuring costs are matched against revenues. Some candidates incorrectly recommended closing the USA facility so that the ‘problem would go away’. This would, in fact, make the situation worse, as it is Merbatty’s revenues that are in US Dollars which are now worth fewer Euros. By taking away the ability to offset some of its US Dollar operating costs, the situation would worsen. This type of comment demonstrated to the examiner a lack of understanding of this important issue. (4) Need to appoint a Sales Director following Stefan Gil’s resignation Although Jesper Blanc (Marketing Director) has been given this role temporarily in addition to his other role, most candidates did recognise that he was the wrong person for such an important role as he was very inexperienced. Many candidates earned good marks for recognising this and for recommending that another, more senior Board member should take this role on until an external person can be recruited into this role. Some candidates earned low marks for stating that all efforts should be made to get Stefan Gil to return. Stefan Gil left Merbatty on 9 November and has joined a rival (the same rival who has made the takeover bid for Merbatty). It is commercially unrealistic for someone of this level to return to the company he has already left. No doubt at the time of his resignation, Board colleagues would have tried to persuade him to stay. However, he has now left and candidates should have prepared more realistic comments on how the position should be filled rather then suggesting that he be enticed back. Many candidates also did not discuss the importance of recruiting a capable Sales Director, who will be able to deliver the 5-year plan.

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(5) Sales agents in the USA Following the notice given by Merbatty’s agent LABS, Jesper Blanc (the new temporary Sales Director) approached a prospective new agent, SFBS, which requested substantially increased agents commission of 8%. Marks were awarded for the recognition that it was commercially unrealistic to appoint a new agent at double the commission and that this could have far reaching implications for all of Merbatty’s sales agents’ worldwide and could potentially impact the profits by over €20 million if all agents insisted on 8%. Alternative available have been shown earlier in this report. Some candidates made an incorrect suggestion that a higher commission percentage should be given for the sale of larger boats to encourage these to be sold, rather than the same commission as a smaller boat. As the commission is a percentage of the revenue generated, agents already get a far higher fee for the sale of larger boats. (6) Location of Merbatty’s global boat building facilities Marks were available for the discussion on Merbatty’s facilities and whether Merbatty should bring forward its planned expansion of facilities and whether it should be in Asia or Europe. There were also marks available for discussion on whether the USA facility should close due to a recent fall in sales. This issue was not intended to trick candidates but too many simply suggested that the USA facility be shut with no recognition of the impact that this could have on sales in the important target market of the USA or indeed the impact this would have on Merbatty’s capacity to build the planned number of boats. Some candidates also muddled the building of boats in the USA with sales to customers in the USA and did not appreciate the significance of this important target market, which generates around 24% of sales. If the USA facility were to be closed, this could have an adverse impact on Merbatty’s ability to sell boats to the important USA market. High marks were available for noting that expansion in Europe would not contribute to Merbatty’s need to cut operating costs and that it should not purchase land speculatively, as there was nothing in the agreed 5-year plan about extending operations in Europe. Overall, the planned move to Asia should still be considered. This, however, was an issue of lesser importance, as Merbatty will cease to exist if it is acquired. Therefore, all management efforts should be spent on managing shareholders expectations and achieving agreed profits and not on additional capital expenditure until additional boat building capacity is required. (7) Computer test results The discussion required here was to balance commercial pressure against the need to maintain high operating standards. The boats concerned should not be delivered to customers despite commercial pressures. If faults that had been ignored during test procedures were found, these would be expensive and time consuming to fix after delivery. Furthermore, there may be an adverse effect on Merbatty’s brand image. It was disappointing that some candidates gave brief unsubstantiated comments on many of these issues and did not discuss commercially sensible alternative approaches to address them. Business is all about managing risks and ensuring that threats to business goals are mitigated. Integration This criterion rewards candidates for their ability to write a cohesive, comprehensive report that ‘flows’ well and reaches well-justified recommendations on each of the issues

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Logic The criterion of Logic carries 20 marks in the assessment matrix and rewards clear, justified, well-argued recommendations. It was a criterion in which fail candidates earned low marks. It is recommended that candidates allocate at least 40 minutes of their examination time to prepare detailed and justified recommendations. Some candidates apparently did not manage their time adequately and prepared rushed recommendations. This is one of the most important areas of the report and will often determine a pass or a fail when the script is marginal, so it is important to ensure that recommendations are clear and the rationale for the recommended course of action is given. It is of paramount importance that the report makes appropriate recommendations and does not leave any of the issues undecided. It is for the consultant (i.e. the candidate) to present all the arguments for and against and to weigh them up in order to make recommendations. There are few right or wrong answers with TOPCIMA – it is the depth of discussion and the strength of the candidates’ arguments and the justification behind the recommendations that earns marks. Ill-thought through analysis and poor recommendations are not rewarded. In this case, no marks were awarded for a recommendation to accept the CCL bid. Additionally, low marks were awarded if the candidate stated that none of the cost saving suggestions should be accepted. It was necessary to recognise in the recommendations that Merbatty has to take some actions and find ways to achieve the agreed 5-year plan. In respect of all of the other issues, there were no right or wrong answers, although the recommendations that were commercially realistic earned higher marks than poorly thought through recommendations. Candidates are referred to the case writer’s answers for detail of what actions were recommended and the rationale for the recommendations. A summary of the recommended actions for the 7 issues in this case are as follows: (1) The CCL takeover bid – it was recommended that the Merbatty Board should persuade JKL to reject the bid as the future potential value of Merbatty is over €6.67 if Merbatty achieves the agreed 5-year plan in 2011. (2) The need to achieve the planned profit of €51 million in 2008. If Merbatty are to be able to keep its investors loyal and not be the target of a further takeover bid, it must find ways to cut costs and achieve the agreed 5-year plan, including the €51 million profits in 2008. Recommended actions included: ● Accept ENG engines for some smaller Merbatty boats and have MNE engines available at an additional cost if customer requires a better engine

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discussed. This criterion rewards a report which is realistic in that it contains commercially viable comments that would help advise the Board of Directors of Merbatty. On the other hand, if it is considered that a company, in receipt of a report of this standard would be dissatisfied due to a lack of sensible recommendations, then low marks are awarded. A report that contained recommendations, which the examiner considered could cause the company problems, was awarded low (fail) marks in this criterion. The recommendation that Merbatty should accept the CCL bid was considered to be incorrect (as Merbatty could be worth substantially more that the CCL bid price of €4.20) and therefore low marks were awarded for candidates who recommended accepting it. However, if other issues in the case were well discussed and culminated in commercially sensible recommendations, the candidate could pass overall. Therefore, accepting the bid resulted in low marks in Integration and Logic but did not directly result in the candidate failing.

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Increase price of P3000 boat and moderately enhance the specification to help this justify price rise, possibly with new Marinatron navigation system ● Reject low specifications as they would damage brand image and Merbatty’s differentiation policy ● Reject cutting developments costs as these are necessary in this industry to remain competitive ● Reject the suggestion to cut sponsorship contracts as the cancellation would generate adverse publicity and could damage brand reputation ● Reduce losses from currency (see below). (3) Currency fluctuations. It is recommended that Merbatty should only allow USA-based customers to sign contracts for Merbatty boats in US Dollars and all other customers around the world should pay in Euros. It is expected that around 74% of sales (i.e. all non-USA sales) should be contracted for in Euros which could save €4.3 million of the forecast €6.0 million currency losses. (4) Need to appoint a Sales Director following Stefan Gil’s resignation. It is recommended that Merbatty recruit and appoint a new Sales Director, once the CCL bid period had ended. (5) Sales agents in the USA. It is not recommended that Merbatty appoint SFBS. It is recommended that Merbatty should try to locate another agent in this area at the usual fee of 4% of revenues. Alternatively, Merbatty could open its own sales office. (6) Location of Merbatty’s boat building facilities. There is no convincing reason to close the USA boat building facility and to construct a new facility in Asia at this point simply to achieve operational cost savings. Merbatty does not need extra capacity until 2011 and therefore this proposal should be rejected at this time. The upheaval and potential problems this could cause could detract from the Merbatty management’s need to manage the business during this growth period and to achieve the agreed 5-year planned level of profitability. The proposal to purchase land in Europe should also be rejected. (7) Computer test results. It is recommended that the Board stop the delivery of boats to customers until it is satisfied that the faults have been rectified, or found out whether there really are software faults in the test program. ●

As a reminder, it is generally better for all recommendations to appear together at the end of the report, rather than at the end of each section concerning each issue, as actions impact on each other. Additionally, recommendations are sometime on related issues. For example, as explained earlier, it was unrealistic to recommend that the CCL bid should be rejected and to persuade JKL to stay loyal, and then to recommend that no actions are taken to bring the forecast 2008 profits back to planned levels. Some candidates even recommended a profits warning – however, it would be more sensible to suggest ways to achieve the profit. If a profits warning were to be issued, it is likely that investors would take the €4.20 now and sell their shares to CCL. Recommendations must be realistic and be consistent for related issues. In real life, many decisions made are inter-related. Ethics Most candidates attempted to address 2 or 3 ethical issues and earned pass marks. In order to earn a pass mark, it is necessary to identify the ethical issues, justify why you consider them to be ethical issues and to advise on how to resolve several of the ethical dilemmas identified. The full 10 marks are awarded for a good discussion and advice concerning two

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justify why the issue is an ethical dilemma or give clear, fully justified advice on how the ethical issue could be addressed and the cost implications for the company.

Candidates are reminded to ensure they justify why an issue is deemed to be an ethical issue. For example, the problem with the test results showing faults is an ethical issue because Merbatty is suggesting that customers’ safety is compromised in order to ensure that boats are delivered on time. A maximum of 4 marks (i.e. marginal fail) was awarded for the discussion of ethical issues alone. It is the advice and recommendations on how the ethical issues could be overcome that earns up to the maximum 10 marks. There were a range of ethical issues in this case including: ●

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Alberto Blanc’s (Chairman) promise of a ‘loyalty’ bonus of €3 million to his son Jesper Blanc to entice him not to sell his shares to CCL. Merbatty has not given its customers a choice as to whether they would like the newly enhanced navigation software to be installed on new boats. Proposed termination of agreed sponsorship with immediate effect, in order to cut costs. Potential faults showing on the specialised software test program that Alain Mina (Technical Director – Systems and IT) is choosing to ignore. Merbatty’s ethical position on greenhouse gases and emissions and sources of renewable materials.

Generally, the advice given on ethical issues was weak and earned low marks. For example, many candidates correctly identified the ‘loyalty’ payment to Jesper Blanc as unethical but offered weak advice such as additional training for the Board on corporate governance whilst failing to recommend that the payment should not be made. Many candidates treated the test results only as an ethical issue. However, as in the real world, this problem is a business issue as well. Candidates earned marks in Judgement as well as Ethics if both aspects of this problem were addressed. 5.0 Recommendations to improve your chance of passing TOPCIMA in the future Candidates are referred to the TOPCIMA Learning System textbook, (www.cimapublishing.com) which is the recommended reading text for this exam. This CIMA Learning System takes candidates through past TOPCIMA cases and demonstrates how to analyse the pre-seen and also what to do on the exam day with the unseen material and how to prepare answers on the exam day. It also contains a chapter on Technical issues, including revision of a range of business and financial techniques that candidates should understand and incorporate in their answers. This CIMA Learning System also contains past TOPCIMA cases and the case writer’s answers. Candidates sitting TOPCIMA for the first time are referred to previous Post Exam Guidance reports or the general TOPCIMA guidance notes (on the CIMA website) for advice on the suggested report format. It is recommended that all candidates should read the financial pages of a good newspaper at least once a week, in order to gain an appreciation of the business world that this CIMA

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or more ethical dilemmas. The problem is that many candidates discuss a number of ethical issues but do not:

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exam is set in. This will enable you to gain a far greater understanding of how companies operate and hopefully will reduce the number of non-sensible comments appearing in reports. In summary, the eight key tasks that will put you in a better position to pass TOPCIMA are: (1) Work (not simply read) through at least 2 TOPCIMA past cases (on www.cimaglobal. com) (2) Read thoroughly 2 past TOPCIMA Post Exam Guidance reports (on www.cimaglobal. com) (3) Research the business setting for the case thoroughly and totally familiarise yourself with the pre-seen material (read newspapers, research using the Internet, use Internet search engines such as Google to identify companies in the industry, etc.) (4) Revise business strategies and suitable techniques and be able to apply them to the case material. The examiner would also like to stress the importance of cash management in any organisation, large or small, listed or unlisted, profit making or not for profit – cash is key. (5) Practice writing answers to previous TOPCIMA cases in a 3-hour session and see how comprehensive an answer you can produce. Check your answer to the case writer’s answer (in the CIMA Learning System or available from www.cimapublishing.com) (6) Read the two articles on the CIMA website (www.cimaglobal.com) about the case you are planning to sit. CIMA commissions independent writers to analyse the preseen material and these articles give a good insight into the industry setting and the problems and opportunities the company is facing. The articles for the September and November 2007 exams on Merbatty are ‘Plain Sailing’ by Adrian Sims of BPP and ‘Navigating uncertain waters’ by Shuaib Masters of FTC Kaplan. There will be other articles for the next TOPCIMA exams on the CIMA website early in 2008. (7) Ensure that the report clearly prioritises the top 5 key issues raised in the unseen material and consider carefully whether the priorities are in an appropriate order given the circumstances of the case. The order in which issues are placed must be justified. (8) Ensure that the answer covers all nine assessment criteria Remember – do your research and prepare for the exam – but on the day, ensure that you write a thorough, well-reasoned answer that covers the relevant key issues raised in the unseen material and ensure that your answer covers all aspects of the requirement, particularly clear well-justified recommendations. The examiner cannot stress enough the importance of practising writing an answer using past TOPCIMA cases. You really must practise your exam technique, as this exam is different to all other CIMA exams. There is no way to prepare for the TOPCIMA exam without investing in hours of work using past TOPCIMA papers and to work on them. Remember it is good preparation that will help you to pass this final test of professional competence. The skills you learn from preparing for your TOPCIMA are the same skills that you will use in the real world when you are a qualified CIMA accountant – so learn them now as you will use them in your future career. Now you have read this report – go and prepare for the TOPCIMA exam that you are planning to sit, but learn from the advice given in this document.

6 How to Analyse the Pre-seen Material and Research the Industry Setting

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How to Analyse the Pre-seen Material and Research the Industry Setting 6.1

6

Introduction

In this chapter, I will show you how to analyse the pre-seen material using the Merbatty case that you will be familiar with from Chapter 5. It is necessary for you to demonstrate an understanding of the real-world context of the industry in order to gain you marks in TOPCIMA by: ●

●

●

providing examples of actions and strategies that companies operating in the real world would follow which could be used by the company in the case study material; demonstrating to the reader of your TOPCIMA report (the CIMA examiner), that you understand the industry and its opportunities and challenges, and therefore your advice is reliable and realistic; helping your report to look professional by avoiding suggestions of unrealistic ideas that could make your report look ridiculous and cast doubt on your competence as a management accountant.

6.2

Why you need to conduct industry research

The pre-seen material usually contains a good summary of relevant information about the industry. This can be relied on as accurate at the time it is published. You should research the industry setting for the case you are working on, or the real TOPCIMA exam that you are preparing for, so that you can demonstrate a sound understanding of the problems (and opportunities) facing companies in this industry. It will also help you to understand the pre-seen material and any industry-specific information given in the case. Hopefully, it will also help you from making unrealistic comments in your answer on exam day. Therefore, many of the factors you should look for can be summarised using the Industry Analysis section of the Technical Toolkit in Appendix A: (1) identify industry lifecycle stage and the factors driving it; (2) identify whether any of the five forces are strong or strengthening and the forces causing this; 143

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(3) consider the competitive strategies being followed by companies operating in the real world and how they are achieved (e.g. special technologies, use of brands) and whether they could be adopted by the company in the pre-seen; (4) identify real-world issues against the PEST framework (this may involve some basic research into the laws and technologies of the industry); (5) consider the impact of globalisation on the future of the industry and on the firm in the pre-seen; (6) consider the problems and challenges facing companies in the real world and to be aware of topical news stories on the issues facing them and how they deal with them. An additional factor to consider is the state of the investment markets, which will affect costs of capital and share prices.

6.3

How to conduct industry research and sources of information

The five sources of industry information are: (1) (2) (3) (4) (5)

personal networks, visits to similar real-world companies, trade media and news media, Internet searching, professionally produced industry analysis.

6.3.1

Personal networks

Some candidates have been lucky enough to find themselves facing a set of pre-seen material describing the industry they work in. In this situation, they have plenty of colleagues they can talk to about. Alternatively, and depending on the industry in the Case Study, it is possible that you know someone in the business from whom you can get information. Likely contacts include: ● ● ● ●

people who work in the industry or who have worked in it; family members or their friends; contacts at work who have dealings with the industry in the case; other people sitting TOPCIMA, either via your college or using online forum, such as www.casestudyaide.com.

Discussing the case and your analysis of the situation of the business with an expert will help you to test out your understanding of what is important.

6.3.2

Visiting similar firms

Again, this depends on the accessibility of the industry. For example, for the Zubinos case, which was about Coffee shops, it was possible students in most parts of the world to visit a range of coffee shops, see how they operate and see the level of customer service provided,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.3.3

Trade media and news media

A journalist is a paid professional who searches out and presents information about an industry. If you can find a trade journal for the industry in the case, it will save you a lot of searching for yourself. It is also easier than a web page or conversation to cite as a source in your final report. Trade journals can be located in four ways: (1) Visit a good newsagent. The difficulty here is that only very large industries such as accounting, financial advising, computing, music and building provide enough customers for a newsagent to consider stocking the magazine. (2) Visit a business library. Most universities and better colleges will permit you a reader’s ticket to consult their journals on a read-only basis. However, such libraries will not let you borrow journals and may place restrictions on photocopying them. Good librarians will be able to locate relevant journals for you too. (3) Ask someone who works in the industry for the name of the journals for the industry. (4) Use the Internet. Many trade journals now have websites and, in many cases, can be downloaded as PDFs. Naturally there will be restrictions on logging in if you have not paid, but there is a surprising amount of free media available. The best approach is to go to a search engine (see below) and type in a search inquiry such as: ‘trade magazine for ⬍name of industry⬎ industry’ or ‘articles on, ⬍name of industry or real-world firm⬎’. News media is more general although some quality business newspapers may carry special supplements on particular industries from time to time. It is also very important to spend time reading the financial pages of any good newspaper, not necessarily the Financial Times. It is relevant to understand what is happening in the real world with acquisitions, mergers, downsizing, boardroom conflicts, etc. The more widely that you read the financial press, the more it will help you to understand and fully appreciate all of the many complex factors that affect companies and the selection and implementation of their strategies. It is also recommended that you should keep yourself updated with latest information on exchange rates, interest rates, government policies, the state of the economy, and particularly what is happening in the business sectors concerning mergers and acquisitions. The acquisition of a competitor, or a hostile takeover bid is a very important strategic move. Acquisitions happen everyday in the real world and you can familiarise yourself with how these work by reading the business press. Furthermore, acquisitions or hostile takeover bids have been examined many times in TOPCIMA. Obviously, news media is available in hard copy from shops but also most good newspapers have websites that give you the day’s stories and also have searchable archives on past stories about the industry or specific firms within it.

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an excellent way in which to gain an idea of what they are doing right and what areas could be improved for you as a customer. In other situations, this might not be possible. Few of us will have had the pleasure of a trip on a luxury yacht, like that in the Merbatty case, although what better excuse to convince someone to give you a ride around on one for the day!

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www.ft.com

Website of UK Financial Times with searchable articles archive

www.nytimes.com

Website of US New York Times with searchable articles archive Website of Economist magazine with searchable articles archive

www.theeconomist.com

www.bloomberg.com

6.3.4

Financial information Website

Useful for ● articles on particular firms ● articles and surveys on industries ● surveys on countries ● articles on technologies and management techniques As FT above but with greater emphasis on US firms Useful for surveys of large industries ● economic surveys of countries ● economic forecasts Useful for ● investor information on particular firms (including history of share price) ● surveys of prospects for particular industrial sectors ●

Using the Internet

This is the most convenient and commonly used method of researching the industry. Generally, you will be looking for the following sorts of information: ●

●

●

● ● ●

Websites of firms similar to the one(s) in the TOPCIMA pre-seen material. This can help you learn about the sorts of products and competitive strategies they follow and may also yield financial information that can be compared with the data in the pre-seen material. Trade journals of the industry in the pre-seen. This will provide information on realworld environmental issues facing the business. Articles on the industry in journals and newspapers. These will keep you up to date on developments. Stock market information on the real firms. Financial statements of real firms. Industry reports produced by organisations such as the DTI and the large accountancy firms, which are surprisingly common, and often available for free on the Internet, if you search well.

If companies can be identified that are in the same or similar industries to the industry in the TOPCIMA case, indicating that they are simple companies, not conglomerates, it is possible to gain much information from these websites. It is not helpful, as some candidates and tutors have done, to concentrate on any one single company, however similar you believe that is to the case. The examination team have made it clear that no past TOPCIMA case has ever been based exclusively on just one real-world company and hence data will differ from any sets of accounts that you may consider the case is based on. In addition, your answer needs to demonstrate a wide industry awareness, and use of examples from a variety of companies is important to show this. Company websites of public companies in similar industries can provide the annual report and accounts, any press releases, publicity material and product descriptions, and

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

● ● ● ●

typical industry working capital ratios, typical ratios of fixed assets to sales, margins, growth rates.

You should then compare the accounts with the current share price and compare the market capitalisation with the asset value, and review all the normal investment ratios. You may provide yourself with some ‘normal’ industry figures as a basis for any comparisons you may wish to make of the unseen material in due course. You should also review all the non-financial information provided, looking in particular for: ● ●

new technological developments, new products; the competitive situation.

6.3.5

Professionally produced industry analysis

Those of you attending college courses, will probably find that your tutorial college produce some information for you on the industry. This is usually of limited detail, and should only be taken as a starting point for the research that you do. One common trend I notice is for students to pick up on a particular example used by these colleges, either in their study material or their mock exam solutions, and believe that since they’ve used that example, that must be a good one for students to use too. While that might be the case, from the marker’s perspective, seeing the same introduction (as an example) as they’ve seen many other students produce does not give a good first impression, and impressions are important in this exam, since you are aiming to produce a high quality report that demonstrates your overall ability. In addition, there are now companies who specialise in producing formal analyses of TOPCIMA exam pre-seens. This can certainly save you a lot of time, although, again another word of warning is that those which I have seen often contain a mass of data of which the majority is not useful for the exam, so, if you do purchase one of these, do pick and choose the aspects from them which you see as important. If you are looking for these, a quick Internet search should help you to find the company, or alternatively join a forum such as www.casestudyaide.com, where you will soon find posts of people discussing the alternative options and the merits of them.

6.3.6

What should you produce?

As a result of the analysis you undertake, there are a number of key things you should do: (1) Produce a folder in which you keep all the information you are able to find, for example industry reports, newspaper clippings, printouts from industry research, your own personal analysis and so on.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

detailed documentation on such matters as rights issues and share option schemes. Often they contain specially commissioned pieces of market research that you can download. However, it’s worth remembering that this research is there to encourage investors to anticipate higher returns in the future and will tend to put an optimistic gloss on events. Some US company sites provide exceptional levels of information including all legal document filings, such as company returns. However, remember this is only background: don’t spend too long on gathering this information. You should review the accounts and establish:

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(2) Create a list of 20–30 key examples from real-life companies, covering a wide range of different issues that the pre-seen company could face, and learn these, so you can use them as good examples in your answer. (3) Update your SWOT analysis for the company with real-life opportunities and threats being faced by real-life companies, which may be relevant to the pre-seen company. (4) Add key points to a PEST analysis (see later) (5) Add key points to a Porter’s Five Forces analysis (6) Add the position of real-life companies to the matrix used for Michael Porter’s Generic strategies analysis (e.g. cost leadership, differentiation and focus). (7) Create a list of key facts about the pre-seen on no more than 2 sides of paper. The aim of this list is that you learn this prior to the exam so you can save yourself time in the exam looking back through the pre-seen for information. Information you might include on this key facts list includes key financial information (e.g. revenue, profits, cash flow, targets), names of people and their roles, the organisational structure, details of key departments and so on.

6.4

Analysing the pre-seen material

You are able to access your pre-seen material a number of weeks prior to the exam from the CIMA website. In the past, the pre-seen material has been between 11 and 18 pages long. You are expected to be thoroughly familiar with it and to use information from it in your final report. If you are attending a tuition course, it is likely that you will analyse the pre-seen information as part of that course. However, if you are studying alone, here is the process which you should go through: (1) Understand the different techniques useful to help analyse the pre-seen. (2) Read the pre-seen page by page making notes on the key information presented and its significance. (3) Undertake a full strategic analysis of the company. This should include a range of models from your strategic level studies, most notably: – Using ratios to conduct a financial analysis of a company’s position – Assessing a business portfolio – Industry analysis – Conducting a corporate appraisal or SWOT analysis – Critical success factors – Assessing information systems strategy – Assessing corporate risk – Business valuations – Generating strategic options You will find a reminder of each of these elements of strategic analysis in Appendix A.

6.5

Making effective notes on the pre-seen material

Psychologists tell us that using conventional linear notes on their own use only a small part of our mental capacity. They are hard to remember and prevent us from drawing

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.5.1

Speed read the pre-seen material

The first step in analysing the material is to speed read the pre-seen material: The technique of SQ3R (SQ3R is Scan, Question, Read, Reap and Review) will help you to get into the pre-seen material quicker. It is also a skill you will need for dealing with the unseen material on exam day where time is very precious.

You will need to have some paper and pens for this. S

Q

R

R

R

Scan the material. Pay attention to main headings, dates and subjects to get a feel for what you have been given and how it fits together. Do not read the fine detail yet. You are just getting an initial impression. Question. Using a scrap of paper try to jot down some initial questions and answers to them. These could include things such as: ● What is the sequence of events here? ● What are the main issues in the situation? ● Who is who and who reports to whom? ● What is the financial situation of the firm? Read the case closely. Try to underline key points (or better still write them on a separate sheet of paper) and conduct any ratio or other calculations. It is a good idea to write this on the face of the material. The spider diagram technique described later is useful here. Recap what you know. Look at your initial questions and the notes you have made since. ● Note any questions that are still unanswered. ● Draw organisations charts. ● Write quick character sketches of any characters in the case. ● Summarise the key financial information. Review the case material by reading it through again. This may expose additional insights you have not noticed so far or contradict your initial assumptions. If so jot down these points too.

6.5.2

Page summaries

Page summaries are a précis of what each page tells us about the firm and an attempt to understand the significance of what we have been told. This is a very useful tool and it is recommended that you should prepare a page summary of what you consider the key data in each page and the significance of each issue. As you prepare and research the case, go back to your page summary sheets and add extra notes. This will also help you to find out whether you had perhaps initially missed out some important points which you discovered later on, so that you can improve your skills at analysing material given to you – especially important for analysing the unseen material on exam day.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

connections between topics. This is because they seek to classify things under hierarchical headings. Here are some techniques that candidates find useful. See which ones work for you as you practice on the past cases in this CIMA Learning System. The examples that follow use the September and November 2006 TOPCIMA case on Kadgee.

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The following headings can be used (using Kadgee pre-seen material): Main information Page 1

Section headed: Clothing manufacturing in Europe There has been a decline in the number of European manufacturers due to cheaper competition from outside Europe. Price pressure exerted by High Street retailer who wield immense buying power.

Few manufacturing companies left in Europe that are having to look hard at their strategic plans.

Section headed: History of Kadgee Fashions (Kadgee) Unlisted family-run company.

Did have 9 factories, but suffered a fall in sales in the late 1960s.

6.5.3

Significance

Kadgee is not the only company facing the decline in Europe. Price competition due to globalisation. Mendelow’s stakeholder theory demonstrates that Kadgee’s customers, the High Street retailers, are in a position to exert huge pressures on a small manufacturing company like Kadgee. This is not just price pressure, but also stock holding, designs, material, quality targets, etc. Many European manufacturing companies have ceased trading (a notable one being SR Gent which used to supply Marks and Spencer). If Kadgee is to survive it must look at its operations and change in order to survive.

Unlisted company with relatively few shareholders. Limited ability to raise extra finance to change its operations. The Board of Kadgee are not answerable to anyone else, such as external shareholders which could exert power on some small companies, which gives it the ability to change. However, small family-run companies often lack the skills or desire to change the strategic direction of the company – but this is where you will come in as a consultant to advise it. Kadgee has suffered setbacks in the past and have made the required changes to become profitable and successful again. However, despite its success in the past to change aspects of its business, Kadgee will require more radical changes if it is to survive in the global markets of the 21st century.

Spider diagrams

Spider diagrams (or clustering diagrams) are a quick graphic way of summarising connections between subjects. On Page 3 of the pre-seen material, details are given on Kadgee’s customer base. On Page 4 details are given on the increase of Kadgee’s manufacturing capacity to 109 million garments in 2005 due to the use of TQM to improve efficiency. This information could be quickly summarised in a spider diagram as shown in Figure 6.1. You cannot put much detail into a spider diagram, just a few key words. However, it does help you to ‘visualise’ the information in the TOPCIMA case.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Kadgee clothing

Revenue 74.4 million in 2005

Private unlisted family-run company

Manufacturing capacity increased to 10.9 million garments

Figure 6.1 Spider diagram (based on Kadgee clothing)

Note also the attempt to connect across the different legs of the diagram, in this case between the loss of Forum, one of its biggest customers and its manufacturing capacity. A few of these can be helpful although trying to draw in a lot of links will make the spider diagram very messy and hard to follow. You must expect to update your spider diagram as you go along and to redraft it when it starts to get too messy. It is all part of the learning process. Candidates usually draw several of these diagrams exploring different aspects of the case. Each one can be drawn on a single piece of A4 paper landscape format (apparently we think laterally not vertically!). The drawings shown in Figure 6.2 are commonly used as the basis for spider diagrams and uses the key personnel in this case to understand the inter-relationships.

6.5.4

Timelines

Timelines are valuable to make sense of the sequence of events in the pre-seen and to understand where the company in the TOPCIMA case presently stands. TOPCIMA takes place in real time, so you need to be clear how long is likely to elapse between the data in the pre-seen and the actual exam. This is the time period during which the issues facing the company or strategic alternative can be incorporated in to the unseen material. The TOPCIMA case writer is not trying to trick you or spring something entirely unexpected on you, but you need to be aware of the timeframe and the changes that have already occurred in the company’s history, so that you can offer realistic advice for the company’s future. The timeline does not need to be to an exact scale (such as an inch equalling a month) but you do need to get things in the right sequence. The pre-seen material will be given to you with real dates on the accounts and other exhibits such as memos and reports. You know the date on which you will be taking the exam. Therefore, in drawing up your timeline you should:

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Lost contract with Forum worth 16.8 million

Six main customers

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Ladies’ clothes Financials

Products Children’s clothes The Company Kadgee

Portrait History Customers

Formed in 1940s

Forum

Diamond

Zeeb Reduced capacity in 1973

Losses made in 1998 to 2002

JayJay

Haus

Others

Figure 6.2 Typical spider diagrams for TOPCIMA cases (based on Kadgee clothing)

● ●

●

start at the right-hand side of your sheet with the date of the exam; work back from right to left slotting in a summary of the information you have at each crucial date; try to use the vertical axis to record the sales turnover or market capitalisation of the business. It will help you to notice whether the firm is growing, stagnant or contracting. You may have a separate line for profit too.

Using the Kadgee clothing manufacturing case as an example, an illustration of timelines is depicted in Figure 6.3.

6.5.5

Organisation charts

Here is an organisation chart (Figure 6.4) for the Kadgee clothing manufacturer. Preparing an organisation chart will familiarise you with the roles and the overlaps, and also help you to identify gaps or ambiguities in roles. It will also help you to remember the names and roles of the key people in the case.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

People in the case

Owns 29% shares

Andre Schnaffer FD Dieter Stutt Sales Director

Owns 8% shares

Kadgee is not generating cash from operations

Loss of key customer

Issues in the case

Reduced margins and increased competition How to survive!

Figure 6.2 (Continued)

6.5.6

Biodata files

A biography of each character is also useful for several reasons: ● ●

●

●

they may be an important source of strength or weakness to the business; you may be required to write your report to them and so will need to understand their perspectives; the unseen material may involve them, for example, they may have left and a new person is filling the role. You should know and understand the key feature of what ‘drives’ each of the key personnel in the case. It will also help you to understand their roles and may prevent you from making ill-informed advice on exam day, most importantly, it helps you to bring the characters in the case ‘to life’!

Here are the biographies of a few of the key personnel in the Kadgee clothing manufacturing case (Figure 6.5).

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Andrin Burnak Chairman and MD

Frankie Bayane Chief Designer

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Sales revenue ( millions)

100 75 50 25 1960

1940 Company formed by Bruno Burnak (father of current Chairman and MD). Founder still holds 29% of shares.

Sales reached 25 million. 9 factories operational. Sold men’s and ladies’ clothes Late 1960s start of sales decline.

1980

1998

By 1980 Kadgee had ceased manufacturing men’s clothes. Capacity had been reduced to 6 factories. New range of girls’ clothing launched.

2005

2006

2005 saw a decline in profit after tax (from 1.2 million in 2004 to 0.9 million in 2005). TQM and efficiency had increased manufacturing capacity to 10.9 million garments.

Kadgee started a 5-year period (1998 – 2002) when it made losses. Increased loans. New IT solutions. TQM introduced.

Loss of key customer, Forum in August 2006. Loss of 16.8 million sales. Need to reduce costs. Increased competition from China.

Figure 6.3 Illustration of a timeline applied to the Kadgee clothing case

Andrin Burnak Chairman and MD

Dieter Stutt Sales Director

Frankie Bayane Chief Designer

Andre Schnaffer Finance Director

Sam Skala Marketing Director

Jan Berzin IT Director

Peter Coletta Factory Operations Director

Lars Veel HR Director

Figure 6.4 Illustration of an organisation chart (based on Kadgee clothing)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Background Age: unknown but estimated to be around mid to late 40s Graduate in textiles Son of Bruno Burnak, the founder of Kadgee Roles Took over as Chairman and Managing Director in 1997 when his father retired Arranged the refinancing of Kadgee’s loans in 2000 in order for the company to invest in IT solutions Has seen many other European clothing companies cease trading but has directed Kadgee through a loss-making period back to profitability Has embraced all of the employees in TQM techniques enabling Kadgee to become more efficient Characteristics Confident in Kadgee’s future Positive attitude towards the business – perhaps naïve of the true effect of global competition Good management skills which has manifested in employees staying loyal to Kadgee and working hard Family-run unlisted company and perhaps holding down 2 roles that he has little business experience of, particularly if hard changes need to be made Issues Lacks the wider business experience that may be required to make Kadgee competitive in today’s global market Lacks the ability to change Kadgee’s business model – it has not gained any new customers for over 10 years. The Chairman’s statement ( given in Appendix 2 of the pre-seen material) thanks the employees for their hard work and is positive for Kadgee’s customers ‘continued commitment’. However, the statement is dated 31 March 2006 and only a few weeks later in April 2006, Kadgee’s second largest customer, Forum, announced that it would no longer be buying clothing from Kadgee. Clearly, Andrin Burnak was unaware that one of Kadgee’s key customers was about to make this drastic announcement which demonstrates a lack of his ability to have established stronger contractual ties with its customers

Figure 6.5 Illustration of biodata files for the Kadgee clothing manufacturing company

6.5.7

Post-it-notes

Post-It-Notes can be used to stick onto each page of the pre-seen material and to jot key points on. Additionally, you may want to keep a Post-It-note for each person, and as you work through the pre-seen material. Additionally, you could stick the notes on your desk, a notice board or wall so that you can keep glancing at them to remember who’s who in the case and what issues and problems have been identified. You could also jot down your ideas for alternative strategies that Kadgee could take, to prepare you for exam day.

6.5.8

Colours

Colours help you remember things you may want to draw upon in the exam room. You could write down all your financial calculations and observations in green whilst having red for organisational and blue for strategic. Some candidates use different colour highlighter pens to emphasise different aspects of the pre-seen material perhaps using the same colour coding suggestion. Additionally, sometimes making notes in different colours help you to remember key facts and some of the preparation that you have done using the pre-seen material.

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Andrin Burnak Current Chairman and Managing Director

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STUDY MATERIAL T4 Andre Schnaffer Finance Director Background Aged 48 Has worked for Kadgee for over 22 years Took over FD role 4 years ago when previous FD retired due to ill health Role Has renegotiated bank loans and extended credit arrangements with many suppliers Helped Kadgee to manage its cash flow during difficult periods Characteristics Concerned over low margins Concerned/worried that other rival clothing manufacturing companies have ceased trading Worried that this could happen to Kadgee Issues Cash flow and possible liquidation of Kadgee Cash is the life blood of all companies, but especially small unlisted companies like Kadgee which are being dominated by the pressure exerted by its customers Kadgee has a 10-year loan for 4.5 million which is due for repayment in 2010. How can Kadgee do this? Kadgee has been reliant on its overdraft for at least the last 2 years, as demonstrated in the Financial Statements in Appendix 3, which shows the overdraft at 1.52 million at the end of 2005 Cash is pouring out of the business as demonstrated in the Cash Flow statement in Appendix 4, where Kadgee used almost 0.6 million of cash before financing in just 1 year No dividends have been paid to shareholders for at least the last 2 years Dieter Stutt Sales Director Background Aged 39 Worked in sales for several clothing manufacturers before joining Kadgee Joined Kadgee in 1999 when Kadgee was in a loss-making period (made losses 1998 up to 2002) Holds 8% of Kadgee’s shares Has retained the same customers with no loss of customers over the last 7 years (until Forum left in 2006) Role Has managed to retain Kadgee’s customer base during a period when other manufacturers have lost business to imported clothing and have ceased trading Good relations with customers Knows all the key personnel in Kadgee’s customers and this has helped him to meet customers’ requirements and to retain business Characteristics Excellent reputation with customers Has ensured that Kadgee is very responsive to customers’ needs Flexibility to meet customers’ requests Issues Has not won any new business Has not been innovative with new product lines or materials as far as we know Has pushed to get the Marketing Director role established, which is now filled by Sam Skala

Figure 6.5 (Continued)

You could write all of your notes on China (Page 5 of the pre-seen material), for example in green, and as you research this case and find out what other companies have done and more about the threat of Chinese imports into Europe, you could make your notes in green if it is relevant to China. Look at which manufacturers supply goods to High Street retailers such as Next plc or Marks and Spencer plc and your notes on the companies that have a connection to China could be written in green.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.5.9

Cut and paste analysis

Some candidates glue each page of the pre-seen onto the left-hand side of an A3 sheet to enable them to write comments and conduct analysis in the blank space on the right. An alternative method is to stick each page of the pre-seen in the centre of an A3 page and use call-outs and thought bubbles to make their notes in. Again, it does not matter what format your analysis is in – but you must MAKE NOTES and either of these analysis methods works well for many people.

6.5.10

Pictures

Pictures can help you. Where a TOPCIMA case has a lot of people some candidates choose to cut pictures of people from magazines to represent the people in the case and create a biography file with each character and the main facts about them. These pictures help to make the case seem more real. The picture below (in Figure 6.6) may help you understand and remember the production volumes (in millions of garments) and the effect of the loss of Forum of Kadgee’s manufacturing capacity. Kadgee has six factories which produced 10.9 million garments in 2005. Forum sales were worth €16.8 million which is about 23% of Kadgee’s sales and represents around 2.5 million garments. Kadgee will not need six factories unless Kadgee can win more sales. If all of the factories are the same size, then Kadgee should close one factory and reduce its staff at a further factory to save costs.

Figure 6.6 Picture to help visualise Kadgee’s six factories and its manufacturing capacity

6.6

Detailed analysis of the pre-seen material

Now that you have learned some of the skills that will help you to analyse the pre-seen material it is now time to analyse the pre-seen material in detail. It is recommended that you follow the following step-by-step guide. In order to show you the type of analysis you should undertake, on the following pages you will find an analysis for the Merbatty, September and November 2007 TOPCIMA case study. If you are working through this book in Chapter order, by now you should be very familiar with this case, as the basis of the mock you attempted in Chapter 5.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Use whatever colours work for you – but it does help to make notes on both the preseen material and the research you do. DO NOT just read the material – you must take notes (in whatever format) and if colours help you to understand and link your research together then use colours.

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Over the next few pages you will find the following:

Paragraph

Technique

6.6.1 6.6.2 6.6.3 6.6.4 6.6.5 6.6.6 6.6.7 6.6.8 6.6.9 6.6.10 6.6.11 6.6.12

The Merbatty, September/November pre-seen information in full A page-by-page analysis of the pre-seen The four elements of strategy (competitive, financial, investment and risk) Using ratios to conduct a financial analysis of a company’s position Assessing a business portfolio Industry analysis Conducting a corporate appraisal or SWOT analysis Critical success factors Assessing information systems strategy Assessing corporate risk Business valuations Generating strategic options

While you do not need to work through the information for Merbatty in detail, you should use this analysis as a guide to the style and format of the analysis which you need to undertake on your pre-seen information.

6.6.1 Merbatty, September/November pre-seen information in full Market overview The developing luxury boat building industry is one with a growing customer base of wealthy, successful individuals and corporate clients. The industry is mostly concentrated in Europe and the USA, although new boat building companies have recently entered the market in Australia and some areas of Asia. Classification of the market and its products can be done in different ways, but the most common are by boat length, engine performance or by hull type. In 2006, the luxury boat building industry generated approximately $5 billion in revenues and delivered nearly 3,500 engine-powered boats globally. The material in this case is confined to boats powered by engines and does not include sailing yachts, which are a completely separate market segment. There are a number of major international builders of luxury boats, which together produce a range of over 150 different models. Most luxury boats have living accommodation and crew quarters. The selling prices for these luxury boats range from around $0.4 million to over $9 million. Each boat type has a choice of different cost options, depending on customers’ specifications and engine size. Boat building companies typically appoint agents to secure sales from the end customer. The sales agent is the ongoing link with the customer from initial contact until delivery of the boat. Most boat building companies have agents in a wide variety of places globally, in order to secure sales, even though they have boat building facilities in only one or two locations. Completed boats are tested, then inspected and then delivered to wherever customers want, with the sales agent fully involved. The individuals and corporate customers who buy these luxury boats are successful, wealthy individuals who expect the highest standards of quality and customer care. As the market has become more competitive, the need to live up to ‘what the customer wants, the

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Merbatty Merbatty was formed 33 years ago by its current Chairman and is based in a northern European country. Merbatty has enjoyed rapid growth in sales and profitability in recent years. Merbatty became listed on a European stock exchange in November 2006. It currently has two boat building facilities, one at its Head Office base in Europe and a second on the West Coast of the USA. It has sales offices at the two boat building locations, staffed by Merbatty employees. The majority of Merbatty sales worldwide are secured through sales agents appointed by Merbatty. Sales revenue is paid to Merbatty in three instalments. A deposit of 20% is paid by the customer on signing a binding contract for a boat as specified by the customer. A second instalment of 30% is paid when the boat’s engines are delivered to the boat building facility. The final 50% is paid on completion of the boat only after inspection by the customer. Delivery to the customer’s choice of location is at an extra cost. Merbatty’s price list is in Euros for European sales. Due to pressure from customers in the USA, sales there are priced in US Dollars. Sales to other parts of the world are in either Euros or US Dollars. Merbatty currently has a range of 15 boats varying in price from between €0.4 million for a 15-metre boat to over €4 million for a 35-metre boat. The selling prices of Merbatty’s range of boats are shown in Appendix 1 and relate to the basic model specification, as prices may vary depending on the customer’s own selection of the specification for interior design and accommodation facilities. Customers usually choose from a range of additional features, to enable them to make the boat very individual to personal requirements. To facilitate this choice, Merbatty offers a full interior design service. In 2006, these additional features generated €50 million of additional revenues. This represents a further 11% on top of basic selling prices. The operating profit achieved for Merbatty’s current range of boats in 2006 was as follows:

Number of boats Revenue Operating costs (including allocated overhead costs) Operating profit Operating profit %

Small boats (up to and including 24 metres)

Large boats (25 metres and over)

Additional features selected by customers

Total 2006 operating revenues and costs

223 € million 256 222

57 € million 196 163

– € million 50 41

280 € million 502 426

34 13.3%

33 16.8%

9 18.0%

76 15.1%

During 2006, Merbatty commenced production on a record number of 280 boats, representing a global market share of around 8%. Merbatty’s statistics for boat construction are based on the number of boats commenced in a year.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

customer gets’ has become even more important. Boat building companies are facing the difficult task of balancing the need to deliver customer choice and a high specification at a price that is competitive. In addition, boat building companies need to generate sufficient profitability to invest in research for future designs in order to stay competitive and to give a return for their shareholders.

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Depending on the model and the size of the boat, the time taken to build a boat varies from 3 months to around 10 months. This time represents the period from the date of the customer signing the order contract to delivery of the completed boat. The boat is only delivered to a customer after successful completion of its sea trials and subsequent inspection by the customer. The geographical analysis of sales according to the home base of the customer in 2006 and by the target markets for 2011, is shown in Appendix 2. Merbatty currently has sales agents worldwide who generate sales. Most of Merbatty’s agents worldwide work exclusively for Merbatty except in a few locations, where the agents also sell boats built by several other boat building companies. The agents receive a fixed percentage of the final revenues of around 4%, including any additional features that the customer orders for the boat. The agent’s fee is paid in two instalments for each sale, 50% of the agent’s fee at the point of signing a sales contract with the customer and the final balance on delivery of the boat to the customer. This split in the agent’s fee creates an incentive for the agent to maintain close contact with both the customer and Merbatty’s boat building facility in order to monitor progress and delivery details. Market research has established that there is a growing market for luxury boats. Recent orders from both new and existing customers have supported this research. Indeed Merbatty has several customers who regularly replace their boats every few years. It also has other customers who have bought two or three boats to keep in different locations round the world. Merbatty’s personnel The career histories of Merbatty’s Directors are shown in Appendix 3. Merbatty employs almost 2,200 employees at the two boat building facilities which are currently operational. The total staff costs were €87 million in 2006. However, additional employees will need to be recruited later in 2007 when Merbatty opens its third boat building facility. The table below shows an analysis by function of Merbatty employees at the end of 2006: Number of employees at 31 December 2006 Skilled boat building technicians (includes supervisory staff ) Office and administration staff Senior management staff Sales staff (excluding external sales agents) Total employees

1,940 188 22 17 2,167

The employee numbers shown above exclude outsourced processes. In addition to using sales agents to secure the majority of sales, Merbatty chooses to outsource several elements of its boat construction process. These include the use of an interior design service, which Merbatty uses for all interior fittings. Merbatty’s recent history Merbatty’s sales have risen by over 10% each year for the last 12 years. The founding shareholder, Alberto Blanc held the roles of Chairman and Chief Executive until September

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Merbatty’s current position Merbatty had signed contracts, and received the required 20% deposits from customers, on future orders for 39 boats (building of which has not yet commenced) at the end of June 2007. The lead time from contract signing to start of construction usually averages 6 weeks. Sales are on target for Merbatty to meet the planned 300 boats commenced in 2007. As soon as an order is contractually placed, Merbatty will order the required supplies, such as the hull, engines and other major bought-in components for the boat. Merbatty will also allocate a specific building space within the agreed boat building facility. However, until it has undertaken around 20% of the construction work, a proportion of customers’ deposits will remain in the Balance Sheet (as a Current Liability) and not be recognised in the Income Statement. The Financial Statements for 2006 (included in Appendix 4) include a revaluation reserve in Merbatty’s Balance Sheet to reflect an increase in the value of the non-current assets, which had been valued in 2006 prior to Merbatty’s flotation. Merbatty’s shareholders Merbatty was listed in November 2006 when a major change in the shareholdings took place. Most executive directors acquired shares in the company. In addition, all of the executive directors have share options in order to encourage them to achieve the planned results, which would lead to growth in Merbatty’s share price. The share options allow all

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

2005, when the management team was strengthened in the lead up to the flotation of Merbatty in November 2006. The flotation issued 120 million new shares, each at a nominal value of €0.50. The flotation price was €2.80 a share and all shares were fully subscribed and generated a cash inflow to Merbatty of €336 million (before issue costs) in November 2006. At the point of flotation Merbatty repaid its then existing bank loan of €120 million and its bank overdraft, which had reached over €120 million. Andreas Acosta also renegotiated a new loan at a more competitive interest rate. This new loan is for €200 million, at an annual interest rate of 7%, and is secured on Merbatty’s assets. This new loan, together with some of the equity raised in the listing will finance Merbatty’s capital expenditure programme over the next few years, as well as finance the increase in working capital in order to achieve the growth targets planned. To meet the growing demand, and due to capacity constraints at its boat building facility in Europe, Merbatty acquired some land in the USA in 2002 and developed a totally new purpose built boat building facility. This has been operational since early 2004. There were some initial operational problems, but Merbatty has been able to put in place experienced and committed employees who have the required skills to meet the exact demands of Merbatty’s growing customer base. The European and USA based boat building facilities both produce all 15 of the models currently offered by Merbatty, although the USA boat building facility rarely produces boats smaller than 20 metres. Merbatty’s profit, before dividends, was €40 million for 2006, a record profit level, as shown in the extract from the accounts in Appendix 4. The country in which Merbatty is based charges tax at 35% of operating profits less finance costs. Merbatty’s Chairman Alberto Blanc was awarded the ‘Business Person of the Year’ in a European awards ceremony in 2004 and this, together with Merbatty’s listing, has raised the global profile of Merbatty.

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directors to purchase up to 5 million shares each, any time up to 30 November 2012, at a price of €5.00. Alberto Blanc had previously held 90% of shares and chose to retain the same number of shares (54 million shares) but after the flotation, his shareholding was reduced to 30%. The new issue of shares brought in external investors and much needed finance in order for the company to expand. Alberto Blanc believes in the huge potential of the Merbatty brand and aims to achieve the 5-year plan. He then intends to retire. Prior to flotation, Merbatty had 60 million shares at a nominal value of €0.50 each in issue and had a total of 500 million authorised shares. At flotation, in November 2006, Merbatty issued a further 120 million shares at a price of €2.80. At the end of 2006, Merbatty had 180 million shares in issue. The shareholdings at the end of 2006 were as follows: Shareholding at 31 December 2006 Directors: Alberto Blanc Jesper Blanc Henri Gaston Stefan Gil Andreas Acosta Tobias Houllier Lukas Dian Alain Mina Marie Lopp Bernie Ritzol Investors: JKL (has Board representative) Corporate fund investors Other shareholders: Small investors Employee-held shares Total shareholdings

30% 8% 3% 3% 3% 2% 2% 2% 1% 1% 28% 12% 3% 2% 100%

JKL is a listed company with a varied portfolio of investments in a range of international companies, mainly in the construction, engineering and maritime industries. At Merbatty’s flotation, JKL purchased 50.4 million shares at a cost of over €140 million as it considers that Merbatty’s growth to date and its range of products, together with its potential for the future, will lead to a substantial return on its investment. Following discussions prior to flotation it was agreed that JKL’s Investment Director, Simone Lellet, would have a seat on the Board of Merbatty and would be involved in helping Merbatty to achieve its 5-year plan. Simone Lellet has been involved in some operational planning meetings and she has proved to be a useful management resource. Merbatty’s shares initially traded at €3.48 shortly after flotation and Merbatty’s directors are pleased with the market’s confidence in the company. By 30 June 2007, the share price had risen to €3.65. The market sector average P/E ratio at 30 June 2007 is 15. Future plans for expansion As a result of the company becoming listed in 2006, the Board of Merbatty was expanded with a number of new Board members. With the input of fresh ideas from the new

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Planned opening of third boat building facility in Surania in 2007 In March 2006, the Merbatty Board approved the proposal to open a third boat building facility. This is located in Surania (a fictitious country) which is a thriving country in the Middle East. The boat building facility is being constructed to meet Merbatty’s exact specifications and is due to be opened in September 2007.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

members of the management team, a number of options have been put forward for expansion of the business. These include producing a much wider range of new models, which would enable Merbatty to offer customers a wider selection of boat sizes and engine capabilities than that currently produced. Merbatty’s 5-year plan for the period up to and including 2011 is shown in Appendix 5. It is this 5-year plan on which the prospectus forecast was based. Currently, Merbatty produces 15 different models of boat (ranging from 15 metres to 35 metres in length). One new model is due to be introduced early in 2008 and there are possible enhancements to existing models by the middle of 2008. Lukas Dian, the Technical Director – Design, believes that there is a strong opportunity to build larger boats which would be in the range of 35–40 metres in length. The main market for these very large boats would be in the Middle East. The press launch of Merbatty’s first 38-metre boat in May 2007 had a good response and this new model will go into full production shortly. In the past, Merbatty has always been very cautious and produced boats when specific orders have been placed, except for a small number of boats built for demonstration purposes. However, after talking to some of Merbatty’s agents in the Middle East, Jesper Blanc is confident that the demand in this region will be so great that Merbatty could sell any large boat that it builds. He has proposed that Merbatty should begin production on a range of large boats before any definite orders are placed, in order to capture sales from customers buying impulsively. Stefan Gil is working on a proposal for Merbatty to open sales offices in over 20 locations worldwide. This would result in the termination of some sales agents’ contracts. He considers that this will be needed to generate the additional sales required in order for the 5-year plan to be achieved. Additionally, it would allow Merbatty to save costs, as it is anticipated that the costs of running Merbatty’s own sales offices would be lower than that paid in agents’ commissions. Detailed operational plans were prepared in the form of Merbatty’s current year budget for 2007, in order to ensure that the planned level of growth in sales and profitability is monitored and achieved. Merbatty is currently on target to achieve the budgeted number of 300 new boats to be commenced in 2007. This is the highest number of new boats Merbatty will ever have commenced building in 1 year. The company currently has two boat building facilities, in Europe and on the West Coast of the USA. The maximum annual capacity for these two facilities will depend on the mix of boat models ordered, as several smaller boats can be built in less time than one larger boat. There is an increasing demand for larger boats. Based on Merbatty’s current product mix during 2006, the existing two boat building facilities have a maximum capacity, in terms of space, of 320 boats in total each year. The 5-year plan includes forecast capital expenditure for the opening of Merbatty’s third boat building facility in September 2007. Additionally, the 5-year plan includes capital expenditure that would be required for a fourth boat building facility planned to be built during 2010 and 2011. Bernie Ritzol considers that this may be located in a new target market, perhaps in Asia.

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The decision to open a third facility was taken in preference to extending either, or both, of the existing facilities for several reasons. First, the 5-year plan is based on strong growth in revenue from customers based in the Middle East, with revenue growing from €40 million in 2006 to €180 million in 2011. Revenues from sales generated in this region are forecast to grow from 8% of total revenue to 18% by 2011. Furthermore, there is an increasing trend for the boats ordered by customers in the Middle East to be for the larger models, so this new facility will specialise in building larger boats. Merbatty’s research also shows that skilled labour is available in Surania and also that there are sufficient skilled employees at Merbatty’s existing boat building facilities who are willing to be seconded to the new facility. Merbatty already has a sales agent located in Surania who has been selling Merbatty boats for over 15 years, who will continue to generate sales through his established reputation and contacts. In addition, Merbatty has recently appointed four additional sales agents in other countries in the Middle East region. The Suranian boat building facility will enable Merbatty to build approximately 180 additional boats each year, depending on their size. However, if the number of large boats in the mix were to increase to a higher proportion than in the agreed 5-year plan, it is estimated that the Suranian facility would only have the space to build 140 boats (albeit larger boats) each year. Merbatty’s development plans Bernie Ritzol, the Global Market Development Director, would like to expand the range of models that Merbatty builds and considers that there is demand for a greater variation of designs within the range of hull sizes that are currently built. He is investigating the possibility of expanding the range of boats Merbatty builds, to have 10 new models over the next 2 years, instead of the planned three new models per year. He has asked Lukas Dian, the Technical Director – Design, to prepare a proposal for investment in research and development needed for this expansion, for the Board meeting in September 2007. Lukas Dian has identified the need for €10 million expenditure on the design of new IT systems, including state-of-the-art boat building CAD and CAM systems, both of which would minimise man hours and thus increase net margins. A further €15 million of capital expenditure would be required to improve Merbatty’s existing boat building facilities, especially to accommodate large boats and the planned 3 new models each year. This capital expenditure is included in the 5-year plan which is shown in Appendix 5. Current use of new technology Merbatty currently uses the latest in modern marine production technology, including Computer Numerical Controlled (CNC) machining and robotic spray systems for automated precision spray painting for maximum hydrodynamic efficiency. Investment in technology in the last 2 years has increased by 10% and has cost the company a total of €10 million. Merbatty has also spent over €4 million on technology to apply glass re-enforced plastic onto each hull to add an external enhanced performance gel coat to increase hull durability and strength. This process was introduced in the USA boat building facility earlier in 2007 and is proving successful in speeding up the time taken at this stage of production of the boats. The previous hull coating technology was very labour intensive, requiring a number

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Merbatty sponsorship contracts Merbatty has signed two different sponsorship contracts which both generate a lot of positive public relations (PR) and have helped to increase Merbatty’s brand recognition. The sponsorship contracts are as follows: (1) €5 million per year for 3 years from July 2006 to June 2009 payable to a major global speedboat race organiser which generates significant publicity for Merbatty through advertising and TV coverage of the race events. The races are also sponsored by a number of other global brands, but Merbatty is the principal sponsor. (2) €5 million per year for 5 years from January 2007 to December 2011 to a global travel and high quality hotel chain. This company promotes Merbatty boats in a variety of ways, including advertising on all of its websites worldwide, and through promotional information at all of its hotels. Merbatty also works with this company to arrange travel for its customers to inspect their boats. Merbatty’s supplier relationships Merbatty has a number of key suppliers. There has been a trend for more professional relationships with suppliers in Merbatty since Paul Lavie, Merbatty’s new Procurement Director, joined the company earlier in 2007. Merbatty has introduced supplier rating systems and KPIs for all suppliers. Paul Lavie would like to see Merbatty work more closely with a few key suppliers and to build long-standing supplier relationships. Merbatty’s ability to work closer with its key suppliers has also been facilitated by the recent development of an online order tracking and processing system between Merbatty and two of its key suppliers, which are MNE and Marinatron (see below). This system allows Merbatty to place specific orders for standard engines and satellite control panels to be delivered to Merbatty’s boat building facilities and to track the orders right through from the early stages of the boat building process to delivery and installation. Marinatron is Merbatty’s key supplier of radar and satellite navigation systems. This USA-based company supplies over 30% of the market for marine satellite navigation systems and they are used in all of Merbatty’s boat models. It also supplies to a number of Merbatty’s competitors in the USA. Topcrest is a manufacturer of boat hulls and is based in the same European country as Merbatty’s European boat building facility. Merbatty has been a long-standing customer of Topcrest and has built up a very strong relationship with Topcrest’s design and manufacturing team. Topcrest has a reputation as one of the top three hull manufacturers in the world and demand for its hulls (ranging from 12 metres to over 40 metres long) has been growing rapidly in the last 5 years. Merbatty is a key customer of Topcrest and both companies recognise the importance of working closely together on future designs. The lead time for hulls varies from 2 to 6 weeks depending on the size of the hull and the design specifications. Sea Safety Equipment (SSE) is a European-based company, which supplies most of the on board safety equipment such as inflatable life boats and life jackets. MNE Engines, based in Europe, is a large manufacturer of nautical engines for both commercial and military purposes, and it supplies engines worldwide to a wide range of

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

of skilled operators using hand-held machines to apply the external gel coating. The old technology is still used in the European boat building facility and for smaller boats built in the USA facility.

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customers. MNE is one of only five specialised nautical engine manufacturers in Europe. MNE supplies all of the diesel engines for all models of Merbatty boats. The order value of engines in 2006 was approximately €38 million. Aqua Designs is an internationally renowned firm of interior designers which specialises in the design and interior fittings for luxury boats. This includes all of the teak wood panelling to cabins and decks, air conditioning, interior furnishings, on board entertainment systems, satellite telephone systems and underwater lighting facilities. All Merbatty boats have a standard specification for interior design but customers can opt to add to this specification from a vast range of options provided by Aqua Designs. These additional internal specifications can add around 11% to the price of a boat, depending on customers’ preferences. Aqua Designs operates throughout Europe and the USA, but it does not have operations in the Middle East. Aqua Designs has declined all requests from Merbatty to provide the same interior design service for Merbatty’s new Suranian boat building facility. Merbatty is currently finalising alternative arrangements for its interior design service for boats to be built in Surania. Merbatty’s investment in new IT systems In 2006, Merbatty invested in a newly released ‘off the shelf ’ state-of-the-art production management software system. This software system is designed to improve productivity and increase resource utilisation. Its most significant advantage is that it enables areas for improvement in labour efficiency and workforce allocation, to be easily identified. In addition, the real-time information provided can be used to manage production more effectively by providing clear information on Work-In-Progress. The result has been on-time delivery of all boats, with no penalties for late delivery of boats to customers, since this new IT system has been operational. This software allows Merbatty’s management team to respond quickly to minimise potential, and actual, disruptions to production by providing real-time data on workforce utilisation and shop floor processes, material delays, machine downtime and employee idle time. This has resulted in increased productivity. This software has been installed at both the European and USA facilities and it is intended that it will also be installed within the new Suranian facility.

Charitable work Alberto Blanc has been involved in charitable work for many years and feels strongly that Merbatty should continue to support a range of charities. Merbatty financially supported a number of fund-raising events throughout the USA in 2006, which raised $4 million as a contribution towards a new hospital wing. Additionally, the company made donations totalling €0.5 million towards a European Child Poverty Prevention Charity. Alberto Blanc spends much of his spare time advising and working for charitable organisations in Europe, as he strongly believes that those who are as fortunate as he is should do as much as possible to help those less fortunate. Merbatty receives much good publicity from Alberto Blanc’s charitable work and every employee is encouraged to spend 2–6 months seconded from Merbatty, on full pay, to undertake a range of short assignments for charitable organisations. Every member of staff is eligible to participate in one charitable assignment every 4 years.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Analysis of Merbatty’s range of boats Model

Length (metres)

Maximum speed (knots)

2006 Standard selling price (€ million)

Units sold in 2006

Units sold in 2005

40 38 38 35 31

4.4 3.4 2.9 2.8 2.3

10 10 11 12 16

– 8 10 19 21

31 31 31 30

3.4 3.2 3.0 2.5

11 10 16 20

– 10 13 29

22 20 16

30 30 32

1.0 0.8 0.6

25 24 27

22 24 27

18 16 15

34 32 30

0.6 0.5 0.4

30 23 35

24 20 26

Performance Motor boats: P Series P-3000 P-2000 P-1000 P-Gold P-Elite

35 25 20 19 18

Motor boat: C Series C-34 C-31 C-28 C-23

34 31 28 23

Flybridge range F-1 F-2 F-3 Cruisers Z-1 Z-2 Z-3

Appendix 2 Sales Revenue analysed by home base of customers Sales revenue 2006 (€ million)

Planned sales revenue 2011 (€ million)

Europe

219

420

USA

148

240

Middle East

40

180

Asia

45

65

Australia

30

60

South America

18

29

Africa

2

6

Total revenue

502

1,000

Note: All figures shown are based on 2006 prices.

Appendix 3 Merbatty’s key personnel Alberto Blanc – Chairman Alberto Blanc, now 62, had an interest in boats from an early age, when he used to spend his summer holidays at his uncle’s boat building facility. Having a keen eye for design and

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Appendix 1

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a love of the ocean, he went to marine college in 1965 and became a marine engineer in 1968. He started Merbatty after his uncle gave up his business in 1974 and passed the boat building facility onto Alberto. He plays an active role in the business and is often seen in the European boat building facility, talking to and advising design and technical staff. He believes in a ‘hands on’ management style and that the best way to learn what is happening in the business is to see the boats actually being built. He is also a strong believer in the importance of charity work. Henri Gaston – Chief Executive Henri Gaston is a 35-year-old MBA graduate who joined Merbatty in September 2005. He has previously worked for one of Merbatty’s major overseas rivals and has a number of contacts throughout the industry. Stefan Gil – Sales Director Stefan Gil, who is 52, has worked for Merbatty for 14 years and was previously a sales director of one of the main engine suppliers, where he worked for 10 years. He has a very strong technical knowledge and previously spent 5 years in the Middle East as an engineer. He is a keen sailor and has recently sailed single-handed across the Atlantic for charity. His main challenge since joining Merbatty has been to create a strong brand image for Merbatty in order to appeal to the wealthy European and American customer base. He is a great asset to Merbatty. Andreas Acosta – Finance Director Andreas Acosta, aged 45, joined Merbatty in 2000. He previously worked as a management consultant for a large international firm of auditors. It was during this time he developed a keen interest in the boat building industry after being in charge of an international investigation of the industry. His main concern is the management of cash and the potential costs involved in overseas developments. Andreas leads a team of 10 accountants in the European office and a further 8 in the US office. Jesper Blanc – Marketing Director Jesper Blanc is the 30-year-old son of the Chairman. He graduated from university 6 years ago with a degree in Media Studies and has worked in the company since then. He has worked within the engineering department and in the Systems and IT department for short periods but did not feel that his talents were in either area. His father initially appointed him as a Marketing Assistant, which he enjoyed immensely. His father later promoted him to the role of Marketing Director 12 months ago. Since his appointment he has visited many different countries, talking to customers and agents and establishing contacts. Tobias Houllier – Operations Director Tobias Houllier, now aged 50, started as a junior carpenter and has now worked for Merbatty for the last 30 years. During his time he has worked in the engineering department, the design department and he has been the European boat building facility manager. He has held the role of Operations Director for the last 10 years and is probably the most experienced person in the whole company. He is very keen on training and encourages all of the designers and engineers to become qualified.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Lukas Dian – Technical Director – Design Lukas Dian, aged 36, has worked for Merbatty for 5 years. He started as the Chief Designer, but due to his leadership and his personnel management skills he was promoted to Director level within 1 year of joining. He leads a team of over 20 designers who meet on a regular basis and he encourages an open door policy in order to create a feeling of freedom of thought and creativity. Marie Lopp – HR Director Marie Lopp, now aged 40, has worked for Merbatty for 3 years. She is the first HR Director as previously Alberto Blanc did not believe in Human Resource departments. However, as the organisation expanded and staff issues and legislation became more complex, he finally agreed to appoint a HR Director. Marie Lopp has a difficult job persuading Alberto Blanc of the importance of human resource issues and in particular, she struggles to get him to invest in training for staff other than the engineers and designers. Paul Lavie – Procurement Director Paul Lavie, aged 38, joined Merbatty in March 2007. He has many years of experience working for a large supplier of components to the automotive industry. He is also concerned that the procurement department had not established a close relationship with some of its major suppliers. Bernie Ritzol – Global Market Development Director Bernie Ritzol, now aged 46, joined Merbatty 12 years ago and has been responsible for a number of strategic developments including the acquisition of land in the USA and the opening of Merbatty’s second boat building facility. He has also worked closely with Tobias Houllier in the development of new boat models and also with the Technical Director – Design, since Lukas Dian was appointed to this new position 4 years ago. Bernie Ritzol was one of the driving forces behind Merbatty’s listing, to enable the company to raise additional finance in order to fund expansion of the company. Bernie Ritzol was also instrumental in the selection of the site in Surania for Merbatty’s third boat building facility. Simone Lellet – Investment Director, JKL Simone Lellet, aged 42, is JKL’s Investment Director and she was appointed to the Board of Merbatty in November 2006, when Merbatty became listed and JKL bought 50.4 million shares, resulting in a holding of 28% of Merbatty’s issued shares. Simone Lellet is very enthusiastic about Merbatty’s 5-year plan and wants to participate in the decision-making process to help Merbatty achieve the goals set out when the company became listed. She has attended every Board meeting and has also been involved in some operational planning meetings, with the Board’s permission.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Alain Mina – Technical Director – Systems and IT Alain Mina, aged 35, has worked for Merbatty for the last 8 months. Previous to this he was a senior IT project manager for an organisation specialising in building and distributing military radar equipment. This is his first role at Director level and he is finding it difficult to take a less hands on role than he has previously been used to.

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STUDY MATERIAL T4

Non-executive directors Merbatty has six non-executive directors. The six non-executive directors hold various other directorships, in a variety of industries. Four of the non-executive directors are based in Europe and two hold directorships of USA listed companies and are based in the USA.

Appendix 4 Merbatty’s Balance Sheet, Income Statement and Statement of Changes in Equity Note: All data in this appendix is presented in international financial reporting format.

Balance Sheet

As at 31 December 2006

As at 31 December 2005

(€ million)

(€ million)

Non-current assets (net)

(€ million) 535

(€ million) 362

Current assets Inventory (including Work-in-Progress) Trade receivables and accrued revenue Cash and short-term investments

165 93 171

126 76 7

Total assets

429

209

Equity and liabilities

964

571

Equity Paid in share capital Share premium reserve Revaluation reserve Retained profits

30 42 – 113

90 318 80 133 621

185

Non-current liabilities Bank loan at 8% interest per year (repayable in 2010) Bank loan at 7% interest per year (repayable in 2014) Payables: amounts falling due after more than 1 year

– 200

120 –

7

2 207

122

Current liabilities Bank overdraft Trade payables and accruals Customers’ deposits Tax Total equity and liabilities Note: Paid in share capital represents 180 million shares of €0.50 each at 31 December 2006.

– 101 13 22

126 112 9 17 136

264

964

571

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Year ended 31 December 2006 (€ million)

Year ended 31 December 2005 (€ million)

Revenue

502

445

Total operating costs

426

380

Operating profit

76

65

Finance costs

⫺14

⫺17

Tax expense (effective rate is 35%)

⫺22

217

40

31

Profit for the period

Statement of changes in equity Share capital (€ million)

Share Re-valuation premium reserve (€ million) (€ million)

Retained Total earnings (€ million) (€ million)

Balance at 31 December 2005

30

42

–

113

185

New shares issued during 2006

60

276

–

–

336

Profit for the period

–

–

–

40

40

Revaluation reserve

–

–

80

–

80

Dividends paid

–

–

–

⫺20

⫺20

Balance at 31 December 2006

90

318

80

133

621

Appendix 5 Extracts from Merbatty’s 5-year plan Financial data

Actual

Plan

2006 2007 2008 2009 2010 2011 (€ million) (€ million) (€ million) (€ million) (€ million) (€ million) Revenue (analysed by home base of customers): Europe

219

240

275

310

350

420

USA

148

160

170

190

210

240

Middle East

40

50

80

110

140

180

Other areas

95

105

120

130

145

160

Total revenue

502

555

645

740

845

1,000

Operating costs

426

471

552

634

725

863

Operating profit

76

84

93

106

120

137

Post-tax profit for the period

40

45

51

60

69

80

Dividends

20

23

26

30

34

40

New boat building facilities

90

30

0

0

60

100

Other capital expenditure

40

25

15

20

20

25

130

55

15

20

80

125

Capital expenditure:

Total capital expenditure

Note: All figures shown in the financial data below are based on 2006 prices.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Income Statement

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STUDY MATERIAL T4

Actual Key business statistics

Plan

2006 2007 2008 2009 2010 2011 (€ million) (€ million) (€ million) (€ million) (€ million) (€ million)

Number of boats commenced in the year

280

300

340

385

435

500

Number of new models introduced

2

3

3

3

3

3

Satisfied customers (as surveyed)

99.5%

100.0%

100.0%

100.0%

100.0%

100.0%

Staff turnover (calculated as number of staff leaving as a percentage of total employees)

20%

18%

15%

12%

12%

12%

Charity – funds donated (€ million) – man years on secondment for charity work

0.5

0.6

0.8

0.9

1.0

3.0

4.0

6.0

7.0

8.0

6.6.2

5.0

Précis of main points of each page

Work methodically through the pre-seen and make a précis of the main information and points. Page

Main information

Page 1

Section headed: Market overview Background on the industry and size of market at over $5 billion revenues annually Total number of new boats built each year is 3,500 Merbatty Details on Merbatty: Formed 33 year ago

Page 2

Listed on a European stock exchange in November 2006 Sales revenue instalments Currency of sales revenue Details on range of 15 boats Analysis of sales revenue and operating profit by small and large boats 2006 – Merbatty built 280 boats

Takes between 3 and 10 months to build each boat depending on 0th size of boat

Significance

Background information for you to compare Merbatty’s market share

Newly listed company. No longer family run. This immediately tells us that key targets will be important to achieve – more later when we look at the 5-year plan

Large boats more profitable See analysis in 5-year plan for ambitious growth in number of boats planned to be built – ?? has Merbatty got enough space/ capacity to build these

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Merbatty outsourced a number of functions – sales agents and various stages of boat construction, and it uses an interior design company for all interior fittings Page 3

Page 4

Page 4

Page 5

Page 5

Merbatty’s recent history Background information on Merbatty: Boat building facility in Europe and new USA facility in 2002 Record profits at €40 million in 2006 Loans – new loans of €200 million and also old loan and overdraft now paid off Chairman and founder – ‘Business Person of the year’ award Merbatty’s current position Signed contracts (i.e. order book) for 39 new boats at end June 2007 Sales on target for 300 in 2007

Merbatty’s shareholders List price was €2.80 per share, 120 million shares issues. Directors have share options up to 2012 at €5.00 per share

Agents commission – 4% of revenue – is this enough to motivate agents to secure sales and what do competitors pay

As the number of boats to be built (and sols) increases, Merbatty will have to recruit and train many more skilled workers Opportunity to take some of these functions in house or to outsource more areas of boat construction or buying in of finished components/sections of a boat important – quality of construction

Highly profitable and growth plans for the future Loans and gearing – see below when we analyse the Balance Sheet

Order book looking healthy Plans to meet key target of 300 boats in 2007. This is a key statistic that investors will want Merbatty to achieve – so remember this – 300 boats in 2007 Listing raised €336 million (before issue costs)

Merbatty expects share price to exceed €5.00 per share before 2012 so that Directors could exercise their share options Analysis of shareholdings Alberto Blanc (founder) now has minority control at 30% and his son has 8% External investors – JKL and others hold 40% JKL have bought 28% of shares and has a of shares seat on the Board. They have invested on the basis of the agreed 5-year plan (see below) and they will expect this plan to be achieved Share price at end June 2007 is €3.65 Since November 2006, share price has risen by €0.85, a rise of 30%. Obviously, there is a lot of confidence in Merbatty’s ability to deliver the 5-year plan. Future plans for expansion Lots of ideas as to how Merbatty could achieve its ambitious 5-year plan Details on lots of areas for expansion including: Range of boats – to be successful, it needs to continue to innovate, but should Merbatty build boats without a specific customer order – risky and uses up valuable cash flow Wider range of boats 3rd boat building facility – see below (Continued)

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Page 3

Agents – Merbatty makes most of its sales through sales agents and pays 4% commission (in 2 instalments) Section headed: Merbatty personnel Merbatty employs 2,167 employees at the end of 2006

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STUDY MATERIAL T4

Refers to 5-year plan (see below)

Page 6

Build to order or build boats ready for sale without a customer order? More sales offices instead of sales agents Extra capacity and plans for new, 3rd boat building facility in 2007 and a 4th boat building facility in 2010/11 Planned opening of 3rd boat building facility in Surania

Page 6

Merbatty plans to open its 3rd boat building facility in the Middle East in fictitious country – Surania in September 2007 Will have the capacity for between 140 and 180 boats depending on size Merbatty’s development plans

Page 7

Development Director’s plans for 10 new boat models over next 2 years Investment in IT systems Current use of technology

Page 7

Details on Merbatty’s investment in IT to increase production efficiency and maintain quality of production Merbatty sponsorship contracts

Page 7

Details on Merbatty’s 2 sponsorship contracts which cost Merbatty €10 million EVERY year. They generate publicity and brand awareness. Most large boat building companies do this. Supplier relationships

Details on Merbatty’s key suppliers: Topcrest supply the hulls MNE are the ONLY supplier of engines Marinatron supply ALL of the radar and navigation equipment Aqua designs supply all of the interior fittings for all boats built in Europe and The USA but are not involved in the new facility in Surania

4th boat building facility – perhaps in Asia in 2010/11 to meet the demands for extra capacity when Merbatty plans to build 500 boats a year

Important new boat building facility – still being built ready to open in September – ?? will this open in time – or will it be late All large buildings often have time overruns – will this??

Show the importance Merbatty attaches to the need for high quality and the need to be innovative in this competitive marketplace

Important to understand why Merbatty uses high tech solutions – to stay competitive, improve quality and also to cut costs Could this technology fail? Should Merbatty roll out the use of the new technology to all of its boat building facilities? Is this cost effective – we do not know. But Merbatty have signed contract that last several more years so they cannot easily be terminated and termination would cause much adverse publicity. Should Merbatty take on more sponsorship – what is usual in this industry? You should research this.

Porter’s five forces – suppliers have much power over Merbatty as they are a key supplier of components for Merbatty’s boats What if the quality is not acceptable What if they put their prices up What if they fail to supply What should Merbatty do if the supplier gets acquired by a competitor? Should Merbatty consider backward integration and acquire one (or more) of its competitors, has it got the skills to manage this?

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

IT systems

Page 8

Details on investment of IT systems to manage production Charitable work

Page 9

Details here on staff secondments and donations to charities that the founder Alberto Blanc has established Appendix 1 – Merbatty’s range of boats

Page 10

Details in a table and graphs showing the range of 15 boats and the number sold for each boat type Appendix 2 – Sales revenue by home base of customers This table analyses revenue by region for 2006 and the planned sales for 2011.

Page 11/12 Appendix 3 – Merbatty’s key personnel

Page 13

Details and brief biographies of all of Merbatty’s key personnel Appendix 4 – Balance Sheet, Income Statement and Statement of changes in Equity Details here on the major changes that have taken place between the 2 financial years as Merbatty was not a listed company in 2005 but was a listed company at the end of 2006. Major changes to be analysed and understood in the Balance sheet Income Statement: revenue up to €502 million, an increase of 13% Post-tax profits at €40 million, up a whopping 29%!! Statement of changes in Equity – Major changes in 2006 as the company became listed. It shows new shares issued in year at €336 million and also Merbatty’s assets were revalued (usual for a company at time of listing) – now up by €80 million

As Merbatty grows and double the number of boats being built over the next 5 years, it will need sophisticated IT systems to help it manage production and to identify nonvalue added areas of production to increase production efficiency

As Merbatty is now a listed company the investors will only tolerate this charity work if it generates good publicity and if profit targets are met. If profits are down, charity donations could get cut

Note that the top of the range boat (the P3000) sold only 10 in 2006 (assumed to be a new model as none were sold in 2005) but generated €44 million in revenues (10 ⫻ 4.4 million each). This represents nearly 9% of the total revenues for the whole company

As you can see sales revenue in total will almost double from €500 million in 2006 to €1,000 million in 2011 The analysis by region is also interesting, with a forecast growth in the Middle East of 450% from €40 million to €180 million The USA market forecast growth only 62% in 5 years You should read and familiarise yourself with these people, their roles and their skills You should also identify weaknesses in the Merbatty Board of Directors THIS IS A VERY IMPORTANT PAGE

This page is analysed in Paragraph 6.4.4 below

You should understand the key figures on this page – and also understand WHICH are the key figures! How did profits go up 29%?

(Continued)

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

Page 8

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STUDY MATERIAL T4

Page 14

Appendix 5 – extracts from 5 year plan This page shows the financials and the business statistics for the 5-year plan

Key information: Revenue moving from €502 million in 2006 to €1,000 million in 2011 Post-tax profit doubling from €40 million to €80 million in 2011 – this will have a significant impact on share prices – will they also double? Capital expenditure – modest capital expenditure each year until 2010/11 when a 4th boat building facility is planned

THIS IS A VERY IMPORTANT PAGE. The case material states that investors bought shares in Merbatty on the basis of the 5-year plan and this is what they will be expecting to be achieved Profits are increasing rapidly – can revenues be achieved and can costs be controlled to meet the agreed profit targets No major capital expenditure on more facilities/added boat building capacity until 2010/11 Number of boats increasing to 500, which is only a 79% increase in this 5-year plan period – so how come revenues and profits are doubling? The answer is more bigger boats which generate more revenue per boat and a higher level of profitability (see Paragraph 6.4.4 below)

Statistics – the most important – which underlies all of the financials is the number of boats to be built (i.e. sold – as boats are only built for specific customer orders): planned to increase from 290 to 500 in 2011.

6.6.3

Four elements of strategy

Merbatty can be analysed using the four elements of strategy as follows: (1) Competitive: Merbatty is competing based on Porter’s generic strategy of differentiation. It competes by producing very high quality boats at high prices – but it still needs to be competitive. Merbatty’s market share is stated to be 8%. Merbatty is operating in a highly competitive market, and its rich customers are very discerning and want a high quality for the large price Merbatty is charging. There is no room for poor quality otherwise Merbatty’s brand reputation could be severely damaged. (2) Financial: Merbatty has just become a listed company and has a stated and agreed 5-year plan which has ambitious levels of growth. It is highly profitable with EPS of €0.22 in 2006, forecast to grow to €0.44 per share in 2011. Its return on sales revenue is 8%. This is analysed below in Paragraph 6.4.4. Merbatty is cash rich at present as it has cash left over from its recent listing. The 2006 Balance Sheet showed cash and short-term investments at €171 million, and we know that capital expenditure (mainly on finishing the new boat building facility in Surania) is €55 million (from Appendix 5). This still leaves cash at around €116 million. Furthermore, Merbatty finances most of its expansion through customer deposits and stage payments. So while some cash will be needed to finance working capital, most of the working capital is financed by customers’ deposits. Therefore, Merbatty is in good financial health with a good return on sales, strong ability to generate cash and a growing EPS to keep its investor happy. (3) Investment: Merbatty is investing in a range of IT solutions to improve the quality of production and also to increase production efficiency. It is investing in its business by

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.6.4

Financial analysis

Using the financial data of the pre-seen material, we can prepare the following information: Ratio/business statistic

2006

2005

Comments

Operating margin

15.1%

13.7%

Net margin

8.0%

7.0%

Increase in revenue Increase in operating profit Inventory days

⫹12.8% 16.9% growth 141 days

– – 121 days

Substantial increase in operating margin – perhaps the start of production efficiency from new IT starting to take effect A 1% increase is very good as this represents an improvement of over 14% (8%/7%) Good growth

Debtor days (including accrued revenue) Creditor days

68 days

62 days

87 days

108 days

Working capital cycle

114 days

74 days

24.4%

57.1%

1.79 million 0.27 million

Not available Not available

Return on equity Gearing ratio (including overdraft) (defined as loans plus overdraft divided into equity plus loans plus overdraft) Average revenue per boat Average operating profit per boat

Increased as revenue and WIP has grown To be expected as revenue has grown Now paying suppliers quickly – although at almost 3 months is still quite late Working capital cycle has grown by 40 days due to higher level of WIP. As customers pay for boats in set instalments, they are partly financing the working capital cycle Significantly reduced level of gearing due to major injection of shareholders equity when Merbatty became listed in 2006

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

growing organically, by building a further boat building facility in Surania. Its capital expenditure in 2006 and (planned) 2007 together was around €185 million. A huge investment in its future ability to generate returns for its shareholders. (4) Risk: There is always risk in any business. Merbatty is a global company with sales all over the world. An economic downturn or a severe recession could affect many of its potential customers and it could find sales will be much lower. There could be accidents at its boat building facility which generates adverse publicity or causes poor staff morale if injury or deaths occur. Its main strength is its employees, who are obviously skilled employees building boats to the standards expected. If the quality of the boat building falls, then Merbatty’s brand reputation could be damaged. Another skill is its boat designers – if they left (or joined a competitor) then this would affect Merbatty’s ability to innovate and stay competitive. Therefore, risks have to be identified and managed so that they can be mitigated.

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An analysis of the growth expected using the 5-year plan in Appendix 5 is summarised as follows: Ratio/business statistic

2006

2011

Comments

Revenue (€ million) Number of boats built Average revenue per boat (€ million)

502 280 1.79

1,000 500 2.0

Increase of almost 100% in 5 years

Operating profit (€ million)

76

137

Operating margin (%)

15.1%

13.7%

Value of Merbatty: Market capitalisation based on profit ⫻ P/E ratio of 15

600

1200

€3.33

€6.67

Indicative share price based on market capitalisation figures above € per share (based on 180 million shares)

6.6.5

Average revenue per boat increased – more larger boats sold. Revenue per boat up nearly 12% Up by 80% – but as revenue is up 100%, this assumes that operating costs will increase by a greater amount, i.e. operating margins are reduced Reduced margins – perhaps due to competitive pressures As profits have doubled from €40 million to €80 million, then this indicates that the company will be worth more in 2011 based on the same P/E ratio. If profits in 2011 are €80 million, then market confidence in Merbatty’s ability to deliver profits will be high, and its P/E ratio may be even higher, making its market capitalisation even higher The pre-seen case material states that Merbatty’s share price at end June 2007 was €3.65, which is already higher than the indicative price using 2006 earnings. If Merbatty is able to deliver the agreed 5-year plan (which its investors bought shares on the basis of ) then Merbatty’s share price could be greater than €6.67, perhaps over €7.00 per share by 2011

Business portfolio

Merbatty has a business portfolio of 15 boats designs at present, ranging in price from €0.4 million to over €4.4 million, plus revenues for interior fittings. It usually introduces two or three new designs each year to stay competitive and to meet the increasing demands for the latest technology from its customers. Merbatty operates three boat building facilities in three different parts of the world – in Europe, in the USA and its soon to be opened facility in Surania in the Middle East. These boat building facilities are valued in Merbatty’s Balance Sheet at the end of 2006 at €535 million, net of accumulated depreciation reserves and this includes the recent revaluation of these assets. A further €55 million is planned to be spent on capital expenditure in 2007, both on finishing the facility in Surania and other capital expenditure projects. Therefore at the end of 2007, Merbatty would have net assets, after depreciation, of

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.6.6

Industry analysis

The boat building industry is still in its growth stages of the industry life cycle with new models and new competitors entering this industry. There is a continued demand by many new customers for better, and bigger, and more luxurious boats. Merbatty already has boat building facilities in three locations around the world. The pre-seen material states that it is planning to open a fourth boat building facility in 2010/11 and that Asia is being considered. From the data presented in the pre-seen material, we can construct a PEST analysis. However, on exam day, if you are planning to include a PEST analysis as part of your answer, you must ensure that it includes the new material given to you on exam day in the unseen material. Using data only from the pre-seen material we can construct the following PEST analysis:

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

around €550 million. Whilst these assets are purpose built boat building facilities, they are in prime locations and these assets will retain their value. Furthermore, as there is an increase in global demand for luxury boats, these assets will be in demand, perhaps by competitors who would wish to acquire Merbatty for its assets – and therefore, these assets will retain, or increase in value. The bottom line is that they are ‘real estate’ in an industry which has a shortage of capacity – a recipe for increased value. The other assets which Merbatty has are its employees and the IPR (Intellectual Property Rights) for the IT solutions that it uses to build its boats. This industry has a shortage of skilled employees and Merbatty employs over 2,000 employees, of which 1,940 (see page three of pre-seen material) are skilled boat building technicians. Merbatty must look after these skilled employees and further develop their skills and must ensure that their skills remain in the company. If employees leave, to go to a competitor, then Merbatty loses valuable assets. Furthermore, Merbatty will need to employ double (or almost double) the number of employees over the next 5 years as it tries to build double the number of boats. It is unlikely that Merbatty will be able to recruit this volume of skilled employees. Therefore, it will be necessary for Merbatty to train and educate its new employees with the skills required to build boats to the high quality expected. Therefore, it will need to further invest in its employees. With the increase in the number of boats being built over the next 5 years, it is important that Merbatty invests in technology to improve production efficiency. It has already invested in a number of new techniques and IT systems to monitor production and to identify areas for improvement. The other important area in Merbatty’s portfolio is its deign team headed by Lukas Dian and his tem of over 20 designers. If Merbatty does not come up with boats that meet (or exceed) customers’ expectations, then it will quickly lose market share. Therefore to retain, or increase its market share, Merbatty needs to continue to be innovative. Its innovative approach needs to embrace not only the boat design, but also the materials used, the amount of ‘cutting edge’ technology installed and also the impact the boat has on the environment. In today’s society, which is becoming increasingly aware of ‘green’ issues, the use of material and engines that are environmentally friendly may play a part in a boat design appealing to potential customers. In summary, Merbatty has many assets in its portfolio, in addition to its cash reserves, from its recent flotation, and it needs to manage all of its assets in order to generate the sales and profits in its ambitious high growth 5-year plan.

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PEST analysis for Merbatty – using pre-seen material only Political/Legal ● Possible operational problems at the new Middle East boat building facility – will it open on time in September 2007? ● If boat building facilities are moved to Asia in 2011, there could be problems with culture, language and work practices ● Potential problems with enforcing IPR’s if boat building facilities in Asia lead to loss of Merbatty’s commercial knowledge and designs ● Unfamiliar legal system in Asia, if Merbatty moves there in 2011 ● Political unrest in some of Merbatty’s export markets – particularly the Middle East Economic ● Merbatty is offering luxury goods and is subject to global changes in demand ● If there were another global recession, there would be a downturn in demand for these luxury goods ● Merbatty is operating in a competitive market ● Merbatty has to ensure that its prices are competitive (against similar models to competitors) Social ● Changes in customers’ behaviour and tastes, resulting in higher (or lower) level of boat sales ● Global changes in weather conditions which may result in loss of confidence and result in lower demand for luxury boats ● Employee welfare and the pressure on employees to meet challenging delivery targets ● Safety standards for employees ● Safety standards expected by customers ● Environmental issues concerning these luxury boats Technological ● The need to continue to be innovative in production to generate better standards for customers and to reduce boat construction costs ● The need to be innovative in boat designs in order to stay competitive ● The use of improved technology to make boats safer and improve market confidence ● Improved use of high technology equipment in order to save staff costs ● Improved use of high technology components in a boat to act as a differentiator to achieve higher sales ● The use of technology in order to improve quality and safety testing of a boat prior to delivery to customers ● Competitor innovations ● Use of new materials in boat building

6.6.7 Conducting a corporate appraisal or SWOT analysis A SWOT analysis is a very useful tool in TOPCIMA. You should learn how to prepare a SWOT, based on the material in the pre-seen material. It is a good way of identifying many issues in the case.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

SWOT analysis for Merbatty based on pre-seen material only Strengths ●

● ● ● ●

●

● ● ●

Listed company with experienced Board of Directors Growing demand for new boats Approved 5-year plan with high growth prospects Good market reputation for quality Good range of boat models with new models being introduced each year (innovative) New boat building facility in the Middle East which gives Merbatty spare boat building capacity to meet demand Strong asset backed balance sheet High market profile with 2 sponsorship contracts Experienced employees, many of whom own shares in Merbatty

Weaknesses ●

● ● ● ●

Dependent on its suppliers for many bought in components Speed of innovation New technologies improving at a fast pace Can Merbatty maintain quality as sales increase Can Merbatty recruit the required level of skilled employees to meet the growth in boat building

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

The use of SWOT analyses is often used in the business world, especially where acquisitions are being considered – does the target company fit (or clash) with our company’s Strengths and Weaknesses, and are there areas that compliment each other. So this is a very useful tool to learn how to prepare. You can also prepare a SWOT as an Appendix to your answer on exam day – it will help you plan and identify many of the priority issues. If you prepare a very good SWOT on exam day, it may earn you a total of 5 marks (in Technical and Application) – this represents 10% of the total marks needed to pass. So learn how to prepare a very good SWOT and practice using this case. You should prepare a SWOT based on the data in the pre-seen material but on exam day you MUST update your SWOT for the new material presented to you. So to practice your skills and prepare a SWOT using the Merbatty pre-seen material. You should aim to have at least 5 issues in each of the four quadrants of Strengths, Weaknesses, Opportunities and Threats. The most important quadrant to concentrate on exam day is the Threats. For each of the Threats that you identify, your report should discuss how these threats are going to be managed or reduced. You should prepare a SWOT analysis by going through the pre-seen material with the quadrant drawn on 1 sheet of paper with a vertical line and a horizontal line, dividing the page into 4 sections for the Strengths, the Weaknesses, the Opportunities and the Threats. Threats are important to identify, as management action will required to reduce or mitigate against these threats. On exam day, having prepared a SWOT beforehand, you need to go into the exam room and prepare a new SWOT. You should remember some (or all) of the issues that you have already identified, but it is MOST important that your SWOT analysis is updated for all of the new issues introduced in the unseen material on exam day. This is discussed further in the next chapter (Chapter 7 – What to do on exam day). Below is an example of a SWOT for Merbatty based on the pre-seen material only, but there is one important Threat missing – can you see what it is. Answer below!

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STUDY MATERIAL T4

Opportunities ● ● ● ● ● ●

New markets in Asia Expansion in range of boat models High growth 5-year plan New boat design Improved production efficiency Improved use of high technology in boat building to save costs

6.6.8

Threats ● ●

● ● ●

Costs higher than current 5-year plan Overstretching management resources due to high growth Retaining management expertise Retaining and motivating employees Operating in a highly competitive marketplace

Critical success factors

What are the critical success factors for Merbatty? They range from financial target, to quality targets, to business and innovation targets – much like the Balanced Scorecard. The two most visible targets for investors will be: (1) The number of boats built compared to plan (2) The profit after tax compared to plan Investors have very recently bought shares in Merbatty and they will expect the 5-year plan to be delivered. It is a very challenging plan. They do not want to be given reasons why the plan has not been met, or why sales have been lower – they are trusting the Merbatty Board to manage the operational problems and to put plans in place to achieve the agreed strategic plan of building the number of boats in the agreed 5-year plan. If Merbatty should fail to achieve the agreed plan, it would be likely that investors, particularly JKL who have a seat on the Board, would remove some (or all!) of the Directors. Alternatively if it does not achieve the planned level of profits, Merbatty’s share price will fall and it could be the target of a hostile takeover. Many companies in this industry have grown by acquisition (rather then the organic growth that Merbatty has grown by). Two examples of boat building companies who have grown by acquisition are Ferretti and Azimut-Benetti, who have acquired many of its small competitors and this has enabled them to expand their production using the acquired companies’ boat building facilities in many countries. The single biggest critical success factor is to maintain the quality of its production, which is quite a challenge as the number of boats built increases over the next few years. Without high quality production the Merbatty brand reputation would be tarnished and make it difficult to generate sales in the future. Another critical success factor is for the design team to come up with ‘the right’ designs that appeals to prospective customers. They also need to stay ‘one step ahead’ of competitors. Another critical success factor will be the opening of the Suranian boat building facility in September 2007. Many new construction projects run over the agreed timescales and the agreed budget – will this open on time? Merbatty is very dependent on sales from the Middle East region and this is the single largest target for revenue growth over the last few years. It will be very visible if this new facility is late and could upset important prospective customers who will not want to be kept waiting.

6.6.9

Information systems strategy

The pre-seen material gives details of Merbatty’s investment in IT solutions. It states that it invested in 2006 (the year of its flotation) in a new management software system which is

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.6.10

Risk

Business is all about managing risks and ensuring that threats to business goals are mitigated. Therefore, in order to manage risks, we should identify what risks Merbatty faces. These risks are often similar to the Threats that we have already identified when we prepared a SWOT (see Paragraph 6.6.7 above). Therefore the risks facing Merbatty can be summarised as follows: ● ● ● ● ●

Risks from competitors and loss of market share Risk that costs could be higher than current 5-year plan Risk of shortage of management resources due to high growth Risk of losing management expertise – particularly the design team Risk of losing key skilled employees

In addition to these risks, Merbatty operates in the global market. It prices its boats in Euros and US Dollars (pre-seen material page 1). As Merbatty is a European company its profits are reported in Euros (and all 5-year plan figures are in Euros). Therefore, another risk that Merbatty faces is exchange rate risk. Whilst you may think that exchange rate risk can be minimised or managed by hedging techniques (such as forward contracts and so on) this still leaves Merbatty exposed to long-term fluctuations in currencies. The only sensible way to reduce Merbatty’s long-term exposure to currency risk is to try to match its revenues and costs in each currency as far as possible, so that its net exposure is smaller. A new possible risk, which is alluded to in the risk from competitors, is whether Asia will have the same effect in this industry as it has in many other industries. Many Asian countries, including China have a much lower cost operation (with lower employee costs) and are able to compete at a far lower price. In recent years, the quality of exports from Asia has significantly increased in quality – to some extent, some production from Asia is higher quality than European production. For example, electrical appliances are produced at lower costs, using higher technology in Asia than in many European countries. As China, in particular, becomes the one of the biggest manufacturing countries in the world, it has the ability to be a real threat to the traditional boat building companies. Merbatty, which operates in other countries, including Europe – which has high labour

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

designed to improve productivity and increase resource utilisation. The case material states that so far this has enabled Merbatty to improve its boat production schedule and ensure that all boats are delivered on time. The case material also gives details on the use of the latest navigation systems and technology to apply glass re-enforced plastic onto the hulls of boats to increase the durability and strength of the hulls. Therefore, Merbatty is using the latest technology both in the production process and also in the management of the production process to improve its quality and competitiveness and to ensure that boats are delivered on time to its customers. You are advised to research and understand some of these IT systems to give you a greater appreciation of their benefits and also to enable you to offer advice to management if the unseen material included information on some of the technology failing. What should Merbatty do, and how can it manage without this technology? Improved research will give you a better understanding of this industry and the IT systems available and will ensure that the advice and recommendations that you give on exam day are realistic and backed up by a sound understanding of the IT solutions that Merbatty has selected.

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STUDY MATERIAL T4

costs – may become uncompetitive in price. Therefore, Merbatty is considering opening its fourth boat building facility in Asia in 2010/11 so that it too could enjoy lower production costs. The ability to ensure high quality of production in some areas of Asia is not the problem that it perhaps was a few years ago.

6.6.11

Business valuations

Valuing a company is not an exact science. However, as Merbatty is recently listed and its assets have been revalued, it is possible to value Merbatty in a variety of ways. Before I take you through a few valuations, it is recommended that you should use the financial data given in the case material from Appendices 4 and 5 (in Chapter 5) and using the valuation techniques in Chapter 4 in Section 4.15. When you have prepared these calculations you can compare them to the ones shown below. A listed company will always be worth what its shareholder can sell their shares for (i.e. the market price). No rational investor would ever choose to sell shares for LESS than the market price. Indeed, in a bid situation, the acquiring company usually adds in a bid premium (usually 25–30%) on top of the share price to entice shareholders to sell. So what is Merbatty worth? The answer is Merbatty is worth what the market or a competitor will pay for it. At the end of June 2007, Merbatty’s share price was €3.65 per share. With 180 million shares, its market capitalisation was €657 million. Using P/E ratios, the valuation using 2006 profits at a P/E ratio of 15 (case material), the company was worth €40 ⫻ 15 ⫽ €600 million. However, based on 2007 planned profits of €45 million, this valuation would increase to €675 million, which is very close to the current share price. As we know the stock market has its ups and downs with million’s being knocked off company’s valuations when the stock market suffers a fall in confidence. If a company suffers a 20% reduction in its share price as a result of market conditions, it does not mean that the company is performing any differently, or that profits will be lower. It is all so dependent on market confidence. Therefore, P/E ratios cannot always be relied on to generate a realistic value, due to the fluctuations in the market. But it does give a good indication of the company’s potential value. It is also simple to use and varies directly by the company’s profits. So let’s look at what Merbatty could be worth as it progresses through its agreed 5-year plan. As the company grows and builds more boats and its profits grow, so will its share price. Using the data in Appendix 5 to the pre-seen material (the 5-year plan) we can see that Merbatty’s market capitalisation and its share price (using a standard P/E ratio of 15) will also grow.

Year

Planned number of boats built

Planned post-tax profits (€ million)

2007 2008 2009 2010 2011

300 340 385 435 500

45 51 60 69 80

Market capitalisation (at P/E of 15) (€ million) 675 765 900 1,035 1,200

Share price (€ per share) 3.75 4.25 5.00 5.75 6.67

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

6.6.12

Strategic options

Every company always has strategic options. There are always other ways of operating. Merbatty may choose to acquire another company. It may choose to close one of its boat building facilities if sales are lower. A company must react to its external environment. However, what it must not do is to simply react to changes circumstances. It has an agreed plan and should endeavour to deliver to it. Merbatty should try to ensure that it does not make too many strategic decisions that vary from the agreed plan, although if new opportunities arise, it should not be ‘blinkered’ by its plan, so that it misses out on profitable expansion opportunities. The future for this newly listed company looks promising, but it must maintain and grow the quantity of sales, it must maintain or improve its production quality and it must maintain or improve its profitability by managing its costs. It could choose to outsource more of its production, or to buy in more ready to install components. On the other hand, it could choose to undertake more work in house, by employing more employees to replace some outsourced activities. The obvious one being the interior fittings for its boats, which it currently outsourced to Aqua designs. Merbatty buys in the engines and electrical goods for its boats from leading suppliers. It is possible that Merbatty could choose to backward integrate by acquiring a supplier, although it may not have the skills, or management time to manage this added complication to its business. You should be aware that there are always strategic options for any company, but your role on exam day is to advise the management based on the information presented. This may be to advise on a potential acquisition or the appointment of new sales agents or the choice of supplier. You should be familiar with Merbatty’s current strategic plan so that you can identify whether the proposal will complement or interfere with Merbatty’s stated aim of achieving the agreed 5-year plan.

HOW TO ANALYSE THE PRE-SEEN MATERIAL AND RESEARCH THE INDUSTRY SETTING

The case material states that the directors have share options of 5 million shares each at a price of €5.00 each, which can be exercised any time until 2012. Therefore after 2009, when the share price is planned to be €5.00 per share, there are able to buy up to 5 million shares at €5.00, which could be worth over €6.67 per share, if the Merbatty Board are able to deliver the planned profits. Each director could exercise his share options in 2012 and make a profit of over €8.3 million (€6.67 less cost of €5.00 ⫻ 5 million shares). This is a good incentive for the Merbatty directors to achieve the plan. As you can see, the current share price of €3.65 is what investors could sell their shares on the stock market for today, but that the potential is there for a significant growth in their capital (as well as receiving dividends) if Merbatty are able to deliver its planned level of profits. That is what they have invested in Merbatty for – they are hoping to capitalise on Merbatty’s planned high growth and to see growth in their shareholder wealth.

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7 Getting Ready for the Exam

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Getting Ready for the Exam

7

LEARNING OUTCOMES By the end of this chapter you should 䉴

be clear about what you need to do going forward to prepare for your exam;

䉴

have completed a checklist of actions needed to pass the exam, so you have identified the key tasks you still need to undertake.

7.1

Introduction

As with all exams, the preparation you do leading up to exam day is vital if you are going to pass. While you were probably clear what you needed to do to prepare for your previous CIMA exams, often a mixture of learning theory and practising past papers, what you do in those last few weeks prior to your TOPCIMA exam, is probably less clear due to the lack of new theory in the exam. In this final chapter, I will examine what you should be doing now to ensure you are well prepared on exam day.

7.2

Use of past papers

If you have done the practise past paper in Chapter 5, and reviewed your script using the checklist therein, you are probably well aware of the need to take a range of further practise exams. In Appendix B, you will find another past exam paper, and, if you have organised your time well and have reached this last section of the book some weeks prior the exam, you will find it useful to work through this pre-seen and do the real exam, taking a similar approach to the way we did Chapter 5. Beyond this, I don’t recommend detailed analysis of pre-seens and the attempting of practise unseens on lots of other past papers, since you now need to be focusing on your pre-seen and the types of issues that company faces. However, there are two exercises which I do recommend you to undertake on these past exams. 189

GETTING READY FOR THE EXAM

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STUDY MATERIAL T4

7.2.1 Exercise 1 – Read through a number of the Post Exam Guides The Post Exam Guides (PEGs) include a range of information about the exam which has just passed. Much of this is specific guidance on how to approach the specific unseen, such as the importance of different unseen issues and areas the examiner felt were important to cover. This element of the PEGs is of little practical use to you unless you are going to study that past exam in detail. However, within the PEGs you will find a lot of information on exam approach and technique, and this information, coming from the examination case writer themselves, gives you many key hints and tips on how to approach your exam. My suggestion is that as you read 3 to 4 of the most recent PEGs and create notes of key lessons on a separate sheet of paper, particularly noting anything which you know from your practise to date is a weakness for you.

7.2.2 Exercise 2 – Undertake a range of prioritisation exercises on past exams While preparing a full pre-seen and taking real unseens can be too time consuming to make it worth doing on more than a couple of past exams, I would advise working through the prioritisation steps we discussed in Chapter 3 with a range of past papers. Doing this should take no more than 45 minutes for each past unseen, and will provide that critical view on the ‘mind of the examination team’ and what they consider to be important, or indeed not so important, and their justification for this. For each new unseen on which you do this exercise, take a very brief flick through the pre-seen, of no more than 10–15 minutes, taking particular note of the first few pages which usually provide a good general introduction to the industry and company, and then work through the unseen, giving yourself no more than half an hour (to further practise exam technique), and produce a prioritisation plan like those we did in Chapter 3. Finally, review the examiner’s order in the exam solution, or PEG. You must remember that you won’t have the full detailed knowledge of someone who has fully prepared the pre-seen, so don’t expect too much of yourself, but do learn from the views of the examiner. Although industries differ from exam to exam, similar issues do regularly repeat themselves, and this exercise will help you with repeated issues which arise on your paper, as well as gaining a general understanding of the types of issues to prioritise, or indeed to leave out of your prioritisation. You will find past pre-seens and unseens, and PEGs on www.cimaglobal.com. Solutions to past exams are available from CIMA publishing.

7.3

Mock exams on your unseen

As you approach the exam date, it is vital that you begin to focus on mock exams for your pre-seen, and not only that, but that you obtain some independent advice on your progress. While the checklist provided in Chapter 5 can be an extremely useful way to learn lessons from your own scripts, some element of bias is bound to creep into a review of your own work. It is also useful to have someone review the logic of your recommendations, the depth of your analysis, the appropriateness of your justifications and the clarity of your explanations, which is very hard to assess for your own work.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

7.4

Time management

As I have made clear throughout this book, time management is crucial to your success. You absolutely must keep to a clear time plan as you do your exam, and you must complete all sections fully if you are stand a good chance of passing. As a final reminder, here are my suggested timings for you for the exam. These are based both on my experience of students writing exams, the marking criteria, and discussions with the examiner over the importance of different sections and the appropriateness of timings given the ways the exams are marked. Do stick to these or very similar timings, therefore in your exam.

Time

What you should be doing?

20 minutes Reading Time ⫹10 minutes of Exam Time

Read case and prioritise Notes on key points of impact and alternative solutions

15 minutes

Do calculations (in the appendix) Reconsider priorities given the calculations

15 minutes

Appendices: SWOT analysis and at least 2 other models of your own choice

5 minutes

Report format, Introduction and Terms of Reference

15 minutes 3 minutes on each key issue

Prioritisation section

55 minutes 13 minutes on top 3 issues 8 minutes on issues 4 and 5

Main body of report. For each major issue: summarise, then analyse, give alternative solutions, and provide an industry example.

15 minutes

Ethics: Identify and explain 3 ethical issues, and make recommendations

50 minutes 12 minutes on top 3 issues 7 minutes on issues 4 and 5

Recommendations, including answering why, how, when and who Conclusion

7.5

Writing to the assessment criteria

As you approach the exam, keep focused on writing a report that earns marks against the assessment matrix. This is critical if you are going to pass. Chapter 4, gives you a clear report format aimed at helping you earn marks on each criteria. As a final reminder to you, here are the criteria again. As you re-read these, ensure you fully understand what they mean, and refer back to Chapter 2 if there is anything on which you are unsure.

GETTING READY FOR THE EXAM

Practise unseens on your mock exam, along with the opportunity to have papers marked to obtain feedback are available from the leading tutorial firms. In addition, you can find practise exercises available from specialist TOPCIMA websites, and also may find it useful to gain feedback from other people currently doing TOPCIMA, who you could meet either through a course you do or via an online forum.

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STUDY MATERIAL T4

Analysis of issues

Typical marks

Technical

Use relevant theoretical techniques and frameworks and perform relevant calculations to help to analyse the case material and support arguments made.

5

Application

Use the techniques, frameworks and calculations you have produced to support your analysis of the issues and your choices of actions.

15

Diversity

Display knowledge of relevant real-life situations within the 5 same or a similar context as that in which the case is set. Additionally, display knowledge of real-life commercial or organisational issues relevant to the situation in the case. These may occur in the industry or organisational setting in which the case is set or in different industries or settings. 25

Strategic choices Focus

Select the issues you feel to be the most important and make sure that you properly address these issues in the report you produce.

5

Prioritisation

Rank the key issues, stating clearly and concisely your rationale to justify your ranking. Issues should be given high priority primarily because of their impact on the organisation in the case. Their urgency may also be a factor. Also, state the issues that you feel deserve a lower priority ranking and give your reasons.

10

Judgement

Exercise commercial and professional judgement to discuss the key issues. Discuss the impact the priority issues have on the organisation. Discuss alternative courses of action, with reasons, that the organisation could take to resolve these issues. Your analysis should include relevant supporting financial analysis.

20

Ethics

Using your judgement, highlight and analyse the ethical 5 issues in the case and state why you consider these issues to have ethical implications. Discuss alternative courses of action that the organisation could take to resolve the issues. 40

Recommendations Logic

Make clear, well-justified recommendations for each of 20 the prioritised issues and ensure the reasoning for the recommended courses of action is clearly stated. The recommendations should follow on logically from the weight of the arguments and choices of actions given earlier in the report.

Ethics

Make clear, well-justified recommendations for each of the ethical issues and ensure the reasoning for the recommended courses of action is clearly stated. The recommendations should follow on logically from the weight of the arguments you make in your report.

5

Integration

Produce a well-structured report in an appropriate format and linguistic style. (3) These marks are awarded holistically according to the overall quality and functionality of your report. (7)

10

35 100

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Preparation checklist

In the table which follows, you will find a full checklist of tasks for you to undertake prior to your exam. This includes a range of exercises from this book, which you may have already completed, as well as other tasks you should undertake. As you complete each of these tasks, tick off the task as completed, and aim to complete all tasks by the day of the exam. Activity

Completed?

Understanding TOPCIMA, planning and prioritisation Understand the complexities of the TOPCIMA exam, including the marking criteria, by reading Chapters 1 to 3 Prioritisation exercise 1 in Section 3.3 Prioritisation exercise 2 in Section 3.4 Planning exercise in Section 3.5 Practise prioritising 3 to 4 past exam unseens (Section 7.2.2) Technical knowledge Review the theory in Appendix A, and ensure you have a broad understanding of the key models Past exam practise Read through a number of Post Exam Guides, making notes on lessons you can learn (Section 7.2.1) Past exam paper 1 Take mock exam (Chapter 5) Personal review of exam using form in Chapter 5 Past exam paper 2 (if time) Take mock exam (Appendix B) Personal review of exam using form in Appendix C Analysing your pre-seen Read through your pre-seen case making notes (Section 6.4) Undertake a full strategic analysis of your pre-seen (Section 6.4), including production of a final SWOT analysis (and other models), which you must learn prior to the day of the exam (Section 6.3.6) Undertake industry research (Section 6.3), creating a folder of industry information which you have collected Create a list of 20–30 examples to use in the exam, noting the relevance to the pre-seen company, and when this will be appropriate to use in the exam (Section 6.3.6) Produce a page of key facts about the pre-seen to learn prior to the exam (Section 6.3.6) Sign up to an online TOPCIMA forum and share ideas with other students Take mock exams based on your pre-seen Mock exam 1 Take mock exam Personal review of exam using form in Appendix C Independent feedback (Continued)

GETTING READY FOR THE EXAM

7.6

193

GETTING READY FOR THE EXAM

194

STUDY MATERIAL T4

Activity

Completed?

Mock exam 2 Take mock exam Personal review of exam using form in Appendix C Independent feedback Mock exam 3 Take mock exam Personal review of exam using form in Appendix C Independent feedback Mock exam 4 Take mock exam Personal review of exam using form in Appendix C Independent feedback Mock exam 5 Take mock exam Personal review of exam using form in Appendix C Independent feedback

7.7

Create a plan and work hard

As we reach the end of this learning system, I just want to remind you of one final point. Despite this exam being so different from others on the CIMA syllabus, it still remains the case that those people who work the hardest will be those people who are most likely to pass. Using the checklist of items to do in Section 7.6, create a plan for your time up until the exam, and then be diligent in your approach. On the day of the exam, keep cool, trust in yourself and the approach you have learnt in this book, stick to your time plan and work as quickly as you can. Finally, best of luck, both on exam day and in your career as a qualified Chartered Management Accountant!

Technical Knowledge

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Technical Knowledge

1

Appendix

A

Introduction

The purpose of this appendix is to remind you of some key knowledge areas from your previous CIMA studies. It is intended merely as an additional resource for you to dip into. The technical content of the whole CIMA curriculum can of course, not be covered in a single appendix, but this does contain most of the key theory which use will use as part of the TOPCIMA exam. Do remember though, that any theory which you have covered as part of your CIMA studies can be referred to as part of the exam, so do consult the relevant CIMA Learning System for any other theories which you feel you might like to use. The technical knowledge in this appendix should be applied to the pre-seen material and also to the unseen material on the exam day. It is deliberately arranged in a logical sequence. You should consider each technique and assess whether it can be used to shed light on the pre-seen.

Refer immediately to Section 4 to refresh your memory on the breadth of technical knowledge you may be required to call upon.

2

Assessment of technical knowledge in TOPCIMA

Technical knowledge is assessed within several of the 9 assessment criteria, which are explained in Chapter 2 of this CIMA Learning System: Technical Application Diversity Focus Integration

A sound technical knowledge of the specific areas of the curriculum Application of any relevant technical knowledge in an analytical and practical manner to the case material Extract from various subjects the knowledge required to solve many-sided or complex problems Solve a particular problem by distinguishing the relevant information from the irrelevant in a given body of knowledge Integrate diverse areas of knowledge and skills 197

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198

STUDY MATERIAL T4

As you can see, demonstrating technical knowledge will gain your TOPCIMA answer a lot of marks. But note the key words. As well as being ‘sound’ this knowledge must be ‘analytical, practical, diverse and relevant’.

TOPCIMA is not a theory exam. Technical knowledge will only gain marks if it is relevant to helping management to understand the problems of the organisation or is used to justify the course of action you are recommending. You will not get marks for brandishing technical knowledge for its own sake.

It must be stressed that you should incorporate in your answer on the exam day a range of technical knowledge. It is suggested that the use of a SWOT and a PEST analyses are prepared, which MUST incorporate the new data given in the unseen material on the exam day. You should also refer and discuss a range of theories, perhaps two or three, that are relevant to the case. It must be stressed that no marks at all are awarded for ‘name dropping’ such as the mention of ‘Porter’. For marks to be awarded in a TOPCIMA exam, it is important that the theory is explained and applied to the case material. Further marks are then awarded for explaining how the use of a relevant technique could help the company in the case overcome some of its problems. The TOPCIMA examiner ensures that all of the material used in TOPCIMA cases is covered in this CIMA Learning System. However, for additional depth of knowledge and understanding on particular topic, such as joint ventures, it is suggested that students refer to the other CIMA Learning Systems. Therefore, be assured that all the Technical Knowledge you need to know to pass TOPCIMA is contained in this appendix, but additional reading is always advisable.

3

Summary of the key areas of technical knowledge covered in this appendix

We have selected the following topics based on a consideration of past CIMA Case Study exams and also our experience of the difficulties facing learners and candidates: Technique

Sections

The four elements of strategy (competitive, financial, investment and risk) Using ratios to conduct a financial analysis of a company’s position Assessing a business portfolio Industry analysis Position audit Critical success factors Assessing information systems strategy Assessing corporate risk Assessing the cost of capital Conducting a corporate appraisal (SWOT and Gap analysis) Business valuations Generating strategic options Sources of business finance Evaluating strategic options

4 5 6 7 8 9 10 11 12 13 14 15 16 17

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

The four elements of strategy

(1) According to the syllabus ‘TOPCIMA (…) requires students primarily to apply strategic management accounting techniques to make and support decisions’. Where the following definitions apply:

Strategy: A course of action, including the specification of resources required, to achieve a specific objective.

Strategic plan: A statement of the long-term goals along with a definition of the strategies and policies which will ensure achievement of these goals.

Strategic management accounting: A form of management accounting in which emphasis is placed on information which relates to factors external to the firm, as well as non-financial information and internally generated information.

CIMA: Management Accounting Official Terminology (2) The following discussion provides an overview of the issues in strategy and how they interrelate (Figure A.1). The remainder of this appendix is devoted to a detailed treatment of the main topics raised here.

Competitive strategy

Risk management strategy

Business strategy

Financial strategy

Investment & resource strategy

Figure A.1 The four elements of strategy

TECHNICAL KNOWLEDGE

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STUDY MATERIAL T4

4.1

Competitive strategy

This deals with how the firm competes for business and where its earnings come from. Considerations in competitive strategy: ● ●

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which countries, markets and customers to target (affects volumes, revenues and risks); the positioning of firm in each market and the quality of its offerings (affects costs of production and cost of developing, supporting and defending brands); what products or services to provide (affects costs and the assets the firm must invest in); methods of gaining access to customers, markets and products (may lead to acquisitions, mergers, joint ventures, etc.); creating appropriate organisational structures and systems to support strategy; the role of the corporate parent in controlling strategy and maintaining control over divisions in the implementation of strategy.

Technical content: ● ●

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Porter’s generic strategies (cost leadership, differentiation, focus); Ansoff product/market growth vector matrix (market penetration, market development, product development, diversification); theories of resource-based strategies (distinctive competences and strategic architectures); Goold and Campbell: strategic styles; strategy and structure: for example, Chandler’s theory of stages, Greiner’s model of organisational growth, virtual organisations, learning organisations, flexible organisations; strategic cultures (e.g. Miles and Snow); multidimensional performance measures (e.g. balanced scorecard).

Importance of competitive strategy: ●

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competitive strategy influences the operating margin of the business (profit/sales turnover ratio) and also the assets it needs to support its business (assets/turnover ratio); competitive strategy therefore determines the return on shareholders’ investment (i.e. ROCE ⫽ operating margin ⫻ asset turnover) from the firm’s core business; success of competitive strategy (e.g. sales growth, winning new orders, adequacy of margins, etc.) will influence investors’ opinions of management and therefore the firm’s share price or ability to borrow investment funds.

Application to passing TOPCIMA: ●

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evaluate the causes of the financial performance of the firm in terms of the adequacy of its competitive strategy in each of its markets/businesses; assess adequacy of management and organisation for carrying out the strategies being considered by the firm; justify any recommendations you make in terms of its strategic rationale and potential impact on ROCE and share price; ensure you consider all the implications of the strategy you recommend (e.g. implications for structures, control systems and performance measures).

4.2

Financial strategy

This deals with the firm’s relations with its investors and other providers of credit. Management must meet the wishes of the shareholders of the business. They must also bear in mind the banks and suppliers who are also sources of capital.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

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ensuring the return to shareholders exceeds the costs of equity in order to create shareholder wealth; maintaining appropriate relations with investors; ensuring that the business has sufficient funds available to meet its present and forecast cash needs; developing a capital structure appropriate to the financial needs of the business and the dynamics of the parts of its business.

Technical content: ● ● ●

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operation of stock markets (e.g. efficient markets hypothesis); methods of flotation and of raising equity finance (e.g. rights issues, warrants, venture capital); raising long-term debt finance (e.g. bonds, bank borrowing, project finance, sale and leaseback of assets); raising short-term finance (e.g. trade credit, factoring, hire purchase, leasing, bills of exchange); calculation of cost of capital; methods of share valuation (e.g. net assets, income flow, dividend, price/earnings, sustainable cash flow); theories of optimal capital structure (e.g. Modigliani and Miller); dividend policy.

Importance of financial strategy: ● ● ●

activities of corporate treasury can improve or reduce earnings of shareholders; loss of support from shareholders will lead to changes in management and strategy; inadequate financial support can lead developing businesses to overtrade (i.e. to run out of cash) despite being profitable.

Application to passing TOPCIMA: ●

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evaluate the financial performance of the firm, and its share price, using ratios to assess whether management are acting in the interests of shareholders and able to maintain shareholder support; use cash-flow forecasting to assess the adequacy of its financing its current strategy; value the company to assess the likelihood of being able to raise further capital, takeover another firm or resist a takeover itself; prepare financial analysis to advise management on how to restore investor support or raise additional finance.

4.3 Investment and resource strategy This area of strategy concerns how management uses funds retained from profits or otherwise borrowed from investors. These provide the resources needed to carry out the firm’s competitive strategy. Considerations of investment and resource strategy: ● ●

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ensuring the business has the tangible and intangible assets it requires to carry out its strategy; ensuring all business investments are undertaken only if it can be shown that there is a reasonable prospect of a net return in excess of the costs of capital involved; evaluating whether existing assets, including entire business divisions, are yielding an adequate return or whether they should be divested or outsourced;

TECHNICAL KNOWLEDGE

Considerations in financial strategy:

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STUDY MATERIAL T4 ●

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appropriateness of potential asset investments (e.g. business acquisitions, tangible asset acquisition, programmes of marketing or human capital development); ensuring that performance measurement systems encourage management to utilise assets for the best long-term financial return.

Technical content: ● ● ● ● ●

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project appraisal (e.g. IRR, NPV); risk and project appraisal including sensitivity analysis; mergers and acquisitions; demergers; divisional performance evaluation (e.g. return on investment, residual income, shareholder value approaches); post-investment audit.

Importance of investment and resources strategy: ●

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the quality of management’s investment decisions will determine the company’s ability to make a healthy return on shareholder investment through time; present financial performance can be improved if assets returning less than the cost of capital are liquidated and the funds invested elsewhere or used to repay capital; strategic investments often contain loose forecasts of earnings, outlays and costs of capital that should be questioned before approval is given; post-audit of investments can reveal issues in the quality of management forecasting and also of its ability to manage projects to generate shareholder returns.

Application to passing TOPCIMA: ●

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assessment of investments undertaken to date will help you to draw conclusions about the quality of management, its strategy and the reliability of its forecasts; be prepared to advise on the suitability of investments being proposed by management in the pre-seen or unseen material; be ready to recommend investments or divestments to management, backed up by appropriate numerical analysis.

4.4

Risk management strategy

Considerations include: ● ● ●

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Business or operational: relating to the activities carried out within an organisation. Financial: relating to the financial operation of a business. Environmental: relating to changes in the political, economic, social and financial environment. Reputation risk: caused by failing to address some other risk. International risk: resulting from exposure to different currencies or political systems.

Technical content: ●

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Risk management policy: this defines the organisation’s approach to risk management and its attitude to, and appetite for risk. Resourcing risk management: the resources required to implement, monitor and co-ordinate the risk management process including risk reporting.

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Implementation of risk management: formalizes the processes involved in identifying and defining risk, the assessment of risk in terms of likelihood and impact, and the key aspects of the business processes that are used to respond to risk. This includes internal controls such as planning, internal audit and the impacts of corporate governance on the top board. Risk management review and reporting: includes the form and regularity of reporting and the risk reporting structure.

Application to passing TOPCIMA You should be prepared to: ● ● ●

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assess the risks presently run by the organisation in the pre-seen material; consider the adequacy of the firm’s current risk management and reporting procedures; forecast how those risks will change in the light of strategies it proposes or environmental factors in the pre-seen or which you subsequently research; identify the risks implicit in any strategies you propose; recommend techniques and procedures to manage risk in future.

5

Using ratios to conduct a financial analysis of a company’s position

(1) As a management accountant it’s your job to advise management on the financial position of the business. Other functional experts will advise them on the detail of the firm’s marketing, human resource or operational position. You must therefore base your analysis of the pre-seen material in the firm’s financial position. (2) Financial analysis seeks to assess two factors: – the quality of earnings management are returning in relation to the shareholders funds they control; – the risks investors, and other stakeholders, are exposed to as a consequence of management’s decisions. Note that although we are analysing a company’s figures, we are really seeking to draw conclusions on the quality of its management, the strategy they have followed to date and the control they exercise over the firm’s operations. When you qualify as a CIMA accountant you will use financial ratios to assess performance within your company or division or to review companies operating in your industry for benchmarking purposes or for possible acquisition. It is very important that you know how to calculate these key business statistics accurately. In your TOPCIMA exam, the correct calculation and interpretation of these financial ratios demonstrates to the examiner that you are competent in calculating and understanding these key business indicators. It is surprising that in this last CIMA exam, there are still students who appear to be unable to correctly calculate even basic financial ratios such as earnings per share (EPS). I have seen EPS calculated on pre-tax profits and even on retained profits after dividends. EPS should, of course, be calculated on profit for the period, that is, post-tax and post-finance charges, but before dividends, divided by the number of ordinary shares in issue.

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STUDY MATERIAL T4

5.1

A tree of ratios

Poor management performance means that they have failed to increase the value of the business. Good business management means the opposite. Increasing the value of the business depends on being able to increase the returns to ordinary shareholders, measured as the earnings per share. The diagram in Figure A.2 shows the ratios driving EPS and therefore shareholder value. Change in share price or value of company

Change in earnings per share

N.B. In practice it is common for EPS and the share price to vary due to factors other than changes in ROCE

Change in return on capital employed

Operating margin (Net trading profit to sales ratio)

Assets/Turnover ratio

Fixed assets to turnover Gross margin (Gross profit to sales ratio)

Expenses to sales ratios

Current assets to turnover ratios

Figure A.2 The tree of ratios driving earnings per share

To analyse the causes of the financial performance of the business, adopt the following approach to work down the two branches that determine ROCE. Calculate changes in the EPS and/or the ROCE. If they are falling through time management is failing. If they are rising management is working and the strategy is successful. Check the margins and costs ●

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Calculate operating margin for each year to look for trends. If it is constant it is not the cause of the changes in ROCE and EPS. Alternatively, if it is changing through time then look for causes by inspecting the gross margin. Changes in gross margin are due to changes in prices or changes in the costs of sales. If the gross margin is falling it suggests competitive pressure on prices, rising costs of sales or that the volume of the firm’s business is not expanding as fast as its capacity. If gross margin is not obviously the cause of changing profitability then check some expenses to sales ratios. Things like administration costs or marketing costs may be changing.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

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Check fixed assets to turnover first. If this ratio is high (or increasing) it suggests that the growth of the business needs to be supported by high fixed investments. In other words, there will be negative free cash flows. This means that management will need to gain further external finance (e.g. debt or additional equity) to help the firm grow. It also means that management will not be able to finance strong dividends from current cash flows. Check the ratios of the various current assets to turnover. For example, you could use this ratio for inventory and debtors. These are uses of working capital and if the ratio is high or increasing it suggests that the strategy being adopted is tying up excess amounts of cash.

5.2

Preparation and revision of ratio analysis

As a revision exercise, it is advised that you should have a sound understanding of ratio analysis and are able to: ● ● ●

Accurately prepare relevant ratios Interpret the ratios correctly (not just comment that the figure is higher or worse!) Understand their relevance to the industry setting

For example a high level of inventory in a retail company may indicate poor inventory control, or seasonality issues. However, this ratio would not be as relevant in a service industry. Table A.1 is a comprehensive list of ratios.

6

Assessing the business portfolio

Portfolio means ‘collection’. A portfolio analysis can be useful in the following situations: ●

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Where the TOPCIMA pre-seen involves a firm with several business divisions. These could be different industries or perhaps in different parts of the world. This was the situation confronting candidates in both the Kadgee clothing case (September and November 2006) and the Merbatty boat case (September and November 2007) TOPCIMA exams. Where the management of the firm are contemplating adding a new, and different, line of business to their current business. This was important in the November 2006 exam on Kadgee clothing and also in the November 2007 exam on Merbatty boats. Where the firm has a number of different products that it relies on for its earnings or is considering adding a product to this mix.

6.1

The key issues in portfolio analysis

Business portfolio analysis was originally developed in the 1970s to mirror the portfolio analysis developed for financial strategy and investment analysis. According to the latter, financial markets invest in shares as a bundle of investments with different returns, prospects

TECHNICAL KNOWLEDGE

Check asset/turnover ratios These ratios check that whether management are utilising the firm’s assets properly or not. If the TOPCIMA pre-seen material contains similar details for previous years or for similar companies then you should conduct a comparative analysis.

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A revision of relevant ratios

Aspect

Indicator

Calculation

Interpretation

Profitability

Net profit of division or firm

Available from profit and loss

If profits are negative or falling through time the firm has difficulties: ●

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Contribution

Sales revenue – variable costs

Used to check: ●

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Contribution margin or Contribution to sales ratio Contribution per unit of limiting factor

Commonly used by multi-product firms to rank alternative products and identify poorly performing ones

Annual contribution/units of limiting factor

Used where firm has a scare resource to maximise total profits by focusing on providing products with high contributions per limiting factor, for example, ●

(Sales – cost of sales)/sales revenue ⫻ 100%

Net profit/sales revenue ⫻ 100%

retail stores consider product contribution per square metre of store space factory considers contribution per hour of machine time

Falling gross margin can indicate: ●

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Net margin or profit to turnover ratio

whether having particular product lines (or customers) is beneficial to the firm assess scope for further price falls

Contribution/sales turnover ⫻ 100%

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Gross margin or gross profit percentage

will be disappointing investors leading to problem with share price or loan renewal will not be able to invest in new or replacement assets may be target of takeover if a listed company

industry or market is maturing and competitive pressure increasing (compare with gross margin of rivals) firm is not controlling its cost of sales (e.g. supplier power high or bad internal control)

Summary of the overall profits made from activities of division or firm. Falling or low net margin can indicate: ● ●

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highly competitive market (if gross margin also low) poor control of costs and expenses by management (check ratio of particular expenses to sales to discover which costs are out of control) need for firm to consider entering new business areas to sustain profits and perhaps ultimately dispose of under-performing business

STUDY MATERIAL T4

Table A.1

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TECHNICAL KNOWLEDGE

Return on capital employed or No single accepted way of calculation Return on net assets or Return on investment ● Profit before interest and tax/year end capital employed

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Residual income

Profit before interest and tax – (net assets ⫻ required rate of return)

Alternative divisional performance measure that calculates the actual amount the division has contributed to shareholder value in a year

Operating leverage or operational gearing

Calculation depends on data given:

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fixed costs/total costs ⫻ 100% Annual change in pre-tax profit/ annual change in sales ⫻ revenue

Ratio denotes how volatile profits will be in relation to changes in activity or turnover. Consequences of a high operational gearing ratio are: ● sharp profit volatility in response to changes in the level of sales turnover ● high financial risk, particularly if combined with high capital gearing, because a fall in activity may endanger ability to pay interest liabilities ● high profit growth if firm increases sales ● need for sales to reach forecast if firm is to ensure it breaks even

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Cash balance

High short-term borrowings and current liabilities are a danger signal:

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Overdraft and borrowings

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Current liabilities

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Balance sheet figures

the lenders can call in the loans or force the firm into liquidation if it does not pay up lenders may refuse to extend credit further which will bring growth of business to an end (Continued)

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Liquidity and cash

Justify disposing of lines of business with relatively low ROCE to invest liquidation proceeds in divisions with higher ROCE to increase overall ROCE of group Trend of falling ROCE may indicate increasing competition or history of poor investment decisions by management

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Profit before interest and tax/ average capital employed during year Profit before interest and tax/net assets

Summary measure that indicates the rate of return the business or division is making on the capital it has Used to: ● consider whether the firm is maximising shareholder wealth. If ROCE of firm is less than a rival then it isn’t because investors would be better-off if they had put their capital in the rival. This tends to lead to share price falls ● Assess whether investing extra capital is worthwhile. If firm’s cost of capital is higher than its ROCE then borrowing further capital will destroy shareholder ● Compare divisions (and quality of divisional management) within the firm or with rivals to assess where improvements could be made wealth

Aspect

(Continued)

Indicator

Calculation

Interpretation ●

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Free cash flow

The profit figure is adjusted using some adjustments familiar to you from constructing cash flow statements:

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A strategic financial consideration is whether the growth of the business yields cash or whether it will demand cash to support it

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To assess this the profit figure is adjusted to take it back to a cash profit basis If the firm has a negative free cash flow then it will have liquidity problems if it cannot raise additional finance A negative flow may reflect poor working capital management or spendthrift investment decisions

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add back depreciation

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add back amortisation

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deduct any increase in inventories during the year deduct any increase in debtors during the year add any increase in creditors during the year deduct any increase in fixed assets during the year

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the firm’s profits may be depressed due to paying large amounts of interest If these borrowings are increasing disproportionately to the growth in the firm’s sales turnover it indicates overtrading firm may have budgeted for too little permanent capital to support its growth plans. This suggests bad financial management the firm has problems in debtor control and working capital management the firm does not have a coherent financial strategy and is borrowing ad hoc. At some point it will run out of lenders high ‘burn rate’. The business overall, or the work of a division, is cash using. This means that despite being profitable the firm will not be able to reward lenders and shareholders in the short-run and will need continual cash injections (a Problem Child according to BCG matrix)

STUDY MATERIAL T4

Table A.1

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TECHNICAL KNOWLEDGE

Quick assets ratio or quick ratio or acid test ratio

Current assets – inventory at end of period/current liabilities at end of period

Normally ratio should be at least 1 if firm is to be able to pay creditors in the short run even if they cannot sell inventory ●

Current ratio

Current assets and end of period/ current liabilities at end of period

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Ratio below 1 means that firm cannot pay creditors without selling fixed assets. This will be hard to do within the time available (danger of creditors applying to have firm wound-up) and would mean that firm is contracting Ratio less than 1 in a growing firm suggests that trade credit is financing fixed assets. Some growing retailers buy on 90 days credit and sell for cash within 3 days, using the 87 days of credit to build new stores and expand sales. They rely on continually expanding revenue to repay suppliers. The capital is free but strategy will cause cash flow crisis if sales growth rate falters

Creditor days

Calculation depends on information Indicates the number of calendar days taken to pay creditors. A long given in case: (e.g. ⬎30 days) or increasing number of days could suggest: ● average trade creditors/average daily ● good working capital management because trade credit is finance for free purchases on credit terms ● using supplier credit as a sales aid in a competitive market (e.g. firm sells ● trade creditors/purchases ⫻ 365 product on to customer with similar generous credit terms) ● cash flow problem. Management are deliberately delaying payments to ● trade creditors/cost of sales ⫻ 365 suppliers because they are not receiving sufficient sales revenue ● vulnerability of firm’s finances to withdrawal of supplier goodwill ● exploitation of suppliers and potential harm to their long-term survival

Debtor days

Calculation depends on information given in case:

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average trade debtors/average daily turnover on credit terms trade debtors/credit sales ⫻ 365

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poor working capital management. The firm may be extending its overdraft to support debtors and so eliminating its profits by higher interest charges (Continued)

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Indicates the average time taken for credit customers to pay. Generally the firm should aim to have debtor days below or equal to creditor days to avoid working capital problems A long (e.g. ⬎30 days) or increasing number of days could indicate:

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

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Retail stores often have quick ratios less than 1. This reflects their confidence that inventory will sell in a shorter time period than their creditor days (check relative inventory turn and creditor days to verify) Overall measure of firm’s liquidity and should always be in excess of 1

Aspect

(Continued)

Indicator

Calculation ●

trade debtors/sales revenue ⫻ 365

Interpretation ●

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Inventory turnover

Inventory value/average daily cost of sales

Can be used to indicate several things: ●

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Profit before interest and tax/gross interest payable

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Efficiency and Fixed asset turnover ratio asset utilisation

Sales per employee/profit per employee/Customers served per employee

poor credit control. The firm is not controlling customer debts or has a lot of bad debts it has not written off. This may also mean its balance sheet is misleading credit is being used as a sales aid in a competitive market

how long the firm can continue business without further deliveries of inventory (e.g. in the case of a disruption in the supply chain) how well it manages its working capital (i.e. low inventory turn suggests too much money tied up in inventory) its vulnerability to obsolescence of inventory due to changes in technology or fashion Assesses how many times over the firm’s profits could pay its interest liabilities A low number (say 3) indicates that a fall in business activity would promote a high risk of default and subsequent liquidation by creditors Measure suffers from being based on profit and not cash. A profitable firm may still not have the cash it needs to pay its interest obligations

Annual turnover/average net book value of fixed assets

Measures how well the firm is using its assets. Used to compare branches or similar companies ● A higher number indicates the machines and premises and generating a lot of saleable output ● Apply ratio of well-performing branch to the assets of a poor performing branch to assess potential for increased sales if managed properly ● Low ratios indicate opportunity to dispose of fixed assets and gain cash providing remaining assets can be worked harder (e.g. branch rationalisation or reduction in number of lorries)

Annual sales revenue/average number of employees

Measures how well the firm uses its human resources

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Usually a comparative measure between divisions/rivals or through time

STUDY MATERIAL T4

Table A.1

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TECHNICAL KNOWLEDGE

Annual gross profit/number of employees Number of customers served/number of employees Activity per limiting factor

Capacity fill

Asset cover

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Generally higher values are signs of efficient use of human resources and lower values indicate over-manning Where personal service is important then low customer/staff ratios are better

Examples Shows how intensively used the resource is. Low ratios indicate: 2 ● Sales per m of sales space ● lost profit opportunities ● Output per machine hour ● poor capacity utilisation planning ● Annual bookings per hotel room ● disappointed customers Actual utilisation/maximum available May be used to compare branches or to compare with competitors. Low capacity (e.g. for a hotel number of capacity fill suggests: room nights sold per year/number of rooms in hotel ⫻ 365) ● inefficient management of resource ● excess capacity with possibility of redeployment or liquidation of capacity ● unabsorbed overhead and consequent low profit ● potential for growth in sales volume without need for increased investment in capacity or operating costs Net tangible assets before deducting A high level of cover indicates low risk for investors and potential for further overdraft and other borrowings/ borrowing. Can be used in three ways: total borrowings including overdraft ● to indicate the security of lenders money by showing that there are enough assets to liquidate to pay it back ● to indicate the scope for further borrowing by the firm ● to show equity holders the value of un-pledged assets available for distribution in the event of company liquidation However interpretation needs care: ignores the value intangible assets which may also be valuable book value of assets is not the same as market value in liquidationl ignores other liabilities of the firm that may rank higher in liquidation such as deferred tax and wages Shows the proportion of finance that comes from debt (or the ratio of debt to equity). A high capital gearing ratio has the following implications:

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Several methods of calculation

(Continued)

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TECHNICAL KNOWLEDGE

Capital gearing or capital leverage

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Capital availability and risk

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(Continued)

Aspect

Indicator

Calculation ●

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Total long-term debt/shareholders funds ⫹ long-term debt Total debt financing/total shareholders funds Total debt ⫹ overdraft/total debt ⫹ overdraft ⫹ shareholders funds from data in case

Interpretation ●

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high financial risk to equity holders of dividend volatility and liquidation of firm if it cannot pay interest limited potential for future borrowing (but compare with asset cover) questions raised about why shareholders will not provide more finance to the business

High capital gearing is less of a risk if: ● ● ● ●

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Investor perspective

Share price

Rise in the share price through time has following implications: ●

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Earnings per share **THIS IS AN IMPORTANT RATIO

the firm works in a market where earnings are not volatile there are adequate tangible assets to give lenders security the debt is owed to a related company such as a holding company the debt is short term due to seasonal factors or investment in particular projects the debt holder is accustomed to high risk (e.g. venture capitalists)

Profit attributable to ordinary shareholders/number of shares issued

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Summary measure of how well the firm earns money for its equity holders

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Usually compared from year to year for the firm Meaningless to compare EPS of rival firms Growing EPS will generally cause share price to rise declining EPS suggests firm is in difficulties in its market and will pull down the share price or force firm to pay higher dividend to bolster share price

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The profit attributable to ordinary shareholders is usually the profit for the period (after tax and finance charges, but before dividends)

earnings of the investors are expected to rise. Usually this will be due to anticipated profit growth by the firm shareholders support management firm will find it relatively easy and cheap to raise extra capital sudden rises in share price without similar improvements in profit suggest market anticipates a takeover bid for firm or a needed change of strategic direction or management

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STUDY MATERIAL T4

Table A.1

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TECHNICAL KNOWLEDGE

Price earnings ratio

Market price per share/earnings per share

A measure of investor confidence in management’s strategy for the firm A high P/E ratio generally indicates: ● ● ● ● ●

Dividend per share/market price per share ⫻ 100%

Essentially the income yield on the share. High dividend yield suggests: ● ●

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Total dividend to ordinary share holders/market capitalisation ⫻ 100% Dividend cover (Dividend Earnings per share/dividend per share payout ratio is reciprocal of dividend cover)

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investors are income seeking and the firm is a cash inventory share price is held up by high dividend policy that will be difficult to reverse profit growth is not expected potentially low level of retained earnings (check dividend cover)

The ability of the firm to continue paying its present level of dividend. A low dividend cover (high payout) ratio indicates: ●

high financial risk for investors because a fall in profit will threaten dividend and potentially therefore share price

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TECHNICAL KNOWLEDGE

Dividend yield

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earnings are expected to grow in the future firm will be expensive to acquire in a takeover investors are happy, however a sudden rise in P/E could mean: rise in share price due to bid rumour improved dividend payout expected from nervous management a collapse in earnings that investors hope will be a one-off event. A P/E ratio is usually industry specific – you should research what the P/E ratios are for other real-life companies operating in the industry in which the case you are working on is set.

TECHNICAL KNOWLEDGE

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STUDY MATERIAL T4

and risks but seek to evaluate them in terms of their contribution to the returns, risks and prospects of the investment portfolio as a whole. Early proponents of business portfolio analysis saw a parallel between the situation of the Wall Street fund manager and the board of a large firms looking down at their businesses. The board seeks to manage shareholder wealth by managing business investments to improve the financial returns of the overall corporation. Therefore, they concluded, it’s important to look beyond the current performance of each business unit in isolation, as ratios do, and in addition consider how the business portfolio fits together and what its prospects are. Portfolio analysis has since been adopted by many business functions including marketing and information systems. Each will have its own special areas of interest. However, as a management accountant sitting a final Test of Professional Competence In Management Accounting you should focus yourself on the following issues: ●

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How well does the portfolio of businesses and products contribute to the current financial performance of the business? What is the rationale for management to have invested shareholders’ funds in these businesses and how do they support each other? What are the prospects for each business or product and its implications for future financing needs or financial returns? What are the risks attached to each business and to the portfolio as a whole? Is there a case for disposing of any of the businesses in the portfolio?

6.2 The Boston consulting group (BCG) growth share matrix The BCG model requires management to plot the position of their business units (or products) against two axis: (1) Relative market share: This is calculated as the firm’s market share against their largest rival, so a firm with a 20% share of the market which has a rival with a 60% share would have 0.3 (20/60 ⫽ 0.3x) whilst the rival would calculate their relative share as 60/20 ⫽ 3x. (2) Market growth rate: This is the annual percentage change in sales volume in the industry as a whole. This allows the business units to be plotted on a two-dimensional space as shown in Figure A.3. An additional factor is the inclusion of sales turnover in the model. The proportion of total group sales turnover accounted for each division is converted to the radius of a circle with its centre as the co-ordinates of the division. High relative share brings several benefits: ●

●

●

The enjoyment of lower unit costs and therefore higher current margins than competitors at the same price levels. The ability to be a price leader. If the firm decides to cut price other must follow to maintain their sales but in doing so may find themselves selling at below unit cost. The dominance of the market means the product will become the benchmark product, ‘the real thing’ against which others may be seen as pale imitations.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

High 10×

5×

1×

0.5×

Low 0.1×

20%

High Question marks (problem children)

Stars Hold

Market growth rate

Invest to build

Divest 10% Cash cows Hold

Dogs Optimum cash flow

Harvest

Divest 0%

Low

Figure A.3 The BCG matrix

Even if you do not have market shares and market growth rates, you can still compare or liken different divisions or different products in the case that you are answering to the BCG matrix categories of Question marks (problem children) or Cash cows, for example. These are commonly used and recognised business terminology and adds credibility and understanding to your answer if it is correctly applied to the case. 1. Question marks (problem children) These products are in a high growth market that means that it is early in the product life cycle and therefore has the potential to repay present investment over its life cycle. Indeed the high market growth rate means that the firm will already be investing considerable sums in it. The low relative market share however means that this business unit is unlikely to survive in the long run because it will have a lower cost competitor. Management must decide between investing considerably more in the product to build its market share or shutting it down now before it absorbs any further investment which it will never repay. Investing to build can include: ● ● ● ●

price reductions, additional promotion and securing of distribution channels, acquisition of rivals, product modification.

2. Stars Stars are very competitively strong due to high relative market share although its current results will be poor due to the need to invest considerable funds into keeping up with the market growth rate.

TECHNICAL KNOWLEDGE

Relative market share (log scale)

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The strategy here is to hold market share by investing sufficient to match the commitment of rivals and the requirements of the marketplace. 3. Cash cows This is a mature product (low growth rate) which retains a high relative market share. The mature stage means that its prospects are limited to falling prices and volumes. Therefore, investment will be kept under strict review and instead the priority is to maximise the value of free cash flows through a policy of harvesting the product. Harvest means to minimise additional investment in the product to maximise the cash the division is spinning off. This cash can be used to support the Question Mark products as well as satisfy demands for dividends and interest. Holding may also be used for early mature stage products where the market may repay the extra investment. 4. Dogs Dogs come from two directions: (1) former cash cows who have lost market share due to management’s refusal to invest in it; (2) former question marks which still had a low relative share when the market reached maturity. In either case the BCG recommend divestment of the product or division. This can mean selling it to a rival, or shutting it down to liquidate its assets for investment in more promising business units. In deciding whether or not to divest a dog the following considerations should be taken into account: (a) Whether the dog still provides a positive contribution or not? (b) What is the opportunity cost of the assets it uses? For example, the contribution from products that could be made using its factory or the interest on the net proceeds from liquidation of the SBU. (c) The impact on the rest of the portfolio that would result from divesting the SBU. Is it essential to attract customers, for example? In later versions, the BCG introduced the notion of a cash dog to accommodate another strategy of creating a niche position for a dog product based on its nostalgia value (e.g. Mini cars) or because a group of loyalist customers remain who will continue to pay high prices for the product (e.g. hand-made cigars).

6.3

Directional policy matrix

Portfolio analysis seeks to guide management in the deployment of shareholders investment. The likely NPV from any investment undertaken in an industry will be the product of the competitive strength of the firm in that industry and the long-term outlook for the industry. A limitation of the BCG matrix is its simple reliance on relative market share to denote competitive strength and on industry growth rate to imply future potential. Critics argue there is likely to be a lot more than these two involved in determining the value of an investment.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Industry attractiveness

High

Medium

Low

H i g h

Build

Build

Hold

M e d i u m

Build

Hold

Harvest

L o w

Hold

Harvest

Harvest

Business unit position Criteria • Size • Growth • Share • Position • Profitability • Margins • Technological position • Strengths/ weaknesses • Image • Pollution • People

Criteria • Size • Market growth, pricing • Market diversity • Competitive structure • Industry profitability • Technical role • Social • Environmental • Legal • Human

Figure A.4 Directional policy matrix

Management consider each of the criteria for business unit position and for industry attractiveness and assign each business unit a score against it. Having considered all criteria, they calculate a general score for business unit position and for industry attractiveness and locate the division in the portfolio.

6.4

Other considerations in portfolios

Business portfolio analysis gained popularity in the 1970s. This was an age when diversification of the business (i.e. deliberately investing in dissimilar businesses and industries with the intention of reducing overall corporate risk) was in vogue as a strategy. Since the 1990s there has been a ‘U-Turn’ in strategic thinking in favour of honing a firm down to focus on core business and core competences (sometimes termed ‘sticking to the knitting’). Diversified portfolios are frequently criticised for being: ●

●

●

●

Unnecessary because shareholders can diversify risk in how they construct their portfolio of shares. Unwise because it frequently involves management in taking on lines of business they cannot run. Value destroying because acquisitions rarely improve in value when purchased as part of a diversification strategy and shareholders mark down the prices of conglomerates due to not being able to evaluate the risks properly. Self-serving because diversification is frequently undertaken to boost managerial prestige or provide opportunities for personal development at the expense of shareholders.

TECHNICAL KNOWLEDGE

The directional policy matrix (or ‘McKinsey/Shell Matrix’ or the ‘GE Business Screen’ depending on which version you read) seeks to overcome this limitation by having the two broader axes as shown in Figure A.4.

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The scope of the techniques discussed above is also constrained by their origins as analogues to financial portfolio construction. In a share portfolio, there are no business relationships between the assets held. This leads business portfolio analysis to ignore the inter-relationships that might exist between business units or products. These could include: ●

●

●

●

better utilisation and retention of a common customer base through offering a wider product range (e.g. supermarkets having divisions offering clothes, utilities and petrol in addition to food); better harnessing of distinctive competences such as technology (e.g. a plastics manufacturer operating divisions making data media, food packaging, adhesive tapes for parcels and sutures for use in first aid and hospitals); spreading of fixed costs across a more diverse range, and therefore greater volume of, products (e.g. a turbine manufacturer using its research and development and production technologies to make aero engines, turbines for power stations, marine engines and guided weapons); a division or product may be a small strategic marker to reserve the firm a place in a market with much greater potential (e.g. a firm having a small sales office in a developing economy which can be used later as a bridgehead for more business if the economy develops).

You should be able to demonstrate in your TOPCIMA exam answer that there are always advantages and disadvantages to diversification and you should come to a reasoned conclusion as to why you consider that diversification in the case that you are answering is recommended or not, with well reasoned and justified recommendations.

6.5

Using portfolio analysis in TOPCIMA

When assessing the businesses or products in the TOPCIMA pre-seen you should consider the following issues: ● ●

●

●

How well are the businesses performing in their own right? Is the investment strategy being followed by management appropriate to the position of the division in the portfolio? Are there other strategic reasons for keeping any under-performing businesses in the portfolio? Is the firm excessively dependent on a particular product or business division and what risks is this division subject to?

In your final report you should be prepared to back up recommendations for disposal, acquisition or development of a business unit or product by reference to its position in the portfolio and the strategic logic of your recommendation. You should additionally consider whether the proposed strategies do fit with the company’s core competences or not and whether management has sufficient experience to manage the proposal.

Use the BCG in an appendix to identify the different products, divisions or businesses of the firm in the case.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Industry analysis

(1) Industry analysis seeks to understand the factors most likely to have an impact on the firm’s present and future success. This in turn will affect: ● the present financial results of the firm; ● the likely success of its current or proposed strategies; ● its future financial returns and therefore ability to keep shareholders and other providers of finance satisfied; ● the decisions it must take to avoid threats or to capitalise on opportunities. (2) In the TOPCIMA exam, you are required to apply the following models specifically to the industry of the firm(s) in the pre-seen. Some of the data you need may be in the preseen material, and the rest you should research for yourself. You should also familiarise yourself with events in the industry by reading the business pages of the quality press.

7.1

Industry life cycle stage

A generalised account of the stages through which an industry passes from birth to death (Figure A.5). Maturity

Decline

Sales volume

Intro. Growth Shake-out

Cash flow Profit

Figure A.5 The product life cycle

The factors that drive industries through the life cycle are: ●

●

●

●

Technical innovation: This creates new industries but at the same time can render old industries obsolete (e.g. as DVD grew so VHS declined). Adoption of the product: For example, in 1995 mobile phones were a growth product with about 15% of persons in developed economies owing a handset. By 2005, it will be a mature industry with about 85% penetration. Fashion and taste for the products of the industry (e.g. off-road MPVs were a growth product during the mid-1990s but by the end of the decade they had given way to small cars and pickups as the fashionable vehicle to own). Legislation and government policy: For example, the liberalisation of financial markets in the UK created a boom in personal financial services from the mid-1980s. The market declined following a series of miss-selling scandals and the introduction of a tighter regulatory regime in the late 1990s.

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To analyse the industry(s) covered by your TOPCIMA pre-seen material you should identify: ● ●

●

which stage the industry is at; how durable the industry is and whether the forces that developed it are likely to decline or supersede it soon; the financial and strategic implications to management of the current and future stages of the industry.

The Kadgee clothing case (September and November 2006) was a good example of an industry in decline in Europe at the end of its life cycle unless the company could be innovative and change the way it operated. The main characteristics of each stage are explained in the following sections. 1. Introduction stage A new product and hence will be unfamiliar to the market. Firms in this stage of an industry will need to invest considerable resources in developing and launching the product (including promotion, inventory-building, staff training and so on) without any guarantees that the product will succeed. Therefore, ● ● ● ● ● ●

strongly negative cash flows, high risk due to product novelty, single or limited product range to avoid confusing the customer, few if any competitors willing to take similar risks, high need to induce recognition and trial of the product, very high costs per customer.

2. Growth stage Rapidly increasing sales due to acceptance of the product and a ‘bandwagon effect’ developing as buyers copy each other. The substantial investment needed to keep up with demand depresses cash flows. The most significant feature of this stage is increasing complexity as rivals enter the market and the range of products widens as producers seek to attract customers from each other with novel features. ● ● ● ●

●

negative cash flows, reducing risk due to product having achieved acceptance, market entry by ‘copycat’ or ‘me-too’ producers, growth sustained by attracting additional types of customers, sometimes through reductions in price or new product features, marketing focus switches to seeking to differentiate the firm’s product and brand in the minds of customers.

3. Shakeout stage The sales growth rate turns down (i.e. becomes ex-growth) due to the market having become saturated. Initially, there will be an imbalance between supply and demand

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

● ● ●

overcapacity creates stimulus for price-cutting; number of producers reduce due to failures or industry concentration; peak levels of profitability.

This is usually resolved by a wave of product or business failures or amalgamation of businesses through takeover or merger. 4. Maturity stage Purchases settle down into a pattern of repeat or replacement purchasing. For fast-moving consumer goods (FMCGs) like canned foods, soft drinks and confectionery these may be habitual purchases. For durables such as televisions, computers, cars and furniture the frequency of re-purchase will be influenced by changing technical features, fashions and wearing-out of old product. The main features will be: ● ●

●

●

●

reduction in investment in additional capacity leads to improved current cash flows; gradual price decline as firms compete against each other for a larger share of a fixedsize market. During this stage, buyer and supplier power (Porter) increase because of the large number of industry members to choose between; firms seek to capitalise on product loyalty by launching spin-off products under the same brand name; gradual fragmentation of the market as firms seek out buyer groups to monopolise with special value-added features on products (e.g. premium quality foods in addition to regular and budget lines); peak profitability and least risk.

The later phases of the mature stage are often characterised by a second wave of consolidations, as some firms pursue industry rationalisation to restore profitability. This has been noticeable in recent years in industries such as oil and banking. 5. Decline stage The industry declines into obsolescence as technically better substitutes replace it. The existence of such substitutes will cause sharp profit reductions amongst producers of the product. Many firms will have already found alternative industries whilst those remaining will be looking for an orderly way to exit the industry: ● ●

falling profitability and marginal cash flows; firms seek to leave industry.

There may be a last-ditch wave of consolidations amongst the few remaining firms in the dwindling industry. When you are researching the pre-seen material for the case that you will be sitting, you should understand the industry life cycle for that industry. For example, the May 2005 TOPCIMA exam on the recycling industry, it would be relevant to comment that this industry is relatively new and is still in its growth stage.

TECHNICAL KNOWLEDGE

because participants will not have forecast the downturn:

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7.2

Five forces analysis

This analysis was developed by Professor Michael Porter (Figure A.6). This analysis argues that competition in an industry is determined by its basic underlying economic structure, the five competitive forces.

Threat of market entry

Bargaining power of suppliers

Rivalry among existing firms

Bargaining power of buyers

Substitute products or services

Figure A.6

Porter’s five forces model (adapted from Porter 1980)

The collective strength of these forces determines the profit potential, defined as longrun return on invested capital, of the industry. Porter identifies three successful types of strategy (or generic strategies) to deal with these forces: (1) Cost leadership: Management aim to cut the costs of providing services and products to below that of rivals. (2) Differentiation: Management aims to escape the pressure of price competition by developing product features or reputation of premium perceived value. (3) Focus: Improve long-run ROI by avoiding the margin pressure and high investment needed to serve a mass market. Instead seek to dominate a niche market. To analyse the industry(s) covered by your TOPCIMA pre-seen material you should identify: ● ● ●

●

whether the industry is presently subject to forces of significant strength; whether any of the forces are likely to grow or decline in strength in the coming years; the consequences of the above for long-run profitability and therefore the value of the firms in the industry; whether management is or can adopt competitive strategies to avoid the power of these forces and so restore its profitability.

You should be prepared to use Porter’s terminology in your final report on exam day. A clear understanding of Porter’s five forces and its application to the material will be rewarded providing its relevant.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) Economies of scale available to incumbent firms giving them the ability to charge prices below the unit costs of new entrants and hence render them unprofitable. (2) Product differentiation: Strong brands, unique product features or established good relations with customers that it will be hard for an entrant to overcome. (3) Initial capital requirements that exclude poorer entrants or ones not prepared to take the risk. (4) Switching costs: One-off costs for a customer that deter them from switching to the new rival. (5) Access to distribution channels where established firms have locked in distributors and retailers by deals or vertical integration. (6) Government policy forbidding imports or preventing rival firms from setting up in competition. Rivalry amongst existing competitors Cut-throat competition reduces profits for all in the industry. Porter suggests that the factors determining competition are: (1) Numerous rivals of various sizes encourage individual firms to reduce price to grab share. (2) Low industry growth rate, where growth is slow the participants will be forced to compete against each other to increase their sales volumes. (3) High fixed or storage costs sometimes called operating gearing it puts pressure on firms to increase volumes to take up capacity. (4) Low differentiation or switching costs mean that price competition will gain customers and so be commonplace. (5) High strategic stakes where a lot depends on being successful in the market so firms fight for a share and to survive. (6) High exit barriers: Economic or strategic factors making exit from unprofitable industries expensive such as costs of redundancies or scrapping of dedicated assets. Pressure from substitute products Products from a different industry that satisfy the same need. The power of substitutes depends on: (1) Relative price/performance: If performance is similar but price is lower it is more of a threat. (2) The extent of switching costs (see above). Bargaining power of buyers Buyers use their power to trade around the industry participants to gain lower prices and/ or improvements to product or service quality. Their power will be greater if: (1) Buyer power is concentrated in a few hands: This denies the industry any alternative markets to sell to if the prices offered by buyers are low. (2) Products are undifferentiated: This enables the buyer to focus on price as the important buying criterion. (3) The buyer earns low profits: In this situation, they will try to extract low prices for their inputs. This effect is enhanced if the industry’s supplies constitute a large proportion of the buyer’s costs.

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Threat of entry Influenced by

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(4) Buyers are aware of alternative producer prices: This enables them to trade round the market. Improvements in information technology have significantly increased this by enabling a reduction in ‘search costs’. (5) Low switching costs: In this case, the switching costs might include the need to change the final product specification to accept a different input, or the adoption of a new ordering and payments system. Bargaining power of suppliers The main power of suppliers is to raise their prices to the industry and hence take over some of its profits for themselves. Power will be increased by: (1) supply industry dominated by a few firms; (2) the suppliers have proprietary product differences: unique features making it impossible for the industry to buy elsewhere.

7.3 Competitive position of the firm: three generic strategies For a private sector organisation the object of competitive strategy is to maximise shareholder wealth. This requires that the firm makes a better long-term return on shareholders invested capital than the return achieved by rivals in the industry. Porter’s three generic strategy model is a useful starting point for understanding a firm’s competitive strategy (Figure A.7). Competitive advantage Lower cost

Broad target (e.g. industry-wide)

Overall cost leadership

Competitive scope Narrow

Figure A.7

Differentiation (e.g. uniqueness perceived by the customer)

Differentiation

Focus Cost focus

Differentiation

Porter’s three generic strategies model (adapted from Porter 1980 and 1985)

Porter’s strategic prescriptions are rooted in his analysis of the impact of five competitive forces on a firm’s profits. He argues that a firm must adopt a strategy that combats these forces better than the strategy developed by its rival if it is to deliver superior shareholder value. According to Porter (1980) ‘there are three potentially successful generic strategic approaches to outperforming other firms in an industry’. He terms these: (1) Overall cost leadership: Low cost relative to competitors. (2) Differentiation: Creating something that is perceived industry-wide as unique. (3) Focus: Serving a narrow strategic target more effectively than rivals who are competing more broadly.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) Lower cost: Achieve the industry’s ‘lowest delivered cost to customer’ by analysis of the entire value chain to achieve substantial cost savings. (2) Differentiation: Premium perceived value in the eyes of the buyer. (3) Focus: Sometimes called a niche strategy this relies on the firm being able to address itself better to a segment of an industry than its broader scope rivals can. This enables smaller firms to survive by exploiting one of two failings by rivals: (a) Underperformance: They do not understand or make a product that fully meets the needs of the buyer in a segment. (b) Overperformance: The broad scope competitor is giving the segment more than it really requires and in the process is incurring extra costs. Stuck in the middle: This competitive position is not recommended by Porter. Management’s failure to make the firm either a differentiator or a cost leader leaves the firm ‘stuck in the middle’ both unable to access the high-volume customers who demand low costs and also the high margin customers who may be put of by its mass market offerings. In TOPCIMA you can use Porter’s model in several ways: (1) (2) (3) (4)

to help analyse the competitive position of rivals; to analyse the current competitive position and strategy of the firm; to decide on a competitive strategy for the firm; to analyse the risks of the present strategy.

Porter suggest that each generic strategy carries intrinsic risks. (a) Differentiation: ● brand loyalty may fail if the cost differential between it and the cost leader becomes too great; ● buyer becomes more sophisticated and needs the differentiating factor less (such as ease of use or technical expertise); ● imitation reduces the differentiation of the brand. (b) Cost leadership: ● technological change could eliminate low cost base or past learning effects; ● imitation of low cost techniques by industry entrants; ● product becomes out-of-date because firm won’t invest in it; ● domestic inflation or exchange rate changes destroy cost advantage at home and abroad. (c) Focus ● broad target firm develops economies of scale which overtake the cost focus player; ● differences between needs or tastes in the market narrow, for example, the invention of the word-processor destroyed the niche strategies of typewriter manufacturers; ● competitors find sub-segments within the focus segment and out-compete the firm; ● segment collapses and leaves the firm with no other source of earnings.

In the November 2007 Merbatty boat case, discussion on Porter’s model and differentiation would have earned good marks for understanding this theory and applying it to the case.

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Management must dedicate themselves to just one of the three types of strategy to risk dilution of their competitive advantages. This is the only way that firms can out perform rivals and deliver high or satisfactory returns to shareholders.

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7.4

PEST analysis

This model segments the environment of the industry into: Political/Legal Economic Social Technological

Laws affecting the industry and political support for it Economic outlook, costs of borrowing, exchange rates Social norms, fashions and make-up of the population Impact of technology on costs and demand patterns

An alternative categorisation is DEEPLIST standing for: Demographic Ecological Economic Political Legal Informational Social Technological

Composition, location and size of population Concern over preservation of natural environment As above As above As above Impact of networks on work, leisure and trade As above As above

This latter typology has the advantage of drawing particular attention to some significant sources of turbulence in the modern business environment such as aging population and that coming from concern over the natural environment plus the impact of the third industrial revolution: that is based on information technology. It is not possible to cover all possible applications of PEST (or DEEPLIST) to industry in a Toolkit like this. You will need to look at the pre-seen and research these factors for yourself.

7.5

Globalisation

Globalisation Refers to the ability of firms from any country to exploit markets or productive resources in other countries. In the TOPCIMA exam this means that the industry you are faced with may be an industry in which there are increasing competitive challenges coming from abroad. Or perhaps major opportunities available to the firm in foreign markets, or the ability to transfer aspects of production abroad to gain skills or save costs. The main drivers for globalisation are: (1) economic and political realignments (e.g. EU, NAFTA, MERCOSUR, ASEAN, APEC and so on) creating zones of free trade between their memberships; (2) the impact of the World Trade Organisation in its policing and development of the General Agreement of Tariffs and Trade to reduce trade barriers through stamping out protectionism; (3) improved communications (telecommunications, travel and common languages) enabling easier co-ordination of offshore operations; (4) increased mobility of staff across national boundaries, often as employees of global firms. This transfers tastes globally; (5) convergence of tastes and lifestyles, such as due to the influence of common cultural drivers (such as technologies, media, music and sports).

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) (2) (3) (4)

the power of the drivers making the industry in the pre-seen into a global one; the potential for firms from abroad to invade the market in the pre-seen; the potential for the firm(s) in the pre-seen to penetrate foreign markets; the potential for the firm(s) to move parts of its operation offshore to save costs and boost margins; (5) the danger that the firm(s) in the pre-seen may find themselves having to cope with competition from new rivals with very different technologies, working methods or levels of costs.

8

Conducting a position audit CIMA defines a position audit as Part of the planning process which examines the current state of the entity in respect of: ● ● ● ● ● ●

resources of tangible and intangible assets and finance, products brands and markets, operating systems such as production and distribution, internal organisation, current results, returns to stockholders.

CIMA: Management Accounting Official Terminology The position audit will be the basis of the marks allocated under the prioritisation criteria and will be worth around 10 marks. Your report should commence with a corporate appraisal of the company that includes the main points from the position audit. It is very important that you prepare a position audit that includes the unseen material given on the exam day.

8.1

The Ms model

A simple model that divides the items in a position audit into factors beginning with ‘M’ Manpower Management

Money

The human assets of the firm such as their availability, skills, morale, relative costs and flexibility (e.g. ratio of full-time to flexible staff ). The quality, expertise and experience of the top team. Is the firm well managed and does it have the skills and vision it will need to progress? (Section 4.9 explains how to conduct a management audit for TOPCIMA.) The financial health of the business and the support management receive from its shareholders and bank. Key factors here are likely to be current results and the availability of capital to finance investment (Section 4.5 described how to conduct a financial appraisal for TOPCIMA.) (Continued)

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You should be prepared to assess the following factors:

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Make-up

The organisational structure and culture of the firm. For example, is the firm centralised or not and how willing are business, unit managers and other staff to take responsibility? (Section 9 explains how to conduct an organisational audit for TOPCIMA.)

Machinery

This covers the physical assets of the business. For example, their flexibility and the relative costs and quality of what they produce. In the case of property assets it would include location, appearance and functionality.

Methods

The processes adopted by the business. Issues here could include the extent to which activities are outsourced and whether the firm uses capital or labour intensive production processes. Just-in-time systems are an important business method in many markets.

Markets

The firm’s products and the markets it currently serves. The position audit should examine the relative quality and position of the firm’s outputs and the extent to which it is exposed to threats from buyer power.

Materials

This covers the relationship the firm has with its suppliers. In modern manufacturing there has been a trend towards ‘partnering relationships’ with suppliers where the firm agrees not to shop-around for lower prices providing its suppliers work with it to improve quality and to reduce inventory costs. Some managers would regard reliance on a single supplier as a weakness and instead hope to see that the firm sources from a wide number of suppliers in order to enjoy better prices.

Management information

This evaluates the quality and timeliness of the information available to managers (and others) and its suitability for basing their business decisions on. Factors to consider here would be whether it is suitably structured to allow managers to see the effects of their actions, its intelligibility to the user and whether it contains any environmental and competitor information. As a CIMA candidate you should expect to be asked to pass judgement on the quality of the management accounting information available (e.g. cost and profit analysis). This is covered in more detail in Section 4.11.2.

9

Critical success factors

These are the things that must go right in order for the firm to be a success in its industry. (1) The Critical Success Factors (CSFs) will vary from industry to industry. In the TOPCIMA exam you will be given the industry context in the pre-seen material and will have time to research the real industry. Things to look out for are: ● Articles on struggling firms in the industry: what went wrong? ● Articles on successful firms in the industry: what went right? ● General industry articles with a competitive analysis of the firms and their prospects. (2) CSFs drive the long-term shareholder value created by the firm. This is its return on employed capital. They can be identified by answering four questions: (a) What factors drive costs in the industry? (b) What factors influence the revenues the firm can generate? (c) What drives asset investment? (d) What poses risks for the firm (and hence will affect its cost of capital)?

9.1

Some suggestions on what to look out for

The following table expands on these by indicating what to look for in the industry and in the TOPCIMA pre-seen material.

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Critical success factor

Considerations

What factors drive costs in the industry?

●

if fixed costs are high this means that gaining sales volume is critical

●

if complexity (e.g. special customisation of products or width of product range) is being used to gain orders it will drive overheads up. Firms must understand and allow for this (e.g. by using ABC/ABM) if economies of scale (volume) or economies of scope (breadth of product range) are available this makes relative size a critical success factor if market necessitates high spending on advertising, research and development or asset refurbishment in order to compete firm must be able to afford it where costs can be reduced by merger/acquisition the firm needs to gain size and be proactive in its own merger activity if costs are affected by exchange rates or availability of cheaper supplies or service provision abroad the firm needs to have foreign exchange hedging and cross-border supply chains.

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●

●

●

●

What factors influence the revenues the firm can generate?

●

●

●

●

●

if the firm’s product commands a premium price this means that promotion, consistent delivery of the promise of the brand image and technical quality are critical if the product competes by low prices it is critical that is market segment continues to feature high price elasticity of demand, that is has a substantial number of buyers willing to buy on price if revenue growth has been gained by accessing new customers and wider locations the marketing and logistic skills of the firm are critical if revenue growth has been accomplished by new products and exploiting the early product life cycle it means that innovation and launch marketing are critical competitors and new entrants will put pressure on revenues and so it is critical that they be kept out.

What drives asset investment?

The critical success factors in industries subject to high ongoing asset investment are: ● ability to afford the costs of investment ● ability to project manage and implement investment swiftly and successfully ensure that the firm’s management (and you) appreciate that ● asset investment includes intangibles such as human resources and brands. Modern shareholder value techniques rework balance sheets to include these ● in consumer industries their rising expectations will necessitate continuous improvement and updating of premises, customer service and facilities ● in technological industries there will be need for continuous investment in R&D and production technology ● sales growth drives asset investment if it needs extra production or distribution capacity ● industries utilising IT strategically will need to ensure systems are kept up to date. The progress of IT applications is swift and continuous.

What poses risks for the firm?

Risk is discussed in more detail in Paragraph 12. Here we are narrowing it down to the risk to business operations from the firm’s competitive strategy. These are events that could close the business down or severely restrict its space to operate and its earnings. ●

Asset risk: Factors that could result in loss of productive assets or their earning power (e.g. theft, destruction, legal challenges to their use)

●

Commercial risk: Reduction of earnings below forecast due to loss of customer, failure of new products, out-competition by rivals (Continued)

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Critical success factor

10

Considerations ●

Operational risk: Breakdown of ability to provide product/service leading to loss of earnings and potential costs of legal claims by customer, suppliers and staff

●

Financial risk: Loss of value of investments due to volatility of markets, adverse foreign exchange movements or adverse interest rate movements.

Assessing information systems strategy

The learning outcomes of TOPCIMA are primarily concerned with strategic and business management decisions. Therefore, you should be prepared to make comments and recommendations on the following issues: ●

●

●

●

the quality of the operational systems to support the transactions underlying the business strategy and to provide the information needed by management; the quality of information being provided to management and its suitability as the basis for decision-making; the quality of the alignment between the firm’s information systems and its business strategy including whether management are making the best use of the potential of modern information systems; the risks attached to the firm’s reliance on IT/IS.

It is crucial to the success of all businesses today and it can create or lose the company’s competitive advantage. It is also a significant source of risk for the firm. Your report should include some relevant comments on the firm’s IT systems and IT/IS management and, where necessary, make recommendations for improvement.

10.1

Four levels of information system

Information systems operate at four levels in an organisation: (1) Operational systems: Support the day-to-day activities of the business. Examples include inventory control, electronic point of sale, sales ledger, automated call routing and performance measurement systems. (2) Knowledge work systems: Decision support systems and workflow systems to provide information to and help knowledge workers to do their jobs. Examples include customer call records, inventory availability, external databases, CAD, financial models and spreadsheets, Intranet, knowledge management systems. (3) Management information systems: Summaries drawn from the operational and knowledge level systems that enable divisional managers to control their businesses. Examples include budget reports, sales data, competitor intelligence reports, performance measurement reports (e.g. balanced scorecards). (4) Executive information systems: High level, often graphical, summaries to enable senior management to assess the performance of the business and its competitive position. Distinctive features of information at this level are the much greater amount of external information, its use of soft and conjectural data (e.g. on competitors’ intentions or potential changes in laws affecting the business) and its highly aggregated nature that enables senior management to concentrate on the ‘big picture’.

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Types of information system Strategic Management

Knowledge

Operational

Sales and marketing

Finance

Human Accounting resources

Manufacturing

Figure A.8 Four levels of information system

10.2

Management accounting information

A key aspect of demonstrating competence as a management accountant will be your ability to assess the reliability and quality of the management accounting information available to management. The power and comparatively low cost of modern IT/IS has greatly increased the potential for improving the financial results of a firm through better understanding of costs and revenue streams. Management cannot afford to be ignorant of these matters any longer. In tightening markets, it is vital that they fully utilise any savings that could be made, or enhance any revenue streams where possible. If they do not, then their rival firms will and this will ultimately lead the laggard firm to record comparatively poor financial performance. Factors to consider include: (1) How are costs attributed to lines of business? Generally management accounting attributes costs to product lines to estimate contribution by product. Where a firm has diverse customers (say in terms of loyalty, volumes bought, location or methods of attracting and retaining them) it may be useful to carry out a one-off exercise to attribute costs to customer type (e.g. wholesale customers versus retail customers) to assess Customer Account Profitability. (2) How are overheads and other fixed costs treated? Conventional management accounting pools these costs and concerns itself with allocating them to divisions and products. There is little attempt made to understand the causes of them. Cost attribution involves understanding what causes these overheads and fixed costs. For example, a bank might conclude that all the fixed costs of its branch network are actually caused by a minority of customers who still require a branch to visit to exchange cash and receive a personal service; a mobile telephone supplier may realise that the majority of its advertising and promotion overhead stems from its attempts to sell air time to pay-as-you-go High Street consumers rather than from selling to corporate users. This would require an activity-based management (or activity-based costing) analysis. This could identify the true value of each client or product. Perhaps it would increase

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As Figure A.8 shows, the operational systems are dedicated to supporting the operations of particular business functions whereas at higher levels this information is aggregated and combined to enable management to take a view of the business as a whole.

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profits by closing branches or by abandoning the pay-as-you-go market? By spreading fixed costs across all lines of business management is not in a position to understand the true profitability of each of the customers or products in its portfolio.

10.3

Some modern IT/IS applications

From your studies in CIMA you will be aware that IT/IS has moved beyond the simple mechanisation of former manual and bureaucratic tasks. Today it is responsible for a ‘third industrial revolution’ which will have profound consequences for the world of work and society as a whole. The following applications should be recalled: (1) Customer relationship management systems (CRM) IT/IS configured to streamline and reduce the cost of customer service as well as improving the information content of such service. Examples of CRM include: ● common database recording salient details of customer correspondence and conversations which can be used by anyone subsequently in contact with the customer; ● expert systems and intelligent agents able to assess customer account behaviour and to alert management to intervene if erratic behaviour or patterns associated with loss of client emerge; ● profiling of customers and their purchases and tastes; this enables recommendation of additional products or services to be targeted at the customer. (2) Supply chain management systems (SCM) network-based technology that facilitates the co-ordination of the supply to the final customer from receipt of the order back the purchase of element. (3) Enterprise resources management (ERM) systems track all orders and components through a production process from arrival of initial order to final delivery. As well as controlling allocation of production resources it can also manage payments for sales and purchases, monitor inventory and provide forecasts of revenues and costs for budgetary control and cash flow purposes. (4) E-commerce (E-Comm) has effectively become a generic term for ‘network-enabled business’ and hence incorporates any of the applications above. Features that may be regarded as distinctively e-commerce include the use of websites to manage customer relationships (e.g. information provision and order taking), electronic transmission of funds, e-procurement (e.g. firms using purchasing exchanges to buy/sell commodity products such as oil, foodstuffs, logistics capacity) and virtual communities (e.g. online auctions, support groups, purchase aggregators). The extension of networks to 3G mobile phone networks and wi-fi technology, both of which can be accessed by portable wireless units (e.g. mobile phones and PDAs), has led to the growth of m-commerce (mobile commerce) in addition to the fixed line PC, interactive TV and intelligent appliance-based versions of e-commerce.

10.4

Assessing the quality of IT systems

The quality of information systems can be assessed against eight criteria (all commencing with a ‘c’ sound): (1) Quickness: How long does it take to process transactions or generate reports? This will be important for costs, customer service and ability of management to respond to developments.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

10.5

Scaling frameworks for IT systems

A scaling framework helps assess the amount of funding and management attention that should be devoted to IT systems. The considerations for you in analysing the TOPCIMA pre-seen material are: ●

●

●

whether the scale of management and resource commitment is appropriate to the firm’s operations and strategy; whether the firm has sufficient resources to support the IT/IS implications of management’s strategy; whether it has the IT/IS expertise it will need to make a success of its strategy.

Earl’s grid This framework considers the level of investment appropriate for a firm’s IS/IT (Figure A.9). It points out that high technical quality, which will include capacity, speed, access, range of applications and security, is likely to be expensive and only justifiable where it is of potentially high business value. This should be remembered and set against claims from management, particularly those from an IT/IS background, for greater financial commitment to IT/IS.

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(2) Capacity: Does the system have enough slack to cope with the growth of the business or any fluctuations in demands upon it (such as seasonality in sales)? (3) Capture: How broad a range of data does the system capture? This could include, at operational level, compulsory fields in a customer order system, headings on a job application form, whilst at higher levels the range of benchmark or other external data should be considered. Although broader data capture increases processing and storage costs it is also necessary for better business decision-taking. (4) Classification: Is the data organised in a way that enables management to gain useful information? Modern multi-relational databases do permit much greater cross tabulation and analysis of data (e.g. customers to products or faults to suppliers) to enable action to be taken. However, if the way the data is initially classified is not standardised this becomes impossible (e.g. if different divisions assign costs to products in different ways then comparisons become difficult). (5) Communication: Is the information available to those who need it? Depending on the style of management adopted there may be a need for lower level managers or operative staff to have access to information normally sent only to senior management. This brings up a second aspect, the method of communication and whether it is timely and appropriate to the interest and understanding of the recipient. (6) Collapse: Are the information systems protected against failure? Normally this requires that the architecture be distributed to allow processing on other systems if one collapses. Management should have a disaster recovery plan. (7) Cost: This will include ongoing costs of support, telecoms and updates but also the high depreciation intrinsic to IT investment. Does the information system represent a sensible level of investment? Obviously improving speed, scope and communications is possible with funds. You must be prepared to pass an opinion on whether the firm will gain an adequate return on such spending. (8) Competence: Finally, does management have the necessary skills and organisational structure to make a success of its systems or should they be outsourced to experts?

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Technical quality

Business value

Divest

Renew

Reassess

Maintain and enhance

Figure A.9 Earl’s grid

However, Earl’s grid alone does not give any guidance to what applications or situations may be of high business value. This requires the use of impact frameworks. McFarlan’s grid A second scaling framework, which, unlike Earl’s grid, explicitly considers future as well as current business value. A similar model was developed by Peppard and called the Applications Portfolio (Figure A.10).

Current importance

Future importance

Support

High potential (Turnaround)

Key operational (Factory)

Strategic

Peppard (McFarlan)

Figure A.10 Applications portfolio

McFarlan draws attention to the significance of IT/IS shifting from left to right across the matrix. This would imply that a management team accustomed to investing in IT/IS solely to support current operations would need to consider investing for future benefits as well. This is most marked if the firm is shifting from Support (low current importance and assumed low future importance) to Turnaround (low current value but high future value). This sort of repositioning affected many small traditional retailers with the advent of e-commerce, jobbing printers with the advert of desk top publishing, colleges seeking to embrace e-learning, or garage service providers as IT/IS became more important in the functioning of cars. The questions raised by a shift across the matrix are: ● ●

does the firm have the funding to support the necessary expenditure? will shareholders and other investors accept the fall in cash flows and gamble that higher investment implies?

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●

does management have the necessary expertise and organisational structure to manage IT/IS at a more intense level? does the risk management strategy of the firm allow for the sorts of risks such a move entails? McFarlan identifies two forces driving the strategic role of IT/IS around the grid:

(1) Internal forces: These include the strategies chosen by the firm (e.g. to deliberately embrace e-commerce) and/or the rising influence of groups within management committed to greater IT/IS (e.g. growth of dedicated IT/IS function). (2) External forces: These include changes in customer demands (e.g. the assumption that it should be possible to order 24/7/365), the strategies of competitors and the arrival of new IT/IS applications (e.g. the development of the Internet). In TOPCIMA you should be prepared to identify the present role of IT/IS and consider whether there are forces driving it across the matrix and if so, whether the firm will be able to make the step change successfully. You should be prepared to advise management accordingly. Porter and Millar: the information intensity matrix A final scaling framework, which takes a different slant on the factors that determine the importance (or ‘intensity’) of IT/IS to the firm (Figure A.11). Information content of end product or service Low

High

High 1. Oil refining

1. Banking 2. Newspapers

1. Cement

1. Perishables

Information content of the value chain

Low

Figure A.11 Information intensity matrix

The model reminds us that IT/IS can have importance both in the product and also in the process of getting the product to market. Using the example of newspapers and banking, IT/IS is most important here because the product is information and the process of supply involves gathering information from diverse places and communicating it to where decisions can be made. Risk from security lapses or breakdown are also greatest here.

11

Assessing corporate risk

A model developed by The Institute of Risk Management et al. in their Risk Management Standard demonstrates the various sources of risk (Figure A.12). Risk can be understood in a number of different ways: ●

Risk as hazard or threat: This entails a reduction in business effectiveness and financial return.

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Externally driven

Financial risks

Strategic risks Competition

Interest rates

Customer changes

Foreign exchange

Industry changes

Credit

Customer demand

M and A integration

Liquidity and cash flow

Research & development Intellectual capital

Internally driven Accounting controls Information systems

Recruitment

Public access

Supply chain

Employees Properties Products and services

Contracts

Regulations

Natural events

Culture Suppliers

Board composition

Environment

Operational risks

Hazard risks

Externally driven

Figure A.12

Sources of risk

Source: A Risk Management Standard IRM et al. ●

●

Risk as uncertainty: This causes problems for decision-makers at strategic, managerial and operational levels. Risk as opportunity: This involves managing the upside of a risk to come out of it better than rivals. The range of risks can be considered under the following headings:

(1) Business or operational risk. Business or operational risk relates to the activities carried out within an organisation, arising from structure, systems, people, products or processes. Business or operational risks include business interruption, errors or omissions by employees, product failure, health and safety, failure of IT systems, fraud, loss of key people, litigation, loss of suppliers, etc. These are generally within the control of the organisation through risk assessment and risk management practices, including internal control and insurance. (2) Financial risk. Financial risk relates to the financial operation of a business, such as credit risk, liquidity risk, currency risk, interest rate risk and cash-flow risk. Some of these risks arise from cultural and legal differences between countries, such as the demand in some countries for cash payments to arrange local sales. Obtaining money

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

11.1

Risk Management process

The Institute of Risk Management et al. has developed the model shown in Figure A.13. The organisation’s strategic objectives Risk assessment

Modification

Risk analysis Risk identification Risk description Risk estimation Risk evaluation

Formal audit

Risk reporting Threats and opportunities Decision Risk treatment Residual risk reporting Monitoring

Figure A.13 Risk management process Source: A Risk Management Standard IRM et al.

● ●

●

Risk assessment: Analysis and evaluation of risk by identification, description and estimation. Risk evaluation: Estimation of probability and impact of risk to reveal its significance leading to a decision on whether each specific risk should be accepted or treated. Risk reporting: Regular reports to the Board and to stakeholders setting out risks, the organisation’s policies in relation to them. This enables monitoring of effectiveness of policies.

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from customers in other countries or recovering the cost of lost goods in transit may also be difficult due to different legal or banking regulations. While these are typically outside the organisation’s control, organisations can take action to mitigate those risks, for example by credit control procedures, hedging, export insurance and so on. (3) Environmental risk. Environmental risk relates to changes in the political, economic, social and financial environment over which an organisation has little influence. Environmental risks include legislative change, regulations, climate change, natural disasters, loss of business, competition, economic slowdown and stock market fluctuations. These are outside the organisation’s control but can be mitigated to some extent through environmental scanning and contingency planning. (4) Reputation risk. Reputation risk is caused by failing to address some other risk. This is within the organisations’ control but requires the organisation to take a wider view of its role in society and to consider how it is seen by its customers, suppliers, competitors and regulators. (5) International risk. Financial risks associated with international operations such as transaction (e.g. fraudulent client), translation (e.g. currency risk), economic (e.g. recession or tax changes) and political (e.g. change of policy towards overseas trade).

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Risk treatment (also called risk response) is the process of selecting and implementing measures to modify the risk such as risk control/mitigation, risk avoidance, risk transfer, risk financing (e.g. insurance). Residual risk reporting draws board attention to any untreated risk.

11.2

Techniques of risk management

1. Identification of risk ● Risk can appear in different ways to different people according to their backgrounds and experience. This leads to collective techniques for risk identification such as brainstorming, stakeholder consultations and scenario analysis. ● Structured techniques include checklists, incident investigation, fish bone (breaking down a business process into its component parts to examine all the risks to that process). 2. Risk estimation Risk estimation looks at the likelihood of occurrence and the possible impacts. Methods include: ● ● ● ● ● ● ●

scenario planning, computer simulations (e.g. Monte Carlo) decision trees, sensitivity analysis, real option modelling, SWOT or PEST analysis, likelihood/consequences matrix.

3. Risk evaluation Risk evaluation is concerned with making decisions about the significance of risks to the organisation and whether those risks should be accepted or whether there should be an appropriate treatment or response. 4. Risk reporting This includes: ● ● ●

●

●

A systematic review of the risk forecast at least annually. A review of the management responses to the significant risks and risk strategy. A monitoring and feedback loop on action taken and variance in the assessment of the significant risks. An ‘early warning system’ to indicate material change in the risk profile, or circumstances, which could increase exposures or threaten areas of opportunity. The inclusion of audit work as part of the communication and reporting process.

5. Risk treatment Risk treatment selecting and implementing measures to modify the risk. Risk response may be: ●

Avoidance: Action is taken to exit the activities giving rise to risk, such as a product line or a geographical market, or a whole business unit.

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●

●

Reduction: Action is taken to reduce the risk likelihood or impact, or both. Sharing: Action is taken to transfer a portion of the risk through for example insurance, pooling risks, hedging or outsourcing. Acceptance: No action is taken to affect likelihood or impact.

12

Assessing cost of capital

12.1

Importance of cost of capital

The principal uses of the cost of capital in TOPCIMA are: (a) to provide a discount rate for project appraisals using discounted cash flow methods; (b) to use as basis for business valuation (see Section 15) (c) to utilise in measuring shareholder value or for setting divisional performance measures related to shareholder value.

12.2

Cost of equity

The cost of equity (or Ke) is the rate of return payment that management must make on the equity in the company if shareholders are to keep their funds in the company. Assume the situation where a firm financed entirely by equity (i.e. zero capital geared) and where Ke is 15%. In this case management would use Ke: ●

●

●

as the discount rate for project appraisal, that is, so that any new assets purchased would have to demonstrate a positive NPV after deduction of 15% p.a. for the capital used; as the hurdle rate for performance evaluation of divisional managers that is, they would be required to show that they were achieving at least a 15% return on the legacy assets in their divisions; as shareholder value measures, that is, the management of the firm would seek to ensure a positive economic profit (otherwise called a residual income or, following some adjustments, Economic Value Added(R)1) after multiplying divisional and overall group assets by 15%. In the case of a division with assets of $20 million it would need to show an income in excess of $3 million (i.e. $20 million ⫻ 0.15).

12.3

Cost of debt

At its simplest, the cost of debt is the post-tax cost of the interest upon it (since unlike dividends to equity, interest payments are tax deductible). Examples Suppose a company issues debt at par (i.e. receives $100,000 for each $100,000 bond it issues) with a coupon rate of 8% in a country with 30% tax rates. K d ⫽ 8%(1⫺ 0.30) ⫽ 5 .6 % The situation is complicated where the firm has issued debt at a discount (i.e. below par) because in addition to the coupon interest it must also take into account the increased redemption value of the bond. Suppose a firm issues its 8% coupon rate debt, redeemable in 5 years time at a discount of 5% to par (i.e. it receives $95,000 for every $100,000 of debt it sells). Tax is 30%. 1

Economic Value Added (EVA) is a registered trademark of Stern-Stewart New York.

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STUDY MATERIAL T4 Here the after-tax cost of debt will be given by the formula:

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240

95 ⫽ 8 (1⫺ 0.3) ⫻ AF5@K d ⫹

100 (1⫹ K d )5

Kd can be obtained by interpolation using two different assumed rates for the annuity factor (AF). Cash flow Year 0 Year 1–5 Year 5

95,000 (8,000) (100,000)

AF @ 10% 1 3.791 0.621

PV 95,000 (30,328) (62,100) 2,572

AF @ 5% 1 4.329 0.784

PV 95,000 (34,632) (78,400) (18,032)

18, 032 (10% ⫺ 5%) 18, 032 ⫹ 2, 572 K d ⫽ 10% ⫺ 4.38% K d ⫽ 5.62% K d ⫽ 10% ⫺

12.4

Weighted average cost of capital (WACC)

This is the percentage rate of return that must be achieved to add shareholder value taking into account all the various sources of finance used by the firm. It is the weighted average of the costs of the individual courses of capital using market values.

Example A firm has a capital structure made up as follows: Equity: 2,000,000 shares with a market price of $1.62 and a Ke of 8% Debt: 12,000 bonds with a market value of $98 and a Kd of 6% The WACC is calculated as: (2, 000, 000 ⫻ $1.62 ⫻ 8%) ⫹ (12, 000 ⫻ $98 ⫻ 6%) (2, 000, 000 ⫻ $1.62) ⫹ (12, 000 ⫻ $98) 32, 976, 000 ⫽ 4, 416, 000 ⫽ 7.47%

The WACC is the more usual basis for calculating the cost of capital because most corporate treasurers will ensure they have a mixture of debt and equity in the balance sheets of their companies to reduce the overall cost of capital. But the WACC has a number of limitations stemming from its dependence on a pool of funds concept. Put simply it assumes that new projects (and existing assets) are financed from a homogenous reserve of funds the costs of which will remain unchanged by alterations in the amount of funds used and variations in the sorts of businesses they are used to support. The WACC is therefore not an appropriate cost of capital under the following situations: ●

where the funds are being used to support operations or assets exposed to significantly different risks from those faced by the majority of the firm’s business;

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where raising the extra funding will significantly change the capital structure (notably the debt/equity ratio) of the firm; where the amount of funds being raised is a significant addition to the total capital employed by the firm. Under these situations it is usual to use the marginal cost of capital. You may be given a discount rate to use in the pre-seen or unseen material. You should always use this rate in your calculations. Do not waste time in the exam room trying to calculate a different cost of capital or in trying to prove the rate you have been given.

However, additional credit will be given for comments or arguments about why this rate might be too high or too low providing this is backed up by reference to the theory here.

12.5

The marginal cost of capital

This assesses the impact on the costs of capital of raising funds for a project. This will include the costs of the capital raised for the project but also include the impact on the costs of existing capital due to changes in the risks faced by the firm and changes to its capital structure. Example A firm operates solely in one country making a basic industrial material. Presently its financing is made up as follows: Equity: 2,000,000 shares with a market price of $1.62 and a Ke of 8% Debt: 12,000 bonds with a market value of $98 and a Kd of 6%. As calculated in the example above, its cost of capital is presently 7.47% on capital of $4,416,000. Management decides to diversify the firm by buying a chain of leisure centres in an overseas market for $3,450,000 paid for in debt issued at par. As a consequence of the greater risks and capital gearing Kd for the firm as a whole rises to 8% and the original Ke of 8% rises to 10%. The firm has raised an additional $3,450,000 of capital but it must now make a return of $69,408,0004 and not the $32,976,000 previously. Therefore, the marginal cost of capital for the project is: $3, 450, 000 ⫽ 9.47% ($69, 408, 000 ⫺ $32, 976, 000) (2,000,000 ⫻ $1.62 ⫻ 10%) ⫹ (12,000 ⫻ 8%) ⫹ ($3,450,000 ⫻ 8%).

4

12.6

Real options theory

This is another approach to strategic investment. It is an alternative to traditional NPV evaluations for where investments are being made under conditions of high uncertainty. It suggests that management could mimic the sort of investment behaviour of investors in derivative investments such as futures and options covered in the CIMA Risk and Control syllabus. Traditional NPV takes all the cash flows of a project over its lifetime and discounts them back. In a strategic decision these cash flows are far from certain and so very high required rates are applied. The effect is that tentative strategic investments come up showing negative NPVs and are not undertaken.

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Real option theory seeks to take the project apart by pointing out that a small level of investment in a project is rather like paying a deposit to secure the right to subscribe for future financial benefits if matters go a certain way (just like the premium on an option). Consider a firm thinking of entering a line of retail for the first time. Instead of conducting an NPV on building a chain of shops across the country, the theory time-slices the investment decision by pointing out that the first investment is buying the land to build the shops on. Once the firm owns the land it has a number of options (i.e. decisions which can be taken at a later date): (1) The expansion option which means to go ahead and build the shops and perhaps buy more land too. This decision could wait until the future became clearer. (2) The abandonment option is where management decides not to build the shops after all, perhaps because of a recession in the economy. The firm would forfeit some of the money they spent buying the land. However this loss was worth it because it did buy them the opportunity to participate had the economic circumstances been more favourable. (3) The timing options. This suggests that there may be points in the rolling-out of a project at which management can decide to delay or to bring forward further investments. This will affect the NPV of the project. (4) Strategic investment options. These are follow-on opportunities over which the firm has an option if it makes the original investment. These spin-offs are added into the core investment appraisal as a series of ‘what-if ’ analyses to try to get a full view of the potential value of the investment. The effect of real options approach is to give a true NPV for a project calculated as follows: ⎛ NPV of ⎞⎟ ⎛ NPV of ⎞⎟ ⎛ NPV of ⎞⎟ ⎛ NPV of ⎞⎟ ⎜⎜ ⎜⎜ ⎜ ⎜ ⎟ True NPV ⫽ ⎜ expansion ⎟⎟ ⫹ ⎜ abandonment ⎟⎟⎟ ⫹ ⎜⎜ timing ⎟⎟⎟ ⫹ ⎜⎜ strategic ⎟⎟⎟ ⎜⎜ ⎟ ⎜ ⎟⎟ ⎜⎜ ⎟ ⎜ ⎟ ⎝ option ⎟⎠ ⎜⎝ option ⎠ ⎝ option ⎟⎠ ⎜⎝ option ⎟⎠

13 Conducting a corporate appraisal (SWOT and gap analysis) Corporate appraisals have two elements: (1) a SWOT analysis, (2) a Gap analysis. The most commonly used corporate appraisal method in TOPCIMA exams appears to be a SWOT analysis. Candidates can (and should) prepare a SWOT to help them understand the pre-seen material and to understand the weaknesses of the company and the opportunities facing the company or the industry in which it is operating in. If you include a SWOT analysis in your answer, you must ensure that it has been updated to include material that has been given to you in the unseen material on exam day.

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Update your SWOT analysis for the new information and new issues raised in the unseen material on exam day.

13.1 Conducting a SWOT analysis The TOPCIMA exam is likely to require you to make recommendations about what to do with the organisation in the pre-seen material. This will require you to base your advice on an analysis of its present position. The approach recommended here is to prepare a SWOT analysis using the pre-seen material, which can be adapted or modified in the light of any additional unseen material on exam day. This SWOT analysis should appear in two places in your final report: (1) As a cruciform chart in the appendix to your report. This will be brief bullet points showing the breadth of issues that you have noted. (2) As the second section of your report, immediately following the introduction, in which you will highlight the most important conclusions from the SWOT in terms of its implications for the business (Figure A.14). Strengths

Weaknesses

Opportunities

Threats

Figure A.14 The cruciform chart Source: A Risk Management Standard: IRM et al.

(1) Strengths and Weaknesses are usually internal and specific to the firm. A strength is something that, from the information in the pre-seen material, you consider the firm is good at or it is a resource it can call upon to reach its goals. They are sometimes termed distinctive competences. A weakness is generally a resource shortage or inadequacy which renders the firm vulnerable to competitors. A quick recap through the mental checklist of the 9 Ms model will give you some ideas. (2) Opportunities and Threats are generally external to the firm. Opportunities and threats are strategic challenges to the firm. Again these may be obvious to you from the preseen material or perhaps from your own research into the background of the industry. Here frameworks like PEST and five forces can help.

TECHNICAL KNOWLEDGE

For example, if you prepared a SWOT based on the pre-seen material stating that a Weakness includes a shortage of cash for investment, you must update your SWOT is events given in the unseen material changes. For example, in the September 2006 Kadgee case, there were details given about a factory fire and a future receipt of €7 million, which Kadgee could use for a future investment. Therefore, the golden rule must always be:

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Ensure that these are ‘clear and present’ opportunities and threats that you can back up with data from the case or other source. Too many candidates seek to pad out their SWOT analysis with various generic threats like ‘there could be a takeover bid’ or ‘interest rates may rise’ without bringing forward any evidence that this is a possibility. Also avoid confusing opportunities with strategies. The best way to do this is to ensure that nothing you write could have the words ‘management could’ put before it. Your SWOT could include under the heading of Threats any external industry problems, if, for example, the industry as a whole is under price pressures, or is in the decline stage of its life cycle. Alternatively another threat is that of obsolescence if other companies are introducing superior products or services which could affect the sales and profitability of the company in the case, or impending changes in EU or UK legislation that could affect the company.

13.2

Gap analysis

A gap analysis (Figure A.15) can only be carried out if the pre-seen material or unseen material gives an indication of the strategic goals of management.

Ultimate objective Planning gap Objective measurement

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Future plan

Forecast for current operations

Years

Figure A.15 Gap analysis

In past CIMA cases these goals have appeared in the following ways: ● ● ●

as statements of intent at flotation of the firm, in the records of planning meetings, in a 5-year plan for the firm.

Figure A.15 shows the firm’s performance towards a single objective. In TOPCIMA there may be several objectives sought by management simultaneously. For example, in a past CIMA case the strategic objectives for one firm were: ● ●

to achieve a certain number of outlets within 5 years, to maintain a given ROCE,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

to have the largest market share in the industry. You should be prepared to express an opinion on the following matters:

●

● ●

Does the forecast performance of the firm show that it’s likely to reach its strategic objectives in all areas? Are the strategic objectives still realistic and relevant? What will be the likely effect on stakeholders, in particular shareholders, of missing the objectives?

13.3

Getting from corporate appraisal to strategy

Frequently the corporate appraisal can throw up appropriate strategies (Figure A.16). Strengths

Weaknesses Convert

Match

Remedy

Opportunities

Threats

Convert

Figure A.16 Strategic fitting

Here are some techniques that can help with that process: 1. Matching, converting and remedying ● Matching. The firm should build on those strengths that enable it to take advantages of the opportunities in the marketplace. ● Converting. This is a more complex process in which management question their interpretation of a factor as a threat or weakness and consider whether it can be re-interpreted or turned to its advantage (sometimes called flip siding the negative). ● Remedy. Removing weaknesses that leave the firm exposed to threats or unable to grasp opportunities is a priority for strategic action. 2. Closing a planning gap The strategies which may be used to fill the remaining gap are classified as: (a) Efficiency strategies: Designed to increase profits (or throughput) by making better use of resources or cutting them. (b) Intensive strategies: These exploit the firms existing products and markets further. ● market penetration to increase sales to existing markets; ● market development to find additional markets for the products; ● product development to find additional products for the firms existing customer base. (c) Diversification strategies: These aim to reduce the risks of the business or increase its growth prospects by taking it into new industries.

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●

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14

Business valuations

Business valuation has been a common theme in past CIMA case studies. It can be of use in several situations: ● ● ● ●

to evaluate an approach of takeover bid from another firm. Are they offering enough? to set a potential price for shares that will be issued in a flotation to issued to new investors to set a value on shares to see how well an unquoted company has performed to date to set a price to buy back shares from a shareholder who wishes to exit the company.

14.1

Two approaches to business valuation

Business valuation is not an exact science. Rather it is a matter of judging where a firm’s value lies between two methods of valuation: (1) asset-based methods, (2) earnings-based methods.

14.2

Asset-based methods of business valuation

A simple approach is to value the firm at its net assets value. This takes the view that anyone who buys the company will in fact have purchased assets to a particular value, less liabilities such as debt or creditors. Example The following items are extracted from the balance sheet of a company: Fixed assets Current assets Current liabilities Long-term debt Called up share capital ($0.50 shares) Net asset value of company Value per share

$380,000,000 $120,000,000 $103,000,000 $98,000,000 $200,000,000 $299,000,000 $299,000,000 (200,000,000/0.5) ⫽ $0.75

Asset-based valuation methods suffer from the following limitations: (1) Net asset values are not reliable. A predator buying another company may do so to get its assets. However, the book value of the assets may not convey their true value to the predator. The true value could be their replacement value (i.e. how much it would cost the predator to buy them on the market) or their net realisable value (i.e. how much the predator would earn if they liquidated the assets). (2) Method ignores valuable intangible assets. A predator may seek to buy a firm to get access to its staff skills, customer contracts or brands. These are valuable but for good financial accounting reasons do not appear on the balance sheet. (3) Method ignores earnings potential. The management of a successful firm can take ordinary assets and earn supernormal profits on them. For example, a modern thriving club may be located beside an old-fashioned hardware store in a High Street.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Asset valuations should be regarded as a floor or minimum value for a firm.

14.3 Earnings-based methods of valuation 1. Dividend yield approach Here the firm is valued according to the annuity value of its dividends using the formula Market value ⫽

Dividend Dividend yield

The dividend yield of a similar firm is calculated and applied to the firm for which a value is sought. Example Company A has a share price of $1.28 and a dividend of $0.32. Company B pays a dividend of $0.17. It has 22.2 million shares in issue. What is the value of B$$? Dividend yield for A ⫽ $0.32/$1.28 ⫽ 25% Value of B ⫽ $0.17 / 0.25 ⫽ $0.68 per share Total value ⫽ $0.68 ⫻ 22.2 million ⫽ $15.1 million In effect this is the same thing as using the formula Value of firm ⫽

Dividend Ke

that is, it values the firm as the annuity value of its dividend assuming that the dividend yield it has taken from the other firm equals Ke for the industry.

2. Dividend growth approach This accepts that in most cases firms are expected to pay higher dividends in the future because the firm is growing. Value of firm ⫽

D0 (1 ⫹ g ) Ke ⫺ g

where g is the forecast growth rate of dividends estimated from past history or by application of Gordon’s growth model where g ⫽ b ⫻ r in which b is the retention ratio and r is the rate of return on retained earnings. Example A company paid a total dividend of $230 million last year. This represents a 5% increase on the previous year. The industry has a Ke of 12%

TECHNICAL KNOWLEDGE

According to a real estate surveyor both properties have the same asset values, but because the club generates a much better income than the store it is worth more.

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STUDY MATERIAL T4 $230 million (1⫹ 0.05) (0.12 ⫺ 0.05) ⫽ $3, 450 million

Value ⫽

This approach assumes that the firm will be able to grow its dividends at 5% per annum in perpetuity and, despite its growth, that Ke will remain unchanged. Both are probably unrealistic assumptions.

This approach breaks down in the following cases: (1) Where the firm does not pay a dividend. Microsoft was formed in 1983 but did not pay any dividend until 2002 yet clearly it had a very high value during the intervening years. (2) Where the growth rate of the firm’s dividend exceeds Ke. In this situation, the denominator becomes a negative and therefore gives the firm a value of infinity. 3. Earnings growth approach The dividend valuation approach effectively values the firm from the point of view of its existing shareholders. These shareholders are not able to determine the dividend payout decided by management. This is, however, a useful figure for understanding the minimum price that is likely to be acceptable to the target’s shareholders. Another firm which takes control of the board of a firm can enjoy the entire earnings stream and not just the dividend. Therefore, the dividend valuation model is subtly adapted: Value of firm ⫽

E0 (1 ⫹ g ) Ke ⫺ g

where E0 refers to the total earnings attributable to ordinary shareholders. There may be arguments for using the profit before interest and tax instead. For example, if the acquiring firm enjoys a Ke below the acquired firm’s cost of debt it would presumably redeem the debt with equity and avoid the interest payments. Similarly is its cost of debt were lower it might be able to refinance the debt at lower interest. Finally its tax rate could be different from that of the target company. 4. Price earnings approach The formula for this approach is Value of firm ⫽ maintainable earnings ⫻ price earnings ratio Maintainable earnings are a floor level of future earnings which actual earnings are not expected to fall below. Operating profit less tax is the basis for this calculation. The price earnings ratio will be a ratio from another firm in the same industry, assuming one exists. Example Company A has earnings after interest and tax of $755 million and balance sheet debt of $238 million at an interest rate of 15%. Company B is in a similar industry to Company A and has a P/E ratio of 17. What is the likely value of Company A?

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

The balance sheet debt is ignored and not deducted from the value. This is because the interest on the debt has already been deducted from profits before arriving at the $755 million. The valuation assumes that anyone who acquires Company A will simply maintain the debt out of earnings in the same way. However, if there are any reasons to believe that a firm’s debt has been used to purchase a wasting asset (such as a renewable license to exploit a resource) then it seems likely that interest will not be repaid out of sustainable earnings but rather the capital sum will need to be written off over time. In this situation, it is prudent to deduct the debt from the valuation.

This valuation method makes a number of assumptions that should be highlighted if you choose to use it in your TOPCIMA exam: ●

●

●

It depends on how similar the industries of the two firms are. Clearly if Company A is in a more risky industry than Company B we should use the potential P/E of the joint company. This is because the higher risk if the combined company will increase Ke and so depress the P/E ratio. It assumes that the share price of the acquiring company is set by a liquid market in its shares and hence, according to the efficient market hypothesis, its price reflects its future earnings power. It assumes that the management of the two firms will be able to grow earnings at the same rate as the management of the acquiring company could.

Where a company is not listed, it is possible to generate a share price by applying a ‘proxy’ P/E from a listed company in the same line of business. However, some deduction from the resulting value should be made to reflect the non-tradability of the share. Remember – the ‘Golden Rule’ for a listed company – the company will never be worth less than the market price for its shares. Furthermore, for the company to be acquired it is usual for the acquiring company to offer a premium over the market price as an incentive for shareholders to sell their shares 5. Discounted cash flow approach This values the business at the present value of its free cash flows and is based on the assumption that the stock market will arrive at a value for a share that is equivalent to the present value of its free cash flows. A free cash flow is the cash profits of the firm. However, there is considerable disagreement about what this may include or exclude in practice. A rough rule of thumb is: Operating profit ● ● ● ● ●

less interest, less tax, plus depreciation and amortisation, plus increase in provisions for tax or doubtful debts, less any increases in fixed or working capital ⫽ free cash flow.

The second issue concerns how far ahead to forecast these free cash flows. If they are expected to continue indefinitely at their present amount per year then valuation is simply an annuity value Current annual free cash flow Cost of capital

TECHNICAL KNOWLEDGE

Maximum value of Company A is $755 million ⫻ 17 ⫽ $12, 835 million

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Otherwise it is usual to adopt one of the following approaches: ●

●

discount the free cash flows from the present business plan to arrive at a present value and then add on a notional amount for the earnings for the years after the plan; assume and annuity value for a set number of years corresponding to the life cycle of the product or industry.

A final issue is arriving at a suitable discount rate. This was discussed in the section on the cost of capital above. 6. Valuation to include synergies Some acquisitions are carried out with the intention that the resulting group of companies will have higher profitability than the sum of the profits of the constituent parts. Summarised as the 2 ⫹ 2 ⫽ 5 effect. Potential synergies include: ● ● ●

● ●

elimination of the fixed costs of duplicated assets (e.g. factories, offices and so on); reduction in operating costs due to combination of administrative functions; greater capacity fill through better loading of assets (e.g. instead of two firm’s with halffull lorries there will be one firm with half as many lorries, each running fully loaded); increased sales revenues through cross selling to common customers; higher prices if the strong brands of one firm can be conferred on the mundane products of the other.

To calculate the maximum value of a company where synergies are available you should use the increase in group earnings post-acquisition as the basis for valuation. Example Company A seeks to acquire Company B. Both are logistics firms. Company A presently has turnover of $1397 million, post-tax profits of $293 million and long-term borrowings of $217 million at 7%. It estimates its WACC at 8%. Company B presently has turnover of $987 million, post-tax profits of $187 million and long-term borrowings of $300 million at 8%. Company A has estimated the following data about Company B: ●

●

●

it has a chain of warehouses which could be sold for $280 million within a year of acquisition and all functions absorbed within A’s, own warehouses at an increased cost of $28 million. B’s warehouses presently cost $132 million per year to operate, and closure would lead to redundancy costs of $117 million; its administration costs of $200 million could be reduced by 50% if it were to adopt B’s computerised ordering systems; reducing competition from Company B will increase prices of logistics contracts by 12%. What is the maximum price that A should pay for B? Combined profit of A & B ($293 ⫹ $187) Increase in profit from 12% rise in revenues 0.12 (1397 ⫹ 987) Increased profits due to transfer of warehousing (132 ⫺ 28) Reduction in administration costs (0.5 ⫻ 200 m) Reduction in interest costs (300 ⫺ 280) ⫻ (8%-7%) Total group sustainable earnings Less existing earnings of Company A Increased earnings Assume earnings continue 10 years at WACC of 8% AF⫽ PV of increased earnings Plus net proceeds from disposal of warehouses ($280 ⫺ $117) ⫻ 0.926

$480 million $286 million $104 million $100 million $0.2 million $970.2 million $293 million $677.2 million 6.145 $4161.4 million $150.9

Total value

$4312.3 million

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

15

Generating strategic options

The following models can be used in two ways to help you pass TOPCIMA: (1) The pre-seen or unseen may contain information on strategic options being considered by management. These models will help you critique these options. (2) You may be required to recommend options of your own. These models may help you generate them.

15.1 Choice of generic strategy Porter’s prescriptions for generic competitive strategy were reviewed in Section 7.3. The point to recall here is that high levels of profitability are believed to result from a firm dedicating itself to one of the generic strategies.

15.2

Product market strategy – the Ansoff matrix

Demonstrates the choices of strategic direction open to a firm in the form of a matrix (Figure A.17). Products Present

Present

Market penetration

New

Product development

Markets

New

Market development

Diversification - related - unrelated

Figure A.17 The Ansoff product-market scope matrix

1. Market penetration strategy Firm increases its sales in its present line of business. This can be accomplished by: ● ● ● ●

price reductions, increases in promotional and distribution support, acquisition of a rival in the same market, modest product refinements.

These strategies involve increasing the firm’s investment in a product/market and so are generally only used in markets which are growing and hence the investment may be recouped. In this respect, the strategy is similar to the invest to build and holding strategy discussed by the Boston Consulting Group.

TECHNICAL KNOWLEDGE

Of necessity these calculations can be rough and ready and shareholders in A might question why they are paying 23 times current earnings for B. Of course Company A would not offer $4,312.3 million for B but something less in the hope that the synergies here would come to its own shareholders rather than all being given to the shareholders who are selling B.

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2. Product development strategy This involves extending the product range available to the firm’s existing markets. These products may be obtained by: ● ● ● ●

investment in the research and development of additional products, acquisition of rights to produce someone else’s product, buying in the product and ‘badging’ it, joint development with owners of another product that need access to the firm’s distribution channels or brands.

The critical factor to the success of this strategy is the profitability of the customer group for which the products are being developed. Also the firm’s present competitive advantages in serving the market must confer on to the new good. These can include: ● ● ●

customer information that allows accurate targeting, established distribution channels, a brand which can be credibly applied to the new product.

3. Market development strategies Here the firm develops through finding another group of buyers for its products. Examples include: ●

● ● ●

different customer segments: for example, introducing younger people to goods previously purchased mainly by adults; industrial buyers for a good that was previously sold only to households; new areas or regions of the country; foreign markets.

This strategy is more likely to be successful where: ● ● ● ●

the firm has a unique product technology it can leverage in the new market, it benefits from economies of scale if it increases output, the new market is not too different from the one it has experience of, the buyers in the market are intrinsically profitable.

4. Diversification strategies Here the firm is becoming involved in an entirely new industry, or a different stage in the value chain of its present industry. Ansoff distinguishes several forms of diversification: (1) Related diversification. Here there is some relationship, and therefore potential synergy, between the firm’s existing business and the new product/market space. (a) Concentric diversification means there is a technological similarity between the industries, which means that the firm is able to leverage its technical know-how to gain some advantage. (b) Vertical integration means the firm is moving along the value system of its existing industry towards its customers (forward vertical integration) or towards its suppliers (backward vertical integration). The benefits of this are assumed to be: ● taking over the profit margin presently enjoyed by suppliers or distributors, ● securing a demand for the product or a supply of key inputs,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

●

(2) Unrelated diversification. This is otherwise termed conglomerate growth because the resulting corporation is a conglomerate, that is, a collection of businesses without any relationship to each other. The strategic justifications advanced for this strategy are: ● to take advantage of poorly managed companies which can then be turned around and either run at a gain to the shareholders or sold-on at a profit, ● to spread the risks of the firm across a wide range of industries, ● to escape a mature or declining industry by using the positive cash flows from it to develop into new and more profitable areas of business.

15.3 Strategic development and risk Developing a firm beyond its present product/market space exposes it to a combination of four sorts of risks. These risks are particularly acute where diversification is concerned because of the simultaneous novelty of both product and market. (a) Market risk: The firm has entered a new market where established firms already operate. The risks here are: ● not correctly understanding the culture of the market or the needs of the customer, ● high distribution costs due to lack of economies of scale, ● failure to be seen as credible by the buyers in the market due to lack of track record or brand, ● exposure to retaliation by established firms with more entrenched positions. (b) Product risk: The firm is involving itself in a new production process, which is already being conducted by rival firms: The risks this poses are: ● higher production costs due to lack of experience, ● initial quality problems or inferior products causing irreparable harm to reputation in the market, ● lack of established production infrastructure and supply chain relations which will make costs higher and may limit product innovation and quality. (c) Operational and managerial risk: This boils down to the danger that management will not be able to run the new business properly. This carries with it the second danger that management will also be distracted from running the original business effectively too. (d) Financial risk: This relates to the share price of the business. Shareholders are generally suspicious of ‘radical’ departures (and particularly diversification) for the following reasons: ● the product and market risks lead to volatile returns, ● the firm may need to write off substantial new net assets if the venture fails, ● the investment needed will reduce dividend and/or necessitate new borrowing, ● a diverse and unique portfolio makes it harder to compare the firm to others in the same industry when trying to evaluate its risks and returns. The effect will be for the share price to decline to reflect the uncertainties created by the strategy.

TECHNICAL KNOWLEDGE

better synchronisation of the value system, reduction in buyer or supplier power. However, it also means increasing the firm’s investment in the industry and hence its fixed cost base. ●

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15.4

The expansion method matrix

Lynch (1997) presents the alternative growth strategies as shown in Figure A.18. Company Internal development Internal development

Merger Acquisition Joint venture Alliance Franchise/license

Exporting Overseas office Overseas manufacture Multinational operation Global operation

Merger Acquisition Joint venture Alliance Franchise/license Turnkey

Home country

Geographical location

International

External development

Figure A.18 Lynch’s expansion method matrix (adapted from Lynch 1997)

1. Internal development (organic growth) Here the firm grows by using its own capital sources to invest in new capital assets, product development and staff development. The principle benefits of this approach are: (a) firm does not need to assimilate the differing personal, cultures or operating systems of another organisation; (b) investment can be controlled and incremental unlike acquisition when the firm must commit substantial funds in an all-or-nothing gamble; (c) provides development and learning opportunities to staff; (d) avoids the need for a goodwill premium at acquisition; instead assets are acquired at just their market value; (e) demonstrates to investors the ability of management to grow their own business and create opportunities. This should improve the share price. The drawbacks are: (a) firm will not at first enjoy the economies of scale and experience effects available to rivals; (b) market entry may be too slow if the industry is developing quickly; (c) increases the number of firms in the industry which increases complexity and may provoke hostile responses from established firms; (d) firm may lack access to key resources or customers if the industry features complex long-term supply contracts. 2. Mergers and acquisitions (external growth) Benefits of a firm pursuing strategic development into a product/market space by mergers or acquisition are: (a) firm acquires the goodwill (expertise, contacts customers and reputation) of the acquired firm;

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Drawbacks of acquisition led growth are: (a) difficult to arrive at the correct price for the acquisition due to lack of financial information, bid fever and possibility of third parties bidding against the predator; (b) high cost of integrating systems of work, management controls, human resource procedures and information systems; (c) need to rationalise operations will incur costs of redundancies, asset disposals, cancellation of leases and supplier contracts; (d) failure of most mergers and acquisitions to realise the benefits originally envisaged; (e) problems of uncontrolled staff losses and falling morale due to rationalisation programme and clashes of culture amongst staff from senior management down; (f ) very high initial capital costs because the predator must compensate the target’s shareholders for at least the expected present value of the profits from the target; (g) excessive reliance on external growth will depress the predator’s share price because investors cannot assess the level of future earnings of the business without knowing what the next acquisition will be; (h) high degrees of share price volatility fuelled by bid rumours; (i) failure to win a bid will leave the impression that the predator’s strategy is failing. 3. Joint development strategies These involve the firm working with another firm under an arrangement of greater or lesser formality. (1) Joint venture. The partners form a separate company in which each holds an equity stake. Usually management is provided by the parties to the agreement and is able to draw on the expertise of the parties. Benefits are: (a) reduces risk because the firm’s capital commitment is halved; (b) each party gains access to the competences of the other; (c) avoid developing the opportunity separately and ending up in competition; (d) partnership with firms in host economies allows foreign firms a route into otherwise protected markets. Drawbacks are: (a) disputes over operational matters such as use of trademarks, pay levels and approach to markets; (b) possibility that partners will gain confidential information about each other which may be used to compete elsewhere or if the venture breaks down;

TECHNICAL KNOWLEDGE

(b) eliminates a potential rival in the market; (c) swifter access to the industry than internal development; (d) possibility of some risk spreading if the acquired company has businesses in unrelated areas; (e) lower commercial risk because the target will have already established itself in the industry; (f ) possibility of acquiring assets cheaply if the target is undervalued by investors, for example, due to poor present management.

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(c) disputes over the amount of effort being put in, the allocation of partner’s costs and the division of rewards; (d) lack of support from joint venture management from parent companies because neither feels they own it. Joint ventures were examined in the September and November 2006 Kadgee clothing cases, and a disappointing number of candidates clearly did not understand that the joint venture would be a separate legal entity of which both companies would hold shares. Many candidates simply assumed that as Kadgee would only have a 40% share in the joint venture with Xina (November 2006) this would put it at an unacceptable disadvantage. Although there were a number of problems with a minority shareholding, the NPV for Kadgee’s 40% share was forecast to generate an NPV of over €17 million. It must be considered whether a 40% share generating such a high NPV is more or less preferable to Kadgee owning 100% of a loss making company. (2) Strategic alliances. Two or more firms agree to work together to exploit common advantages. The precise arrangements will differ from merely an informal agreement between management, through a legal arrangement, to a cementing of the relationship with the swapping of equity. The benefits are similar to joint ventures but in addition a strategic alliance is often used to allow smaller firms to present an effective alternative to a large dominant player in the market. However there are some special difficulties: (a) ambiguity in the alliance agreement or the breakdown of trust between partners will jeopardise the alliance; (b) some informal alliances risk breaking laws against collusion and cartels; (c) because partners remain essentially separate many alliances fail to achieve the integration and commitment necessary to gain significant strategic advantage. The May 2004 case on Ofood4U (organic food manufacturing company) introduced an opportunity for a strategic alliance in the unseen material and candidates were required to calculate the NPV of the proposed strategic alliance and to comment on whether this was a suitable expansion strategy for Ofood4U. Answers were generally disappointing as many students simply commented on the financial results and not the long-term strategic effects, and risks, of the proposed strategic alliance. This expansion strategy has been examined once, and therefore it could come up again! (3) Franchises. Here the firm expands its business by granting other firms the right to use its business systems. The firm (the franchiser) will provide a variety of supports to the buyer of the business package (the franchisee). These may include: ● management training, ● a set of procedures and instructions for supplying the product/service, ● central marketing support (e.g. inclusion in national advertising), ● inputs such as materials or products to sell-on, ● technical and business consultancy, ● staff training programmes, ● preferential access to capital.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Franchising was examined in the May 2006 TOPCIMA case on Zubinos coffee shops. Franchising is a common method used for fast expansion in the fast food restaurant business and the coffee shop industry. Many UK coffee shop chains have used franchising to expand. This was a very predictable issue for this case and was badly handled by many candidates who did not understand the principles behind franchising. Again, this important method of expansion could be examined in TOPCIMA again – make sure that you understand this. (4) Agency agreements. These are usually restricted to marketing and product support arrangements. They are particularly useful in the following situations: ● where the customers like to compare a range of products and take advice (e.g. financial services, carpets, software); ● the sales volumes are too low to justify a dedicated distribution channel (e.g. specialist holidays); ● the sales are enhanced by social and family networks (e.g. cosmetics, children’s books and toys). The agent receives a set of samples, literature and product training. They also receive a commission from their sales that are supplied from the parent company. Agency agreements have a number of problems: (a) the danger that the product will be miss-sold by agents anxious for commissions;

TECHNICAL KNOWLEDGE

In return the franchisee will provide: ● an initial lump sum to buy the franchise, ● a share of earnings (usually turnover), ● specific payments (e.g. for training). The benefits of franchising to the franchiser include: (a) quicker business expansion than would be possible using its own management and financial resources; (b) reduced risk due to the capital having been provided by the franchisee; (c) retains the dynamism of local management because they run their own business; (d) control over the activities of the franchisees to the extent provided for in the franchise agreement; (e) reduced costs of control due to franchise manager being responsible for finances, assets and staffing. The drawbacks of franchising include: (a) reduced profits because they must be shared with franchisee; (b) need to monitor franchisee to assure consistency of product service (quality, pricing, product range, sales methods); (c) danger that poor franchise performance will harm the parent’s brand; (d) problem of protecting intellectual capital from being copied by franchisees who later become rivals. Licenses are very similar to franchising in their financial aspects. However, the degree of central control and support is usually less. Licenses include: ● the right to exploit a natural resource (e.g. a logging license); ● the right to use a brand or image on a product; ● the right to produce a product using the licenser’s recipes and brand names (e.g. computer manufacturers installing Windows XP).

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(b) the firm fails to build a relationship with the customer, or gain data, because this would undermine the agent and make them suspicious of being cut out; (c) the danger that agents will desert the firm and take the best customers with them.

4. International growth strategies (1) Exporting strategies. The firm sells products made at home to buyers abroad. Often this starts with the receipt of a chance order or perhaps poor sales at home force the firm to export or perish. As a strategy it has a number of advantages over other international growth strategies: (a) firm can make use of any economies of scale it enjoys to compete in the foreign market (and home market too); (b) no need for any extra fixed capital investment; (c) does not expose the fixed capital investments of the firm to risk; (d) helps to insulate the firm from recessions in their home economy. The disadvantages are: (a) distance from the customer means customer relationship cannot be developed nor goods customised; (b) increased working capital needed to support inventories in transit; (c) the firm exposed to foreign exchange risk which will affect its earnings or the competitiveness of its prices; (d) firm has less information about the credit status of the customer. By establishing an overseas office or appointing an agent, the firm can overcome some of the problems of lack of customer contact or the need for minor modifications. (2) Overseas manufacture. This strategy has two aspects: (a) The firm arranges for its products (or some parts of them) to be manufactured abroad and then imported back to its home economy. (b) The firm arranges for its products to be manufactured in a foreign country for sale there. The possible use of Overseas manufacture was examined in the Kadgee clothing case in September and November 2006 TOPCIMA cases, and is an area that is likely to be examined again due to the importance of globalisation in many industries. In both cases the firm is involved in direct foreign investment because it is purchasing productive capital assets in the country. This brings certain advantages: (a) firm can benefit from lower costs of local economy (labour, buildings and inputs); (b) reduced transportation costs; (c) reduced foreign exchange exposure because production costs are now incurred in the same currency as the good are paid for in; (d) because it provides jobs the firm may gain access to markets previously closed to foreign goods; (e) cheaper goods bolster margins in home markets. The drawbacks are: (a) assets exposed to risk in the foreign economy (e.g. war, sequestration, sabotage, or collapse of the local market); (b) firm may have difficulty obtaining its profits due to currency controls or punitive taxation on exported dividends;

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(3) Multinational operation. Two features setting multinational enterprises (MNEs) apart from other firms with foreign trading activities: (a) it has a deliberate policy of coordinating its value-adding activities across national boundaries; (b) it internalises the cross-border trades (i.e. it does not rely on a market to carry them out but rather uses its own bureaucratic processes). The advantages of this arrangement are: (a) the firm can take maximum advantage of natural resources and lower production costs; (b) the firm is insulated from the effects of hostile governments or trade unions in any specific country because it can always switch (or threaten to switch) output elsewhere; (c) the firm can manage its taxation by arranging to make its profits in low-tax economies; The main drawback is that the multinational is often viewed with suspicion by the governments of host countries because of its foreign ownership and high-potential power. (4) Turnkey operations. These are factories and facilities in foreign countries with which the home firm can establish production contracts. When the firm requires output it exercises the contract (i.e. it turns the key). This is sometimes termed contract manufacturing.

16

Sources of business finance

(1) TOPCIMA may require you to comment on the ways in which a firm is financed or to suggest ways it could improve its financing or raise more capital. (2) The principal sources of finance will be reviewed in this section. Broadly they can be divided into two forms: (a) equity capital: investors buy a share in the business; (b) debt capital: the firm takes on a legal obligation to repay interest and capital.

16.1

Issuing equity to raise capital

The main equity markets available to UK firms are: ●

The Official List : Admission to this allows a firm’s shares to be traded on the ‘main market’ of the London Stock Exchange. Listing costs are many hundreds of thousands of pounds and the requirements for entry, administered by the United Kingdom Listing Authority, are stringent and include a 3-year trading record (except new technology stocks which can join techMARK with 1 years’ record), that no person or connected persons should hold more than 30% of the equity and that at all times at least 25% of the shares should be in public hands in order for a liquid market to exist. These requirements and initial costs that run into several millions of pounds effectively prohibit small and young companies from joining.

TECHNICAL KNOWLEDGE

(c) absence of an exit route if production depends on a license because if the firm wants to sell the factory the national government can decide who it goes to (and the price) because it’s worthless without the license.

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The Alternative Investment Market (AIM): A cheap and less regulated market operated by the London Stock Exchange where small and young companies can have their shares traded. There is no minimum size nor minimum trading record. There are no restrictions on the percentage of shares that can be closely controlled. Although cheaper than a full listing it will still cost between £250,000 and £1,000,000 to achieve admission. Candidates often suggest that an unlisted company could ‘simply’ raise money by becoming listed on AIM. It was even suggested by many candidates for the ailing Kadgee clothing company that was examined in November 2006. Becoming listed is a difficult decision for a company to make and the process would take about 2 years and would only be possible if a healthy 5-year plan and a positive future for the company is forecast. Therefore it is not a ‘quick fix’ to raise cash, nor is a method available to many small companies, particularly those which are in decline or experiencing difficult trading conditions. The listing would not be successful. The candidates which suggested a listing for Kadgee, which was in decline and experiencing very low margins, falling levels of profitability and no dividends having been paid for the last few years, demonstrating a lack of professional judgement as this method of raising finance would NOT be available (or successful) for a company like Kadgee. ● Private markets: Some brokers operate screen-based markets (e.g. Ofex) where shares can be traded on a matched trade basis. Effectively this is a bulletin board where buyers and sellers of a stock post offers and bids and conduct matched trades. ●

Some global firms elect to have listings on several markets (say London, New York and Tokyo) for the following reasons: (1) to broaden the shareholder base to get a better price for shares; (2) to gain access to more capital than the domestic market alone can provide; (3) to raise greater global awareness of the company. The process for gaining a listing (or designation on AIM) is: (1) Appoint a sponsor: This will be a member firm of the London Stock Exchange such as a large bank or brokerage. They will: ● advise on method of flotation and issuing of shares; ● ensure directors and firm is of sufficient quality to join the market; ● arrange a broker and market maker to hold stock and buy and sell it; ● advise on price and timing of flotation; ● arrange for underwriting of shares (i.e. standby buyers who agree to buy at a minimum price if the float is under subscribed). (2) Produce a prospectus outlining history of firm, trading record, future plans and reasons for seeking finance. (3) Engage solicitors, accountants/auditors and registrars acceptable to investors and the market. (4) Decide method of selling shares and issue price. Issue methods include: (1) Offer for sale: Shares are advertised at a set price and buyers subscribe for them. Alternatively in and offer for sale by tender buyers write in and bid for set amounts of shares at a price of their own choosing. Shares are then allotted starting with the highest bidder and working down.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

16.2

Venture capital

Specialist firms well connected to banks and networked well into the business world who rely on their judgement to make deals to provide equity capital for start-up businesses and developing or recovering businesses. The high risks lead these equity investors to expect a 500% ⫹ return within 5–10 years from the sale of their equity: ● ●

in a flotation, in a trade sale of the business to another firm.

Average investment is £5–10 million for which very high-annual rates of return are required (e.g. up to 80% ROCE) in order to ensure the EPS rises sufficiently to give a large capital gain on sale of the shares. VCs will often effectively control the company by: ● ● ●

●

allocating themselves special voting rights, selecting the Chairman and several of the non-executives, building in further releases of equity to themselves if the required ROCE is not hit in order to maintain earnings at the expense of other shareholders, providing the means by which a bank will agree to provide debt to the firm, based on the participation of the VC.

Equity may be provided for a number of purposes: (1) Seedcorn capital – to support a new business concept by financing R&D or writing of a business plan (in the dot.com era this was called ‘incubator capital’). (2) Start-up capital – investment in initial capital assets to start production. (3) Development capital – fast growth companies with negative cash flows will use this to continue building their businesses. (4) Management buy-outs (MBOs) – members of the management team gain capital and buy the firm from its present owners. (5) Management buy-ins (MBIs) – an outside team of managers, often known to the VCs, borrow the money and purchase the business from its present owners. (6) Buy-in management buyout (BIMBO) – a hybrid of an MBO and an MBI. Venture capital was a feature of the Zubinos coffee shops case (March and May 2006) and should be revised as it could occur again as a source of finance.

16.3

Raising debt capital

Methods are: (1) Corporate bonds: Sometimes called loan stock these are a long-term contract to borrow money in return for a periodic payment of interest and eventual repayment of capital. Debentures are bonds secured on specific assets or on a floating charge over a group of assets.

TECHNICAL KNOWLEDGE

(2) Introduction: This raises no capital but merely allows the shares to be traded on the market. It can be a good exit route for otherwise locked-in shareholders. (3) Placing: The sponsoring broker arranges for the shares to be sold to their own private clients. This saves money on advertising and gives a more certain value for the shares. It can also avoid the shares falling into hostile hands.

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Bonds often carry covenants constraining management: for example, from issuing further debt; paying dividends above a certain level; disposing of assets or breaching certain financial ratios: Specific forms of bond include ● Deep discounted bonds which carry very little coupon interest but which are sold at a substantial discount to face value to give a large capital gain at redemption. This enables firms with little or no free cash flows to borrow without struggling to pay the interest. ● Mezzanine debt (or junk bonds): Pay high rates of return because they are issued by firms with little collateral and are hence high risk. ● Convertible bonds (or equity-linked bond): In addition to carrying interest, this bond also gives the holder the right to exchange them for a set number of shares at a future date. The hope value of the equity leads lenders to accept a lower rate of interest than they would seek for a plain bond. ● Foreign bonds (or eurobonds): These bonds are denominated in a foreign currency. Firms that receive revenues in the same foreign currency may prefer these in order to hedge some of their foreign exchange risk by matching the servicing currency for debt to their earnings currency. (2) Commercial paper: Sometimes called commercial bills these are short-term IOUs issued by a firm under a revolving underwriting agreement with a bank. They are issued at discount to redemption value and the holder makes a capital gain at maturity. They principally finance cash flow needs. (3) Project finance: Finance raised specifically for a discreet project and hence separate from the financial structure of the rest of the firm. This insulates the parent company from some of the risks of the project and also avoids a risky or unusual project pulling up the WACC of the whole firm. It also provides a vehicle for attracting funds from sources with a special interest in a project such as a key supplier, the World Bank or a sovereign government in the project’s home country. (4) Sale and leaseback: Firm sells assets such as buildings, cars or machines to a finance house and then leases the use of them back. This releases a cash sum that can be ploughed into the business (or to pay a dividend if the firm is struggling). The drawback of this method is that the firm will now have to make a perpetual payment for the use of the assets which, although tax deductible, will still reduce distributable profits. Therefore, it is critical that the released funds can be invested in projects with a higher rate of return than the effective cost of the lease. (5) Bank loans: The most common form of debt finance for firms. Usually between 5 and 20 years with a floating or fixed charge against assets of the firm and liable to a fixed or floating interest charge. (6) Bank overdraft: This carries a high rate of interest and can be called in at very short notice. It should only be used for financing short-term cash flow needs. (7) Trade credit: Provided by suppliers of materials, stocks or services. This initially seems free credit but recipient firm that relies on this may find itself tied to a particular supplier or forced to accept less good prices or early payment discounts on invoices. (8) Debt factoring: Firm seeks to liquidate its trade debtors by assigning them to a discount to a finance house in return for an initial cash sum. This sum increases with the quality of the debtors assigned and under a recourse factoring arrangement the sums ultimately received by the firm will only be what debtors pay, less an administration fee to the finance house. Non-recourse factoring arrangements shift the risk of non-payment

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

17

Evaluating strategic options

In TOPCIMA you may be called upon to comment on the appropriateness of a strategy being suggested by the board. Alternatively you may decide to argue for a strategy you have thought-up yourself. To do either you must evaluate strategies against three criteria.

17.1

The three criteria for strategic choice

Johnson and Scholes (1997) outline three tests for assessing whether a strategic option should be undertaken: (1) Suitability test. This considers whether the option is the right one given the circumstances of the firm. This boils down to its fit with the SWOT analysis and its accordance with the firm’s mission. (2) Acceptability test. Considers whether the option will gain the support it needs to be successful. This involves an assessment of the likely response and power of key stakeholders such as: ● shareholders, ● management, ● customers, ● regulators and government, ● employees, ● suppliers. (3) Feasibility test. This considers questions such as: ● the reliability of the data or assumptions that support the strategy, ● the availability of resources or competences to make a success of the strategy, ● the firm’s track record in similar strategies. The use of the Johnson and Scholes framework of suitability/acceptability/feasibility is useful to use in your answer to assess any new proposals that you may be given on exam day in the unseen material.

17.2

Stakeholder mapping

Mendelow (1991) proposes the diagram shown in Figure A.19 to help analyse stakeholders.

TECHNICAL KNOWLEDGE

to the debt factoring house but this will involve a smaller amount of cash being paid for the debts when they are assigned. (9) Leasing: Paying for the use of an asset, which remains owned by the finance house. With finance leases the firm is obliged to continue to pay for the use of the asset whether it needs it or not. An operating lease holds out the prospect of returning an asset if it is not needed which can help reduce the fixed cost base of a firm.

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TECHNICAL KNOWLEDGE

264

Level of interest

Low

Low

High

A Minimal effort

B Keep informed

C Keep satisfied

D Key players

Power

High

Figure A.19 Mendelow’s power-interest matrix

Scholes (1998) suggests the following strategies to deal with stakeholders in each quadrant: Box A Box B

Box C

Box D

Direction. This means their lack of interest and power makes them malleable. They are more likely than others to accept what they are told and follow instructions. Education/Communication. The positively disposed groups from this quadrant may lobby others to support the strategy. Also if the strategy is presented as rational or inevitable to the dissenters, or a show of consultation gone through, this may stop them joining forces with more powerful dissenters in C and D. Intervention. The key here is to keep the occupants satisfied to avoid them gaining interest and shifting into D. Usually this is done by reassuring them of the likely outcomes of the strategy well in advance. Participation. These stakeholders can be major drivers of the change and major opponents of the strategy. Initially there should be education/communication to assure them that the change is necessary followed by discussion of how to implement it.

Bibliography Ansoff, H. I. (1965) Corporate Strategy. New York: McGraw-Hill. Davidow, W. H. and Malone, M. S. (1993) The Virtual Corporation. US: Harper Business. Earl, M. (1989) Management Strategies for Information Management. Hemel Hempstead: Prentice Hall. Greiner, L. (1972) Evolution and revolution as organisations grow. Harvard Business Review, July–August. Institute of Risk Management, The Association of Insurance and Risk Managers, The National Forum for Risk Management in the Public Sector (2002) A Risk Management Standard. Internet publication at www.theirm.org.uk. Lynch, R. (1997) Corporate Strategy. London: Financial Times Management. McFarlan, F. W. and McKenny, J. L. (1983) Corporate Information Management: The Issues Facing Senior Management. Homewood II: Dow-Jones-Irwin. Mendelow, A. (1991), ‘Stakeholder Mapping’, Proceedings of the 2nd International Conference on Information Systems, Cambridge MA. Miles, R. E. and Snow, C. C. (1978) Organization Strategy, Structure and Process. New York: McGraw-Hill. Nolan, R. L. (1984) Managing the crisis in data processing. Harvard Business Review, March–April.

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TECHNICAL KNOWLEDGE

Porter, M. E. (1980) Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York: The Free Press. Porter, M. E. (1985) Competitive Advantage: Creating and Sustaining Superior Performance. New York: The Free Press. Porter, M. E. and Millar, V. E. (1985) How information gives you competitive advantage. Harvard Business Review, March–April.

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May 2008 – Solberri

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May 2008 – Solberri

1

Appendix

B

Introduction

In this appendix you will find the pre-seen analysis for the May 2008 exam, based on a resort hotel chain called Solberri. Do remember that as you approach the exam that the priority of your practise should be based around mock exams on your own case study, but for those of you with additional time to practise, or where do not have access to other mocks, this appendix provides you with everything you need to attempt and learn from this exam. Included in this section is the following: Section 2 Section 3 Section 4 Section 5

2

Pre-seen material Unseen material Case writer’s answer Post Exam Guide

Solberri – Pre-seen material

It is likely to be a poor use of your time to read the full pre-seen and analyse this in depth. I suggest that you read the first few pages in detail, since these give you a good summary of the case, and then skim over the remainder of the material, taking no more than 30 minutes in total.

Market overview The holiday industry is a large, varied industry which is very competitive and tourism generates enormous revenues. Branded chains of hotels differentiate from each other according to the level of quality and facilities they offer. The ‘package holiday’ trend started in the 1960s and concentrated on specific tourist destinations. Since then the holiday industry has changed and matured enormously. Since the early 2000s, Internet bookings have made a significant impact on the way customers choose to book their holidays. Increasingly, holiday makers have become much more selective and, through the use of a variety of media, they are able to identify facilities available at their chosen hotel. European holiday makers choose particular destinations depending on weather, facilities, value for money and levels of comfort at the chosen hotel. Significant numbers of holiday makers choose to 269

MAY 2008 – SOLBERRI

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take their holiday in the Peak season. The Peak season in Europe is defined as the months of May to September inclusive. There are a large number of international hotel chains that offer levels of comfort based on the internationally recognised ‘star’ rating system. There are also many holiday resort hotels which offer a wide range of sports and other facilities to customers within the hotels’ grounds. These often include golf courses and a wide range of sports and water sports. A resort hotel is defined as a hotel that includes a far wider range of facilities on site than a typical hotel. There are increasing numbers of resort hotels around the world. These resort hotels, which are designed specifically for holiday makers, are situated in prime tourist areas at popular destinations. The hotel industry relies heavily on its employees and its IT systems to deliver the quality of service expected by its customers. Following a downturn in air travel in 2001, many hotels suffered a decline in bookings and were forced to look hard at ways to differentiate themselves in order to attract customers. The majority of European holiday bookings are still made through established travel companies (whether through travel agent shops or using the travel agents’ websites) although a growing number of bookings are made by the customer with hotels directly.

The Solberri hotel group Solberri is a group of mainly resort hotels, all in Europe. It was established in the mid 1980s by its founder, Richard Berriman. The first two Solberri hotels were located in two different countries around the coast of the Mediterranean Sea. These two Solberri hotels established a high reputation for quality. By the late 1980s the two Solberri hotels were regarded by many other international hotel chains as the benchmark for the standards to aspire to. The success of these first two hotels helped to finance the expansion of the Solberri hotel group. This success financed the expansion of new purpose built resort hotels, which included a wider range of facilities on site, including golf facilities, water sports, spas and beauty treatments. To enable the group to expand further, it needed additional finance, rather then relying solely on loan finance. In 1998 the company became listed on a European stock exchange. By the end of 2000 the Solberri group had 10 resort hotels and the original 2 hotels, which have a smaller range of facilities. These 12 hotels are situated in several European countries, along the Mediterranean coast. The 10 Solberri resort hotels were among some of the most prestigious in Europe at that time. The company continues to invest in new facilities and has a rolling refurbishment programme, which ensures that the high standards which customers expect, are met.

Solberri’s personnel The career histories of Solberri’s key personnel are shown in Appendix 1.

Routes to the market Solberri hotels have 3 main routes to the market. ●

The main route is that bookings are secured as part of a ‘holiday package’ offered by travel agents, where the customer pays a fixed price, inclusive of flights and accommodation,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

In the financial year ended September 2007, around 60% of bookings were made through travel agents. Around 30% were made by new customers directly with Solberri. Around 9% were repeat business. There were a small number of bookings from other sources.

Difficult market conditions for the Solberri group During 2003 to 2005 it became clear, through falling customer numbers and disappointing customer feedback, that the Solberri hotel group had become complacent. The management team had considered that its successful growth and level of profitability would continue. In 2005, the group made its first ever operating loss and the then Chief Executive resigned in early 2006. The financial year ended September 2006 also resulted in an operating loss. The Solberri Board recruited a new Chief Executive, Johan Alnetti, in September 2006.

Pricing changes effective from May 2007 Solberri’s management had previously resisted any change to the pricing structure, although the Board recognised the need to increase its occupancy level. When Johan Alnetti joined Solberri he worked closely with Richard Berriman to review the pricing structures at Solberri hotels in order to boost occupancy levels. Over the last decade, many competitors in the Mediterranean region have offered ‘all inclusive’ accommodation arrangements. An ‘all inclusive’ room rate is defined as a fixed price for the room inclusive of all meals, most drinks and use of many of the available leisure facilities. The room rate varies depending on features, the location of the room and assumes 2 people sharing. Therefore, there are no additional charges, unless spa treatments or particular sports activities are booked by customers. Following extensive market research the Solberri Board decided to change the pricing structure effective from the Peak season which commenced in May 2007. This new ‘all inclusive’ price structure is competitive with other ‘all inclusive’ resort hotels. It has also enabled Solberri to market itself as one of the leading ‘all inclusive’ resort hotel groups in Europe. Prior to the launch of the ‘all inclusive’ room rate for Solberri in May 2007, Johan Alnetti and Piers Lui agreed on which facilities would be included in the ‘all inclusive’ room rate, and which facilities would be charged as extra charges to customers. For example, all of the Solberri hotels have spa facilities including swimming pools, hot tubs, steam rooms and saunas, as well as a range of spa treatments. The use of these spa facilities are not charged as an additional charge. However, all spa treatments which involve the use of highly trained, skilled employees are charged to customers and generate additional revenues. These spa treatments have proved to be very popular with customers and are in high demand. Solberri also has a number of sports activities which generate extra revenues.

MAY 2008 – SOLBERRI

to the travel agent. The revenue generated from bookings made by travel agents is lower than the revenue generated from bookings made by customers who book directly with Solberri, as the travel agents deduct their agreed discount. ● Bookings are made by new customers directly with Solberri using Solberri’s website. These customers usually book as a result of Solberri’s marketing campaigns and make their own flight arrangements. ● Repeat business. Customers return to Solberri and they book directly with the hotel or by using Solberri’s website to secure a repeat business discount.

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These extra revenues generated €21 million in the financial year ended September 2007, which represents an additional 15% of revenue, over and above that which is generated from the ‘all inclusive’ room rate. Giorgi Kahle launched a major marketing campaign to promote the Solberri brand in early 2007 using a variety of media, including direct marketing, radio and TV advertising and the use of other media. This has proved to be effective as the average occupancy level has shown an increase on the level achieved during the 2006 Peak season, to 74% in the 2007 Peak season (see Occupancy levels).

Summary of Solberri hotels The 12 Solberri hotels in the group are currently categorised into 3 types depending on the range of facilities they offer. Solberri does not participate in the international star ratings system, but its range of hotels shown in the table below, is comparable to the international star rating system. The table below also shows the number of rooms available and the average price per room for the 2007 Peak season. The average price per room represents the price for 2 people at the ‘all inclusive’ room rate including food, drinks and all of the inclusive activities. Solberri hotel category

Number of hotels (as at September 2007)

Number of rooms at each hotel

Premier (equivalent to 5 star)

2

250

500

650

Superior (equivalent to 4 star)

7

200

1,400

525

Super plus (equivalent to 3 star)

3

150

450

350

Totals

12

Total number of rooms available

Average price per room per night (Peak season 2007 prices) €

2,350

The average price per room is substantially lower in the Non-peak season, at around 45% of the Peak season price per room. The average price per room shown above is before deduction of the discount given for rooms booked by travel agents and the repeat business discount. It should be noted that two of the hotels currently categorised as ‘Superior’ are now being refurbished during the Non-peak season 2007/08. They will then be re-categorised as ‘Premier’ for the 2008 Peak season (see Investment and refurbishment programme). Johan Alnetti is concerned about the three ‘Super plus’ hotels as they offer limited leisure facilities, spa facilities and water-sports, which is reflected in the lower ‘all inclusive’ room rate.

Growing demand for improved spa facilities Richard Berriman and Johan Alnetti both agree that the range and luxury of the hotels’ spa facilities is a key factor that affects the customers’ decision as to whether or not to book their holidays with Solberri. Market research has been conducted that confirms that spa facilities are a key selling point. Johan Alnetti would like to extend and enhance the size of the spas at all Solberri hotels and also to extend the range of spa treatments on offer. This

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Johan Alnetti is confident that if Solberri were to have enhanced spa facilities at its resort hotels then these could generate additional revenues, sufficient to cover all operating costs of the spa, and also be a selling point to improve the level of bookings for Solberri hotels.

Investment and refurbishment programme Solberri has established world class spa facilities at both of its 2 ‘Premier’ hotels, which has proved very popular. These 2 ‘Premier’ hotels, underwent a thorough refurbishment programme during the Non-peak season in 2006/07, involving the expansion of their spa facilities, as well as refurbishment of other areas around the hotels, costing €6 million each. The improved spa facilities have generated high additional revenues and have made these facilities at the 2 ‘Premier’ hotels profit generating within the first Peak season. These 2 ‘Premier’ hotels have experienced the highest level of accommodation bookings for over 10 years and Richard Berriman considers that this is mainly due to the new enhanced spa facilities. The spa facilities at these 2 ‘Premier’ hotels have also generated much favourable publicity for the Solberri group of hotels. The latest 5-year plan, for the period starting October 2007, was approved in May 2007. It includes plans to continue to invest €12 million annually in the group’s rolling refurbishment programme to bring 2 further hotels each year up to the ‘Premier’ hotel standard. Furthermore, by providing improved spa facilities, additional revenues are generated from customers who book spa treatments. Currently, Richard Berriman considers that only the 2 ‘Premier’ hotels in the group meet the standards to which he wants the Solberri hotels to conform. During the Non-peak season ending in April 2008, a further 2 ‘Superior’ hotels are currently undergoing a refurbishment, which will include improved accommodation facilities as well as enhanced spa facilities. Therefore by the start of the 2008 Peak season, there will be 4 ‘Premier’ hotels in the Solberri group, which meet Richard Berriman’s desire for ‘world class’ spa facilities. Therefore, there will be only 5 ‘Superior’ hotels from the 2008 Peak season. Richard Berriman wants to enhance and extend the spa facilities at the remaining 8 Solberri hotels as soon as possible, but is constrained by a lack of finance. Johan Alnetti has stated that these spa facilities should be extended as a matter of urgency as he believes that the investment will be repaid very quickly by higher occupancy level and also additional revenues generated by the spa treatments. However, the timing and financing for this work has not yet been agreed. Antonio Skrip is reluctant to take on additional loan finance for the refurbishment and extension of spa facilities at the remaining 8 Solberri hotels. He considers that this can be done using cash generated from operations over the next few years.

Key Performance Indicators The Solberri Board uses a variety of key performance indicators (KPIs) to monitor the performance of the group. These KPIs are commonly used in this industry, and include the following: ●

Occupancy level. This most important business measure is defined as the proportion of rooms available during the period which were occupied during the period.

MAY 2008 – SOLBERRI

would require capital expenditure at all hotels and also necessitate the recruitment of additional skilled employees to provide spa treatments.

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●

●

Return on capital employed (ROCE). Solberri defines this KPI in the same way as is the norm for this industry, which is the operating profit generated (after allocated group overheads) divided by Non-current assets at the end of the last financial year. Revenue Per Available Room (RevPAR). This is defined as the total revenue generated from room bookings only for the Peak season (that is after the discounts given to travel agents and for repeat business and before additional revenues from extras, such as spa treatments) divided by the total available rooms during the Peak season, expressed as a daily figure. Level of repeat bookings. This is defined as the number of bookings made by those customers who have stayed at any Solberri hotel within the last 5 years expressed as a percentage of the total number of bookings.

A summary of the KPIs for the Solberri group for the year ended 30 September 2007 is shown in the table below. Hotel category

Number of hotels

Occupancy level (Peak season)

ROCE %

RevPAR (Peak season only) €

Repeat bookings

Premier

2

89.5%

10.7%

471.8

9.0%

Superior

7

72.0%

7.5%

306.6

8.7%

Super plus

3

63.0%

4.0%

178.8

10.0%

12

74.0%

8.1%

317.3

9.0%

Total

The RevPAR figures above are shown for the Peak season only and are based on the revenue generated at the average price per room (as shown in the table) at the average Peak season occupancy level less the proportion of discounts given to travel agents and for repeat business. For example, the RevPAR figure of €471.8 for the ‘Premier’ hotels is calculated on the total revenue, after discounts of 18.9% overall, which was €36.093 million. This amount is divided by 500 (representing the 500 ‘Premier’ rooms), and further divided by 153 (representing the 153 days in the Peak season). This results in the RevPAR figure of €471.8. The Balance Sheet, Income Statement and Statement of Changes in Equity for Solberri for the last 2 financial years are shown in Appendix 2.

Occupancy levels The key driver for profitability is the occupancy level achieved. A low level of occupancy is acceptable to the Solberri management team for the Non-peak season providing it covers the operating costs. However, the overall level of profitability is mainly affected by the occupancy level achieved in the Peak season. The planned occupancy level for the 2008 Peak season is 85%. Giorgi Kahle has an agreed marketing budget of almost €22 million for the financial year to September 2008 to stimulate demand to achieve this planned higher occupancy level. He has allocated this budget between a number of marketing areas, including marketing literature, direct mail and advertising on radio and television. There was a marketing campaign during the last few months of 2007 and early 2008 and he is currently finalising a further follow-on marketing campaign in order to deliver the planned higher occupancy level in the 2008 Peak season. All of these marketing campaigns will be achieved within the agreed marketing budget of €22 million.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

As far as Solberri’s management can establish two of its main competitors managed to achieve occupancy level of around 90–95% during the 2007 Peak season. Indeed, some of the enquiries by Giorgi Kahle’s market research team have established that some competitors’ resort hotels were fully booked (100% occupancy) during some weeks of the 2007 Peak season. It remains a challenge for the Solberri group to try to achieve fully booked hotels during the 2008 Peak season. The average occupancy level across the 12 hotels in the Solberri group, compared to planned occupancy levels, are shown in the following table. Average occupancy level across all 12 Solberri hotels

Non-peak season

Peak season

Overall

(7 months: October to April inclusive)

(5 months: May to September inclusive)

Financial year ended:

Actual

Plan

Actual

Plan

Actual

Plan

September 2006

19.0%

30.0%

65.0%

75.0%

38.3%

48.9%

September 2007

25.0%

30.0%

74.0%

80.0%

45.5%

51.0%

September 2008

Not available

30.0%

Not available

85.0%

Not available

53.1%

September 2009

Not available

30.0%

Not available

90.0%

Not available

55.2%

Revenue targets The budgeted revenue target for the financial year ended September 2008 is €193 million. This higher level of revenues is driven primarily by the higher average planned occupancy of 85% for the Peak season. Furthermore, effective from the 2008 Peak season there will be 4 ‘Premier’ hotels, as 2 hotels are being refurbished during the Non-peak season ending April 2008 (as detailed above in Investment and refurbishment programme). The ‘all inclusive’ room rates which were introduced for the 2007 Peak season are budgeted to remain the same, due to pressure from competitors. During the financial year ended September 2007, the revenue generated from additional charges was 15% of the revenues generated from the ‘all inclusive’ room rate. Additional revenues are generated by customers using facilities which are not included in their ‘all inclusive’ room rate, including all spa treatments, and the tuition fees for a variety of sports. The 2007/08 revenue budget includes a growth in revenue generated by additional charges, to 17% of the revenues generated from the ‘all inclusive’ room rate.

Operating costs Each hotel is managed by a General Manager who reports directly to Johan Alnetti, the Chief Executive but has functional responsibility to other Directors. Johan Alnetti has instructed the General Manager of each hotel to re-examine its operating costs and to find ways to make savings without any impact on the quality of service or customer perceptions. Furthermore,

MAY 2008 – SOLBERRI

The average period that customers stay at a Solberri hotel is 10 nights, with 50% of customers staying only 7 nights. 37% of customers stay for 14 nights and the remaining 13% of customers stay between 8 and 14 nights.

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STUDY MATERIAL T4

all of the General Managers are under pressure to achieve the targets set out in Solberri’s Corporate Social Responsibility report, which is shown in Appendix 3. Each General Manager is responsible for procurement at the hotel he or she runs, with little interference from Head Office. However, decisions on the range of spa treatments and sports facilities are the responsibility of Piers Lui, who also determines the prices for all spa treatments and sports which are not included in the ‘all inclusive’ price. The operational aspects of the spa and sports facilities are managed by each General Manager. Following the change in the pricing structure in early 2007 to the ‘all inclusive’ room rate, there was a substantial fall in administration work and most General Managers achieved the agreed planned reduction in the level of administration staff. Together with the introduction of new IT solutions, which will further simplify administration, each hotel is planning to achieve further cost savings. Solberri has outsourced many of its routine operations, including laundry, property maintenance and maintenance of pool and sports facilities. The companies Solberri has outsourced these operations to have had Service Level Agreements imposed on them. However, the General Managers at some hotels have had difficulty enforcing the agreed quality service levels. There are still a number of outsourced operations that are not being delivered to the required standard, due to clashes of priorities. For example, a General Manager has insisted that the outsourced maintenance company does not turn off water supplies at certain times to undertake repairs. This has led to the outsourcing company complaining that this has prevented it from carrying out the contracted work in accordance with agreed deadlines. One of the planned cost savings is the introduction of solar panels at each hotel which it is forecast will be capable of saving around 30% of the electricity costs. However, the required investment for this has repeatedly been delayed. The solar panel proposal is to invest €6 million across the group of 12 hotels. Richard Berriman has delayed the solar panel proposal as he wants all available investment channelled towards improving visible customer facilities. An analysis of operating costs by main cost categories for the financial year ended 30 September 2007 is as follows: Cost category

Financial year ended 30 September 2007

%

€ million Employee costs

62

42%

Food and drink

21

14%

Outsourced functions

15

10%

Marketing costs

20

14%

3

2%

15

10%

IT costs Depreciation Other costs

12

8%

Total costs

148

100%

Solberri loan finance At the end of the financial year ended 30 September 2007, Solberri had loans totalling €33 million, including a loan of €12 million that was due for repayment in December 2007.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

This new loan for €20 million has been used to repay the loan due for repayment and left €8 million to be used for further capital investment. This €8 million, together with some of the cash generated from operations, will be used to finance the refurbishment and enhanced spa facilities at the 2 ‘Superior’ hotels currently being upgraded to ‘Premier’ status (as outlined above in Investment and refurbishment programme).

Improvements to Solberri IT systems Pietro Heys was requested by the Board to review all of Solberri’s IT systems when he was appointed to his role in Solberri in April 2006. The Bookings Management System (BMS) provides information for the management on room rates and availability. In November 2006, Solberri selected and began implementation of a new BMS system and is paying an annual licence fee for the use of a standard internationally recognised bookings software system. This new BMS system is designed to optimise customer management and hotel occupancy rates. Additional specialised functions include sophisticated availability search facilities, itinerary reservations (for spa, restaurant and sports bookings) and customer accounting and billing. This became operational in November 2007. The Corporate Information System (CIS) is a management tool to provide information to the senior management team both at Head Office and within each hotel. The CIS consolidates information about each customer such as spending patterns, preferred accommodation and leisure facility requests. Other functions include centralised travel agency booking statistics. The Business Intelligence (BI) system provides a variety of strategic analysis and planning tools for the entire business, in much the same way as an Executive Information System (EIS) does. It extracts data from other Solberri IT systems to enable data analysis. The BI system produces key industry performance indicators (KPIs) for each of the hotels in the group and for the entire group (see above for KPIs). The BI system produces data on ROCE and Revenue per Available Room (RevPAR) (these terms are defined above in KPIs). These KPIs are produced weekly to closely monitor business performance. It also enables the Board to compare the revenues across each of the hotels in the group, and also to compare its KPIs with published data of its competitors. The total cost of all the IT investment in hardware and software has been €6 million over the last 2 years and Pietro Heys is confident that Solberri has now got efficient systems in place. However, Solberri has still some further IT projects to undertake to bring it up to the standards of its competitors, let alone for it to be a market leader. The next phase of development will be to introduce some software, which would allow prospective customers to see typical rooms and hotel views and also the range of facilities on offer at all 12 Solberri hotels. The forecast cost of this development is €5 million and Pietro Heys has requested budget allocation for the entire amount in the financial year 2008/09.

MAY 2008 – SOLBERRI

Antonio Skrip has taken out a new loan for €20 million, which has been secured on 6 specific hotels in the Solberri group including the 2 ‘Premier’ category hotels and 4 of the 7 hotels in the ‘Superior’ category. This new loan is at 10% interest per year and is repayable in December 2014. Therefore, at the end of December 2007, Solberri had loans totalling €41 million.

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Human Resource issues Solberri operates a human resources policy which is laid down in its procedures manual. This includes procedures on appointment, customer/employee relationships, code of conduct, leave entitlements, termination of employment and workplace health and safety. In order to meet the latest European standards on employee working conditions and terms of employment, Suzanne De Loore is currently updating the procedures manual. This will now include policies on the prevention of drugs and alcohol misuse, sexual harassment, theft and stress. The revised policies will additionally cover environmental awareness and the use of computers. The updated procedures will be implemented in April 2008. The new HR policy will also set clear guidance for managers on the pay rates and working hours for all employees. The majority of Solberri’s employees are temporary employees who are employed only for the Peak season on short-term contracts. Of these temporary employees, over half work for Solberri for one Peak season only and do not return. These are often young people travelling around Europe, who have limited knowledge of the hotel industry and are only working to earn money to continue their travels. These inexperienced employees are working in a range of positions from housekeeping and catering employees to sports instructors. Suzanne De Loore has raised concerns with Richard Berriman that these short-term contract employees do not have job descriptions setting out their areas of responsibility and sometimes they do not possess the core skills required to perform their duties. She is also concerned that the induction programme is not taken seriously by the employees. The other half of the short-term contract employees are experienced Solberri employees who return each Peak season, as this is their main source of employment in their local area. The minority of employees are employed on long-term contracts. Many of these have worked for Solberri for over 10 years. These employees have job descriptions and contracts of employment which set out conditions of work including hours, leave, remuneration, benefits, appropriate use of business assets and confidentiality in respect of Intellectual Property.

Customer service and quality management programme All short-term contract employees receive 2 days induction training, which includes all aspects of customer service and issues such as health and safety and hygiene awareness. Whilst the majority of the short-term contract employees are hardworking and polite to customers, there are some who do not provide the standard of service expected at Solberri hotels. Despite providing training to all employees, it is clear to hotel General Managers and Board members that the level of service provided by some of the employees is not up to the standard expected. Richard Berriman has made it clear to all employees, as well as hotel General Managers, that this situation must be improved. Furthermore, the level of customer service expected by Solberri customers is greater now than ever before, as a result of the increasingly high standards being provided in top luxury international hotels. Many customers choose to return to a hotel based on their experience, which can be positively or negatively affected by the level of customer service received during their stay. Possibly as a result of lower than expected customer service, repeat bookings

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Suzanne De Loore and Nik Silva are currently working together to update and implement a rolling training programme for all employees of Solberri. All employees will continue to receive basic customer service training. Those employees dealing directly with the customers, such as waiters, receptionists and sports instructors, will attend specifically tailored customer service training sessions. For those employees on longer term contracts, training will be carried out annually. Other initiatives, which are planned to be introduced by June 2008, include an environmental awareness programme and stress management training, which will be available for senior employees and management. In order to improve employee focus upon quality issues, Suzanne De Loore introduced a quality management initiative in September 2007. As part of this initiative, all employees are required to participate in quality teams, which meet on a monthly basis. Each team is made up of employees from a variety of jobs and levels and each team is responsible for a particular aspect of quality management in the hotel. These multi-disciplinary teams meet for 1 hour to discuss issues that have arisen during the month and to suggest ways to improve. However, these quality teams have not been popular with employees, as many have seen little evidence of any change occurring as a result of their suggestions and some employees feel that their input is not valued. A further issue is that attendance at these meetings is compulsory, regardless of whether the employee is scheduled to be working on that day. The results of the latest customer survey, compared to 2006 results and the target for 2010 is shown in Appendix 4.

Solberri shareholders The Solberri hotel group was founded in the 1980s and became listed in 1998. The company has 24 million shares of €0.50 each in issue and has a total of 50 million authorised shares. Suzanne De Loore launched an employee share scheme in 2001 and all long-term contract employees receive free shares at the end of each financial year dependent on a range of performance related indicators. Solberri’s shares are owned by a number of institutional investors as well as other shareholders. The shareholdings at the end of the last financial year, 30 September 2007, are as follows: Number of shares held (million) Institutional investors Other shareholders Richard Berriman (Chairman) Directors Employees Total

9.2 3.8 7.2 3.6 0.2 24.0

Solberri’s share price at 31 December 2007 was €4.47. The highest share price for the preceding 12 months was €5.33 and the lowest was €3.57. The highest share price that Solberri has achieved was in 2002 when the shares were traded for over €10.00 per share.

MAY 2008 – SOLBERRI

are anticipated to be lower than previously, at only 7.5% during the forthcoming 2008 Peak season.

279

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280

STUDY MATERIAL T4

Appendix 1 Solberri’s key personnel Richard Berriman – Chairman Richard Berriman, aged 46, grew up in a family which owns and operates a chain of restaurants. He has been involved in the leisure industry for all of his working life. He has no formal qualifications, but has much practical experience at all levels. His ambition was always to operate a small hotel chain and he was very proud when the Solberri group was listed. Since 2006 he has been under much pressure from shareholders to turn the business around. He has recruited an experienced new Chief Executive, Johan Alnetti, who he respects greatly and they work well together. Johan Alnetti – Chief Executive Johan Alnetti, aged 36, joined the Solberri group in September 2006 following a decline in occupancy level and a substantial fall in group profits over the previous few years. He has previously managed a small chain of hotels and relished the challenge of turning around the fortunes of the Solberri group. He is very decisive, has many innovative ideas and is not afraid of making difficult decisions in order for Solberri to compete effectively. Giorgi Kahle – Director of Sales and Marketing Giorgi Kahle, aged 40, joined Solberri in late 2004 and has made significant changes in the way that the Group’s hotels are marketed. He has raised the profile of many of the resort hotels and has been a keen supporter of the changes being made by the new Chief Executive, Johan Alnetti. He is under much pressure to increase customer numbers and to increase the occupancy level, but has struggled to achieve this in the face of competition, and the need for Solberri to refurbish many of the hotels in the group. Giorgi Kahle is also working with a number of international companies to try to secure bookings as part of their employee reward systems. Antonio Skrip – Group Finance Director Antonio Skrip has been with Solberri since 1995 and was instrumental in the company achieving a listing. Since then he has been under pressure from its shareholders to deliver the high levels of dividends that they expect. Following the operating losses in the financial years ending September 2005 and 2006, he has worked hard, as part of the management team, to try to improve the finances of the group and to make it once again become a cash generator. Pietro Heys – Group IT Director Pietro Heys, aged 32, is the youngest member of the Board and joined Solberri early in 2006. He was recruited to improve the quality and timeliness of information available for all 12 hotels and to implement a new Business Intelligence (BI) System. He is continuing to select and implement innovative IT solutions to improve Solberri’s ability to compete. Dimitri Vitt – Director of Design Dimitri Vitt, aged 35, has been involved with design for many years. He was recruited by Johan Alnetti in December 2006, due to his excellent reputation for innovative designs. He has inspected all aspects of all of the hotels in the group and has a long list of changes that he would like to make to improve the ambience and standards of reception areas and bedrooms. He would like to have themed sections for each hotel, with customers being

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Piers Lui – Leisure Facilities Director Piers Lui was recruited into the Solberri group in 2005, as Richard Berriman considered that the Solberri hotels were not being innovative enough and that this was leading to the decline in the number of customers. Piers Lui had been responsible for the facilities at a world class hotel in Asia and wanted to expand his responsibilities across a hotel group in Europe. He is responsible for the selection and operation of all leisure facilities at Solberri hotels. Suzanne De Loore – Human Resource Director Suzanne De Loore, aged 38, has worked in the hotel industry all her career and is familiar with the many roles and requirements of the industry. She joined the group in 1997 just before the company was listed. She was initially very pleased with the prestige of the group and the treatment of its employees. However, despite her continued hard efforts to recruit and retain people with appropriate skills, she is now disappointed and rather de-motivated because the group has seen a decline in its popularity. Richard Berriman does not have a good relationship with her, and considers her to be too protective of all employees rather than the reputation of the group. She is admired for her fairness and respected by all employees. Nik Silva – Director of Customer Service Nik Silva, aged 40, was recruited by Johan Alnetti in early 2007, as Johan Alnetti did not consider that customer service was given the high profile in the group that it required. Previous to his appointment, each of the hotel General Managers was responsible for customer service at the hotels each managed. Nik Silva wants to raise the standard of service provided and to implement best practice across all hotels in the group. He also wants to improve the management training programme, and is working closely with Suzanne De Loore to prepare and implement an improved programme, which will affect all employees, not only customer facing employees, as he considers that only by involving all employees can standards be raised. Anna Roet – Director of Property Management Anna Roet has worked for the Solberri group for over 22 years and has managed the increased portfolio of properties, from the original 2 hotels, up to the current 12 hotels. She liaises closely with a range of external agencies and construction companies, who undertake all of the routine property maintenance and repair work. Hotel General Managers The company also employs a General Manager for each of its 12 hotels. They have responsibilities to each of the functional directors, but report directly to the Chief Executive. The Hotel General Managers do not have Board responsibility. They are responsible for the day-to-day operations at each of the hotels in the group. They liaise closely with Nik Silva, the Director of Customer Service, in order to provide feedback from customers and to inform Nik Silva of current problems. Non-executive directors Solberri has four non-executive directors. The four non-executive directors hold various other directorships in the travel and leisure industry and are based in Europe. Two of the non-executive directors are members of Richard Berriman’s family.

MAY 2008 – SOLBERRI

given the choice of room design. He has also worked closely with the group’s external architects on the design for the extended spas.

281

MAY 2008 – SOLBERRI

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STUDY MATERIAL T4

Appendix 2 Solberri’s Balance Sheet, Income Statement and Statement of Changes in Equity Balance Sheet

As at 30 September 2007 € million

Non-current assets (net) Current assets Inventory Trade receivables and prepayments Cash and cash equivalents

As at 30 September 2006 € million

€ million

136 14 9 3

123 11 7 2

26 162

Total assets Equity and liabilities Equity Share capital Share premium Revaluation reserve Retained earnings

€ million

12 28 30 18

20 143

12 28 10 15 88

Non-current liabilities Loans: Loan at 10% (repayable in December 2007) Loan at 8% (repayable in September 2010) Loan at 11% (repayable in June 2012)

–

65

12 6 15

6 15 21

Current liabilities Bank overdraft Loan at 10% (repayable in December 2007) Trade payables and accruals Customers’ deposits (for future bookings) Tax Total Equity and liabilities

– 12 28 10 3

33 2 – 35 8 –

53 162

45 143

Note: Paid in share capital represents 24 million shares of €0.50 each at 30 September 2007 Income Statement

Revenue Total operating costs Operating Profit / (Loss) Finance costs Tax expense (effective tax rate is 32%) Profit / (Loss) for the period

Year ended 30 September 2007 € million 159 148 11 3 3 5

Year ended 30 September 2006 € million 138 145 (7) 3 0 (10)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Share capital € million

Share premium € million

Balance at 30 September 2006 Profit for the period Revaluation reserve Dividends paid Balance at 30 September 2007

12 – – – 12

28 – – – 28

Revaluation reserve € million 10 – 20 – 30

Retained earnings € million

Total € million

15 5 – (2) 18

65 5 20 (2) 88

Appendix 3 Corporate social responsibility report for year ended September 2007 Achievements in year ended September 2007 Environmental policy Solberri is committed to its focus on green initiatives, focusing upon green policies, monitoring and reducing consumption levels and converting environmental efforts into cost-reduction and revenue generating opportunities

●

●

1 hotel won a Bronze Award in the Green Tourism Business Awards 2007 90% of employees trained in environmental awareness during induction

Targets for years ended September 2008 to 2010 ●

●

●

●

Resources Solberri intends to reduce its use of water and materials through awareness programmes and through the design of new buildings, equipment and better working practices

●

●

●

●

●

●

Introduction of dual flush toilets in 8 of the 12 hotels 2 dedicated recycling units set up Reduced electricity consumption by 0.5% across all hotels Recycling of 80% of plastic, paper, cardboard, glass, waste cooking oil Customers choose to retain 60% of towels each day, and only request that these towels are changed after the second day 90% of all light bulbs replaced with energy efficient alternatives

●

●

●

●

●

Appointment of an Environmental Director Investigate and implement new technologies to improve efficiency in energy and waste management processes Work with suppliers to encourage them to operate in an environmentally responsible manner Environmental responsibility to become a condition for all suppliers and outsourcing companies. Re-use / donation of all viable furniture and fittings when furniture and fittings are replaced Installation of energy efficient windows and solar panels to improve thermal performance of all new building work Recycling of 90% of plastic, paper, cardboard, glass, waste cooking oil and toner cartridges by 2010 To save 90% of towels for changing after second day 100% of all light bulbs replaced with energy efficient alternatives

MAY 2008 – SOLBERRI

Statement of Changes in Equity

283

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STUDY MATERIAL T4

Working with local communities Solberri is committed to working with its local communities, to build strong relationships and to encourage partnerships with local business and industry Health and safety Solberri continues to apply high standards of health and safety to all employees and customers. The company strives to provide a safe environment.

●

●

●

●

Sponsorship of local community gardens at 6 locations 70% of fresh produce sourced from local suppliers

●

100% of newly recruited employees trained in Health and Safety issues 2% reduction in reported employee accidents

●

●

●

To continue to support charitable organisations both locally and internationally. Sourcing of 100% of fresh produce from local suppliers Provision of annual training programmes in Health and Safety for all employees Further reduction in employee accidents to no more than 5 minor accidents per year and 0 major accidents

Appendix 4 Results of customer feedback survey 2007 The data in this appendix is based on survey information for the last 2 years. It should be noted that customer feedback surveys are completed for fewer than half of the rooms booked. However, the Solberri Board is committed to improving the percentage of customers that rate the facilities or service as excellent, although it is aware that this is a challenging task.

Overall assessment of hotel service: 1. Level of overall customer service you received in the hotel 2. Overall standard of your room Overall assessment of leisure facilities: 3. Range of sporting and leisure facilities at the hotel 4. Overall standard and quality of the leisure and sporting facilities at the hotel Overall Assessment of the Spa Facilities: 5. Overall standard of the spa facilities 6. Range of treatments at the Spa facilities 7. Quality of treatments in the Spa facilities

3

Actual year ended September 2006

Actual year ended September 2007

Target year ended September 2010

Rated as ‘Excellent’ by customers

Rated as ‘Excellent’ by customers

Rated as ‘Excellent’ by customers

15%

18%

50%

16%

20%

50%

16%

19%

50%

16%

21%

50%

10% 9% 10%

11% 12% 7%

60% 60% 60%

Solberri – Unseen May 2008

Forecast of high booking levels for the 2008 Peak season The Solberri group of 12 hotels has achieved a very high level of advance bookings for the 2008 Peak season, following a pre-Peak season marketing campaign, which has proved to

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Due to Solberri’s effective marketing campaigns, it is forecast that the average occupancy level during the 2008 Peak season will be 95% across all hotels, compared to 74% in the 2007 Peak season. For the 2008 Peak season there are now 4 ‘Premier’ hotels (following the refurbishment and extension of spas facilities at 2 hotels during the last Non-peak season). These 4 ‘Premier’ hotels are fully booked (100% occupancy level) for some weeks during the current 2008 Peak season and the other Solberri hotels are forecast to be around 92% full. Nik Silva, the Director of Customer Service, has been reviewing an analysis of the 2007 customer service questionnaires (summarised in Appendix 4 of the Pre-seen material) from all 12 hotels and has identified some problems associated with poor quality. These are due to a shortage of fully trained, skilled employees in a number of areas. Although all new employees are trained in customer service during induction, there still seems to be a problem with the level of service being provided. In addition, Nik Silva is reviewing staffing levels in order to meet the demands from the high bookings for the current 2008 Peak season. Several senior managers working within the hotels have had to take time off during the last year due to stress. One General Manager is currently on long-term sick leave as a result of stress. Many of the hotel senior managers work more than 16 hours each day during the Peak season, despite their employment contracts stating that maximum working hours per day should be no more than 12 hours. Additionally, most General Managers state that allowing their hotel senior managers to take their contractual days off is difficult, as the hotels are severely understaffed in terms of senior management employees.

Cash forecast Following the recent high level of bookings, Antonio Skrip has prepared an updated forecast which shows post-tax profit for the year ended September 2008 will be €27 million. This large increase in profit is due to many of the costs being fixed. Therefore, the forecast increased occupancy level will have a direct positive impact on profitability. This forecast would result in cash generated from operations for the year ended 30 September 2008 of €59 million, before finance costs, tax and dividends. At the Solberri Board meeting in early May 2008, there was some discussion of how the cash generated from operations for the financial year ended September 2008 could be used. The Board has a choice of a number of alternative proposals including: ● ●

● ●

Proposal A – Extend the number of rooms at ‘Premier’ hotels (see proposal below) Proposal B – Invest in refurbishment and extended spa facilities at the remaining hotels (see proposal below) Proposal C – Acquire an additional resort hotel (see proposal below) Proposal D – Invest in environmentally friendly initiatives (see proposal below)

MAY 2008 – SOLBERRI

be very successful. Solberri was the winner of a holiday award on a European TV travel programme, which has stimulated a higher number of bookings. Several additional mailshots were also made and these appear to have been very effective in terms of generating a substantial number of bookings across all 12 Solberri hotels. Solberri has contributed towards a joint marketing campaign with two travel agents. The majority of the bookings made by travel agents in the 2007 Peak season were made through these two travel agents.

285

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STUDY MATERIAL T4

Following the announcement of Solberri’s high booking levels, its share price rose. Solberri’s current share price, at Friday 16 May 2008, was €6.25.

Proposal A – Extend the number of rooms at ‘Premier’ hotels The Board is considering extending the number of rooms at some, or all, of the 4 ‘Premier’ hotels. Some of these 4 ‘Premier’ hotels are fully booked for some weeks during the Peak 2008 season. There is adequate space within the grounds of each of these 4 ‘Premier’ hotels for the construction of an additional 200 rooms and supporting facilities. This proposal would increase the number of rooms across these 4 ‘Premier’ hotels from 900 rooms to 1,700 rooms. This would increase capacity of the Solberri group of 12 hotels to 3,150 rooms if all 4 ‘Premier’ hotels were to be extended. The forecast cost of expanding the accommodation is €9 million at each of the ‘Premier’ hotels. Antonio Skrip, the Finance Director, considers that the expansion of these 4 ‘Premier’ hotels should proceed, as the proposal is forecast to generate an NPV of €10 million for each hotel, over a 5-year period. This is based on achieving a forecast occupancy level in the Peak season of 80% for each expanded hotel. However, Giorgi Kahle, the Director of Sales and Marketing, does not believe that customers will accept the more crowded and less exclusive environment resulting from this proposal. He has also questioned whether the Peak season 80% occupancy level for the expanded ‘Premier’ hotels can be achieved.

Proposal B – Invest in refurbishment and extended spa facilities at the remaining hotels Richard Berriman is keen to bring forward the capital investment programme to refurbish and extend the spa facilities at all of the remaining 8 Solberri hotels. The 4 ‘Premier’ hotels have been refurbished and have had extended spa facilities built over the last 2 Non-peak seasons. Under the current agreed capital expenditure plan, a further 2 ‘Superior’ hotels will be refurbished and have their spa facilities extended during the next Non-peak season, later in 2008 to 2009. Following the success of the spas at 2 ‘Premier’ hotels during 2007 and the high level of bookings at the 4 ‘Premier’ hotels during the 2008 Peak season, it is proposed to bring the refurbishment programme forward. The forecast cost of the refurbishment and extension of spa facilities at the remaining 8 Solberri hotels is €6 million each. As a result of the proposed refurbishment and extension of spa facilities, the ‘Superior’ hotels would be re-categorised to ‘Premier’ and the ‘Super plus’ hotels would be upgraded to ‘Superior’. However, the 3 ‘Super plus’ Solberri hotels have very limited space available to extend the spa facilities, unless some of the existing accommodation space is used. In order to extend the spas at the 3 ‘Super plus’ hotels, a total of 10% of the accommodation, 15 rooms in each hotel, would need to be closed permanently. The operating profit for the 3 ‘Super plus’ hotels was €0.6 million for all 3 hotels for the year ended September 2007.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

A hotel in a very popular coastal resort location has been put up for sale as the current owner is retiring. Giorgi Kahle, Solberri’s Director of Sales and Marketing, is proposing that Solberri should acquire it. The forecast NPV’s using varying occupancy levels for the important Peak season for this proposal, based on 10 years post-tax cash flows have been prepared (by Giorgi Kahle and Antonio Skrip). The NPV figures shown below include all relevant cash flows for the Peak and Non-peak seasons, but the NPV figures vary directly according to the Peak season occupancy levels. Peak season occupancy level 95% 80% 50%

NPV € million 100.0 35.0 (25.0)

Probability 25% 60% 15%

The post-tax cost of acquiring this hotel is forecast to be €5 million. It would need extensive refurbishment which is forecast to cost €16 million (post-tax) to bring it up to the standard of a Solberri ‘Premier’ hotel and it would have 250 rooms. These capital costs are included in the above NPVs. Additionally, because the hotel has been in need of major refurbishment for some time, Giorgi Kahle has forecast that additional one-off marketing costs of €3 million, post-tax, would be required to re-launch the hotel as part of the Solberri group. This is not included in the NPVs above.

Proposal D – Invest in environmentally friendly initiatives Luc Pinard, Solberri’s newly appointed Environmental Director, has prepared a proposal to invest in a range of technology to improve Solberri’s environmental profile. Many companies are facing the challenges of reducing their damage to the environment. Luc Pinard would like Solberri to change the way it operates in order to become more environmentally friendly. He considers that his environmentally friendly proposal is the correct business stance for Solberri and that it could also lead to higher bookings as customers become more aware of environmental issues. Luc Pinard’s proposal is to invest in a range of environmentally friendly initiatives with a total cost in the financial year ending September 2009 of €15 million. The proposal includes the installation of solar panels at all 12 hotels at a cost of €6 million. The investment in solar panels at each hotel has repeatedly been delayed due to lack of financing. It is forecast that this could save 30% of the electricity costs, which would result in an annual saving of €0.6 million. In addition, he would like to invest €9 million in a range of other environmental initiatives, including improved management of waste, IT solutions to reduce electricity usage and improved employee training on environmental issues.

Fall in spa revenues at one ‘Premier’ hotel The spa manager at one of the ‘Premier’ hotels left Solberri at the end of April 2008 and has established her own spa business less then 500 metres outside of the hotel. Her contract did not prevent her from establishing a business so close. This has led to a reduction in spa bookings at this ‘Premier’ hotel and resulted in spa revenues falling by 8% over the last 3 weeks.

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Proposal C – Acquire an additional resort hotel

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Finance Director resigns There have been a number of Board room disputes in recent months and Antonio Skrip has resigned. With the agreement of Johan Alnetti, Antonio Skrip left Solberri on 16 May, serving only 1 week of his contractual 3-month notice period.

Loan covenant restriction Johan Alnetti has only just discovered that the €20 million loan that was negotiated at the end of 2007 has loan covenants stating that no further loan finance can be taken on at all within a 2-year period from December 2007.

Distribution of tips All of the 12 Solberri hotels have a range of evening entertainment facilities, including dining rooms, function rooms, lounges, outside terraces and bars. Most of these facilities are staffed by short-term contract employees who rely upon the tips left by customers to supplement their basic wages. It is accepted policy throughout the Solberri group that all tips left in cash are distributed only to customer facing employees who worked that evening. However, at one ‘Superior’ hotel, the General Manager has instructed his managers to hand all tips into his office at the end of each day. The tips are then distributed to all employees, irrespective of whether they were on duty that evening. He believes that this encourages more of a team spirit and rewards employees who are not customer facing. However, the customer facing employees who work evening shifts at this hotel are very unhappy about the changed way of distributing the tips. Furthermore, they do not trust the management to distribute all of the tips that are collected. This changed method of distributing tips has had an adverse effect on customer service at this hotel.

Appointment of a consultant At the Solberri Board meeting held in May 2008, it was agreed that a consultant would be appointed to advise the Board on the issues facing Solberri.

4

Solberri hotels – Case writer’s answer for May 2008

TOPCIMA – Solberri hotel case – May 2008 exam REPORT To: Solberri Board From: Consultant Date: 22 May 2008 Review of Solberri

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

1.0 Introduction 2.0 Terms of reference 3.0 Prioritisation of the issues facing Solberri 4.0 Discussion of the issues facing Solberri 5.0 Ethical issues and recommendations on ethical issues 6.0 Recommendations on business issues 7.0 Conclusions Appendices: Appendix 1 Appendix 2 Appendix 3 Appendix 4 Appendix 5 Appendix 6 Appendix 7 Appendix 8

1.0

SWOT analysis PEST analysis Summary of key ratios and other financial data Summary of investment proposals Summary of cash available for investment Dividend proposals Proposal to acquire an additional resort hotel Recommendation on which investments to undertake with cash generated from operations in 2008

Introduction

Solberri is a listed company that operates a group of 12 hotels in holiday destinations in Europe. Solberri has been profitable for many years and became listed in order to finance the expansion of the number of Solberri hotels. However, it became less competitive and made losses for the 2 financial years ended September 2005 and 2006. The Solberri Board appointed a new Chief Executive who helped to initiate a number of changes, including an ‘all inclusive’ pricing structure and a refurbishment programme creating new ‘Premier’ category hotels. At the start of the 2008 Peak season there are 4 ‘Premier’ hotels and these have got very high levels of bookings. The forecast high level of bookings for the 2008 Peak season, which is what Solberri has been working to achieve, needs to be actively managed to ensure customer satisfaction. The 2008 Peak season has already started in May 2008 and there is still a problem with the level of customer service being provided and that staffing levels are being reviewed. Solberri has a number of investment opportunities to review and decide on as well as a range of operational problems which could affect its strategic plans.

2.0

Terms of reference

I am a consultant appointed by the Solberri Board to prioritise and discuss the issues facing Solberri and to make appropriate recommendations. This report will discuss a wide range of alternative strategic choices and make recommendations which will generate an increase in shareholder value.

MAY 2008 – SOLBERRI

Contents

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3.0

Prioritisation of the issues facing Solberri

3.1 Top priority – Customer service and quality issues If customer service and quality issues are not addressed, by recruitment of additional employees and better training, then Solberri may not achieve the forecast cash surplus and is in danger of damaging its reputation for future years. 3.2 Second priority – How to spend the forecast cash surplus There are four alternatives that the Board is considering. If the cash surplus is not spent and retained in the Balance Sheet, Solberri could be the target of a hostile takeover bid as it is cash rich. Also investors will demand increased returns in the form of dividends. It is possible (and probable) that low dividends, or even no dividends, had been paid in the loss making years. During the year ended 30 September 2007, Solberri paid €2 million in dividends. The four proposals will be assessed in the report below. These four proposals are to extend the number of rooms, invest in refurbishment and extended spas at remaining Solberri hotels, acquire an additional hotel or invest in environmentally friendly initiatives. These four proposals cannot be ranked until the advantages and disadvantages of each have been assessed. 3.3 Third priority – To appoint a new Finance Director Following Antonio Skrip’s resignation there is a need to appoint a new Finance Director. This is especially important at this time when long-term investment decisions are being made and Solberri has a forecast cash surplus which needs to be managed. 3.4 Fourth priority – Fall in spa revenue Solberri’s management must address the problem which has caused the fall in spa revenue at one hotel and it must also ensure that restrictive covenants are put in place to stop this occurring at other Solberri hotels. There is no point investing millions to enhance spas, if its employees are allowed to leave and compete directly with Solberri so close to its hotels. 3.5 Fifth priority – Employee morale and distribution of tips Solberri cannot afford to damage the morale and motivation of its employees when it has such high levels of occupancy for the first time in several years. Customer satisfaction must be achieved. 3.6 Sixth priority – What level of dividends to plan to pay to shareholders Solberri paid dividends of €2 million in the last financial year, and it is assumed that these dividends all related to that financial year. It represented a dividend per share (DPS) of €0.083 per share. The payout ratio was 40% of profits, although with the higher forecast profits in 2008 and a range of good investment opportunities, it is not recommended that Solberri should maintain a 40% payout ratio. However, after 2 years of losses, during which time it is not known whether dividends were paid or not, it would be expected that an increase in DPS is paid for the current financial year. 3.7 Seventh priority – Restrictive loan covenants Solberri’s recent loan for €20 million has a restrictive covenant attached precluding Solberri from taking out any further loan finance until December 2009. However, as the

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

A SWOT analysis summarising the strengths, weaknesses, opportunities and threats is shown in Appendix 1. The greatest threat facing Solberri at this time is its shortage of fully trained employees, which could adversely affect the level of customer service provided during the current 2008 Peak season when Solberri has achieved its highest level of bookings for some years. Solberri has four opportunities to invest in, which are: ● ● ● ●

Proposal A – Extend the number of rooms at ‘Premier’ hotels Proposal B – Invest in refurbishment and extended spa facilities at the remaining hotels Proposal C – Acquire an additional resort hotel Proposal D – Invest in environmentally friendly initiatives

The Solberri Board needs to decide how to use the cash generated from operations to increase shareholder value. A PEST analysis for Solberri is shown in Appendix 2. Examiner’s note: It was not necessary to have the issues prioritised exactly as shown above. The full 10 marks for Prioritisation would have been awarded provided that customer service and quality issues were placed in the top 3 priorities and that the need for discussion on how to spend the cash surplus (rather than each of the 4 proposals individually) also appeared within the top 3 priorities. It was also necessary to have placed the need to fill the Finance Director role in the top 5 priorities. If the 4 investment proposals were prioritised individually, then it was still possible to be awarded pass marks in Prioritisation, assuming that some of the proposals and the customer service issues were placed in the top 3 and the need to fill the Finance Director role was placed within the top 5 issues.

4.0

Discussion of the issues facing Solberri

4.1 Overview The hotel industry is a very competitive industry. Solberri competes at the ‘top end’ of the market with hotels ranging from the equivalent of 3* to its 5* ‘Premier’ hotels. Customers are very discerning and expect a high quality of customer service and will often not appreciate their surroundings and facilities except when they fall short of their expectations. So the emphasis for Solberri’s management must be to eliminate as far as possible areas where customer service is falling short of the management’s requirements and to build on its strengths, which are its good brand reputation and the wide range of its holiday facilities, including the newly extended spas at the ‘Premier’ hotels. Spa facilities exist at 3.5% of all hotels currently in Europe with a further 5% of hotels planning to introduce spa facilities in the near future. Therefore the provision of spa facilities is becoming an increasingly important feature of luxury hotels. This emphasises the importance of Solberri’s refurbishment programme being completed successfully. Furthermore, the European tourism industry is a maturing one. Growth rates in European hotel bookings in 2007 were only 0.3%, which is substantially lower than the global average

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4 proposals total €123 million, there are clearly insufficient funds to take on all of the proposals, as no further loan finance can be obtained in the next 2 years.

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growth rate of 5%. Therefore it is increasingly important for Solberri to differentiate its hotels. Solberri markets its hotels using Porter’s Generic strategy of differentiation. It is not marketing at the low cost or medium-priced sectors of this market, but at the luxury end of the market by providing high quality hotels, a range of high standard facilities and good customer service. In order to maintain this level of differentiation, Solberri must maintain a high level of customer service. If Solberri is unable to achieve a high level of customer service then this would be the biggest threat facing the company at this time. Solberri operates holiday hotels where customers stay for 7 to 14 night holidays. It does not particularly attract business travellers. Therefore the average stay is longer for its customers than many city centre hotels where customers typically only stay 3 or 4 nights. This longer period makes it even more difficult for Solberri’s management to ensure that the entire stay for each customer is not spoiled by any poor experiences, such as poor quality of facilities, facilities out of commission or poor customer service. Solberri must make its aim of achieving an ‘excellent’ rating (in its customer feedback forms) from its customers its key target for 2008. In order to achieve this it must have adequate numbers of employees in place to meet the high level of bookings that it has secured. It must also ensure that the employees are fully trained and ready to meet the challenges of the high occupancy levels. In 2007, a leading European hotel chain, Sol Melia, established an alliance with lastminute. com. This resulted in an increase in revenues from higher occupancy levels of around 56%. There are several hotel chains that target the holiday market at the luxury end of the market, including ‘Club Med’ in the Mediterranean and ‘Sandals’ in the Caribbean. Many of the large global hotel chains such as ‘Hilton’ and ‘Four Seasons’ offer a wide range of sports and spa facilities and several smaller chains, with 5 to 20 hotels (similar in size to Solberri) offer ‘all inclusive’ prices for holiday makers. There is also a large range of individual luxury hotels catering for this exclusive market segment. If Solberri is to satisfy its shareholders, by increasing shareholder value, both through dividends and an increase in share price, it needs to remain focused on its customers and to stay innovative so that it continues to lead the market, rather than to follow its competitors. Solberri’s share price has risen from €4.47 at 31 December 2007 to €6.25 on 16 May 2008, following the announcement of the high level of bookings for the 2008 Peak season. This increase of 40% has increased Solberri’s market capitalisation to €150 million (24 million shares ⫻ €6.25). 4.2 – Customer service and quality issues Nik Silva, the Director of Customer Service, is reviewing staffing levels in order to meet the demands from the high bookings. However, the 2008 Peak season started at the beginning of May 2008 and with all hotels 95% full for the entire season, on average, he should be doing more than reviewing. The level of staffing needs to be in place already if the high standards of customer service are to be delivered. Therefore this is the top priority as Solberri must get this right. It has had low occupancy and losses for 2 years and having finally achieved a high level of bookings, it is urgent that adequate short-term employees are recruited, trained and in place to deliver the ‘excellent rating’ of customer service that Solberri is targeting to achieve. Therefore it is strongly suggested that recruitment of additional employees and additional training is put in place. It is not known what level of employee costs are included in the latest forecast and in the forecast cash generated from operations figure. However, in 2007,

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

There have been some problems identified due to poor quality and that these problems are due to a shortage of fully trained skilled employees. Among the actions required by Solberri’s management, is to provide adequate training to all of its employees to ensure that they meet the quality standards expected. Employees who do not achieve the quality standards expected should be moved to non-customer facing positions or have their contracts of employment terminated. Training should never be compromised. With the entire Peak season ahead of them all hotel General Managers, supported by the HR Director, Suzanne De Loore, and Director of Customer Service, Nik Silva, should ensure that their employees have been provided with suitable training for them to do their job. All employees should be surveyed at regular intervals during the Peak season to establish whether they think they have received the training that they need to perform their job. Often training is seen as un-necessary, but if improved training helps the employees to perform their jobs better, and provide a better standard of customer service, then this would be a good investment. Solberri’s employees are ‘key players’ as defined in Mendelow’s matrix and the employees have the power over the company to enhance or to damage the brand reputation, depending on whether they deliver good or bad customer service. The Ritz hotel has a compulsory training programme that lasts for 15 weeks to ensure that its staff delivers the highest possible level of customer service. Some of the cash generated from operations should be ‘invested’ in Solberri’s employees to help them achieve the stated targets of higher number of ‘excellent’ ratings from customers. Furthermore, other incentives should be provided to motivate employees, such as employee of the month awards at each hotel and recognition for outstanding customer service. More recognition of good service should act as an incentive to all employees. Free shares or end of contract bonuses for short-term employees could be offered based around a range of performance measures. The Balanced Scorecard technique could be used to assess how well each hotel has performed against a range of targets, including financial results as well as quality and customer related targets. The case material also states that the 12 hotel General Managers and the senior management team at each of the 12 hotels are overworking and unable to take leave. This is a business issue as well as an ethical issue. Solberri, as a listed company, needs to act responsibly and treat its employees fairly. Expecting its senior managers to work 16 hours a day is not good business practice. Furthermore, the hotel General Managers are not acting responsibly by making it difficult for its senior managers to take their contractual days off. This is not ethically correct and will be discussed below in Ethics. However, the business issue here is that these managers cannot be performing to their best abilities if they are working so many hours. Incorrect decisions could be made, and they will feel too stressed to cope with customer service problems and employee crises. It is therefore proposed that each hotel has a greater number of support managers to relieve the pressure. Each function within each hotel, such as restaurant, housekeeping, spa facilities and sports managers should each have a deputy manager appointed, to share the managerial burden and to allow managers to take their contracted time off. These deputies should be promoted from

MAY 2008 – SOLBERRI

staff costs were €62 million. With such a high level of bookings, it is realistic that an extra 10% cost, that is €6 million could be incurred on employee costs, training and incentives. It is proposed that Solberri should not compromise on customer service and that €6 million is put aside from the forecast cash generated from operations in order to finance additional employees, training and performance related incentives for all employees.

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within each hotel, both for speed of appointment and for motivation purposes. Therefore additional junior employees in each of these functions may need to be recruited to fill the gaps left by employees promoted to fill managerial roles. More emphasis needs to be put on staffing levels and standard of customer service during this Peak season, as it is the highest level of occupancy that Solberri has achieved for many years. If standards of customer service are poor, customers will not return and occupancy may be lower in 2009. For this to be the turning point for Solberri, and the start of many years with high occupancy, it is imperative that adequate, well-trained employees are in place to deliver what is expected by customers. Solberri has got the bookings – now it needs to fulfil, or exceed, customers’ expectations. 4.3

– How to spend the forecast cash surplus

4.3.1 Overview of investment opportunities Solberri has a high number of bookings for the 2008 Peak season, and this is known with certainty. The operating costs will vary depending on staffing levels and other operating costs, but the current forecast for the financial year ended 30 September 2008 is for €59 million cash to be generated from operations. Solberri has 4 investment proposals. These are summarised in Appendix 4 and shows a maximum total of €123 million. Clearly Solberri has insufficient funds to undertake them all. Furthermore, the case material states that there are loan covenants attached to the recent €20 million loan which states that no further loan finance can be taken on for a 2-year period from December 2007. Therefore until December 2009, no further loan finance can be taken on despite the large range of positive NPV projects available to Solberri (see Paragraph 4.8 below on Loan Covenants). Before the investment proposals are considered, the cash available for investments needs to be established. Appendix 5 shows that of the €59 million cash generated from operations, finance costs will be around €4 million and tax will be around €13 million. Therefore there is only around €42 million available for any of the investment proposals. Furthermore, before deciding on what to invest the €42 million in, Solberri needs to reward its shareholders with dividends. The dividend proposals are discussed in Paragraph 4.7 below. Overall only around €39 million is available for investment after the proposed dividends, as shown in Appendix 6. Of the €39 million available for any of the following investment proposals, it must be remembered that several of the projects are divisible that is Solberri could choose to extend the accommodation at only 1 ‘Premier’ hotel, or refurbish and extend the spas at only some of the 8 ‘Superior’ hotels. The only project that is clearly not divisible is whether to purchase the additional resort hotel. Therefore Proposal C is all or nothing. 4.3.2 Proposal A – Extend the number of rooms at ‘Premier’ hotels This proposal is to spend €9 million for each of the 4 ‘Premier’ hotels to extend the accommodation by adding an additional 200 rooms and supporting facilities. By doubling (or almost doubling) the number of rooms at the 4 ‘Premier’ hotels (2 of these have 250 rooms and 2 have 200 rooms) this will make the hotels much more crowded. The NPV of €10 million per hotel over a 5-year period is based on an average Peak season occupancy level of 80% of the total number of rooms. In 2008 the 4 ‘Premier’ hotels have 900 rooms and are forecast to be fully booked for some weeks of the Peak season. The average occupancy across all hotels is 95% and ‘Superior’

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

● ● ●

5 ‘Superior’ ⫻ 200 rooms ⫹ 3 ‘Super plus’ ⫻ 150 rooms at 92% ⫽ 1,334 rooms occupied. Total rooms ⫽ 2,350 ⫻ 95% occupancy overall ⫽ 2,233 rooms occupied in total. Therefore ‘Premier’ occupancy levels ⫽ 2,233 – 1,334 ⫽ 899/900 ⫽ 99.9% average occupancy level.

The question to decide is how to provide more ‘Premier’ rooms. Solberri has 3 choices: (1) It can extend the number of rooms at ‘Premier’ hotels. (2) It can refurbish some or all of its ‘Superior’ hotels up to ‘Premier’ level, which is Proposal B, below. (3) Acquire an additional hotel of ‘Premier’ standard (see Proposal C in Paragraph 4.3.4 below). This is the first year that Solberri has achieved such a high level of bookings and caution should be exercised. If accommodation is extended by adding a further 200 rooms at each ‘Premier’ hotel, this may detract from the ‘exclusivity’ enjoyed by Solberri customers at present, as the hotel and facilities will be more crowded. Even if additional facilities, restaurants, swimming pools and sports facilities are also built, it will make the resort much more cramped as these would need to be built within the current grounds of the hotel. Additionally, is it realistic to expect an average occupancy level of 80% on the higher level of rooms? Solberri has only had this one Peak season of high bookings for its ‘Premier’ hotels. It should wait and see what level of bookings is achieved in 2009. It is still too early to decide to undertake this radical change to Solberri’s ‘flagship’ hotels. Indeed, such an investment may deter existing customers from returning. 4.3.3 Proposal B – Invest in refurbishment and extended spa facilities at the remaining hotels Solberri has created the category of ‘Premier’ hotels by refurbishment and extending the spa facilities at 4 of its ‘Superior’ hotels. 2 hotels were upgraded to ‘Premier’ category in the Non-peak season 2006/07 and a further 2 in 2007/08, resulting in 4 ‘Premier’ hotels for the 2008 Peak season. As shown above these 4 hotels are almost fully booked for the entire Peak season. ‘Premier’ hotels command a high revenue per day and the RevPAR at ‘Premier’ hotels was €471.8 in 2007 Peak season. This is substantially higher than the RevPAR for ‘Superior’ rooms at €306.6 in 2007 Peak season (54% higher based on 2007 RevPAR figures). According to the BCG matrix, Solberri’s ‘Premier’ hotels would be classified as cash cows, due to their high cash generating abilities. Given the very high level of bookings achieved in 2008 Peak season it would be commercially sensible to refurbish and extend the spas, so that the ‘Superior’ hotels could become ‘Premier’ hotels. The question is whether all 5 of Solberri’s ‘Superior’ hotels should be refurbished all at once, as this would leave a gap in Solberri’s mid-priced hotels. The gap could be filled if the current ‘Super plus’ hotels were to be refurbished and the spas extended but this would result in the permanent loss of 10% of the accommodation, 15 of the 150 rooms, resulting in a maximum of 135 rooms. The ‘Super plus’ hotels have a forecast occupancy of 92%, which represents 138 rooms (150 rooms ⫻ 92%). The operating profit

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and ‘Super plus’ are 92% full. Therefore the 4 ‘Premier’ hotels would achieve an even higher average occupancy level. This can be calculated to be 99.9% as follows:

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for these 3 hotels was only €0.6 million last financial year. Therefore it seems that there is limited scope to increase profitability and it does not seem commercially sensible to close rooms to extend the spa when higher levels of bookings have been received. Therefore at this stage it does not seem sensible to refurbish and extend the spas at the 3 ‘Super plus’ hotels. Therefore Solberri should refurbish and extend the spas at some, but not all, of the 5 ‘Superior’ hotels, using the forecast cash surplus. However, it would seem sensible to retain 1 hotel within the ‘Superior’ hotel category. In summary the proposed course of action would be to refurbish only 4 of the 5 ‘Superior’ hotels and none of the ‘Super plus’ hotels at this stage. This would cost 4 ⫻ €6 million ⫽ €24 million. 4.3.4 Proposal C – Acquire an additional resort hotel The proposed hotel that is available for acquisition is in a suitable location and has the same number of rooms as some of the other ‘Premier’ hotels. The expected NPV, as shown in Appendix 7, is €39.2 million after the extra marketing costs. The total cost of acquiring this hotel, including the refurbishment and the required marketing costs is €24 million. This is within Solberri’s available cash for investment. It also happens to be the same figure as refurbishing 4 of the ‘Superior’ hotels as above. Solberri does not have sufficient cash to acquire this hotel and also to refurbish 4 of its ‘Superior’ hotels. Therefore there is a choice of how to allocate scarce resources. This proposal is analysed below using the Johnson and Scholes suitability, acceptability, feasibility framework: Suitability The proposal to acquire this resort hotel is suitable for Solberri as it meets the criteria of its other hotels, and is in a suitable very popular coastal location. If Solberri were to acquire it and achieve a 95% occupancy level (as it has in Peak season for 2008), then a high NPV of €100 million, before marketing costs, could be achieved. Acceptability This proposal would be acceptable for Solberri’s shareholders as it is relatively low risk. It is an expansion within the same business sector and has high forecast NPV’s at 80% and 95% occupancy. If the forecast occupancy was 50% or lower, the NPV would be negative and this would not be acceptable to shareholders. The breakeven level of occupancy, shown in Appendix 7, is 64%. Therefore a negative NPV would be achieved if the average occupancy was between 50% and 63% inclusive. As Solberri has achieved a higher than 64% level of occupancy in the Peak season since 2006, this therefore looks acceptable on this key underlying assumption. Feasibility It is feasible for Solberri to use some of its available cash resources to acquire this hotel. However, a concern would be whether €3 million would be adequate to re-launch this hotel as a Solberri ‘Premier’ hotel and whether it could damage the Solberri brand as the hotel is currently in need of extensive refurbishment. This hotel, under its current owners who have not invested in refurbishment, may have a poor reputation and this could take some time to ‘turn around’.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

The decision for the Solberri Board is whether the forecast cash surplus should be used to enhance the revenue generating abilities of the assets that Solberri already owns, or whether the time is right to expand its asset base. 4.3.5 Proposal D – Invest in environmentally friendly initiatives Solberri has recently appointed an Environmental Director, Luc Pinard. This was a stated objective in Solberri’s Corporate Social Responsibility (CSR) report shown in the pre-seen material as Appendix 3. Having appointed an Environmental Director, Solberri must allow him to do his job and to fund the required initiatives that the Board has stated are targets to be achieved between 2008 and 2010. For the first time in many years, Solberri has a forecast cash surplus and the question is how much of this (or none) should be invested in environmentally friendly initiatives that are not visible to Solberri’s customers. However, customers are becoming increasingly aware and concerned about environmental damage. There are a growing number of environmentally aware consumers who may see these initiatives as a positive move by Solberri and could give Solberri a business advantage. If Solberri is considered by its customers and the media as an environmentally responsible company it could generate additional business and boost the company’s image. In real life, Marks and Spencer has generated much favourable media coverage for its ‘Plan A, as there is no Plan B’ environmental initiatives and recycling targets. Consumer awareness of ‘green’ issues is high and this is another differentiator for consumers. However, Solberri is providing luxury hotel accommodation not selling ethically produced clothing. It is in an entirely different market. Therefore, while investing in the proposed environmentally friendly initiatives is a sensible and responsible action for a listed company, the question remains as to whether this proposal is the best use of Solberri’s forecast cash surplus. The environmental initiatives are split into 2 proposals: (1) €6 million for solar panels at all hotels (2) €9 million for a range of other environmental initiatives, including improved management of waste. The solar panel proposal was included in the published CSR report (Appendix 3 to the preseen material) and is forecast to achieve savings of €0.6 million per year. This would achieve a non-discounted payback of 10 years. This initiative would at least generate a direct cost saving. The second proposal on other environmental initiatives including improved management of waste is unlikely to achieve any cost savings but would make Solberri a more responsible environmentally friendly company. However, can Solberri afford to spend €9 million of its cash surplus this year, when it has other positive NPV projects available to spend its cash on? Shareholders will want to achieve higher returns after the 2 years of losses, and perhaps this is one project that could be deferred and funded from future cash generated from operations. However, as the Board has appointed an Environmental Director, it is not realistic to state that none of his proposals will be funded. Therefore some compromise in the short term

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This may be a good opportunity to buy an additional hotel relatively cheaply at €5 million, although extensive refurbishment is required, which is forecast to cost €16 million.

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is necessary. Perhaps the solar panel proposal could proceed this year followed by a series of other environmentally friendly initiatives next year. Furthermore, the solar panels are a visible form of ‘green’ energy, which could generate much favourable publicity for Solberri. 4.4 To appoint a new Finance Director Antonio Skrip resigned and left Solberri on 16 May having served only 1 week of his notice period. Antonio Skrip has worked for Solberri for around 13 years and the company has lost a Board member with much experience. The reasons for the Board disputes which led up to his resignation are not known, although the restrictive loan covenants that were negotiated could be part of the reason. The restrictive loan covenants do not allow Solberri to take on any more loans for a 2-year period from December 2007, therefore protecting the bank which provided the recent €20 million loan. It is not known whether anyone has been appointed temporarily into this role. There is a need for a strong Finance Director to see Solberri through the months ahead while it decides how to spend the forecast cash surplus. Therefore it is recommended that another Board member, perhaps a non-executive director, could take this role on temporarily until a permanent appointment is made. The permanent appointment could be either an internal appointment (as Solberri should have some succession planning in place) or an externally recruited experienced individual. There are many advantages in external recruitment as this brings ‘fresh blood’ to the Board and perhaps experience in other industries, or a different hotel chain. 4.5 Fall in spa revenue At one of its ‘Premier’ hotels, the spa manager has left and established her own spa business less than 500 metres outside of the hotel. This has led to a fall in spa revenues of 8% in the last few weeks. The Solberri management team cannot affect what businesses could be set up outside its hotels, if business premises are available within the marketplace. In fact, all over the world there are usually a small range of restaurants and shops that are established very close to high quality hotels to meet the needs of guests who choose to leave the hotel and see what is available, whether food, gifts or any other services. Therefore Solberri cannot stop a spa being established nearby. However, what Solberri can do is to restrict the area in which Solberri employees can work if they leave the company. In some countries, restrictive clauses such as this as part of the contract of employment are now non-legal. So much would depend on local employment law. What Solberri needs to do is to incentivise and motivate its employees so that they do not leave Solberri in the first place. The skilled spa employees, who offer highly trained specialist treatments, need to be retained within the business. Solberri has already invested over €6 million at each of its ‘Premier’ hotels in the refurbishment and extension of spas – but without the skilled employees, the spas will not generate the extra revenues expected. Therefore Solberri needs to keep its key spa employees satisfied, through incentive schemes, targets, bonuses and perhaps free shares linked to achieving a range of targets. As the cost of establishing a spa which is at the same high standards of Solberri’s own spas would be millions of Euros, this small business set up by the ex-spa manager is likely to be very small in comparison. Therefore Solberri should publicise, within this hotel the

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.6 Employee morale and distribution of tips This is another issue that has a business and an ethical dimension. The ethical side of this issue will be discussed in Ethics, in Paragraph 5.0 below. The business side is that Solberri’s management have taken some actions which have adversely affected its employees’ motivation and subsequently the standard of customer service being provided at this ‘Superior’ hotel. Solberri’s management must work with its employees to urgently solve the situation. On the face of it, the management changed the distribution of the tips to include more employees being eligible for tips so that this engendered more of a team spirit. However, it has back-fired and employees are not happy. The hotel General Manager is responsible for the smooth running of his hotel and must resolve this as a matter of urgency. It is important that Nik Silva, Director of Customer Service, maintains standards of customer service across all of the Solberri hotels. Whilst each hotel General Manager has autonomy to manage the day to day operations at the hotel he runs, changes to routines such as the distribution of tips should not have been made without approval from Head Office, or at least after discussion with Nik Silva. It is proposed that Solberri change the distribution of tips back to the old accepted way, so that customer facing employees once again share the tips left by guests. It is quite correct that a team spirit should be engendered and that non-customer facing employees, and employees working on other (non-evening) shifts should be rewarded. It is proposed that a team bonus, perhaps monthly, should be paid to all employees who meet an agreed range of performance-related targets. This should ensure that all employees are rewarded for their contribution. This should be paid by Solberri, and not from tips left by guests. 4.7 What level of dividends to plan to pay to shareholders Solberri paid dividends of €2 million in the last financial year (assuming all the dividends related to that financial year), which represents a dividend per share (DPS) of €0.083 per share. The payout ratio was 40% of profits. It is unrealistic to pay out 40% of 2008 profits (forecast at €27 million) as Solberri has a range of investment proposals. In reality it could choose to pay no dividends as it has such a long list of investment proposals. However, after a few years of losses, during which time it is not known whether dividends were paid or not, it would be expected that an increase in DPS is paid for the current financial year. Following the announcement of the high level of bookings, Solberri’s share price has increased by 40% so shareholders have seen an increase in their wealth, so dividends are

MAY 2008 – SOLBERRI

advantages of its own spa, so that its customers do not look to use the spa facilities outside the hotel. It could offer all guests a free treatment or some special offers, such as 2 treatments for the price of one, as it should not allow its own spa facility to decline. Competition is always good – both for the customer and also for the business, as it does not allow Solberri to become complacent. Guests will only use Solberri’s spa treatments if they are high quality and good value for money. If the same, or better, is provided by the ex-spa manager outside of the hotel, this means that Solberri is doing something wrong. This needs to be corrected.

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perhaps less important than growth in share price. Solberri’s shareholders are ‘key players’ as defined in Mendelow’s matrix and their needs should be considered. Therefore, it is proposed that a 50% increase in DPS is paid, which would be €0.125 per share. This would cost €3 million, as shown in Appendix 6. This would result in cash generated from operations, after tax, finance costs and dividends to be €39.4 million. 4.8 Loan covenant Solberri’s recent loan for €20 million has a restrictive covenant attached precluding Solberri from taking out any further loan finance until December 2009. This restriction should have been brought to the Board’s attention before the loan was taken out. As there is a forecast for a large cash surplus this financial year, then this restriction does not damage Solberri’s liquidity. If the company had slipped into a loss making situation, then this covenant could have proved disastrous. However, as the 4 proposals total €123 million, there are clearly insufficient funds to take on all of the proposals, as no further loan finance can be obtained in the next 2 years. Furthermore, it is unlikely that a rights issue would be successful at this time as the company has only just returned to a reasonable level of profitability. Additionally a rights issue would take time to undertake (around 12–18 months) and therefore additional equity finance in the short term should be ruled out. Therefore the only way to increase Solberri’s debt finance capacity would be to try to negotiate with the bank and to show the bank the latest forecast figures with the high level of bookings. Perhaps Solberri’s CEO would be able to negotiate a relaxation or a change to the loan restriction with the bank, perhaps for a fee, although it is unlikely that the bank would negotiate as the restrictive covenant is there to protect it from loan default and a high level of bookings has not generated the cash. A further, rather extreme solution would be to use some of the forecast surplus cash to repay this loan (although there may be early repayment penalties) and then to take out a new loan with no restrictive covenants. However, in today’s economic climate it may be hard for Solberri to secure loan finance at a better interest rate. Overall, perhaps the safest route would be for Solberri to retain its current loan and to ensure interest payments are met and that it retains sufficient cash for working capital needs, before any of the proposals are invested in.

5.0 Ethical issues and recommendations on ethical issues 5.1 Range of ethical issues facing Solberri There are a number of ethical dilemmas facing Solberri, as follows: ●

●

Poor training – Some of Solberri’s employees are not professional and competent in their roles. Poor treatment of hotel General Managers and key senior employees. Putting employees under high stress levels is not ethical and will also affect morale and motivation of these key employees.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

●

Investment in Green initiatives and solar panels – ethical aspect of investing in ‘green’ energy sources and other environmentally friendly initiatives. Tips – how to distribute fairly and to ensure all tips reach employees and are not retained by the hotel. Also motivational aspect and how to stop employees who are threatening to walk out over this issue.

5.2

Poor training

5.2.1 Why this is an ethical issue It is the responsibility of Solberri’s management to ensure that the training for its employees is adequate to enable them to perform their role in a professional and competent way. If they are not well trained, or not trained at all, then the management are failing in providing employees with the required skills and this will be reflected in poor customer service. Using CIMA’s ethics code, Solberri’s management are failing to show professional competence and due care to its employees, who look to the management to provide the right quantity and quality of training for them. 5.2.2 Recommendations for this ethical issue It is recommended that the Human Resources Director, Suzanne De Loore, should establish a database of what training has been provided for each of its employees. However, this cannot be done in the very short term. There is an urgent need to address employee concerns and to meet high quality of service targets. Each hotel General Manager should be asked to identify areas of weakness and for them to ask their employees to identify areas where they consider they need to be trained. It is recommended that much of the training can be done in house, by instigating ‘best practice’ and employees in one hotel learning from another hotel. Additionally, experienced employees should be rewarded for taking time and care to train others. They will not provide training for fellow employees if this is not recognised and rewarded. It would be less costly, and less inconvenient, to get employees to train their colleagues at each hotel. This would also engender the team spirit that the hotel General Managers are trying to establish. However, for this to work effectively for the 2008 Peak season, given that all employees are under pressure due to high bookings, it is recommended that there needs to be a reward element to ensure that employees allocate sufficient time for training. 5.3 Poor treatment of hotel General Managers and key senior employees 5.3.1 Why this is an ethical issue Solberri is a listed company and it is unprofessional to work its hotel senior management team 16 hours a day and to not allow them to take time off. Solberri must operate in a more professional way and show more care for its employees. Not only is this unethical, it is possibly illegal in some countries to work such long hours. 5.3.2 Recommendations for this ethical issue It is recommended that Solberri’s management should urgently take action to ensure that hotel senior management employees do not work such excessive hours. If these long hours

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●

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STUDY MATERIAL T4

are required, then deputy managers should be appointed to take on some of the work. By the very nature of this industry, long anti-social hours are worked. However, it is unprofessional for a company to knowingly allow such long hours to be worked. It is the start of the 2008 Peak season and the busy period with high bookings is ahead of them. There is a need for action to be taken to ensure that hotel General Managers and senior staff are not absent with stress-related illnesses during this time. Therefore, this problem needs to be urgently addressed. A deputy (or possibly 2 deputies on different shifts) should be appointed to spread the workload. It is recommended that these promotions should be internal appointments. In respect of the other problem of key senior managers who are unable to take contractual time off, action should also be urgently taken to stop further problems escalating and the situation getting worse by the possible resignation or absence through illness of any of these key employees. This is not ethical as they are entitled by their contracts of employment to take time off. It is necessary to appoint further senior managers, both using internal appointments as well as more external appointments. Where internal appointments are made, further staff recruitment will be necessary to fill the more junior post left empty, as Solberri cannot allow the problem of employee shortages to cascade down. This is a business and an ethical issue. Ultimately Solberri wants to deliver a high quality of customer service. It will only be able to do this if it has an adequate number of well-trained managers in place who are not stressed and not working excessive hours. This business must be run professionally in order to achieve its objectives. Therefore it is recommended that additional managers, and deputies for the hotel General Managers, are immediately put in place to help relieve the current workload. The cash generated from operations is €39.4 million, after finance costs, tax and dividends. It is recommended that a total of €6 million is allocated as an additional budget towards ‘investing’ in Solberri’s employees. Ultimately, much of the customer feedback will be affected by the standard of customer service provided rather than on the actual standard of accommodation and facilities provided. Solberri’s management should recognise the importance of investing in its employees. 5.4

Investment in Green initiatives and solar panels

5.4.1 Why this is an ethical issue This issue is an ethical and a business issue. It is an ethical issue as Solberri should be looking to act ethically and responsibly by using electricity from renewable sources, such as solar power. This proposal has a long pay back period (undiscounted the savings of €0.6 million would take 10 years. Discounted, it would take longer) and therefore it would not be top of the proposals as it makes less commercial sense than some of the other proposals which generate higher NPVs. Solberri also has stated in its Corporate Social Responsibility Report (Appendix 3 to the pre-seen material) that it intends to install solar panels in the period 2008 to 2010. Solberri has also appointed an Environmental Director. The environmentally friendly proposals are discussed in Paragraph 4.3.5 above. There is a strong case for this business issue as it may generate additional business due to positive

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

5.4.2 Recommendations for this ethical issue It is recommended that Solberri does proceed with the investment of €6 million on solar panels. It is recommended that the €9 million on other environmentally friendly initiatives is deferred as there are proposals which could increase shareholder wealth. However, it is recommended that these initiatives should be invested in as soon as further finance becomes available, perhaps with cash generated during 2008/09. 5.5

Tips – how to distribute fairly

5.5.1 Why this is an ethical issue The distribution of the tips is not an ethical issue in itself, as it could be argued that Solberri is trying to be fairer to all employees through this new method. What is the ethical issue is that the employees do not trust the management of Solberri to distribute all of the tips. It would be unethical if they were not all distributed. 5.5.2 Recommendations for this ethical issue As this new method of distribution of the tips is causing employee concern and has led to poor customer service at this hotel, it is recommended that all tips that are left in cash each evening are distributed by a senior employee to customer facing employees, in the usual way. This should be done with immediate effect.

6.0 Recommendations on business issues Note: All of the recommendations on the ethical issues have been included in the Ethics section above and this section of the report deals with recommendations on the business issues only. 6.1 Customer service and quality issues It is recommended that Solberri needs to ensure that staffing levels are adequate and that employees are motivated to ensure a high quality experience and high levels of customer satisfaction. There is over €59 million of cash forecast to be generated from operations due to the high level of bookings. Some of these funds should be used to increase the number of employees and to provide improved, effective training to meet quality of customer service targets. It is recommended that €6 million is funded to invest in additional employees and managers to support each hotel’s General Manager so that Solberri can try to achieve an improved level of customer service. Some of this funding should be used for training and performance-related incentives. It is recommended that Nik Silva should quickly draw up an action plan for recruitment and training. He should also devise and circulate to all employees a clear realistic range of specific performance measures which employees can try to achieve and which will be used as a basis for paying performance-related bonuses. Additional rewards, such as employee of the month at each hotel or best employee in each department should be set up as motivational tools and to reward good performance.

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PR. However, the ethical dilemma is whether other business issues or even the payment of dividends should take priority over environmentally friendly initiatives.

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STUDY MATERIAL T4

6.2 How to spend the forecast cash surplus Due to Solberri’s inability to take on any further loan finance, due to the loan covenant restrictions on its recent loan, then Solberri’s choice is limited to the cash available. Of the 4 proposals being considered, the recommendations are summarised as follows: Proposal A – It is not recommended that Solberri should invest in Proposal A, to extend accommodation at the 4 ‘Premier’ hotels at present. Solberri has only had one Peak season when it has had high occupancy levels and it is considered too soon to extend the accommodation. Additionally this proposal could damage the setting and ambience at ‘Premier’ hotels. It is recommended that if the 2009 Peak season is also full, then accommodation could be expanded for 2010, or Solberri could experiment with extended accommodation at only one ‘Premier’ hotel. Proposal B – It is recommended that Solberri should use €24 million of the available cash to bring forward the refurbishment and extension of spas at a further 4 ‘Superior’ hotels. This would leave just one ‘Superior’ hotel. It is not recommended that Solberri invest further in the 3 ‘Super plus’ hotels as the low level of profitability and the reduced number of rooms (if spas were to be extended) would not justify this investment. Proposal C – It is not recommended to acquire another resort hotel as Solberri has other uses for its forecast cash surplus. However, this proposal has a high NPV and a realistic breakeven point of 64% occupancy. However, with cash required for refurbishment and extending spas at 4 hotels and cash required for additional recruitment and staff related issues, there is not sufficient surplus cash for this investment. Additionally, it is recommended that Solberri ‘consolidates’ its position with its current 12 hotels before it expands the number of Solberri hotels. Proposal D – Investment in environmentally friendly initiatives. Having appointed Luc Pinard as the new Environmental Director, the Board needs to make funds available to achieve agreed environmental targets. However, after the recommendation to invest in employees and upgrading 4 further ‘Superior’ hotels to ‘Premier’ category, there is insufficient cash for a further €15 million for all of these proposals. However, it is recommended that the investment of €6 million in solar panels should proceed. It is recommended that the rest of the environmentally friendly proposals, at a cost of €9 million, could be financed from cash generated from operations in the next financial year. 6.3 To appoint a new Finance Director It is recommended that another Board member, perhaps a non-executive director, could take this role on temporarily until a permanent appointment is made. A permanent appointment should be recruited as soon as possible. There are many advantages in external recruitment as this brings ‘fresh blood’ to the Board and perhaps experience in other industries, or a different hotel chain. 6.4 Fall in spa revenue It is recommended that Solberri should ensure that its contracts of employment preclude employees leaving to work in direct competition to Solberri within a 6-month period of time, assuming the local employment laws in each country allow this.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

In order to boost revenues at the ‘Premier’ hotel which has recently seen a fall of 8% in its revenues, it is recommended that the hotel publicise a range of special offers to attract its customers back to its own spa and away from the competitor’s business. 6.5 Employee morale and distribution of tips It is recommended that Solberri changes the distribution of tips back to the old accepted way, so that customer facing employees once again share the tips left by guests. It is also recommended that Solberri rewards all employees, including non-customer facing employees and employees working on other (non-evening) shifts. It is recommended that a team bonus should be paid to all employees who meet an agreed range of performancerelated targets. 6.6 What level of dividends to plan to pay to shareholders It is recommended that Solberri should pay a dividend of €0.125 per share, which equates to a 50% increase in DPS since last financial year. This would cost €3 million. 6.7 Loan covenant It is recommended that Solberri’s CEO, together with the interim new Finance Director, should meet with the bank and to try to negotiate the restrictive covenant. If they are not successful in getting the restrictive covenant removed, then Solberri should ensure that it retains sufficient cash to cover any increase in working capital. The Board should also tighten its procedures to ensure that any restrictive loan covenants are brought to the attention of the Board before new debt finance is agreed in future.

7.0

Conclusions

Solberri hotels have achieved a high level of bookings for the Peak season in 2008. This could be the turning point since Solberri started to decline in 2003. It is very important that sufficient trained and qualified employees are urgently appointed to meet the challenges of the high level of bookings, so that Solberri can again establish itself as a leading high quality hotel chain. This would also help to achieve high levels of repeat bookings and also demonstrate its ability to compete at the highest level in this very competitive market place. Solberri also needs to maintain its level of innovation so that it stays profitable. The forecast post-tax profit of €27 million in the year ended September 2008 is a 440% increase since the previous year. It needs to ensure the cash generated from operations is used wisely, both to reward investors who have had low (or possibly no) dividends for some years, as well as to invest for the future. If the recommended actions to recruit additional employees and to motivate them with performance-related targets are taken, then Solberri is well placed to achieve the forecast profits and to generate increased shareholder value.

MAY 2008 – SOLBERRI

It is also recommended that the skilled spa employees are motivated by performance-related targets (both quality and financial targets) to keep them motivated through the use of incentive schemes, targets, bonuses and perhaps free shares linked to achieving a range of targets.

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Appendix 1 SWOT analysis Strengths ●

●

● ● ●

● ● ● ●

●

●

Listed company with experienced Board of Directors Appointment of Johan Alnetti which is seen to be having a positive impact on company and investors Good market reputation for quality Strong asset backed balance sheet Of the full-time employees, many are experienced and own shares in Solberri (and have been employed for over 10 years) Employee share scheme High level of bookings for Peak season 2008 Winner of TV travel programme holiday award Strong level of bookings by two-key travel agents Solberri has established 4 ‘Premier’ hotels with world class spa facilities Large cash surplus is forecast for this year

Weaknesses ●

● ●

●

●

●

●

●

●

● ● ● ●

●

Opportunities ●

●

●

●

Solberri has a forecast cash surplus of €59 million which it can use for a variety of proposals to improve or expand its hotels through expanded accommodation, acquiring another hotel or bringing forward its planned refurbishment programme It can use some of the cash to increase the level of dividends It can use some of the cash to invest in environmentally friendly initiatives It could invest in enhanced IT systems to provide the software for prospective customers to view each hotel’s facilities

Overstretched management and employee resources due to high level of bookings for 2008 Peak season Operating in a competitive market Current share price of €6.25 still lower than previous all time high price of €10.00 in 2002 Problems with poor customer service as identified in Customer Feedback surveys Solberri still far short of its target of 50% of bookings rating Solberri as excellent Stress amongst senior managers and weak management structure which is causing managers to work long hours Restrictive loan covenant, which is restricting Solberri from taking out any further loan finance until December 2009 Recent resignation of experienced Finance Director, Antonio Skrip Adverse effect on customer service at hotel with the new method of distributing tips Low ROCE at ‘Super plus’ hotels Low level of repeat bookings IT systems still lagging behind competitors Problems with quality and motivation of shortterm employees Solberri only has 4 non-executive directors and 2 of them are related to the Chairman, Richard Berriman

Threats ●

● ●

●

●

Threat of poor customer service due to a shortage of fully trained employees, which could damage Solberri brand reputation Competitive industry Under pressure from shareholders to deliver high profits following high level of bookings 8% reduction in spa revenues following an ex-spa manager establishing her own business so close to a Solberri hotel Threat of Solberri being unable to recruit sufficient short-term employees to meet the high level of forecast bookings, as the Peak season has already started

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

PEST analysis Political/Legal ●

●

●

● ●

New employee legislation could be costly in this industry which is very reliant on large numbers of employees Solberri could face employment tribunals for the hours worked by senior managers and for stress-related illness Solberri needs to meet ever-changing and tighter EU legislation on food preparation, fire precautions, safety issues and employee protection Employment law could change Taxes could increase

Economic ●

●

● ● ●

Solberri operates entirely in Europe and an economic downturn could severely affect its occupancy and profitability Solberri is reliant on large numbers of employees to deliver the level of customer service expected and salary increases, as a result of minimum wage level increases, could affect profitability Solberri may be forced to cut prices in this competitive market Need to remain innovative in a changing and more demanding marketplace More discerning customers expecting the latest electronic ‘gadgets’ to be provided in hotel rooms, could lead to higher depreciation charges and asset write-offs

Social ● ●

●

Changes in customer tastes Pressure on customers to reduce their ‘carbon footprint’ by not flying to holiday destinations Solberri could achieve a marketing coup by investing in environmentally friendly initiatives, which customers will find appealing

Technological ●

●

●

Investment in more IT solutions to improve business efficiency and improve profitability Investment in IT software to provide prospective customers with a viewing of hotel facilities Investment in environmentally friendly initiatives, including solar panels and improved management of waste

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Appendix 2

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Appendix 3 Summary of key ratios and other financial data Financial year ending September:

2008 Forecast

2007 Actual

2008 change from 2007

2006 Actual

Revenue (€ million)

N/A

159

N/A

138

Operating profit (€ million)

44

11

⫹300%

7 loss

Post tax profit (€ million)

27

5

⫹440%

10 loss

Earnings per share (€)

1.125

0.208

⫹440%

N/A

N/A

27.3%

N/A

35%

Market capitalisation: Date of share price Share price (€) Market capitalisation (€ million)

16 May 08 6.25 150

31 Dec 07 4.47 107.3

⫹40%

Occupancy level – Peak season

95%

74%

⫹28.4%

Gearing (Defined as loans and overdraft as a percentage of Equity plus loans and overdraft)

N/A

65%

Note: N/A is data not available

Appendix 4 Summary of investment proposals Investment cost Maximum per hotel number of hotels € million

Maximum total investment cost € million

Proposal A – Extend accommodation at ‘Premier’ hotels by 200 rooms each

9.0

4

36.0

Proposal B – Invest in refurbishment and extended spa facilities

6.0

8

48.0

Proposal C – Acquire an additional hotel

24.0

1

24.0

Proposal D – Invest in environmentally friendly initiatives

15.0 (for all hotels)

All

15.0

Maximum total cost of all proposals

123.0

Clearly there are insufficient funds to undertake all of the proposals.

Appendix 5 Summary of cash available for investment It is important to establish what other uses there are for the cash generated from operations. The €59 million is cash generated from operations before finance costs and tax and also dividends. Let us establish what finance costs and tax payable is, as these costs would

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Finance costs: Loans: €6 million at 8% €15 million at 11% Old loan repaid in December 2007 €12 million at 10% for 3 months only (1 October 2007 to 31 December 2007) New loan: €20 million at 10% for 9 months only (1 January 2008 to 30 September 2008) Total finance costs

€ million 0.48 1.65 0.30 1.50 3.93

Examiner’s note: In exam conditions any similar approximation of €4 million for finance costs would be awarded marks. If the forecast post-tax profits are €27 million then we can establish that tax (at 32%) would be €12.7 (i.e. (€27 million/(1 ⫺ 0.32)) ⫺ €27 million. Therefore we can establish operating profits as follows:

Operating profit Finance costs Sub total – taxable profit Tax at 32% Profit for the period EPS (on 24 million shares)

€ million 43.6 (3.9) 39.7 (12.7) 27.0 €1.125/share

Summary of cash available for investment: Cash generated from operations Less: Finance costs (as above) Tax (2007/08 tax figure used for prudence) Cash available for investment (before dividends)

€ million 59.0 3.9 12.7 42.4

Examiner’s note: Any range of valid alternative answers for the cash available for investment was acceptable for full marks. (For example, if candidates’ deducted €3 million for tax, then this would have resulted in €52.1 million available before any dividends)

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need to be deducted from the cash generated from operations to establish how much cash is available for investment:

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Appendix 6 Dividend proposals In 2007 dividends of €2 million were paid. This equals dividend per share of €0.083. It is not known whether dividends were paid in previous loss making years. Therefore in the financial year ended September 2008, the first very profitable year since 2004 (losses in 2005 and 2006) shareholders will want to see a substantial increase in dividends. However, as Solberri has a range of profitable proposals, a large dividend should not be paid, but there is a need to reward shareholders. The proposal would be to increase DPS by 50% to €0.125. The total dividend payout would be €3 million. ●

●

Based upon the proposed dividend payment of €3 million, dividend cover would be very healthy at 9 times (€27 million/€3 million). Dividend yield on the current share price of €6.25 would be 2% (€0.125/€6.25) implying that further growth in the share price is anticipated.

Therefore the cash available for investment would be as follows: € million Balance available for investment after Finance costs and Tax (Per Appendix 5) Less dividends Total available for investment after dividends

42.4 3.0 39.4

Appendix 7 Proposal to acquire an additional resort hotel The forecast NPV at different peak season occupancy levels are as follows: Peak season occupancy level 95% 80% 50%

NPV € million

Probability

100.0 35.0 (25.0)

25% 60% 15%

Expected NPV € million 25.0 21.0 (3.8)

Expected NPV Less: Marketing expenditure not included in NPV figures above

42.2 (3.0)

Net expected NPV

39.2

The breakeven level of occupancy is as follows: 80% ⫽ NPV of €35 million less €3 million marketing costs ⫽ €32 million 50% ⫽ NPV of € (25) million less €3 million marketing costs ⫽ € (28) million Using these figures, it can be seen that the NPV decreases by €60 million for 30% reduction in occupancy ⫽ €2 million reduction for each 1% decrease in occupancy (assuming a straight line relationship between these variables).

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Therefore the breakeven level of occupancy would be 64% occupancy.

Examiner’s note: It would be acceptable for full marks if a candidate calculated the breakeven occupancy level based on the overall change between 95% occupancy levels and 50% occupancy level. The breakeven point would be 60% using this methodology.

Appendix 8 Recommendation on which investments to undertake with cash generated from operations in 2008 Proposed expenditure € million Cash generated from operations:

59.0

Finance costs

(3.9)

Tax

(12.7)

Dividends

(3.0)

Sub total: cash available

39.4

Invest in refurbishment and extended spas at 4 of the existing Superior hotels 4 hotels ⫻ €6 million ⫽

24.0

Solar panels

6.0

Additional finance for employee recruitment, employee training and incentives

6.0

Total investments/additional employee costs Cash retained

36.0 3.4

Examiner’s note: Any range of alternative answers on how to spend the forecast cash surplus would be awarded marks, assuming the total of the recommendations did not exceed the total cash available. The above example of the recommended use of the cash available has been set out to show one way of spending the €39.4 million cash available, but it does not take account of tax on any additional employee costs for simplicity.

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Therefore, a reduction of €32 million NPV/€2 million for 1% reduction ⫽ 16% reduction in occupancy levels. 80% less 16% ⫽ 64% occupancy is the breakeven level where the forecast NPV (after marketing costs) ⫽ €0 million.

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5 1.0

Solberri hotels – Post Exam Guide for May 2008 General Overview

The primary purpose of this report is to give help and advice to candidates who were not successful in the May 2008 sitting of the Solberri TOPCIMA exam. This report explains what the examiner was looking for in candidates’ answers and also includes the most common mistakes made by candidates sitting this exam. This report also discusses areas omitted by some candidates, so that candidates sitting the TOPCIMA exam in the future can ensure that their answers cover all areas of the assessment matrix. This report will also be useful to candidates planning to sit a future TOPCIMA exam, as the advice given is not necessarily specific to the May 2008 TOPCIMA case. It can be taken and used to improve candidates’ understanding of the higher level analysis skills required to pass this final CIMA exam. This case was about an international hotel group called Solberri. Candidates were asked to write a report to the Board of Solberri, which: ● ●

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Prioritises the issues facing Solberri. Analyses and evaluates the issues and provides a choice of alternative actions to address them. Makes appropriate recommendations on what actions should be taken, together with the rationale for why each particular course of action has been selected.

The TOPCIMA assessment matrix has 9 criteria, each of which carries between 5 and 20 marks. It is stressed that it is important to earn high marks in Judgement (for analysis of the issues) and Logic (for recommendations), as each carries 20 marks. Also, whilst the TOPCIMA exam is not a ‘numbers’ paper, it is necessary to prepare relevant calculations to support the analysis of the issues in the case. In this particular case, the most relevant evaluation was to calculate the amount of cash available after tax, finance costs and also dividends. The figure of €59 million, given in the case, was before these costs and was not the ‘free’ cash available to invest. By the start of the Peak season in 2008, Solberri had 12 hotels, including 4 recently refurbished ‘Premier’ hotels. It also had 5 remaining ‘Superior’ hotels and 3 ‘Super plus’ hotels. The planned occupancy level for the 2008 Peak season was 85%, but the actual level of bookings is substantially higher at 95%. The 2 main issues in the unseen material concerned: (1) The level of customer service, as Solberri does not appear to have the resources to meet the demands that come with the high level of bookings. In this industry, a high level of customer service is demanded by customers and this is an area of weakness according to Solberri’s customer feedback. (2) The decision on which of the 4 proposals, or a selection of them, that Solberri should invest its surplus cash in. There were 4 proposals, A to D, ranging from extending accommodation, refurbishing the remaining 5 ‘Superior’ and the 3 ‘Super plus’ hotels, acquiring an additional hotel or environmental initiatives.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(1) The Finance Director had resigned and had left Solberri on 16 May after serving only 1 week of his 3-month notice period. (2) The spa manager at one of Solberri’s ‘Superior’ hotels had resigned and opened a competing spa within 500 metres of the hotel. This has had an adverse effect on Solberri’s spa revenues of 8% within the last 3 weeks. (3) The recent €20 million loan that had been taken out in December 2007 had a restrictive covenant which did not allow Solberri to take on any additional loan finance until December 2009. (4) With the forecast high level of cash for the current financial year, Solberri’s shareholder will expect a dividend. It was expected that candidates would discuss the need to pay an enhanced dividend in this good year to compensate for the possible low, or absence of dividends, in the loss making years in Solberri’s recent history. Prioritisation is very important, with the need to identify and subsequently analyse around 5 issues. Therefore it was not necessary to discuss all 6 issues in this case. However, without discussing either of the 2 main issues, namely of customer service and what Solberri should do with its forecast cash surplus, it would be difficult to earn sufficient marks to pass. In fact, almost every candidate did discuss one or both of these 2 important issues.

2.0

Areas that were well attempted by candidates

The format of candidates’ reports remains generally good. Technical knowledge was also good, with most candidates demonstrating a sound knowledge of a wide range of models and management theories. The majority of candidates earned pass marks in Prioritisation as they had correctly included the concerns over the level of customer service and the proposals on what to use the cash surplus for, in their top 3 priorities. Almost every candidate also included the need to fill the Finance Director role in their top 5 priorities. Ethical issues were generally well answered, although advice tended to be weak.

3.0

Areas that were not well attempted by candidates

There are 20 marks for Judgement and 20 marks for Logic. Therefore these two criteria have a significant impact on the total marks awarded. It is in these two criteria that unsuccessful candidates often did not achieve high marks, resulting in marginal fail marks overall. There appears to be a worrying trend for some candidates not to prepare any supporting calculations at all, or to prepare very few calculations. Whilst TOPCIMA is not about preparing large volumes of calculations, as there are only 15 marks available in Application, it is vital that candidates prepare a small range of relevant calculations to support their analysis of the issues in the case. After all, how can the candidate (in the role of a consultant) advise on the financial viability of the proposals or how much cash to spend, without calculating how much cash will be available after finance costs, tax and also what level of dividends should be paid to shareholders. It is disappointing that so many candidates muddled profits with cash. Furthermore, many candidates wrongly assumed that retaining earnings in the Balance Sheet were further cash

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The unseen material also included 4 issues of secondary importance:

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reserves. Candidates are reminded to ensure that they can understand and interpret a Balance Sheet, as this is a skill which will be needed for their professional life as an ACMA. Within the 3 criteria of Application, Judgement and Logic there were 4 main areas of weakness: (1) Less than half of all candidates made any attempt to calculate the cash available and this resulted in them not earning the marks available in several criteria, including Application, Judgement and Logic. Many candidates wrongly assumed that the entire €59 million was available for the range of alternative investment proposals, even though the unseen material clearly stated that this was before finance costs, tax and dividends. Before candidates could advise on how the forecast cash surplus should be spent, it was necessary to calculate how much of this cash surplus was required for finance costs and tax – as these costs have to be paid, to calculate the discretionary cash available for dividends and the alternative investment proposals. (2) Some candidates did not identify the customer service issue at all and did not discuss or make any recommendations on actions that Solberri should immediately take to improve staffing levels, training and motivation so that Solberri’s customers can receive the standard of customer care expected at luxury hotels. (3) The majority of candidates completely omitted to discuss dividends. It was expected that candidates would recognise that in this first very successful year, after some loss making years and years of low profits, that Solberri’s shareholders should be rewarded. Therefore out of the €59 million cash available, there should have been some discussion of dividend payout and what level should be paid to shareholders and what should be retained for investment to improve shareholder wealth in the future. (4) Some candidates prepared very muddled recommendations on which of the proposals the surplus cash was to be spent on. They often exceeded the €59 million limit, with no reduction for finance costs and tax and any dividends the Board make choose to pay. As Solberri was unable to raise further cash through debt finance in the short term due to the loan covenant restrictions, if their recommendations exceeded the €59 million limit, then substantially lower marks were awarded. There is a need for more consideration of the impact of the key issues on the company in the case, rather than simply repeating theoretical strategies, with little understanding of their relevance to the strategic decision-making process. Candidates are reminded that all the analysis given in the appendices should be referred to in the body of the report including the implications of any calculations prepared. Appendices should not simply be ‘stand alone’ but should be used to help with the analysis of the issues.

4.0

Assessment matrix and areas for improvement

4.1 Overview of the TOPCIMA assessment matrix The examiner was generally pleased with the format of candidates’ reports although the discussion was often ‘thin’ and lacked depth of analysis and many of the supporting theoretical frameworks were not referred to in the reports. Candidates and tuition providers are reminded that more depth of discussion of each issue is required for higher marks rather than simply providing brief unexplained bullet point lists. As stated above, all candidates are reminded that they should prepare a small range of relevant calculations to support the analysis of the issues and also their recommendations. This

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.2 Technical There are 5 marks available for Technical. Many candidates earned very high marks for a good display of relevant technical knowledge. Indeed many candidates produced at least 4 or 5 relevant theories or analyses, including a SWOT, a PEST analysis, references to Porter, Ansoff, Mendelow, etc. There was ample opportunity to earn marks in this criterion for the display of any of the following techniques: ● ● ●

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SWOT analysis PEST analysis for the hotel industry operating in holiday resort locations The Johnson and Scholes model to structure the answer by using the suitability, acceptability and feasibility framework for the 4 investment proposals Porter’s Generic Strategies to demonstrate that Solberri differentiates itself on quality and excellence in service Porter’s Five Forces to demonstrate that barriers to entry in the industry are relatively high and that customer power is also a major force Mendelow’s stakeholder analysis which should analyse the many stakeholders that Solberri has, including its shareholders and more importantly, its customers. Motivational theories such as content theories offered by Herzberg, Maslow and other content and process theories Other applied models such as Ansoff ’s growth vector matrix, the BCG matrix, value chain analysis and the balanced scorecard Relevant ratios

However, candidates are reminded not to spend too much time preparing detailed appendices (which are then not referred to or discussed within the body of the report). The 2 criteria of Technical and Application are together worth 20 marks. Therefore no more than 20% of exam time should be spent on them. It is suggested that with exam planning time and time spent prioritising issues, no more than 30 minutes should be spent on appendices, including all calculations. Exam time would be better spent in preparing a more in-depth analysis, which would earn higher marks in Judgement. 4.3 Application The Application criterion carries 15 marks and is used to reward candidates for applying technical knowledge (both theories and calculations) to the case material. In order to earn high marks for the SWOT, candidates should have identified the forecast surplus cash as a Strength (or as an Opportunity). Additionally, candidates should have incorporated customer service and the absence of a Finance Director as Weaknesses (or Threats). Candidates are reminded that it is necessary to incorporate all of the new information

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should have included the total cost of the 4 proposals at €123 million. This clearly exceeded the cash available. Furthermore, marks would have been awarded for a summary of the value of the recommendations made (either within the recommendations section of the report or as an appendix) to show what it was recommended Solberri should use the surplus cash for. In many scripts it was unclear what action was actually being recommended. Vague unspecific recommendations earned low marks or no marks at all. Remember, marks are only awarded in Logic for clear well-justified recommendations of what actions are being recommending to the Board and why these have been selected as recommended courses of action.

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given in the unseen material in the SWOT in order to earn high marks. A pre-prepared SWOT based on the pre-seen is insufficient. Candidates are also reminded that all the issues prioritised should also be included in the relevant section of the SWOT. A good range of theoretical knowledge was prepared and applied to the case material and many candidates earned high marks for the theories applied. Within the available 15 marks, approximately half of the marks were available for applying theoretical knowledge and the other half for the preparation of relevant and accurate supporting calculations. Numerical analysis is required to provide a platform on which to discuss the issues and to help with understanding the financial impact of the alternative issues in the case. The NPVs for the different proposals could be compared using profitability indices, for example. In this case the most important calculation was to identify the €42 million cash available after finance costs and tax. This could be calculated in 2 ways – either by calculating finance costs and tax and deducting it from the €59 million or adding back non-cash items such as depreciation from the forecast post-tax profit figure of €27 million. Either method resulted in roughly €42 million and would have been acceptable for full marks. In summary it is recommended that candidates should spend a total of 30 minutes on appendices, including relevant supporting calculations. Calculations that could have been prepared include: ● ● ● ● ● ●

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The total value of the 4 Proposals A – D which was €123 million Calculation of cash available after finance costs and tax Calculation of a proposed dividend payment Expected NPV for Proposal C – to acquire an additional hotel Breakeven occupancy for Proposal C Calculation of the impact on revenues, using a higher room rate if ‘Super plus’ hotels were refurbished up to ‘Superior’ standard but for fewer number of rooms Summary of the investment cost of all recommendations made Relevant ratios for Solberri on gearing and profitability

4.4 Diversity Diversity carries 5 marks. Many candidates earned high marks for industry awareness and relevant comments on international hotel chains. Most candidates appeared to have some understanding of the hotel and holiday industries and had obviously undertaken research or been taught about this industry sector prior to the examination. Many candidates started their reports with an introduction which made reference to the hotel industry and its major competitors, and the use of Internet portals such as lastminute.com, tripadvisor.com and expedia.com. There were also references to sector reports on the hotel industry by firms such as PriceWaterhouseCoopers and Deloitte’s. Many candidates quoted specific real-world examples to illustrate the points being made including Sol Melia, Hilton, Marriott, Club Med, RIU and Intercontinental. Unfortunately, the information some candidates gave about the real-life companies was often not considered when preparing the rest of the report. Many commented on the recent ‘credit crunch’ and exchange rate movements which made holidays in Europe uncompetitive. However they then went on to recommend Proposal A, the extension of the number of rooms. This contrasted with the real-life examples previously given. The real-life examples that candidates should research, should help to understand the industry setting, and empower you to make commercially sensible comments and recommendations.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

4.6 Prioritisation Prioritisation carries 10 marks. Almost all candidates clearly prioritised a range of issues at the start of their reports, and attempted to justify the rationale behind their ranking. This resulted in high marks for prioritisation for many candidates. The two most important issues affecting Solberri were considered by the examiner to be: (1) The level of customer service for the current Peak season with its high occupancy levels. (2) The choice of investment proposals and how the forecast surplus cash should be invested. Additionally, the issue of the Finance Director role, following the recent resignation of Antonio Skrip, should also have been placed in the top 5 prioritised issues. In summary, in order to earn pass marks in Prioritisation it was necessary to place the customer service issue and the investment proposal issues in the top 3 priorities, and also for the Finance Director role to be placed in the top 5 priorities. Some candidates chose to deal with each of the proposals as separate issues. Pass marks in Prioritisation were awarded provided that at least 1 of the proposals and the customer service issue were placed within the top 3 priorities and also the FD role in the top 5. There continues to be a lack of understanding by some candidates regarding the nature of prioritisation. It is not about urgency – it is about the impact on the company. A minor issue that requires a decision next week is less important than a major strategic issue that will affect the future success or very existence of the company. The level of customer service is key to success in this industry. Additionally, the investment decision as to what to do with the forecast surplus cash is important for 2 reasons: first, to invest for future growth in shareholder value and secondly, a cash rich company may be the target for a hostile takeover. This latter point was identified by only a few candidates. 4.7 Judgement This is a very important criterion, which carries 20 marks. Marks are awarded for analysing each of the issues and explaining the impact they have on the company, but more importantly, for high marks, it is necessary to discuss a variety of alternative solutions. Candidates who analysed and discussed several of the issues well and showed good commercial judgement on several issues earned pass marks in Judgement. However, candidates who demonstrated poor commercial and professional judgement usually earned between 3 and 8 marks. Therefore it must be stressed that this criterion is an area that unsuccessful candidates need to improve in. Marks are only awarded in Judgement for comments and choices of action that are commercially viable, realistic and sensible. Disappointingly, common sense and general business awareness were often not displayed. As in previous sittings, the most significant failing on Judgement was that candidates tended to provide only a brief analysis of the key issues or merely re-iterated facts from the scenario without adding anything of significance. Many candidates used the Johnson

MAY 2008 – SOLBERRI

4.5 Focus There are 5 marks available for the Focus criterion. These are awarded for discussing the issues raised in the case. There was the opportunity to earn marks in Focus for the discussion of any of the issues. These included customer service issues, each of the 4 proposals (A to D), Finance Director role, the competing spa, the loan covenant restriction and dividends. Most candidates earned the full 5 marks available for discussion of 5 relevant issues.

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and Scholes framework to structure their answer but sometimes only looked at the positive aspects of each proposal rather than provide a balanced and critical analysis. In the May 2008 Solberri hotel case, there were 6 main issues for which marks were available in Judgement: (1) Customer service and HR issues In this industry, the standard of customer service is vitally important to Solberri in order to maintain its ability to compete by differentiation, and therefore to achieve long-term success. Whilst Solberri has a high level of bookings for 2008, if it does not satisfy these customers, it may not have repeat business and poor customer service could damage its reputation. Solberri has bookings for an average of 95% occupancy in the 2008 Peak season, which started on 1 May 2008. The unseen material stated that ‘Nik Silva is reviewing staffing levels’. Solberri still has a very long way to go to reach their target level of ‘excellence’ in customer service of 50% in 2010. It was your role as a consultant to advise the Board on the importance of high levels of customer service in order to ensure that this year’s high level of occupancy results in positive impressions for its customers and that the level of customer service is not poor. If the level of staffing and the standard of customer service are not addressed urgently, this could result in a fall in occupancy in 2009. Therefore, for example, the extra rooms in Proposal A, would be very difficult to fill. Ultimately the long-term success of Solberri is dependent on delivering the high level of customer service expected by customers staying at high quality hotels. For this reason it was considered by the examiner that the issue of customer service should have been prioritised in the top 3 issues and discussed in depth. The discussion should have covered many aspects of how Solberri could improve its level of customer service, including training, recruitment of additional staff (at all levels including support for managers working excessive hours) and the mix of short term versus permanent staff. Also, it was important to discuss what actions should be taken to improve employees’ motivation. Whilst many candidates discussed training and recruitment of additional staff, few discussed the important issue of staff motivation and the direct link between having highly motivated employees and the delivery of a high level of customer service. (2) Investment proposals The unseen material included details on 4 investment proposals. The mark scheme also rewarded candidates for the recognition that the forecast cash should be adjusted to reflect the finance costs and tax, resulting in a lower figure than the €59 million given in the unseen material. The marks were for the recognition that not all of the €59 million was available for investment. (2a) Proposal A – to extend accommodation at the ‘Premier’ hotels. This proposal was to extend the accommodation at 1 or more of the 4 ‘Premier’ hotels by 200 rooms per hotel at a cost of €9 million. Therefore this proposal was divisible, that is it was possible to extend only some of the hotels. What was expected here was a discussion of the risk of damage to Solberri’s reputation regarding the ‘exclusivity’ of the resorts and customer perception of a more crowded hotel resort. Additionally, it should be questioned whether the higher occupancy levels could be achieved and whether there are adequate staff to provide the required level of customer service if the hotels were to be enlarged so substantially.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(2b) Proposal B – to refurbish and extend spa facilities at Solberri’s remaining hotels This proposal was to refurbish and extend the facilities at 1 or more of Solberri’s remaining 8 hotels. Its recent refurbishment programme appears to have been successful, as shown by the winning of a TV programme award and the high level of bookings for the 2008 Peak season. Therefore, this proposal was the logical choice. This proposal was divisible, that is some or all of the remaining 8 hotels could be refurbished. There was an added complication that the smaller ‘Super plus’ hotels would lose 15 rooms as a result of the spa extension plans. However, the greater revenue per room from being a ‘Superior’ status hotel outweighed the loss of revenue from 15 rooms. Many candidates earned marks for discussing the possibility of divesting the ‘Super plus’ hotels and only undertaking the refurbishment of the remaining 5 ‘Superior’ hotels, which was an acceptable alternative. Marks were also awarded for the depth of discussion of Proposal B and for recognising that this proposal was a good strategic fit and was already the chosen route for Solberri and has been approved by the Board. This proposal simply allowed plans to be brought forward, if some of the forecast surplus cash was to be used for this proposal. There was less business risk associated with Proposal B as this had already been tried with the 4 current ‘Premier’ hotels and the high bookings for 2008 confirmed that this was a proposal that would be acceptable to both shareholders and also to customers. (2c) Proposal C – to acquire an additional resort hotel This proposal was to expand the Solberri group to 13 hotels by acquiring an additional hotel at a total cost of €24 million (including acquisition costs, refurbishment costs and marketing costs). The key question here is risk and whether Solberri is ready to spend so much of its cash surplus in acquiring just one more hotel. However, the NPV’s at different occupancy levels look promising and not too ambitious with an expected occupancy level of 80% and a breakeven occupancy level of 64%. So realistically, this hotel should be profitable if it were to be acquired. The question here is the use of the forecast cash surplus. As cash is limited, should this acquisition go ahead or will there be other opportunities for expansion in the future? This proposal was a higher risk than Proposal B but gave Solberri more capacity and therefore the opportunity to create shareholder wealth. (2d) Proposal D – to invest in environmentally friendly initiatives This proposal was to invest €6 million in solar panels and a further €9 million in other initiatives including improved waste management, IT solutions to reduce electricity and improved staff training in environmental issues. This proposal does not in itself create value for shareholders, except that this could be used as a marketing tool to enhance Solberri’s ‘green’ credentials, which is important in today’s increasingly environmentally aware society. However, it is an expensive option. Solberri has had the solar panel proposal in its CSR report for some time, and after such a good year, there is some merit in allocating funds to meet this CSR objective. It has been put off in the past due to lack of funds, and therefore, it is something that Solberri can now afford if it chose to do so.

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Solberri has not yet experienced one Peak season of such high levels of occupancy, and therefore there should have been some recognition and discussion that it was rather premature to be looking at extending the ‘Premier’ hotels. With cash limitations, Proposal A should have been considered to be too risky. Therefore it would be better for Solberri to select Proposal B, which entailed refurbishing more hotels to ‘Premier’ status.

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Furthermore, the unseen material stated that Solberri had appointed a new Environmental Director and therefore it would be necessary for the Board to allocate him a budget to achieve some of his objectives. Therefore it would be appropriate for some of the environmental initiatives to be approved. Otherwise the new Director could leave Solberri and this could generate adverse publicity for Solberri. It was disappointing that many candidates did not discuss this proposal at all, perhaps due to exam time pressure, and those that did generally dismissed the initiatives as poor value, with little recognition, or concern for, Solberri’s CSR statement. (3) The Finance Director role The Finance Director had resigned after a number of Boardroom disputes and had left Solberri on 16 May after serving only 1 week of his 3-month notice period. The need to fill the Finance Director’s role was generally well handled by most candidates. Many candidates correctly discussed an interim appointment of either an internal person from the Finance department or one of the NED’s or even an external interim manager. Furthermore, additional marks were awarded for comments and recommendations concerning the appointment of a new permanent Finance Director who would bring in new innovative ideas to the company. The previous Finance Director had left after Boardroom disputes, which could have concerned the loan covenant restrictions which the FD had not brought to the attention of the Board. No marks were awarded for comments on bringing Skrip back or insisting that he served his notice period. Equally no marks were awarded for to the few candidates who recommended giving him a pay rise to entice him back. The issue here concerned the role of the FD and how this could be filled and the urgent need to appoint someone to this role during this important time when investment decisions are being made and cash flow needs to be managed carefully. (4) The spa manager resigning and setting up a competing spa The spa manager at one of the ‘Superior’ hotels had resigned recently and had established a competing spa within 500 metres of the hotel. This had already impacted revenues at the Solberri spa with an 8% fall in revenues within the last 3 weeks. In your role as consultant it was important to advise what actions could be taken to address this fall in revenue as quickly as possible. It was especially disappointing that so many candidates advised that no action should be taken, except that the situation should be monitored closely. This is not what the Solberri Board has ‘employed’ you as the consultant to advise – it was your role to advise on a range of actions that should be taken. There were 2 different actions that could be taken to address this issue, which were: (a) The marketing and pricing actions that Solberri should take to attract its customers back into its own spa. The candidate was expected to advise the Solberri Board that if Solberri’s spas are to be successful, after the considerable investment, they need to attract customers on their own merits through the use of exclusive treatments and products. They also need to provide the very best of customer care. Customers at these high quality hotels will only use facilities outside of the hotel if they deem them to be better in some way than that provided by the Solberri spa. So Solberri spas need to become more attractive in order to compete. (b) The skilled employees at Solberri spas need to sign revised contracts restricting them from competing or working at a spa in such close proximity to the hotels. This should

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Additionally, the HR Director needs to find ways to motivate and retain skilled spa employees so that they do not want to leave the Solberri to work elsewhere. Therefore motivational aspects and financial rewards, perhaps linked to levels of customer care (such as employee of the month) need to be established to retain and motivate spa employees. (5) Loan covenant restriction The recent €20 million loan that was taken out in December 2007 has a restrictive covenant which does not allow Solberri to take on any additional loan finance until December 2009, despite the changed fortunes following the high forecast bookings in the 2008 Peak season. Many candidates approached this issue rather simplistically and not very commercially, and stated that the loan should be renegotiated. However, there are a range of actions that the Solberri Board could take. This includes repaying the loan with some of the surplus cash and renegotiating a new loan. However, there may be early repayment penalties and perhaps a new loan may not be available. Alternatively, representatives from the Solberri Board could meet with the loan provider and show them the financial forecast for 2008 and the details of the projects that they wish to undertake and negotiate a relaxation of this restrictive covenant to allow a small amount of additional loan finance. However, the loan has been signed and the purpose of the restriction is to protect the loan provider by restricting any additional debt finance being taken on. However the Solberri group has a reasonable gearing ratio of 27.3% and with the high level of bookings, renegotiation of the restrictive covenant may be possible. Some candidates also discussed rights issues, sale and leaseback of hotels, sale of ‘Super plus’ hotels and better working capital management. (6) Dividends With the forecast high level of cash for the current financial year, Solberri’s shareholders will expect a dividend. It was expected that candidates would discuss the need to pay an enhanced dividend in this good year to compensate for the possible low, or absence of dividends, in the loss making years in Solberri’s recent history. Solberri is a listed company with shareholders who want to be rewarded with dividends, although they have seen a growth in share price recently. It was rather disappointing that so few candidates discussed dividends at all. It was expected that candidates would discuss a range of dividend policies and the level of dividends per share (DPS) that could be paid out, and whether the Board would pay a lower dividend since it had a range of projects with positive NPV’s which would create shareholder wealth in the future. In 2007, Solberri paid out €2 million in dividends which equates to 40% of posttax profits and represents a DPS of €0.083 per share. If Solberri were to maintain its payout ratio of 40% (which most candidates assumed would continue) this would result in a dividend payout of €10.8 million (€27 million ⫻ 40%). However, this represents a DPS of €0.45, which would be an increase in DPS of 442%. The case writer’s suggested answer was to increase the dividends by 50% and to pay out a total of €3 million, therefore allowing more cash to be invested in the alternative proposals.

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stop other employees being trained and getting experience at a Solberri spa and then leaving to set up or work at a competing business. Whilst employees can leave Solberri, a restrictive clause will stop them from working so close to a Solberri hotel.

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4.8 Integration This criterion rewards candidates for their ability to write a cohesive, comprehensive report that ‘flows’ well and reaches well-justified recommendations on each of the issues discussed. This criterion rewards a report which is realistic in that it contains commercially viable comments that would help advise the Board of Directors of Solberri. Conversely, the Board would be dissatisfied if they received a poor quality report due to a lack of sensible recommendations, then low marks were awarded in Integration. A report that contained recommendations which the examiner considered could cause the company problems was awarded low (fail) marks in this criterion. Low marks were awarded in Integration if customer services issues had not been discussed at all and also if the total sum of the recommendations exceeded the €59 million cash available. Furthermore, if candidates had not prepared any calculations adjusting the €59 million cash generated from operations for finance costs and tax, then lower marks were awarded in Integration, as the cash available was an important feature of this case, since a report recommending how to spend €59 million is not very useful, as finance costs and tax have to be paid before any investments are made. 4.9 Logic The criterion of Logic carries 20 marks in the assessment matrix and rewards clear, justified, well-argued recommendations. It was a criterion in which fail candidates earned low marks. It is recommended that candidates allocate at least 40 minutes of their examination time to preparing detailed and justified recommendations. Some candidates apparently did not manage their time adequately and prepared rushed recommendations. This is one of the most important areas of the report and will often determine a pass or a fail when the script is marginal, so it is important to ensure that recommendations are clear and the rationale for the recommended course of action is given. It is of paramount importance that the report makes appropriate recommendations and does not leave any of the issues undecided. It is for the consultant (i.e. the candidate) to present all the arguments for and against and to weigh them up in order to make recommendations. There are few right or wrong answers with TOPCIMA – it is the depth of discussion and the strength of the candidates’ arguments and the justification behind the recommendations that earns marks. Ill-thought through analysis and poor recommendations are not rewarded. Remember who the report is addressed to. In this case, the candidate was addressing the report to the Solberri Board and for this to be a helpful report, the recommendations should be clear and well justified and the actions to be taken explained. The recommendations should also have summarised what the forecast surplus cash is to be spent on. It was disappointing that so many recommendations were vague and unclear as to what was to be spent, with many recommendations totaling a figure greater than the €59 million. A summary of the recommended actions for the 6 issues in this case are as follows: (1) The level of customer service. It is recommended that Solberri needs to ensure that staffing levels are adequate and that employees are motivated to ensure a high quality experience and high levels of customer satisfaction. Some of the forecast surplus cash should be used to increase the number of employees and to provide improved, effective training to meet quality of customer service targets and for performance-related incentives. It is recommended

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

(2) The decision on which of the 4 proposals, or a selection of them, that Solberri should invest its surplus cash in. Due to Solberri’s inability to take on any further loan finance, due to the loan covenant restrictions on its recent loan, Solberri’s choice is limited to the cash available, which is forecast to be €42 million after finance costs and tax. There was a range of acceptable answers on how the cash could be invested. The case writer considers that the €42 million forecast cash surplus should be invested as follows: Proposal A – It is not recommended that Solberri should invest in Proposal A, to extend accommodation at the 4 ‘Premier’ hotels at present as Solberri has only had one Peak season with high occupancy levels and it is considered too soon to extend the accommodation. Proposal B – It is recommended that Solberri should use €24 million of the available cash to bring forward the refurbishment and extension of spas at a further 4 ‘Superior’ hotels. Proposal C – It is not recommended to acquire another resort hotel as Solberri has other uses for its forecast cash surplus even though this proposal has a high NPV and a realistic breakeven point of 64% occupancy. However, with cash required for refurbishment and extending spas at 4 hotels and cash required for additional recruitment and staff-related issues, there is not sufficient surplus cash for this investment. Additionally, it is recommended that Solberri ‘consolidates’ its position with its current 12 hotels before it expands the number of Solberri hotels. Proposal D – Investment in environmentally friendly initiatives. Having appointed Luc Pinard as the new Environmental Director, the Board needs to make funds available to achieve agreed environmental targets. It is recommended that the investment of €6 million in solar panels should proceed but that the rest of the environmentally friendly proposals, at a cost of €9 million, could be financed from cash generated from operations in the next financial year. (3) The Finance Director role. It is recommended that another Board member, perhaps a non-executive director, could take this role on temporarily until a permanent appointment is made. A permanent appointment should be recruited as soon as possible. There are many advantages in external recruitment as this brings ‘fresh blood’ to the Board and perhaps experience in other industries, or a different hotel chain. (4) The competing spa. It is recommended that Solberri should ensure that its contracts of employment preclude employees leaving to work in direct competition to Solberri within a 6-month period of time, assuming the local employment laws in each country allow this.

MAY 2008 – SOLBERRI

that Nik Silva should quickly draw up an action plan for recruitment and training. He should also devise and circulate, to all employees, a clear realistic range of specific performance measures which employees can try to achieve and which will be used as a basis for paying performance-related bonuses. Additional rewards, such as employee of the month at each hotel or best employee in each department should be set up as motivational tools and to reward good performance.

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It is also recommended that skilled spa employees should be motivated by performancerelated targets, incentive schemes, bonuses and perhaps free shares linked to achieving a range of targets. In order to boost revenues at the ‘Premier’ hotel which has recently seen a fall of 8% in its revenues, it is recommended that the hotel publicise a range of special offers to attract its customers back to its own spa and away from the competitor’s business. (5) The restrictive loan covenant. It is recommended that Solberri’s CEO, together with the interim new Finance Director, should meet with the bank and to try to negotiate the restrictive covenant. If they are not successful in getting the restrictive covenant removed, then Solberri should ensure that it retains sufficient cash to cover any increase in working capital. The Board should also tighten its procedures to ensure that any restrictive loan covenants are brought to the attention of the Board before any new debt finance is agreed. Many candidates recommended raising additional cash via a rights issue and did not discuss the likelihood of a rights issue being acceptable to shareholders or discuss the time scale that this method of raising finance could take. Raising equity finance is never an easy or low cost method of raising finance and is never a ‘quick fix’ for a short-term cash shortage. A rights issue is not instant cash, as it could take 12–18 months before shares could be issued. Therefore a recommendation to raise finance by this method was not awarded marks unless the timing of a rights issue had been discussed as the cash could not be instantly raised to finance the proposals which were to be undertaken during 2008. (6) Dividends. It is recommended that Solberri should pay a dividend of €0.125 per share, which equates to a 50% increase in DPS since last financial year. This would cost €3 million. As a reminder, it is generally better for all recommendations to appear together at the end of the report, rather than at the end of the section concerning each issue, as actions impact on each other. Recommendations must be realistic and be consistent with related issues as in real life many decisions are inter-related. 4.10 Ethics Most candidates attempted to address 2 or 3 ethical issues and earned pass marks. In order to earn a pass mark, it is necessary to identify the ethical issues, justify why that issue is considered to be an ethical issue and to advise on how to resolve several of the ethical dilemmas identified. The full 10 marks are awarded for good discussion and advice concerning two or more ethical dilemmas. A common problem is that many candidates discuss a number of ethical issues but do not justify why the issue is an ethical dilemma. Candidates also fail to give clear, fully justified advice on how the ethical issue could be addressed and the cost implications for the company. There were a range of ethical issues in this case including: ●

●

Poor training – Some of Solberri’s employees are not professional and competent in their roles. Poor treatment of hotel General Managers and key senior employees. Putting employees under high stress levels is not ethical and will also affect morale and motivation of these key employees.

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

●

●

Investment in Green initiatives and solar panels – ethical aspect of investing in ‘green’ energy sources and other environmentally friendly initiatives. Tips – how to distribute fairly and to ensure all tips reach employees and are not retained by the hotel. Also motivational aspect and how to stop employees who are threatening to walk out over this issue. Corporate Governance issues, with a lack of independence of 2 non-executive directors, as they are related to the Chairman.

Candidates are reminded that there are marks available for justifying why the issue has an ethical dimension. However, the majority of the marks available in Ethics are for the advice (or recommendations) on how the ethical issue could be addressed. It is often the advice which is brief and thin, and therefore earns low marks. A maximum of 4 marks, (i.e. marginal fail) is awarded for the discussion of ethical issues alone. It is the advice and recommendations on how the ethical issues could be overcome that earns up to the maximum of 10 marks. Generally the advice given on ethical issues was weak and earned low marks. For example, many candidates discussed the excessive hours worked by senior managers or the stress suffered by General Managers. Candidates were rewarded with higher marks if they recommended the need for greater staffing resources and suggested how this might be achieved, as opposed to the weak answer suggesting that managers are offered counseling or for them to be sent on time management courses. Others simply advised that managers be prevented from working such hours without suggesting how this might be effectively achieved, or called for overtime payments to be offered. Such comments are superficial and tended to treat the symptom rather than the cause. Furthermore, some candidates (especially from overseas) regarded the FD’s failure to serve his notice and the Spa Manager setting up near to the hotel as ethical issues. This could be due to a cultural difference in the perception of these issues. The Spa Manager and FD issues do have ethical dimensions, but for the individuals concerned, not the company. The candidate is in the role as a consultant advising the company, not the individual, and therefore no marks were awarded in Ethics for these comments as they were not relevant to Solberri.

5.0 Recommendations to improve your chance of passing TOPCIMA in the future Candidates are referred to the TOPCIMA Learning System, (www.cimapublishing.com) which is the recommended reading text for this exam. This CIMA Learning System takes candidates through past TOPCIMA cases and demonstrates how to analyse the pre-seen and also what to do on the exam day with the unseen material and how to prepare answers. It also contains a chapter on Technical issues, including revision of a range of business and financial techniques that candidates should understand and incorporate in their answers. This CIMA Learning System also contains past TOPCIMA cases and the case writer’s answers. Candidates sitting TOPCIMA for the first time are referred to previous Post Exam Guidance reports or the general TOPCIMA guidance notes (on the CIMA website) for advice on the suggested report format. It is recommended that all candidates should read the financial pages of a good newspaper at least once a week, in order to gain an appreciation of the business world that this CIMA

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exam is set in. This will enable you to gain a far greater understanding of how companies operate and improve your commercial knowledge. In summary, the eight key tasks that will put you in a better position to pass TOPCIMA are: (1) Work (not simply read) through at least 2 TOPCIMA past cases (on www.cimaglobal. com or in the CIMA Learning System or available from www.cimapublishing.com ). (2) Read thoroughly 2 past TOPCIMA Post Exam Guidance reports (on www.cimaglobal. com ). (3) Research the business setting for the case thoroughly and totally familiarise yourself with the pre-seen material (read newspapers, research using the Internet, use Internet search engines such as Google to identify companies in the industry and so on). (4) Revise business strategies and suitable techniques and be able to apply them to the case material. (5) Practice writing answers to previous TOPCIMA cases in a 3-hour session and see how comprehensive an answer you can produce. Check your answer to the case writer’s answer (in the CIMA Learning System or available from www.cimapublishing.com ). (6) Read the two articles on the CIMA website (www.cimaglobal.com ) about the case you are planning to sit. CIMA commissions independent writers to analyse the pre-seen material and these articles give a good insight into the industry setting and the problems and opportunities the company is facing. The articles for the March and May 2008 exams on Solberri are ‘Solberri Hotel Case’ by Adrian Sims of BPP and ‘Check out of Heartbreak Hotel’ by Shuaib Masters of Kaplan Financial. (7) Ensure that the report clearly prioritises the top 5 key issues raised in the unseen material and consider carefully whether the priorities are in an appropriate order given the circumstances of the case. The order in which issues are placed must be justified. (8) Ensure that your answer covers all nine assessment criteria. Remember – do your research and prepare for the exam – but on the day, ensure that you write a thorough, well-reasoned answer that covers the relevant key issues raised in the unseen material and ensure that your answer covers all aspects of the requirement and in particular, gives clear, well-justified recommendations. The examiner cannot stress enough the importance of practicing writing an answer using past TOPCIMA cases. There is no way to prepare for the TOPCIMA exam without investing in hours of work using past TOPCIMA papers. Remember it is good preparation that will help you to pass this final test of professional competence. It is strongly recommended that you should practice by working through past TOPCIMA cases and writing a full report using real past TOPCIMA cases, as this will improve the skills required for this last CIMA exam. The skills you learn from preparing for your TOPCIMA are the same skills that you will use in the real world when you are a qualified CIMA accountant – so learn them now as you will use them in your future career.

Practise Exam Review Checklist

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Practise Exam Review Checklist

1

Appendix

C

Practise exam review checklist

This appendix provides a copy of the practise exam checklist for you to copy and use when analysing your past papers or mock exams. It is important that you keep copies of each of your reviews and note common areas on which you need to improve. I also suggest that you review the past review sheets prior to each subsequent practise session, and the real exam to ensure you learn lessons from what went well and less well in the past. ✔

✘

What will you do differently next time to improve?

Time management Did you finish in the required time? Did you keep to the timetable throughout? Report formats Contents page, clear with correct formats Introduction: completed, including an industry example Terms of reference completed Numbered headings for each section and sub-section Script is legible and well laid out Planning and prioritisation Did you complete this section within 30 minutes? Had you made a clear decision on your prioritisation order at the end of this time? Had you planned some key discussion points and alternative solutions for each of your 5 top issues? Were the examiner’s top 2 issues within your top 3 issues? Is your overall top 5 approximately in agreement with the examiner’s? (Continued ) 329

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✔

✘

What will you do differently next time to improve?

Analysis of the issues Did you complete this section in the allotted time? Issue 1 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 2 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 3 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 4 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered – Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Issue 5 Some or all of the following may be relevant to this issue: – Stakeholders affected clearly stated – Financial impact considered (Continued)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

✘

What will you do differently next time to improve?

– Related to Strengths and Weaknesses – Links to other unseen issues – Alternative actions suggested – Alternative actions analysed (e.g. ads/disads) – Industry example given The right balance is obtained, so that alternative actions analysis is more than half of the total amount written Ethics Did you finish this section within 15 minutes? Issue 1 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Issue 2 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Issue 3 Is this issue fully analysed, considering: – Duty of care owed – Values – Ethical policies – Laws/norms? Have you made a recommendation for this issue? Was your recommendations justified? Recommendations Did you complete the recommendation section of your report within the full time of the exam (remembering it is the most important section)? Issue 1 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? (Continued)

PRACTISE EXAM REVIEW CHECKLIST

✔

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STUDY MATERIAL T4

✔

✘

What will you do differently next time to improve?

Issue 2 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 3 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 4 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Issue 5 Have you made a range of recommendations for this issue? Is it clear what precisely your recommendations are? Was there justification for each recommendation made? For each recommendation made is it clear: – Who should do it? – When it should be done? – How it should be done? – Why that is the best course of action compared to other options? Are the recommendations on all five issues consistent with each other? If this were a real-world company, and this report was given to a real world Board of Directors, would they be happy taking these recommendations? Are they logical, well thought through, justified, and ultimately would they leave the company in a stronger position going forward? (Continued)

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

Conclusion Have you done a suitable conclusion? Appendices A SWOT analysis was undertaken The SWOT analysis was updated for unseen issues The SWOT includes all of the top 5 issues in the report Have you done at least 2 further theory appendices? Have these additional appendices been updated? Have you done 2–3 calculation appendices? Are calculations clearly laid out? Have you cross-referenced every one of your appendices in the main body of your script at least once? Overall As you review your script as a whole, what are the key areas you need to improve for next time?

✘

What will you do differently next time to improve?

PRACTISE EXAM REVIEW CHECKLIST

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Exam Q & As

At the time of publication there are no exam Q & As available for the 2010 syllabus. However, the latest specimen exam papers are available on the CIMA website. Actual exam Q & As will be available free of charge to CIMA students on the CIMA website from summer 2010 onwards.

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Index

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Index

A Acceptability test, 18–19, 27, 263 Agency agreements, 257–8 AIM see Alternative Investment Market Alnetti, Johan, 271, 272–3, 275, 280, 281, 288 Alternative Investment Market, 260 Ansoff ’s matrix, 19, 251–3 Answer analysis, self, 70 Appendices, report writing: calculation based, 60 exercise, 61 solution, 61–3 theory-based, 63 PEST analysis, 65–6 SWOT analysis, 64–5 Applications portfolio, 234 Appointment of consultant, Merbatty boat case, 99 Assessment matrix: report writing and, 191–2 Solberri hotel case, post exam guide for May 2008: application, 315–16 diversity, 316 focus, 317 judgment, 317–18 overview, 314–15 prioritisation, 317 technical, 315 Asset-based methods, of business valuation, 246–7 Asset/turnover ratios, 200, 205 Asset utilisation, 205 B Balance sheet, Solberri hotel case, pre-seen material for May 2008, 282

Bank: loans, 262 overdraft, 262 Bargaining power: of buyers, 223–4 of suppliers, 224 BCG matrix see Boston consulting group, growth matrix Berriman, Richard, 270, 271, 272, 273, 278, 280, 286 BIMBO see Buy-in management buyout Biodata files, 153, 155 BMS see Bookings Management System Boat building costs, reduction in, 115–16, 121 Boat building facilities, Merbatty’s see Merbatty’s boat building facilities Bonds: corporate, 261–2 debt discounted, 262 Bookings Management System, 277 Boston consulting group, growth matrix, 20 cash cows, 216 dogs, 216 market growth rate, 214 question marks, 215 relative market share, 214 stars, 215–16 Business ethics, 31 Business issues, recommendations, Merbatty boat case: appointment of new sales director, 119–20 boat building facilities, 120–1 CCL takeover bid, 118 computer test results, 121 management of currency fluctuations, 120 recommendations on new sales agent in the USA, 120 339

INDEX

340

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING T4

Business issues, recommendations, Merbatty boat case: (Continued) reduction in boat building costs, 121 safety issues, 121 ways to achieve planned levels of profits, 118–19 Business issues, Solberri hotel case, case writer’s answer for May 2008: appointing finance director, 304 customer service and quality issues, 303 dividends, 305 employee morale, 305 fall in spa revenue, 304–5 loan covenant, 305 spending forecast cash surplus, 304 tips distribution, 305 Business portfolio see Portfolio analysis Business risk see Operational risk Business valuation, 20–1, 184–5 asset-based methods of, 246–7 earnings-based methods of, 247–51 Buyers, bargaining power of, 223–4 Buy-in management buyout, 261 C Capital assessment, cost of see Cost of capital assessment Case writer’s answer for May 2008 (Solberri hotel case), 288–9 business issues: appointing finance director, 304 customer service and quality issues, 303 dividends, 305 employee morale, 305 fall in spa revenue, 304–5 loan covenant, 305 spending forecast cash surplus, 304 tips distribution, 305 cash availability for investments, 308–9 discussion of issues facing Solberri: appointing finance director, 298 customer service and quality issues, 292–4 dividends allocation to shareholders, 299–300 employee morale, 299 fall in spa revenue, 298–9 how to spend forecast cash surplus, 294–8 loan covenant, 300 overview, 291–2 tips distribution, 299

dividend proposals, 310 ethical issues: investment in green initiatives and solar panels, 302–3 poor training, 301 poor treatment of general managers and senior employees, 301–2 range of, 300–1 tips distribution, 303 introduction, 289 investment proposal summary, 308 PEST analysis, 307 prioritisation of issues facing Solberri, 290–1 proposal to acquire an additional resort hotel, 310–11 SWOT analysis, 306 terms of reference, 289 Cash availability for investments, Solberri hotel case, case writer’s answer for May 2008, 308–9 Cash cows, BCG growth matrix, 216 Checklist, preparation, 193–4 Checklist of questions, to review before exams, 99–104 CIMA curriculum, 17 CIMA exams, 3 CIMA website, 3 CIS see Corporate Information System Clustering diagrams see Spider diagrams CNC see Computer Numerical Controlled Commercial judgement, 25 Commercial paper, 262 Competitive strategy, 200 Computer Numerical Controlled, 164 Computer test program, Merbatty boat case: faults showing on, 117 possible faults and, 99 Computer test results, Merbatty boat case, 115, 121 TOPCIMA assessment matrix, 136 Conglomerate growth see Unrelated diversification Convertible bonds, 262 Corporate appraisals, 242–3 gap analysis, 244–5 strategies, 245 SWOT analysis, 243–4 Corporate bonds, 261–2 Corporate governance, 31–2 Corporate Information System, 277 Corporate risk assessment, 235–7

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

D Debt: capital, 261–3 cost of, 239–40 factoring, 262–3 Deep discounted bonds, 262 DEEPLIST analysis, 226 De Loore, Suzanne, 278, 279, 281, 301 Development capital, 261 Directional policy matrix, portfolio analysis, 216–17 Directors, remuneration of, 31 Discounted cash flow approach, for business valuation, 249–50 Diversification strategies, 252–3 Dividend growth approach, 247–8 Dividend valuation approach, 130, 248 Dividend yield approach, 247 Dogs, BCG growth matrix, 216

E Earl’s grid, 21, 233–4 Earnings-based methods, of business valuation: discounted cash flow approach, 249–50 dividend growth approach, 247–8 dividend yield approach, 247 earnings growth approach, 248 price earnings approach, 248–9 synergies, 250–1 Earnings growth approach, for business valuation, 248 Earnings per share, 203 CCL’s, 99, 108 TOPCIMA exam, 203 E-commerce (E-Comm), 232 Enterprise resources management, 232 Environmental risk, 237 EPS see Earnings per share Equity, cost of, 239 Equity markets, financial sources: AIM, 260 issue methods, 260–1 official listing, 259 private markets, 260 ERM see Enterprise resources management Ethical issues, Merbatty case study, 116–17 loyalty payment, 116 new navigation software, 116–17 proposed termination of sponsorship contracts, 117 range of, 116 TOPCIMA assessment matrix, 138–9 Ethical issues, Solberri hotel case, case writer’s answer for May 2008 investment in green initiatives and solar panels, 302–3 poor training, 301 poor treatment of general managers and senior employees, 301–2 range of, 300–1 tips distribution, 303 Examination, time plan: for PC-based, 59 for written, 58–9 Exams: mock, 190–1 preparation checklist, 193–4 report writing, 191–2 time management during, 191 use of past papers, 189 PEG, 190 prioritisation exercises, 190

INDEX

risk management: process, 237–8 techniques, 238–9 Corporate social responsibility report, Solberri hotel case, pre-seen material for May 2008, 283–4 Cost leadership, 222 Cost of capital assessment: cost of debt, 239–40 cost of equity, 239 importance, 239 marginal, 241 real options theory, 241–2 WACC, 240–1 Critical success factors, 182, 228–30 CRM see Customer relationship management systems Currency fluctuation, Merbatty’s, 113 change in Merbatty price list to minimise, 106 effects on profitability, Merbatty boat case, 97 management of, 120 TOPCIMA assessment matrix, 135 Customer feedback survey 2007: Solberri hotel case, pre-seen material for May 2008, 284 Customer relationship management systems, 232 Customer services: Solberri hotel case, pre-seen material for May 2008, 278–9 Cut and paste analysis, 157

341

INDEX

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TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING T4

Executive information systems, 230 Expansion method matrix: international growth strategies, 258–9 joint development strategies, 255–8 mergers and acquisitions, 254–5 organic growth, 254 Exporting strategies, 258 External growth see Mergers and acquisitions F Feasibility test, 18–19, 27, 263 Finance, sources of: debt capital, 261–3 equity markets, 259–61 venture capital, 261 Financial analysis, 177–8 Financial risk, 236–7, 253 Financial strategy, 200–1 Five forces analysis, 222–4 Foreign bonds, 262 Franchises, 256–7 G Gap analysis, 244–5 Globalisation, 226–7 H Harvest, defined, 216 Heys, Pietro, 277, 280 Holiday industry, 269 Human resource issues: Solberri hotel case, pre-seen material for May 2008, 278 I IES see International Education Statement IFAC see International Federation of Accountants Income statement: Solberri hotel case, pre-seen material for May 2008, 282 Industry analysis, 147, 179–80 five competitive forces, 222–4 globalisation, 226–7 life cycle stages, 219–20 decline, 221 growth, 220 introduction, 220 maturity, 221 shakeout, 220–1 PEST analysis, 226 three generic strategy model, 224–5

Industry information, sources of: personal networks, 144 professionally produced industry analysis, 147 trade media and news media, 145–6 using the internet, 146–7 visiting similar firms, 144–5 Industry research, 143–44 Information systems strategy, 182–3 four levels of, 230–1 IT/IS applications, 232 management accounting information, 231–2 quality assessment, 232–3 scaling frameworks, 233–5 Intensity matrix, of information, 235 Internal growth see Organic growth International Education Statement, 17 International Federation of Accountants, 17 International growth strategies: exporting, 258 multinational operation, 259 overseas manufacture, 258–9 turnkey operations, 259 International risk, 237 International Yacht Collection, 109 Internet, the using, 146–7 Investment and refurbishment programme: Solberri hotel case, pre-seen material for May 2008, 273 Investment and resource strategy, 201–2 Issues analysis, report writing and: alternative solutions, to examine, 72 company’s position, 72 current issues, 72 ethical, 79–80 exercise, 75 explanation, 71 financial implications of issue, 71–2 impact on stakeholders, 71 industry example, 72–3 issues facing Kadgee, 73–5 solution, 75–8 IYC see International Yacht Collection J JKL, 109 Johnston and Scholes’ SAF model, 72 Joint development strategies: agency agreements, 257–8 franchises, 256–7 joint venture, 255–6

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

K Kadgee: cash flows, management of, 77, 85 ethical issues: redundancies and closure costs, 81–2 Rita Scree, dismissal of, 81 wage cut and changes to contracts of employment, 81 history, 67–8 issues analysis: proposed joint venture with Xina in China, 74–5 Rita Scree’s dismissal, resolving, 73–4 IT solutions, investment in, 78, 85–6 NPVs for two alternative locations in Asia (not China), 76–7 prioritisation, of issues facing, 69 recommendations: dismissal of Rita Scree, resolving, 83 proposed move to China, 83–4 Kadgee clothing case, November 2006: applying technical knowledge, 21–2 Kadgee clothing case, pre-seen material for September and November 2006, 149–57 prioritisation, 40 SWOT analysis, 40 TQM, 39 Kadgee clothing case, unseen material for November 2006, 44–50 affecting operational performance, 48–9 board meeting, 45 investment in a new factory elsewhere in Asia, 47 investment in IT, 47–8 proposal to close Europian factories, 47 proposal to set up in China in a joint venture, 46 transformational change, 44 Kadgee clothing case, unseen material for September 2006, 40–2 accidents at factories, 42 fire at factories, 42 human resource issues, 42 legacy of, 42 loss of sales contract with forum, 41 meeting with Kadgee’s bankers, 40–1

new contract, 41 new product line, 41 proposal to LIN, 41 revised prioritisation matrix, 42–3 Kahle, Giorgi, 272, 274, 280, 286, 287 Key performance indicators: Solberri hotel case, pre-seen material for May 2008, 273–4 Knowledge work systems, 230 KPI see Key performance indicators L Leaseback, 262 Leasing, 262–3 Lewin’s Forcefield analysis, 21 Life cycle matrix, 20 LIN, 41 Loans, 262 Solberri hotel case, pre-seen material for May 2008, 276–7 Loan stock see Corporate bonds Loyalty payment, Merbatty case study and, 116 Lui, Piers, 271, 281 Lynch’s expansion method matrix see Expansion method matrix M Management, time, 57, 191 for PC-based exams, 59 for written exams, 58–9 Management accounting information, 231–2 Management buy-ins, 61 Management buy-outs, 261 Management information systems, 230 Marginal cost, of capital, 241 Market development strategies, 252 Market growth rate, 214 Market penetration strategy, 251 Market risk, 253 Matching, 245 MBI see Management buy-ins MBO see Management buy-outs McFarlan’s grid, IT scaling framework, 234–5 McFarlan’s strategic grid, 21 Mendelow’s stakeholder analysis, 19–20 Merbatty boat case, pre-seen material for November 2007 exam: PEST analysis, 93–4 summary, 92 SWOT analysis, 93

INDEX

strategic alliances, 256 Joint venture, 255–6 Judgement, 25–7, 132–7, 317–21 Junk bonds see Mezzanine debt

343

INDEX

344

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING T4

Merbatty boat case, pre-seen material for September and November 2006: boat building facility, 163–4 business portfolio, 178–9 business valuation,? 184–5 charitable work, 166 critical success factors, 182 current position, 161 development plans, 164 financial analysis, 177–8 four elements of strategy, 176–7 future plans for expansion, 162–3 history, 159–60, 161 information system strategy, 182–3 IT systems, 166 market overview, 158–9 personnel, 161, 167–70 PEST analysis for, 179–80 risk, 183–4 shareholders, 161–2 sponsorship contracts, 165 strategic options, 185 supplier relationships, 165–6 SWOT analysis, 180–2 technology, 164–5 Merbatty boat case, unseen material for November 2007 exam: appointment of consultant, 99 appointment of new sales director, 106 boat building facilities, 96–7 computer test program, possible faults and, 99 effects on profitability due to currency fluctuations, 97 operating costs, 97–8 preparation of issues for prioritisation, 105–7 profits, 106 sales agents in the USA, 98, 106–7 sales director resigns, 98 takeover bid by CCL, 99, 105–6, 108–10 updated navigation software, 95–6 weather conditions and reduced stock market confidence, 95 Merbatty’s boat building facilities, 96–7 change of locations, 107, 114–15 recommendations on global locations, 120–1 TOPCIMA assessment matrix, 136 Merbatty’s boat building facilities, 96–7 Merbatty’s takever bid by CCL, 99 recommendations on business issues, 118

TOPCIMA assessment matrix, 133 TOPCIMA exam report, 105–6, 108–10 valuation and comparison to future values, 124 Mergers and acquisitions, 254–5 Mezzanine debt, 262 Michael Porter’s Generic strategies, 19 Mock exams, 190–1 Motivational theories, 20 Move model, 21 Multinational operation, 259 N Navigation software system, Merbatty boat case, 95–6 ethical issues and, 116–17 Net asset values, 246 Net Present Value, 20, 241, 242 Net realisable value, 246 News media, 145–6 NPV see Net present value O Occupancy levels: Solberri hotel case, pre-seen material for May 2008, 274–5 Operating costs: Merbatty boat case: higher than planned, 97 proposals to reduce, 97–8 Solberri hotel case, pre-seen material for May 2008, 275–6 Operational risk, 236, 253 Operational systems, information systems, 230 Organic growth, 254 Organisational chart, 152–3 Overseas manufacture, 258–9 P Package holiday, 269 Past papers, use of, 189 PEG, 190 prioritisation exercises, 190 PEG see Post Exam Guidance P/E ratio, Merbatty shares and, 109 Personal ethics, 30–1 Personal networks, 144 Personnel: Solberri hotel case, pre-seen material for May 2008, 281–2 PEST analysis, 18 of industry, 226

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

logic, 322–4 overview, 312–13 recommendations to improve chance of passing exam, 325–6 Post-It-Notes, 155 PR see Public relations (PR) Practise exam checklist, 329–33 Pre-seen material, 5–6 analysis of, 148 detailed analysis of, 157 Merbatty boat case, pre-seen material for September and November 2006 see Merbatty boat case, pre-seen material for September and November 2006 effective notes on, 148 biodata files, 153, 155 colours, 155–7 cut and paste analysis, 157 organisation chart, 152–3 page summaries, 149–50 pictures, 157 Post-It-Notes, 155 spider diagrams, 150–1 SQ3R technique, 149 timelines, 151–2 Pre-seen material for May 2008 (Solberri hotel case), 269 balance sheet of, 282 corporate social responsibility report, 283–4 customer feedback survey 2007, 284 customer services, 278–9 group of hotels, 270 growing demand for improved spa facilities, 272–3 human resource issues, 278 income statement of, 282 investment and refurbishment programme, 273 IT systems improvements, 277 key performance indicators, 273–4 loans, 276–7 market conditions, 271 market overview, 269–70 occupancy levels, 274–5 operating costs, 275–6 personnel, 281–2 pricing changes effective from May 2007, 271–2 quality management programme, 279 revenue targets, 275 routes to market, 270–1 shareholders, 279

INDEX

for Merbatty, 93–4, 122–3, 179–80 for proposed joint venture in China with Xina, 65–6, 74 Solberri hotel case, case writer’s answer for May 2008, 307 Planning: for solution, 50–2 Porter, Michael, 222 see also Five forces analysis; Three generic strategy model, of industry analysis Portfolio analysis, 178–9, 205 BCG growth share matrix, 214–16 criticism, 217–18 directional policy matrix, 216–17 key issues in, 205, 214 Position audit defined, 227 M model, 227–8 Post Exam Guidance, 8, 190 Post exam guidance report, for unseen material for November 2007 exam (Merbatty boat case), 125–40 areas not well attempted by candidates, 128–9 areas well attempted by candidates, 127–8 overview, 125–7 preparation of issues for prioritisation, 126–7 TOPCIMA assessment matrix, 129–39 application criteria, 130–1 diversity criteria, 131 ethical issues, 138–9 focus criteria, 131 integration, 136–7 judgement criteria, 132–6 logic criteria, 137–8 overview, 129 preparation of issues for prioritisation, 131–2 technical criteria, 129–30 Post exam guide for May 2008 (Solberri hotel case) assessment matrix: application, 315–16 diversity, 316 focus, 317 judgment, 317–18 overview, 314–15 prioritisation, 317 technical, 315 ethics, 324–5 integration, 322

345

INDEX

346

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING T4

Pre-seen material for May 2008 (Solberri hotel case) (Continued) statement of changes in equity, 283 summary of, 272 Pre-seen material September and November 2006 (Kadgee Clothing), 149–57 Price earnings approach, for business valuation, 248–9 Prioritisation, 35–9, 68 answer analysis, self, 70 criterion, 35 exercise, 69–70 grading impact, 37–8 grading likelihood, 38 of issues facing Kadgee, 69 of issues in Merbatty boat case, 105–7, 126–7 order, 38–9 in real exam, 53 report writing, 52 score, 38 setting blank page, 36–7 solution, 70–1 timing, 38 TOPCIMA assessment matrix, 131–2 Private markets, 260 Product development strategy, 252 Product risk, 253 Professional ethics, 30–1 Professional judgement, 25 Profitability/profits, Merbatty’s: achieve planned level of, 106 of post-tax, for 2008, 110–12, 125 ways to achieve, 118–19 currency fluctuations effects on, 97 Project finance, 262 Public relations (PR), 165 Q Quality management programme: Solberri hotel case, pre-seen material for May 2008, 279 Question marks, BCG growth matrix, 215 Questions, to review ourself before exams see Checklist of questions, to review ourself before exams R Ratio analyses, 203–5 preparation and revision, 205, 206–13 tree, 204–5 Ratio analysis, 20

Real options theory, 241–2 Refreeze model, 21 Related diversification, 252–3 Relative market share, 214 Remedy, 245 Report writing, 57 assessment matrix and, 191–2 calculation appendices, 60 exercise, 61 solution, 61–3 contents page, 66–7 ethics, 78 exercise, 81 issues analysis, 79–80 recommendations, 80 solution, 81–2 format, 59–60, 86 introduction, 67–8 issues analysis: alternative solutions, to examine, 72 company’s position, 72 current issues, 72 exercise, 75 explanation, 71 financial implications of issue, 71–2 impact on stakeholders, 71 industry example, 72–3 issues facing Kadgee, 73–5 solution, 75–8 prioritisation section, 68 answer analysis, self, 70 exercise, 69–70 of issues facing Kadgee, 69 solution, 70–1 recommendations and conclusion: ethics section, aims for, 82–3 examples, 83–4 exercise, 84 solution analysis, 84–6 terms of reference, 68 theory-based appendices, 63 PEST analysis, 65–6 SWOT analysis, 64–5 time plan for, 86–7 Reputation risk, 237 Return on capital employed, 274 Revenue Per Available Room, 274 RevPAR see Revenue Per Available Room Risk, 183–4 see also Corporate risk; Risk management Risk assessment model, 20 Risk management:

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

S Safety issues, Merbatty boat case, 115, 121 Sale, 262 Sales agents in the USA, Merbatty’s, 98 need to appoint new, 106–7, 113–14 recommendations on new, 120 TOPCIMA assessment matrix and, 136 Sales director, Merbatty’s: appointment of new, 106, 112–13, 119–20 resigns, 98 TOPCIMA assessment matrix, 135 Seedcorn capital, 261 SFBS, 98 Shareholders: Solberri hotel case, pre-seen material for May 2008, 279 Silva, Nick, 279, 281, 285, 292, 299 Skrip, Antonio, 273, 277, 280, 285, 286, 298 Solberri hotel case, case writer’s answer for May 2008, 288–9 business issues: appointing finance director, 304 customer service and quality issues, 303 dividends, 305 employee morale, 305 fall in spa revenue, 304–5 loan covenant, 305 spending forecast cash surplus, 304 tips distribution, 305 cash availability for investments, 308–9 discussion of issues facing Solberri: appointing finance director, 298 customer service and quality issues, 292–4 dividends allocation to shareholders, 299–300 employee morale, 299 fall in spa revenue, 298–9 how to spend forecast cash surplus, 294–8 loan covenant, 300 overview, 291–2 tips distribution, 299 dividend proposals, 310 ethical issues: investment in green initiatives and solar panels, 302–3

poor training, 301 poor treatment of general managers and senior employees, 301–2 range of, 300–1 tips distribution, 303 introduction, 289 investment proposal summary, 308 PEST analysis, 307 prioritisation of issues facing Solberri, 290–1 proposal to acquire an additional resort hotel, 310–11 SWOT analysis, 306 terms of reference, 289 Solberri hotel case, post exam guide for May 2008: assessment matrix: application, 315–16 diversity, 316 focus, 317 judgment, 317–18 overview, 314–15 prioritisation, 317 technical, 315 ethics, 324–5 integration, 322 logic, 322–4 overview, 312–13 recommendations to improve chance of passing exam, 325–6 Solberri hotel case, pre-seen material for May 2008, 269 balance sheet of, 282 corporate social responsibility report, 283–4 customer feedback survey 2007, 284 customer services, 278–9 group of hotels, 270 growing demand for improved spa facilities, 272–3 human resource issues, 278 income statement of, 282 investment and refurbishment programme, 273 IT systems improvements, 277 key performance indicators, 273–4 loans, 276–7 market conditions, 271 market overview, 269–70 occupancy levels, 274–5 operating costs, 275–6 personnel, 281–2 pricing changes effective from May 2007, 271–2

INDEX

process, 237–8 strategy, 93 techniques, 238–9 ROCE see Return on capital employed Roet, Anna, 281

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INDEX

348

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING T4

Solberri hotel case, pre-seen material for May 2008 (Continued) quality management programme, 279 revenue targets, 275 routes to market, 270–1 shareholders, 279 statement of changes in equity, 283 summary of, 272 Solberri hotel case, unseen materials for May 2008: acquisition of additional resort hotel, 287 appointment of consultant, 288 booking forecast for 2008 peak season, 284–5 cash forecast, 285–6 environmentally friendly initiatives, 287 extending room numbers at premier hotels, 286 fall in spa revenues, 287 finance director’s resignation, 288 investment in refurbishment and extended spa facilities at remaining hotels, 286 loan covenant restriction, 288 Solution, 104 Spider diagrams, 150–1 SQ3R technique, 149 Stakeholders: mapping, 263–4 Stars, BCG growth matrix, 215–16 Start-up capital, 261 Stock market: impact of weather conditions on, Merbatty boat case, 95 Strategic alliances, 256 Strategic management accounting, defined, 199 Strategic options, 185 Ansoff matrix, 251–3 development and risk, 253 evaluating, 263–4 expansion method matrix, 254–9 Strategic plan, defined, 199 Strategy, elements of, 176–7 competitive, 200 financial, 200–1 investment and resource, 201–2 risk management, 202–3 Strengths, weakness, opportunities, threats analysis, 18, 64–5, 243–4 application of, 22 for Merbatty, 93, 121–2, 180–2

Solberri hotel case, case writer’s answer for May 2008, 306 Suitability, Acceptability, Feasibility model, 72 Suitability model, 18–19 Suitability test, 27, 263 Suppliers, bargaining power of, 224 Supply chain management systems, 232 SWOT analysis see Strengths, weakness, opportunities, threats analysis T Technical knowledge techniques, 17–21 Three generic strategy model, of industry analysis, 224–5 Timelines, 151–2 Time management, 57, 191 for PC-based exams, 59 report writting see Report writting for written exams, 58–9 Timetable: for PC-based exams, 59 for written exams, 58–9 TOPCIMA assessment criteria: application, 21–2 diversity, 22–3 ethics, 29–32 focus, 23–4 history of marking grid, 17 integration, 27–8 judgement, 25–7 logic, 28–9 overview, 15–17 prioritisation, 24 theoretical techniques, 17–21 writing, marking criteria, 32 TOPCIMA assessment matrix, Merbatty boat case, 129–39 application criteria, 130–1 diversity criteria, 131 ethical issues, 138–9 focus criteria, 131 integration, 136–7 judgement criteria, 132–6 logic criteria, 137–8 overview, 129 preparation of issues for prioritisation, 131–2 technical criteria, 129–30 TOPCIMA exam: aims of, 4–5

TEST OF PROFESSIONAL COMPETENCE IN MANAGEMENT ACCOUNTING

U Unfreeze model, 21 Unrelated diversification, 253 Unseen material, 6 mock exams on your, 190–1 Unseen material for November 2007 exam (Merbatty boat case): appointment of consultant, 99 boat building facilities, 96–7 computer test program, possible faults and, 99

effects on profitability due to currency fluctuations, 97 operating costs, 97–8 post exam guidance report for, 125–40 areas not well attempted by candidates, 128–9 areas well attempted by candidates, 127–8 assessment matrix and areas for improvement, 129–39 overview, 125–7 preparation of issues for prioritisation, 105–7 sales agents in the USA, 98 sales director resigns, 98 takeover bid by CCL, 99 updated navigation software, 95–6 weather conditions and reduced stock market confidence, 95 Unseen materials for May 2008 (Solberri hotel case): acquisition of additional resort hotel, 287 appointment of consultant, 288 booking forecast for 2008 peak season, 284–5 cash forecast, 285–6 environmentally friendly initiatives, 287 extending room numbers at premier hotels, 286 fall in spa revenues, 287 finance director’s resignation, 288 investment in refurbishment and extended spa facilities at remaining hotels, 286 loan covenant restriction, 288 V Venture capital, 261 Vitt, Dimitri, 280–1 W WACC see Weighted average cost of capital Weighted average cost of capital, 240–1

INDEX

changes from 2010, 11–12 CIMA website, 3 exams each year, four, 12 how to pass, 9–10 learning system, 12 post exam guidance, 8–9 practical experience, 10–11 preseen material, 5–6 recommendations to improve chance of passing, 139–40 requirement, 6–8 unseen material, 6 TOPCIMA exam report: Merbatty boat case, November 2007, 104–21 conclusions, 121 discussion on issues faced, 108–16 ethical issues and recommendations, 116–17 preparation of issues for prioritisation, 105–7 recommendations on business issues, 118–21 terms of reference, 105 TOPCIMA Learning System, 130, 139 Trade credit, 262 Trade media, 145–6 Turnkey operations, 259

349