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Module MN7006/D Accounting for Managers Edition 21 First published in Great Britain by Learning Resources 292 High St, Cheltenham, GL50 3HQ England
Contents
Preface
This study book ii
Financial Accounting Case Study Part II Next's Accounts: Interpretation and Ratio Analysis
Principal financial statements Share capital Dividends Debt capital Segmental analysis for 2006 Cashflow statement 53 56 56 56 57 58
Key Readings: Interpreting financial statements under International Financial Reporting Standards (IFRSs) from Accounting for Managers and Governance and the Operating & Financial Review (OFR): Understanding the context of accounting from Accounting for Managers
Financial Accounting Case Study Part III Next plc: Impact of Governance and International Accounting Standards
New regulatory regime Corporate governance Corporate Social Responsibility (CSR) 77 78 83
Financial Accounting Case Study Part IV Next plc: Share Prices and Share Options
Importance of a market perspective Directors remuneration policy Employees share ownership trust 101 103 104
Management Accounting Case Study Part II Pearl: Pricing Decisions Section 8 Operating Decisions
Resources Accounting for resources Advanced manufacturing environments Service environments 147 150 151 154
Key Readings: Operating decisions from Accounting for Managers and Accounting decisions from Accounting for Managers
Management Accounting Case Study Part III Pearl: Operating Decisions Section 9 Budgeting Decisions
What are budgets for? Control theory Budget preparation The master budget Budgetary control Criticisms of budgeting Key Reading: Budgeting from Accounting for Managers 165 166 167 169 170 172
Management Accounting Case Study Part IV Pearl: Budgeting Section 10 Performance Management
Dimensions of performance Balanced scorecard 183 184
Divisional performance management Return on investment (ROI) Residual income (RI) Performance review Key Reading: Performance evaluation of business units from Accounting for Managers
Management Accounting Case Study Part V Pearl: Performance Measurement Appendix A Solutions to Tutorial Exercises
Section 4 Section 5 201 202
Preface
This study book provides the core learning material for those studying the module Accounting for Managers with the University of Leicester School of Management. Accounting for Managers is designed for managers and not for aspiring accountants. Managers need to interpret, not prepare, accounts. They need to: know their way around published and internal accounting reports, understand the meaning of accounting terms and parameters, be able to call upon appropriate financial information for a variety of business decision contexts, recognise the conventions under which accountants prepare data and the consequential limitation of the information they provide, and be aware of the bigger, wider and deeper setting within which accounting data and financial imperatives are but a part. This module combines this pragmatic capability to understand accounting information with a critical perspective on the theories of its provision in business and society. In practical terms, the module equips students with information appraisal techniques and cognition of its relevance for decision making and performance assessment. The module specifies the following learning objectives; that, at the end of this course, students will be able to: adequately interpret the meaning of a published set of accounts,
critically question the parameters under which accounting information has been provided and recognise the implications of this process and its content, call for accounting data appropriate in different decision making contexts, understand the relevance and limitations of accounting data in context.
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Many articles are referenced in this study book, but the following journals are recommended to keep pace with contemporary writing: Accounting and Business Research Accounting, Auditing and Accountability Management Accounting Research Corporate Governance Together, the dedicated material and the textbook reading offer an insightful guide through the subject matter, relating conceptual perspectives to the real world. Enjoy the learning experience!
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MN7006/D SECTION 1
Perspectives on Accounting
Section 1
Perspectives on Accounting
Learning Objectives
After studying this section you should: be able to define accounting and explain why there is a difference between the reporting requirements of management and external users, have an appreciation of how modern accounting developed, and recognise that there are many theoretical interpretations of the role and purpose of accounting.
What is accounting?
The current entry (July 2006) in Wikipedia states that accounting, is the measurement, disclosure or provision of assurance about information that helps managers and other decision makers make resource allocation decisions. Whilst this is not an authoritative source, lets see what we can take from this populist definition. Measurement requires the collection of data from
primary sources and the recording of that data in some rational manner for subsequent quantitative analysis. The word financial is not present, and whilst accounts are expressed monetary terms, accounting can use non-financial data to generate useful information. To be useful, this meaningful data is disclosed to recipients often in the form of formal, routine reports so that they are able to judge the progress of an organisation toward its aims and to make informed decisions. The definition mentions managers as recipients of this accounting communication, but who are the other decision makers? They include any employee within an organisation and stakeholders outside the organisation. For internal users, this means that the extent and content of accounting information is tailored to the users scope of responsibility. For external users, accounting information is revealed for commercial or societal interest: to declare taxes; to reveal solvency to suppliers and profitability to investors; to demonstrate corporate citizenship. Much of the content of published accounting reports is governed by law, regulation, standards and audit to assure the validity and accuracy of the information released. The definition asserts the purpose of accounting information to be the making of resource allocation decisions. There is a multitude of such decisions, so those that follow are merely illustrative: a Board of a company agreeing a change in strategy, a production manager prioritising the schedule of process time based on product profitability, an HRM manager considering a redundancy package, a supplier assessing the extent of credit to grant, or a shareholder reviewing an investment portfolio. All of these are resource allocation decisions human, infrastructure, material, and financial resources and are made using accounting information. Collier states on the first page of his introduction, Business is not about accounting ... accounting is the financial representation of business activity. As masters of business administration, your interest in accounting stems from the model it provides of the activities you manage and the information it provides on the financial consequences of past administration, current decisions and future plans. As a strategic manager, you will face both external
accounting reports (e.g. to assess a competitors performance) and internal information (e.g. to make a one-off decision). You need to be equipped with the ability to call for, interpret, and critically review the data provided.
[1]
Pacioli, L. (1494), Everything about Arithmetic, Geometry, and Proportion included a section on the observed practice of Venetian merchants.
financial accounts. Significantly, this meant that owner-managers could not tell the extent to which each process contributed to the overall creation of profit. By documenting internal processes and attributing costs to each of these, a comparison with external prices could be made, and the problem eased. Cost accounting had been introduced. This has since evolved into management accounting where a wider range of techniques have been designed to meet the requirements of complex organisational forms in different sectors of the economy. Financial planning, performance measurement, control and decision making are all supported by this development.
[2]
The oldest professional accounting body which became the Institute of Chartered Accountants of England and Wales was formed in 1870.
propriety has been an issue of contemporary concern following scandals involving large European and American companies since the turn of the millenium. The financial reporting requirements of companies, covered in Section 3 of this study book, are therefore complemented by International Accounting Standards and corporate governance arrangements, covered in Section 4.
Theoretical perspectives
You could be excused for thinking that the theory of accounting might be limited to arithmetic equations representing its renowned double entries. However, you should now have become aware that accounting operates in a historical, political, economic, social and organisational setting. Thus, the regulation, purpose, and use of accounting information add dynamics to its purely technical function which give rise to many theoretical positions. Collier summarises these theories in Chapter 5 and explores them further in each subsequent chapter in his book as they relate to specific applications of accounting practice. Accounting might rationally be regarded as a neutral observer of economic activity, providing an objectively verifiable assessment of performance in relation to an organisations aims. Accounting systems thus use feed-forward and feed-back loops to support planning and control and are cybernetic in that they are self-organising. Indeed, their design may be contingent on the volatility of the external environment: the extent of competition, pace of change in technology, and the stability of the economy are influential. This value-free consideration of the role of accounting is challenged within the organisation where managers may pursue self-interest or make sub-optimal decisions because incomplete data limits their comprehension. The rational-economic perspective is also challenged on the grounds that accounting is used as a means to convey or reflect organisational values and beliefs, and that control is exerted through its impact on culture. The possession of information reflects power and so accounting endorses the autonomy and responsibility of individuals within an organisation. Managerial priorities, attitudes and performance are driven by targets and therefore accounting parameters are not value-neutral they influence managerial action. Just as notions of power and behaviour affect or reflect accounting practice within an organisation, so can such humanistic considerations be observed in its external relations. Accounting is, after all, a social construction: it is not the product of natural laws or physical science we decide how to account for our activities and to whom we account. Traditionally associated with profit,
there is strong pressure to account for a triple bottom-line: a score for investors, for the environment, and for social responsibility. Is the purpose of published accounts merely a way for shareholders to monitor the performance of their agents? Or is the Board of Directors accountable to a wider senate as stakeholder theory would morally or pragmatically assert? In most countries, statute requires directors to observe a duty of care in the interests of the company, but what are the interests of the company? Companies are the workhorse of an economy, providing a means of income to its population. Politically then, the relationship of business to society, economy, and government is highly important, and accounting is a public report of that relation. Critical theorists seek change in these relations, and those of a Marxist persuasion argue that society is controlled and the workforce exploited by an alliance between the state and big business. Power and selective use of information conveys power means that accounting can be used a mechanism to justify and legitimise actions of the elite in society. Marx would argue that there is a historical determinism about the evolution of capitalism from its roots in the industrial revolution to the global reach of todays multinationals. Nation states, which define the boundaries of legal jurisdiction, are competing for inward investment on the one hand and variously coalescing to regulate markets and business activities on the other. The wide yet recent adoption of International Accounting Standards and codes of corporate governance are examples of this. Yet plural forms of capitalism remain across the globe. The shareholder-centric form of Anglo-American capitalism contrasts with continental European practice (where equity capital has less historic relevance), South Africas (post-apartheid) inclusive stakeholder variety, and centralist versions in China and Russia. Theorists of political economy argue that the polity of a nation influences the structure of its markets and the form of accounting. Anglo-American practice is liberal, Franco-German practice bureaucratic, developing countries are heavily influenced by colonial legacies, whilst Communist governments used accounting as the specific channel for resource allocation and reward. Institutional theorists include the role of professions as a deterministic structure in the design, content, and role of accounts. They specify the body of knowledge, the form of training, and award the qualification and thus influence the mindset of practitioners. The globalising professional bodies are US, UK or Commonwealth in origin as many countries have limited recognition of accountants. In continental Europe and Japan for example, management accounting is not formally recognised as a distinct profession and thus the practice of accounting is less linked to the financial accounts than to engineering, operations and marketing. Fortunately, this has made management accounting open to influence from a variety of disciplines. This theoretical perspective is not a review of the many theories pertinent to accounting. It uses selected illustrations, deliberately without reference, to
demonstrate the plurality of thought and to invite a more critical response from the reader. To take from this brief introduction an appreciation that accounting is not just an impartial computational framework but that it is both a product of and an influence upon power and behaviour is enough for the moment.
Key Reading
Now read the following chapters from the module companion textbook, Accounting for Managers by Paul Collier:
Chapter 1 Introduction to accounting Chapter 5 Interpretive and critical perspectives on accounting and decision-making
Concluding Comments
This section provides the context for your subsequent studies. It defines the twin branches of accounting and gives a theoretical and empirical perspective on their emergence. Deepen your understanding by reading Chapters 1 and 5 of Collier, but do not be concerned if you dont fully grasp the theoretical positions. Their relevance will become clearer as you examine accounting applications in the rest of the study book. As an exercise, list the differences between financial and management accounting.
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MN7006/D SECTION 2
Section 2
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Introduction
The principal financial statements were introduced in the previous section. Here we explore the purpose of each, their content, and the conventions by which they are compiled. We start with profit, then differentiate it from cash, before moving onto capital and the asset and liabilities that make up a balance sheet.
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in July, 70/100ths of this asset ($280) has been used to provide sales of $700 and generate the profit of $420. The $700 owing to the business is a debtor (an asset), in August, the remaining $120 of stock is exhausted to provide cash sales of $300 (thus the profit of $180) whilst the remaining cash inflow results from Julys sales on credit.
Cashflow Profit
June -400
July 420
1,000
Profit
Cashflow
June
July
August
Total
At the end of August, there is no stock left, nor any amounts owed or owing. The assets are now represented by a cash balance of $600, complemented as we see by profits of $600. The accrual concept means that accountants assess supplies or services that have been received but not yet invoiced (as a liability), receipts in advance of work done on a contract (also a liability), and prepayments for supplies of services like rent (as an asset) in the calculation of profit. A similar matching process operates in the longer term where assets are bought that have economic lives of many years. For example: a distribution companys trucks, a manufacturing companys machinery, a shops fixtures and fittings, a software houses office equipment. All of these fixed assets provide commercial benefit over several years that is they generate sales so that it is inappropriate to charge the full cost of these assets against profits in the year of their purchase. Instead, accountants spread the cost over their estimated lives and depreciate the value of the asset as it ages. In the case of an intangible asset such as a patent, the charge to profit is called amortisation. An example demonstrates the result. A delivery van is
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bought for $20,000 and is expected to have a productive life of 4 years, at which time it will be sold for $4,000. The depreciation on the vehicle is expected to be $16,000, or $4,000 per year (see Figure 2.2). This annual cost contrasts dramatically with cashflows which occur at the beginning and end of its life. The difference between the two figures is the depreciated value of the asset: $16,000 at the end of the first year; $12,000 at the end of the second; $8,000 at the end of the third; zero at the end of the fourth. Over the four years, however, the depreciation cost is the same as the cash outflow.
Cashflow Profit
Year 2 -4,000
Year 3 -4,000
Year 4
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The profit & loss account (income statement in the US): statement of sales and related cost, over a period ending in the balance sheet date, bottom-line is the profit retained and added to shareholders funds. The cashflow statement: statement of receipts and payments, over a period ending in the balance sheet date, represents the net cash movement on the balance sheet. These three statements form the focus of your studies into financial accounting and their format and content will be explored in this and the next section.
[3]
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capital aggregate investment in the business by shareholders: - includes accumulated profit [Note 4]. Assets are shown as debit entries, whilst liabilities and capital are credits. In a balance sheet, Capital = Assets Liabilities
CASHFLOW STATEMENT
Receipts Payments
BALANCE SHEET
Debtors
Creditors
Stock
Long-term Liabilities
Fixed Assets
Reserves
Loss
Retained Profit
Costs
Sales
Debits (DR)
Credits (CR)
Figure 2.3 The relationship between capital and assets/liabilities, and profit and cashflow.
The relationship between capital and assets/liabilities, and profit and cashflow, is depicted in Figure 2.3. Debit entries and balances are shown on the left-hand side, whist credits are on the right. Debit entries in the balance sheet comprise fixed and current assets. Fixed assets are better thought of as long-term assets like buildings and equipment, with the book value of the latter falling over time (CR) as depreciation is charged to the profit/loss
[4]
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account (DR). New fixed assets (DR) will be bought (CR to Cash) or leased (CR to Long-term Liabilities). Current assets include stocks of raw materials and finished goods and, for manufacturing businesses, work-in-progress. Stocks rise (DR) when they are acquired (CR to Cash or Creditors) or made (CR to Costs of Sale). Debtors exist wherever customers are granted credit, rising when sales are credited and falling when invoices are settled (DR to Cash). The amount of cash available is shown as an asset (DR), unless the bank account is overdrawn in which case it becomes a liability (CR). Other Current Liabilities include Creditors and any accrued debts of the business which are extinguished (DR) when paid during the course of the next year (CR to Cash). Net Assets = Fixed Assets + Current Assets Current Liabilities Net Assets = Capital Employed Capital Employed = Long-term Liabilities + Capital and Reserves The net assets of a business are funded by capital debt and equity. Loans are a common example of debt capital and form a CR in Long-term Liabilities when arranged (DR to Cash), falling as they are repaid until they become a Current Liability. Note that the interest paid to service the loan does not affect the amount outstanding: it is a DR to Costs and a CR to Cash. Capital and Reserves represent the invested funds of the shareholder (DR to Cash when shares are issued) and are supplemented by profit retained by the business (CR balance on the profit & loss account). Reserves vary in composition, but a common situation arises from an upward revaluation (CR to Reserves) of Land and Buildings (DR to Fixed Assets).
Balance Sheet June July DR Stock DR Debtors CR Stock $400 $700 $280
August CR Stock CR Debtors Closing Balance Stock Debtors $120 $700 $nil $nil
DR Receipts DR
$600
Figure 2.4 Illustrating double entry using the three financial statements.
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This is a rather shallow exposition of the constituent parts of a balance sheet, but is sufficient as an introduction. Any transaction can be represented by double entries involving Asset, Liability, Capital, Cash or Profit & Loss accounts. We can demonstrate this by using the data in the earlier widget example (see Figure 2.4).
Accounting conventions
Accounts are kept and financial reports produced using certain rules that accountants are trained to apply and professionally maintain. These rules have become formalised into quality standards which are now internationally adopted (see Section 4). For now, we will limit consideration to a simple interpretation of the most important ones. A business accounts separate the affairs of the business from that of its owner. The owners interest is recorded as capital and reserves a liability from the perspective of the business. Accounts are largely prepared from third-party transactions which have already occurred an obvious observation in respect of the cashflow statement. What is significant, however, is that both the calculation of profit and (most) assets and liabilities in the balance sheet is based upon historic costs and not realisable value. This means that net asset value is an eclectic collection of cost over the past and does not represent the market value of a business (see Section 5 for a discussion of this). Financial accounting observes four principles. An awareness of these principles and conventions helps you to recognise the scope for subjectivity in the financial reports so that you are better able to critically review accounting information.
Going concern
This is the presumption that there is no known impediment to the business continuing to trade in the future fundamentally, that there is no risk of insolvency. This means that asset values justify their potential to generate commercial return. The liquidation value of a business is likely to be much less than even its historic cost as many of its assets are specific and have limited alternative utility in particular, the value of stock and fixed assets other than property would be heavily written-down (i.e. reduced).
Accruals
This practice has already been employed earlier in this section. Some small businesses, public sector and non-for-profit organisations will prepare
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accounts on a cash basis alone. As we have seen, the calculation of profit through the accrual process provides a better picture of viability, but the smoothing of cashflow that profit represents can give rise to manipulation and abuse.
Comparability
When accounts are published, figures for the previous year are required. To be consistent, it is important that the same accounting policies have been used and, if changed, explanation provided and the comparative figures adjusted. You should note that this does not overcome the effect of inflation, and caution is necessary in economies where the purchasing power of money is falling rapidly.
Reliability
Accountants should be prudent in their assessment of profit and the value of assets. Profits can only be declared when sales are made, but if future losses on a contract are predicted, they must be recognised immediately. The potential for customers not settling their accounts should give rise to a provision for bad debts and stock value should be similarly written down if it is thought to be obsolete. This is largely judgemental and is normally the subject of discussion with a companys auditors.
Key Reading
Now read the following chapters from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 3 Recording financial transactions and the limitations of accounting Chapter 6 Constructing financial statements and the framework of accounting
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Concluding Comments
Make sure you work through the double entries and balance sheet preparation in Tables 3.1 to 3.4 in Chapter 3 of Collier. Review the reporting formats for the balance sheet, profit & loss account, and cashflow statement in Collier Chapters 3 and 6. Much of the content of Chapter 6 develops the ideas and processes in Chapter 3, but any repetition will help embed the foundations of accounting for those with no experience and dont worry if you cant cope with the paragraph accounting for leases. Attempt Questions 6.2 and 6.3 in Appendix 1 of Collier and check your answers against the solutions in Colliers Appendix 2. This will provide a useful check on your progress toward the Learning Objectives set out in the introduction to this section. Congratulate yourself! Finally, read through the initial case material on Next plc get a sense of its business context and an outline feel for what the accounting numbers are telling you. There are some simple exercises for you to follow, but formal analysis will follow in Section 3.
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Commercial context
Next plc is a multi-national clothing retailer, headquartered near Leicester in the UK. The company was originally called J. Hepworth & Sons, established in 1864. The Next brand was launched in 1982 and the companys name was changed in 1986. The group has grown dramatically, though not consistently, over the last 24 years and now has a turnover in excess of 3 billion. Its principal business (Next Retail) is conducted through over 550 outlets, including 100 foreign franchise stores, a significant mail order business (Next Directory), and a growing call-centre operation that developed out of the mail order operation. Nexts core business remains clothing, but diversification is evident into home, jewellery, flowers, electrical devices, and financial services. Next plc has eight wholly owned subsidiaries, including a garment manufacturer in Sri Lanka and a buying operation in Hong Kong. Next
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subsidiaries also have non-controlling equity interests in two further retailing and home shopping companies.
Sales, (m)
Trading Profits, (m) 146 173 158 187 214 259 302 376 443 471
After-tax Profits, (m) 118 137 124 140 158 190 211 250 305 314
Dividends, (m)
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
947 1177 1239 1425 1589 1872 2203 2516 2859 3106
(56) (67) (69) (76) (74) (89) (86) (89) (104) (105)
421 490 543 607 500 547 275 155 277 256 37m 6m 44m 22m 4m 15m
The figures shown in the final column are shares bought back by Next plc from their own shareholders. This means that the company pays market prices for their shares. The shares are shown in the balance sheet at their historic issue price. There were 246 million shares in circulation at the end of 2006, 90 million less than five years earlier.
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Next Retail
In the year we increased our net selling space by 980,000 square feet to 4,300,000 square feet. Despite difficult trading conditions we are forecasting that the sales performance of our portfolio of new stores will be in line with their appraised target, giving payback of the net capital invested in 18 months. The table below shows how the profile of our stores and space has changed over the last three years:
Store Size, (square feet) Number of Stores 2006 less than 5,000 5,00010,000 10,00015,000 15,00020,000 greater than 20,000 Total 133 132 99 35 40 439 2005 152 112 61 29 30 384 2004 166 99 45 25 23 358 % of Selling Space 2006 9% 23% 28% 14% 26% 2005 14% 25% 22% 15% 24% 2004 18% 26% 19% 15% 22%
We currently expect to increase net selling space by around 450,000 square feet in the year ahead.
Next Directory
NEXT Directory had a good year with sales up 13.7% and profits up 18.5%. Sales continue to benefit from increased use of the Internet, whilst improved gross margins and tight control of costs moved profit ahead faster than sales. Significant economies of scale were made over central overheads with Directory catalogue production, marketing and call centre costs all declining as a percentage of sales. The number of active customers grew by 11% to 2.1 million as at January 2006.
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Product development
Fashion is moving faster and we have reorganised our buying cycle to deliver new product more often. New ranges will now be introduced into stores every six weeks. The effects of the new buying process will begin to be seen in April this year. Going forward we need to be more focused in controlling the number of different styles in our ranges. We need fewer styles with more colour-ways of the better selling lines, which have been understocked from the start of this season. We expect to make further progress through the course of the year.
Business development
This year we will be conducting a number of trials to extend and add to the NEXT brand. These products will, if successful, add to our business in the years ahead and provide new avenues of growth as our core product areas approach maturity. In particular we will aim to leverage our two million Directory home shopping customer base. To this end we are trialling an electrical brochure (NEXTelectric) with 300,000 customers and if this is successful we can rapidly roll it out to the rest of the customer base in the Autumn.
Next franchise
Our overseas franchise operation continues to grow, with sales increasing by 17% and profit by 30% to 7.9m. At the year end there were 96 franchise stores compared with 80 the previous year. The Middle East continues to be our largest region with 41 stores. Our partner in Japan has 25 stores. During the year franchise stores were opened in Gibraltar, Hungary and Turkey. We anticipate that at least 20 new franchise stores will be opened during the coming year, including several in Russia.
Ventura
Several existing contracts were renewed during the year and three significant new customers have been added to the client list. Ventura employs in excess of 7,000 people and its UK call centres are operating close to full capacity. Its call centre in Pune, India opened during the year and handles business on behalf of NEXT Directory and two other clients.
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Other activities
Other Activities include profits from our Property Management Division, Choice (an associated company which operates fourteen discount stores) and Cotton Traders (an associated company which sells its own brand products).
Outlook
We believe the competitive and economic environment will remain very challenging in the year ahead. Whilst we think we have the opportunity to make improvements to some of our ranges, we are still budgeting on the basis of negative like-for-like retail sales for the year. We will focus on the following activities: Improving our core product offer, in particular simplifying some of our ranges to deliver better stock availability and clearer in-store merchandising. Growing top line sales through the addition of profitable new space in NEXT Retail. Adding more customers and product ranges to NEXT Directory. Defending the bottom line through the continued management of costs and improving gross margin. Developing new product areas.
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Current assets Stock of finished goods Trade and other receivables Prepayments Other financial assets Cash 311 415 85 31 70 912 Current liabilities Bank overdrafts Unsecured bank loans Creditors and other liabilities due within a year (31) (100) (625) (756) Non-current liabilities Corporate bond Pension obligations & other liabilities (298) (164) (462) 256 (300) (132) (432) 277 (22) (566) (588) 289 349 76 25 72 811
The financial statements have been prepared on the historical cost basis except for certain financial instruments, pension assets and liabilities and share based payment liabilities which are measured at fair value. (Annual Report, p. 36)
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Freehold and long leasehold buildings Plant, shop fronts and retail fittings in the high street retailing business All other plant, fixtures, fittings, IT assets and vehicles Leasehold improvements
Plant and Fittings (m) 643 179 (20) 802 295 81 (16) 360 442 347
Total (m) 730 179 (25) 884 306 81 (17) 370 514 424
Cost as at January 2005 Additions Disposals Cost as at January 2006 Depreciation as at January 2005 Charged against profits for the year On disposals Depreciation as at January 2006 Carrying amount as at January 2006 Carrying amount as at January 2005
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Exercises
Now try these exercises. Outline solutions are given in Appendix B. (2a) Review the data in the ten-year history. What does this tell you about the financial performance of Next plc over the last decade? (2b) Calculate the capital employed as at January 2006 using the formulae given in Section 2 and the balance sheet data for Next plc. Is it rising? (2c) What does the shareholders funds figure in the balance sheet mean? (2d) Is there something strange about the capital and reserves? (2e) What can you determine from the balance sheet about the cash position of Next plc over the course of the year? (2f) Why are prepayments shown under current assets in the balance sheet?
(2g) Why are pension obligations shown under non-current liabilities in the balance sheet? (2h) Using data in Note 9 to the 2006 Annual Accounts, calculate the average life over which depreciation is charged on plant and fittings and the average age of those fixed assets. (2i) (2j) What do you deduce about the rate of fixed asset replacement in view of the strategic growth of the company? What is the likely impact of the historical cost convention on the reported value of freehold property?
(2k) In view of the above, what is your view of Next plcs balance sheet and its reported shareholders funds?
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MN7006/D SECTION 3
Section 3
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their meaning. The case material from Next plc will provide an opportunity to test your skills, but first they will be developed on simpler examples. Interpretation requires purpose: without purpose, you flounder in a sea of data. Is the object to assess the potential for investment; the prospect of acquisition? Is it to forecast growth, to judge credit worthiness, or the possibility of insolvency? Over what timescale is the evaluation? Solvency is an immediate consideration, profitability longer-term in nature. Interpretation requires a perspective: who wants to know? Each stakeholder creditor, supplier, shareholder, employee, community has different interests that embrace profit, risk, security, and social responsibility. Interpretation requires benchmarks, not absolutes. Have things got better or worse? Check the figures for the previous year, they may suggest a trend. Is there competitive advantage? Compare performance with leading competitors or the industry average. Important also are shareholder expectations, as management must generate returns on productive investment greater than those available on financial markets. How else do you judge whether a 15% annual return is good? It might be good in a stable sector of a low inflation economy, but is it adequate for off-shore mineral exploration?
Approach to interpretation
There is a procedure which you can follow as you begin to analyse a set of accounts. It comprises five simple and fundamental tasks.
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the composition and age of assets, the form, cost, and term of loans and other debt capital, the gains or losses made on acquisitions and disposals, the contingent liabilities not included in the balance sheet. The Chairmans Statement and Report of the Directors also provide a rich source of information (e.g. remuneration) and tell you much about context.
Illustrative interpretation
Table 3.1 provides some data for NARC Ltd. Other than that NARC is evidently a medium-sized company, no context is included, so we start with a quick review of the abbreviated financial statements. Turnover has fallen by 10% in the year and this percentage change gives the benchmark for further prior-year comparison. Since cost of sales has reduced by the roughly the same proportion, gross margins appear unaffected and mean that management have not responded to the fall in demand by discount pricing. Operating profit has been cut by 20% because of depreciation a pre-defined, though notional, fixed cost. Intriguingly, earnings have risen by a third because of the dramatic reduction in interest costs is this because base rates have fallen or because loans have been repaid? Reference to balance sheet debt suggests the latter. Dividends a discretionary payment proposed by the Board of NARC have been increased, a sign of confidence to the shareholders despite the sales collapse. The balance sheet reveals a major contraction (over 50%) in the fixed asset base of the company including its land and buildings. These could have given rise to major gains on disposal, though none are evident so perhaps this is a sale that has been forced upon the Board by lenders. This is possible given the reduction in debt, but the remaining 1.2m is not shown as current liabilities (indicating that none is due for repayment within the next year). Whatever the case, it is commendable that management generated the sales that they did
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2002, 000s Profit & Loss Account for year ending Sales Cost of Sales Depreciation Other Costs Operating Profit Interest Payable Corporation Tax Profits after Tax (earnings) Dividends Retained Profit for the Year 5000 (2000) (1000) (1600) 400 (100) (100) 200 (100) 100
2001, 000s Balance Sheet as at 31 Dec 5555 (2200) (1055) (1800) 500 (270) (80) 150 (90) 60 Land & Buildings Machinery etc @ cost Less acc depreciation Fixed Assets (net book value) Stock Debtors Cash Current Assets Bank Overdraft Creditors Current Liabilities
2002, 000s
2001, 000s
600 4500 (3600) 1500 400 500 200 1100 (300) (300) 2300
1200 5000 (3000) 3200 500 500 1000 (300) (500) (800) 3400
Cashflow Statement for the year ended Receipts Payments Net Cashflow Opening Cash Balance Closing Cash Balance
Capital Employed
Long-term Debt
(1200) 1100
Ordinary Share Capital (2m shares) Reserves Acc Retained Profit Shareholders Funds
Table 3.1 Summarised annual accounts for NARC ltd (Not A Real Company).
out of this reduced infrastructure facility. Stock has fallen 20% which either indicates that buying decisions have been improving, or that stock has remained on the shelf for less time. Debtors have stayed the same. Creditors, in contrast, have dropped 60%, and reveal restrictions on credit granted to NARC by its suppliers or a more liberal payment policy by the management. Despite this, the cash position has dramatically improved from overdraft to surplus. Capital and reserves are stable, with no share capital issued or
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retired, and shareholders funds have simply risen 10% from the bottom-line of the profit & loss account. The cashflow statement shows receipts in 2002 to be the same as sales (there being no change in debtors), and you should note that the movement reflects the change in the balance sheet position over the year. Unlike the other two, the cashflow statement does not adopt the format called fundsflow used in reported accounts, it concurs with the simple cashbook form that you met in Section 2. You will recall from this section that all double entries can be represented in the three principal financial statements. So it should be no surprise that, given two of the three statements and sufficient notes to the accounts we can construct the third.
000s Operating Profit Add back depreciation charge Decrease in stock Decrease in creditors Cash generated from operations Capital expenditure less disposals 400 1000 100 (200) 1300 700
Notes
this is a non-cash cost thus releasing cash equal to 500 400 a source of funding equal to 500 300
the movement in the gross book value of fixed assets equal to 1200 + 5000 (600 + 4500) 400, difference between change in depreciation & the charge assuming amounts payable are paid giving 100 + 100 +100 2400 1200
Interest, dividend, & taxation Repayment of debt finance Net Cashflow (this is the same as the earlier cashflow statement showing receipts and payments)
Though somewhat a distraction, a fundsflow statement for NARC will now be formulated (as seen in Table 3.2). This is a useful exercise as it clearly demonstrates the difference between profit and cash. In NARCs case, it makes clear that whilst the disposal of fixed assets has funded the repayment of debt, it has continued to invest in new machinery. It also shows that cash generated from operations is not just a result of profitability, but the effective management of current assets and liabilities relating to those operations. Stock and debtors (less creditors) are collectively the working capital of a business, and growth usually causes an increase in the requirement, draining
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cash. In NARCs case, there is a net increase in working capital of 100,000 because of the more rapid payment of supplier invoices. This format is much more informative because it shows what funds have been raised (or repaid) in a period and how they have been used.
Profitability
Gross margin
Gross Margin = (Sales - Cost of Sales) 100% Sales
Gross margin relates sales to its directly attributable purchased and process costs and provides an indication of the mark-up in selling price. It is therefore particularly important in retail.
Net margin
Net Margin = Operating Profit 100% Sales
Net margin is calculated after all operating costs have been taken into account, but before taxation and the costs of servicing finance.
ROCE can also be termed RONA (return on net assets) and is a popular measure of return. It relates profit to the historic investment in the asset base used to generate that profit.
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In conclusion, as Table 3.3 shows, the return on funds invested in NARC has improved despite falling sales. Management have successfully held selling prices or maintained a comparably profitable portfolio of products.
2002 results Gross Margin Net Margin Return on Capital Employed (5000 - 2000 ) = 5000 400 = 5000 400 = 2300 60% 8% 17%
Efficiency
Asset turnover
Asset Turnover = Sales Total Assets
This ratio indicates how hard assets are being worked and is especially important for capital intensive industries. When used together with net margin, it sharply demonstrates how ROCE can be improved by reducing the asset base (as in NARC). Margins can improve by raising selling price and this can damage sales, which reduces asset turnover and has the opposite effect on ROCE. Note then that, ROCE = Profit Sales Sales Assets
Stock turnover
Stock Turnover = Cost of Sales Stock
This ratio shows how often stock turns over in a year by relating the amount in stock to the amount used in production or sold in retail. It requires a balanced judgement between having too little in stock and missing sales opportunities, and having too much and so tying up funds for working capital and risking obsolescence.
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In conclusion, as Table 3.4 shows, by cutting capacity and doubling its utilisation, the management of NARC have improved ROCE by more efficient use of stock and infrastructure.
2002 results Asset Turnover Fixed Asset Turnover Stock Turnover 5000 = 2300 5000 = 1500 2000 = 400 2.2 x 3.3 x 5.0 x
Liquidity
Settlement period
Settlement Period = Debtors 365 days Sales
This is a measure of credit granted to customers. The more liberal the policy or ineffective the debt progression, the more funds are tied up in working capital. Similar calculations (see NARC) can be made for the credit taken from suppliers, a flexible and much abused form of funding.
Current ratio
Current Ratio = Current Assets Current Liabilities
This is a simple and simplistic measure of a business ability to meet its immediate liabilities. The reality is highly affected by context, and an appropriate level is best gauged by comparison within the industry sector.
Acid test
Acid Test = Monetary Current Assets Current Liabilities
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By excluding stock, which is not quickly convertible into money (especially in manufacturing), this is a slightly more realistic parameter of liquidity, but still suffers many of the faults of the current ratio. In conclusion, as Table 3.5 shows, NARC has dramatically improved its liquidity by creating a cash surplus and paying its suppliers more promptly.
2002 results Credit Taken Current Ratio Acid Test 300 365 = 2000 1100 = 300 700 = 300 55 days 3.7 x 2.3 x
Risk
Gearing
Gearing = Debt Debt + Equity
Where debt is equivalent to long-term liabilities and equity to shareholders funds. Risk is the degree of volatility in profits. Risk is higher where sales are cyclical and there is a substantial fixed cost base as changes are multiplied (or geared) on the bottom-line. Debt finance is fixed in that interest payments must be met, but dividends are discretionary, therefore a high gearing conveys high financial risk. Where shares are quoted, market values provide a much more realistic indication of this risk than do the book values in a balance sheet.
Interest cover
Interest Cover = Profit Before Interest and Tax Interest
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This indicates the ability to meet interest payments the higher the ratio, the greater the cushion against the geared effect of a fall in sales on profits.
Dividend cover
Dividend Cover = Profits after Tax Dividends
This is similar in concept to interest cover, except that dividends are paid out of earnings.
2002 results Gearing 1200 = (1200 + 1100 ) 400 = 100 200 = 100 52%
4.0 x 2.0 x
1.8 x 1.7 x
In conclusion, as Table 3.6 shows, the repayment of debt, whether forced by the lenders or initiated by NARCs management, has led to a major improvement in all three ratios and reduction in financial risk.
Investor
Note: quoted companies use measures of investor risk and return that are based upon the market price of the share price/earnings ratio, earnings and dividend yield these are explored in Section 5.
This is a comparable measure to ROCE except that ROE relates the profit attributable to shareholders to the book value of their investment, whereas ROCE does not distinguish between the form of capital used to fund the asset base which generates profits, and hence uses the profit figure before interest and dividends have been deducted.
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2002 results Return on Equity Earnings per Share 200 = 1100 200,000 = 2,000,000 18% 10p
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 7 Interpreting financial statements and alternative theoretical perspectives
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Concluding Comments
Competent interpretation comes with practice. Work through Colliers Chapter 7 and its calculations and then, when you reach the Ottakars example, devise ratios under each of the five categories we have looked at from the data, and only then compare with the results in Colliers Tables 7.7 to 7.11. Consider how context affects your interpretation. Later, in the Carrington example, you will see how a financial commentary expresses this competence with little recourse to the numbers. Use Questions 7.1 and 7.2 in Colliers Appendix 1 to reinforce your knowledge of the formulae, and Question 16.4 to prepare a fundsflow statement. Finally, undertake the exercise related to the case material from Next plc, remembering to use the retail context and the companys financial aims to interpret the rather surprising results.
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2006, million Revenue (Sales) Cost of goods sold Depreciation Lease rentals Other expenses Total operating costs Operating profit Interest on loans & overdrafts Profit before taxation Taxation Profits after tax (Earnings) 2014 81 141 399 (2635) 471 (22) 449 (136) 313 3106
2005, million 2859 1830 69 127 390 (2416) 443 (19) 424 (119) 305
Table 3.8 Next's profit & loss account. (Sources: Income Statement and Notes 2, 3 and 5 to the Annual Accounts, 2006.)
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January 2006, million Non-current Assets Property, plant & equipment Intangibles and other non-current assets 514 48 562 Current Assets Stock of finished goods Trade and customer debtors Prepayments Other financial assets Cash 311 415 85 31 70 912 Current Liabilities Bank overdrafts Unsecured bank loans Trade payables Tax and social security liability Other creditors and accruals Other liabilities due within a year 31 100 173 62 328 62 (756) Non-current Liabilities Corporate bond Pension obligations Provision for costs of exiting unwanted leases Other liabilities 298 116 10 38 (462) 256 Equity Share capital Employee share ownership trust reserve Retained earnings Other reserves Shareholders funds 25 89 1751 (1609) 256
424 62 486
22
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Share capital
Authorised ordinary shares of 0.10 each as at January 2006: 400,500,000 (2005: 400,500,000) Allocated, called up and fully paid 0.10 shares as at January 2006: 246,100,000 (2005: 261,103,000) During the year Next plc purchased for cancellation 9,060,984 of its own ordinary shares in the open market at a cost of 126.9m, and a further 5,950,000 under off-market contingent purchase contracts at a cost of 90.6m. The cost of these purchases was set against retained profits for the year (and not other reserves as in earlier years). On 30 April 2005, Next plc issued 8,031 ordinary shares for a cash consideration of 0.1m (source: Notes 26 and 27 to the accounts).
Dividends
Accounting entries related to dividend distributions are shown in Table 3.10.
Declared for 2006, charged against profits Final dividend for 2005 Interim dividend for 2006 Final dividend for 2006 34 71
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Debt capital
As at January 2006, the amount of the outstanding liability was 401m (source: Notes 18, 21, 32 and 33 to the accounts), comprising: 100m in an unsecured bank loan committed borrowing facilities at January 2006 were 450m expiring between 2 and 5 years time, of which 100m was drawn down.
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298m in corporate bonds, repayable in 2013. 3m in finance leases operating lease commitments as at January 2006 amounted to 1,915m. These are not shown as liabilities in the balance sheet (nor required to be under International Accounting Standards) as they are similar to rental agreements. The leases cover vehicles, equipment, warehouses, office equipment, and retail stores.
External revenue, m Sector Analysis NEXT Retail NEXT Directory NEXT Sourcing Ventura Other Eliminations Total Geographical Analysis United Kingdom Rest of Europe Middle East Asia Total 2974 102 20 10 3106 3106 2217 685 9 149 46
Internal revenue, m
Total revenue, m
Operating profit, m
Capital expenditure, m
Assets, m
2217 685 668 5 131 (804) 677 154 177 (804) 3106
164 1 3 11
471
179
1474
1385 31 4 54 1474
Table 3.11 Next's segmental analysis for 2006 (source: Note 1 to the accounts).
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Cashflow statement
Table 3.12 shows Next's cashflow statement. Minor flows have been omitted for the sake of brevity, clarity, and comprehension.
Cash inflows, m Cashflows from operating activities Profit before interest Depreciation Share option charge Increase in inventories Increase in trade and other receivables Increase in trade and other payables Pension contributions less income statement charge Corporation taxes paid 623 Cashflows from investing activities Proceeds from sale of property, plant and equipment Acquisition of property, plant and equipment 8 Cashflows from financing activities Repurchase of own shares Proceeds/(repayment) of unsecured bank loans Interest paid & received Dividends paid Net cash from financing activities Net decrease in cash and cash equivalents Opening cash and cash equivalents Closing cash and cash equivalents (balance sheet) 101 100 1 8 63 471 81 8
Cash outflows, m
22 76
218
Table 3.12 Next's cashflow statement Year to January 2006 (source: consolidated cashflow statement).
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Exercises
Now try these exercises. Outline solutions are given in Appendix B. (3a) Quickly review the three principal statements using the approach to interpretation suggested in this section, starting with the profit & loss account, then moving onto the cashflow statement and balance sheet. Note any inconsistencies. (3b) Conduct an analysis of profitability and efficiency on the segmental data (Table 3.11) from Note 1 to the accounts using ratios. Interpret your results and comment on any other insight that the data provides. (3c) Calculate the following measures for 2005 and 2006 for Next plc:
debtor settlement period, acid test, gearing, interest cover, return on equity, earnings per share.
What do the results suggest about the liquidity, risk and investor performance of Next plc?
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MN7006/D SECTION 4
Section 4
Introductory context
The regulation of accounting reports and the wider issue of corporate governance are of immense contemporary interest: the former to practicing accountants, the latter in Boardrooms.
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The two are related since the current flurry of activity involving both is a response to the failure of audit to check fraudulent accounting and/or abuse of power by executive directors. There is not necessarily a widespread lack of ethical behaviour, but high profile corporate failures have required political action to restore the legitimacy of business in relation to its society. We are all very aware of the failure of Enron and the imploding of Arthur Andersen, but these followed scandals at WorldCom and Global Crossing. Nor are such scandals unique to the US Ahold of the Netherlands Vivendi of France, Parmalat of Italy, and Sumitomo of Japan are examples gathered from around the world or to the recent past Maxwell Communications (of the UK) and BCCI (originally of Pakistan) both fell into disrepute in the early 1990s. There has always been a thin line between creative accounting (see Collier, Chapter 7) and fraudulent disclosure, as there has between tax avoidance and tax evasion. Even with a limited knowledge of accounting, one can appreciate that the concepts of accrual and prudence, and the need for judgement in the full attribution of costs, provide scope for smoothing profits between years. External transactions, ostensibly with third parties, can also be used to advance sales and source funds that are off balance sheet. Regulation has become necessary because the exercise of expertise essential to measuring and reporting organisational performance in accounting terms can go beyond a fair assessment to one that is designed to mislead.
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consequent need for external reporting much less than in Anglo-American forms of capitalism. There, equity finance is much higher relative to gross domestic product and banks are held at arms length. Transparency of financial performance is more significant, and companies seek to impress shareholders and equity markets by reporting enhanced profits. Between the UK and the US, there are significant differences over the valuation of land, buildings, stock and writing off of goodwill on acquisition and research and development expenditure. The US enforces historic cost derived from independently conducted transactions rigorously and its accounting standards specify appropriate treatment of those transactions and other business situations. In the UK, accounting standards are more liberally defined and follow the principle of substance over form. This means that the intention behind a transaction is more important that its mechanics. If a transaction is designed to conceal a liability, it can fail audit scrutiny in the UK because the intention is to deceive, whereas in the US it may withstand audit scrutiny because it is technically valid (e.g. the round-trip trades of US energy companies). However, the greater latitude over measurement in the UK can give rise to higher profit declarations. The UK requirement is that reported accounts portray a true and fair view, whilst the US expects a fair presentation.
Reported earnings for 2004, $bn UK accounting standards US GAAP IFRS Replacement Cost Accounting (an optional disclosure under IFRS) 15.8 17.1 17.1 15.2
Table 4.1 BPs earnings for 2004 according to various reporting standards.
Table 4.1 shows data from BP plc. Profits attributable to shareholders under UK standards are $1.3bn different to those under US rules, but are we to believe that $15.8bn is the true figure when BPs executives prefer to adjust historic costs for inflation and declare $15.2bn? Auditors have a convention termed materiality that the disclosed figures are not materially different to those that could be otherwise argued as correct under the prevailing accounting standards. They define a percentage range for reported levels of sales, profit, and net assets within which they will tolerate sampling errors and discretionary points. There is no absolute truth.
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Corporate governance
In step with accounting regulation, corporate governance has developed on a national basis, sometimes in statutory form but more commonly through codes of conduct. Developments have often been triggered by high-profile corporate
Generally Accepted Accounting Practice. International Organisation of Securities Commissions. International Federation of Accountants.
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misdemeanours, but their root lies in the fiduciary duties of directors defined in company law. These obviously vary, but are rarely expounded beyond acting in the companys interest, observing a duty of care, and not mis-appropriating assets or otherwise deceptively benefiting from position. The lack of positive ethical guidance in these provisions has been addressed by codes of governance which go well beyond the observance of individual propriety. At an international level, the main body that has contributed to this issue is the OECD [Note 8] 30 countries sharing a commitment to democratic government and the market economy. In its Principles of Corporate Governance, first issued in 1999, it effectively provides a definition, The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the boards accountability to the company and its shareholders. The dual position of the Board in holding management to account, and being held to account by the owners, is a demonstration of agency and shows the relevance of corporate governance to the subject of this study book. The use of independent non-executive directors is an important component in policing the executive members of the Board. Paragraph E1 in the OECD guidelines (see Figure 4.1) indicates their role on three committees (paragraph E2): nomination (the appointment of Board members, paragraph D3), remuneration (the performance-related pay of Executive members, paragraph D4), audit (the liaison with auditors and review of financial and risk controls). Most national systems (see later) require exclusive or majority representation of non-executive directors on these committees although the position of the Chairman of the Board (as a non-executive) is controversial in the US. The role of the audit committee is particularly significant in view of the accounting scandals already mentioned. These resulted from failure of internal controls, abuse of executive position, and/or false external reporting. Such failings are potentially inter-related. True and fair financial reports require integrity of financial accounting systems (paragraph D7), and these should be reviewed by internal and external audit. Assuming their technical competence, both these functions need unfettered access and reporting of their findings, a capacity that can be undermined by a chief finance officer (CFO) as employer and client, respectively.
[8]
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E.
F.
The audit committee thus provides an independent point of reference. Recalling that the Board is responsible for strategic guidance, appropriate objectives and plans have to be in place (paragraph D1). One of these objectives will be financial in nature (e.g. to increase earnings per share), and
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the imperative of achieving shareholder returns has driven a number of Boards into risky strategies. The OECD principles make significant reference to the need for risk management (paragraphs D1 and D7), and the audit committee has a number of responsibilities in this respect. Risks are not just linked to the integrity of financial reporting, but include all business exposures from the strategic to the operational, from environmental to internal process. Thus there is a need to define the Boards attitude toward risk, monitor extant and emerging exposures, incorporate risk evaluation and mitigation into decision making, ensure the effectiveness of internal controls, and maintain systems that provide adequate information for planning, control, internal audit and review. This approach to risk management is set out in the widely-adopted COSO [Note 9] framework, depicted in Figure 4.2.
1 Control Environment
Risk Assessment
Control Action
5 Monitoring
Control Information
Control information contains financial accounting data used in corporate reporting but, because it embraces wider strategic and operational control, it also contains management accounting data used for internal reporting. Sections 6 through 10 of this study book explore this further, but the link between governance and management accounting is evident from the OECDs paragraph D1. This explicitly refers to annual budgets (covered in Section 9), corporate performance (see Section 10) and capital expenditure (see Section 6).
[9]
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The role of accounting and auditing is broadening in response to the contemporary concern with risk management. Accounting has to provide historic reports of stewardship with integrity and provide predictive mechanisms and contingent controls in respect of the future. Internal audit (the monitoring step in the COSO framework) is developing into risk management, whilst external auditors are reviewing compliance with the corporate governance regime as well as accounting regulation. The practical impact of this is explored by examining the governance regimes that apply in the UK and the US.
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301, independent audit committee may only comprise non-executives, one of whom must be a financial expert. 302, personal liability of CEO/CFO must certify appropriateness of financial statements and disclosures and that (they) fairly present, in material respects, the operations and financial condition of the issuer. They must disclose any material weakness in controls to auditors and the audit committee. 404, internal control report directors statement of its effectiveness with attestation by auditor. 409, real-time disclosure of material changes. 80X, document destruction illegal and whistle-blowers protected. Both regimes encourage use of the COSO framework, but there is a more rigorous test of the effectiveness of internal controls to manage risk and prevent fraud under the US system. The leading position of a CEO in American business culture has prevented the role separation seen under the British code and remains a potential weakness given the intimidation evident at Enron and WorldCom. In the US and UK regimes the shareholder is pre-eminent, but the OECD recognises that some countries accept a wider responsibility to stakeholders [Note 10].
Supplementary statements
Whilst not mandated, many companies portray the ethical relation of business in society by incorporating sections on social and environmental responsibility in their annual report. This may be rhetorical, but the current concern about health, safety, community, human rights, organic food, recycling and climate change means that stakeholder and ecological interest is no longer seen by corporations as minimising negative effects (e.g. consumer boycotts, pollution fines, or industrial injury claims). They recognise that substantial sections of their markets will seek to buy ethical products. Recommendations and guidelines exist on programmes of action and forms of reporting, including the Global Reporting Initiative (based in the
[10] Of all national systems, the South African code most emphasises stakeholder interests as the country strongly pursues social justice alongside economic development.
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Netherlands), Environmental Accounting Project (US), International Standards Organisation (ISO14001), and Environmental Audit Association (Canada), Eco-Management and Audit Scheme (EMAS), UNEP. The Operating and Financial Review (of the UK Accounting Standards Board) addresses social, environmental, and stakeholder interests and is well explained by Collier (in Chapter 9). Its adoption, though voluntary, marks a major shift in the orientation of published accounts from historic reporting to forward looking statements of strategy, resources, markets, risk and value, and makes more transparent the results of the governance processes covered in this section.
Key Reading
Now read the following chapters from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 8 Interpreting financial statements under International Financial Reporting Standards (IFRSs) Chapter 9 Governance and the Operating & Financial Review (OFR): Understanding the context of accounting
Concluding Comments
I have, up to now, avoided providing references as Colliers listings have been extensive. However, there are no textbook sources listed in his Chapter 8 and the following are recommended to address this deficiency: Aglietta, M. and Reberioux, A. (2005), Corporate Governance Adrift: A critique of shareholder value, Edward Elgar Alexander, D., Britton, A. and Jorisson, A. (2003), International Financial Reporting and Analysis, Thomson Charkham, J. (2005), Keeping Better Company: Corporate governance ten years on, Oxford University Press Choi, D. and Meek, G. (2005), International Accounting, 5th edition, Pearson Education
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Hopt, K. (2005), Corporate Governance in Context: Corporations, states, and markets in Europe, Japan, and the US, Oxford University Press Nor are there any questions related to Colliers Chapters 8 or 9, and so the following exercises are designed to reinforce your knowledge: (4.1) China is a major economy, recently emergent from central state control. How has this history affected its financial accounting practices? (4.2) For your own country, establish which organisation regulates the preparation and publication of annual accounting reports. How do the formats for the principal financial statements differ from those prescribed by IAS1 and IAS7 (International Financial Reporting Standards)? (4.3) Briefly outline the corporate governance regime that appertains in India. Has it been influenced by the UKs Combined Code? (4.4) For your own country, identify the source of corporate governance regulation. Was this regulation in response to an accounting scandal? If so, examine the nature of the scandal and consider whether the regulation would prevent a repetition. Indicative answers to Exercises 4.1 and 4.3 are provided in Appendix A.
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Adopting a new set of standards means that the accounting treatment of transactions changes and affects not only the current period, but also the balances of assets, liabilities and capital accumulated over many years. Reported data is also no longer comparable with prior years compiled under the old regulatory regime, and so the last years results are restated under the new standards. At the point of transition, the effect of changes on the opening balance sheet and on the previous years profit & loss account are reported. Note that no changes are necessary to the cashflow statement because it is not subject to accrual and matching. For Next plc, the overall effect of the change in standards was:
Opening balance sheet as at January 2005 Fixed Assets Current Assets Current Liabilities Non-current Liabilities Equity (capital & reserves) +30m +1m 32m +59m +4m
Profit & loss account for year ended January 2005 Operating Profit Taxation +1m 3m
The adoption of IAS related to financial instruments would have had the effect of reducing the net asset value of the opening balance sheet by 44m. This is because the fair value of these instruments would have had to have been adjusted.
Corporate governance
The following are extracts from the section on Corporate Governance in Next plcs 2006 Annual Report, The Group has complied throughout the year under review with the provisions set out in Section 1 of the July 2003 FRC Combined Code on Corporate Governance.
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Audit Committee
The committee consults with external auditors and senior management considers financial reporting and reviews the Groups accounting policies and annual statements. The committee also reviews the effectiveness of the risk management process (p15)
Remuneration Committee
The committee determines the remuneration of the executive directors and reviews that of senior management. (p16)
Nomination Committee
duties of reviewing the Board structure and composition and identifying and nominating candidates to fill Board vacancies as they arise. (p16)
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Each committee comprises five non-executives, with the Chairman (David Jones) also present on the Nomination committee.
Chairman
The Company maintains a division of responsibilities between the offices of Chairman and Chief Executive, which is set out in writing and agreed by the Board. The Chairman manages the Board to ensure that the Group has appropriate objectives and an effective strategy; that there is a Chief Executive with a team of executive directors able to implement the strategy; that there are procedures in place to inform the Board of performance against objectives; and to ensure the Group is operating in accordance with a high standard of corporate governance. The current Chairman was an executive director of the Group (formerly the CEO from 1988 until 2001). It is intended that he will retire from the Board at this years Annual General Meeting in May and be replaced by the current Deputy Chairman (John Barton), who is an independent director. (p16)
Management Delegation
The most important management meetings are the weekly NEXT Brand trading and capital expenditure meetings which consider the performance and development of the NEXT Brand through its different distribution channels. These meetings cover all business aspects of risk management in respect of the NEXT Brand including product, sales, property, warehousing, systems and personnel. Key performance indicators are monitored daily and weekly. (p16)
Risk Management
The Board sets guidance on the general level of risk which is acceptable and has a considered approach to evaluating risk and reward.
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The Board confirms that it has carried out a review of the effectiveness of the Groups system of internal control covering financial, operational, compliance and risk management. This includes: identifying and evaluating risks, determining control strategies for these risks and considering how they impact on the achievement of the business objectives. The risk management process has been in place for the year under review and is in accordance with Internal Control: Guidance for Directors on the Combined Code. Risk management and internal control is a continuous process and has been considered by the Board on a regular basis during the year. The Board promotes the development of a strong control culture within the business. During the year the Board addressed the business risks which had been identified as key, taking into account any changes in circumstances over the period. The Audit Committee has reviewed the level of internal audit resource available within the Group and believes that it is appropriate to the size and business risks of the Group. The Board considers that the Groups management structure and timely and continuous monitoring of key performance indicators provide the ability to identify promptly any material areas of concern. Business continuity plans, procedures manuals and codes of conduct are maintained in respect of specific major risk areas and business processes. (p17)
External Auditors
Ernst & Young LLP have reported to the Audit Committee that, in their professional judgement, they are independent within the meaning of regulatory and professional requirements and the objectivity of the audit engagement partner and audit staff is not impaired. The Audit Committee has reviewed this statement and concurs with its conclusion. the Board has established policies regarding the provision of non-audit services by the auditors the groups auditors are in some cases able to provide certain services more effectively than other parties. In other circumstances, assignments are subject to
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independent tender, and decisions on the allocation of work are made on the basis of competence and cost-effectiveness. (p17)
Directors responsibilities
The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Company and of the Group and enable them to ensure that the financial statements comply with the Companies Act 1985 and Article 4 of the IAS Regulation. They are also responsible for safeguarding the assets of the Group and hence for taking reasonable steps for the prevention and detection of fraud and other irregularities. (p18)
Going Concern
The directors report that having reviewed current performance and forecasts they have a reasonable expectation that the Group has adequate resources to continue in operational existence for the foreseeable future. For this reason, they have continued to adopt the going concern basis in preparing the financial statements. (p18)
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- 74% of women who took maternity leave returned to work for Next, - 4739 staff are members of Next pension schemes. community: - donated 879,000 to charity and community organisations as well as sponsorship of sports and fashion organisations. Fundraising events also raised an additional 841,000. environment: - 98 stores recycled cardboard and plastic, - 11,935 tonnes of cardboard and polythene recycled, - over 12 million hangars returned by stores for reuse, - 7.1% decrease in CO2 emissions per 1000 parcels delivered/collected.
Exercises
Now try these exercises. Outline solutions are given in Appendix B. (4a) What has been the effect of the adoption of international, rather than UK, accounting standards on Next plcs reported redults? (4b) The directors of Next plc state, they have continued to adopt the going concern basis in preparing the financial statements. What is the meaning of going concern and its implication for valuations in the balance sheet? (4c) The Board of Next plc have stated that they have complied with the requirements of the UK Combined Code. Review the report and identify ten examples of good governance note, these do not have to specifically relate to the UK regulation, but can draw upon other examples provided in Section 4. (4d) Identify the five steps in the COSO framework. What evidence is there that Next plcs approach to risk management reflects this framework?
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(4e) Review the forum, aspects, facts and figures contained in the CSR report. How socially responsible do you consider Next plc to be? (4f) In its CSR report, Next plcs CEO states, Next is a company that believes that it can only deliver long term value to its shareholders if we take an ethical approach to the way we do business. Put simply, this means being fair and honest in our relationships with suppliers, customers and employees. How do these two sentences relate to agency and stakeholder theory? Does this appear to you to represent an adequate approach to reconcile the potentially conflicting interests of shareholders and stakeholders?
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MN7006/D SECTION 5
Section 5
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Shareholders
Bondholders
Capital Markets
Money Markets
Interest
Share capital
Debt capital
Working capital
Balance Sheet
Retained Profit
Asset Base
Operating Profit
Figure 5.1 is a simplified form of this interaction. A quoted company may issue shares or bonds (a loan from the holder) on a capital market. Shares form the equity capital of a company, shown in the balance Sheet as Capital and
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Reserves. Bonds and other forms of loan form the debt capital, and are shown as Long-term Liabilities. Both equity and debt capital inject cash into the business which is converted into the productive assets that create wealth. With a growing business, additional stock and debtors are required and this working capital is funded by debt capital and bank overdraft facilities. Shareholders funds, long-term and short-term liabilities, therefore represent the cash raised to purchase fixed and net current assets. From this asset base, sales are generated, and cash flows back into the business to repay the borrowing (reducing the liability) and service the borrowing (reducing the profit). Interest on debt is paid first, then the dividend, and finally the retained profit, which adds to shareholders funds, becomes an internal source of funds for further growth in the business. For the sake of simplicity, only the injection of funds and their servicing is shown in the diagram the repayment of loans, redemption of bonds, and buy-back of shares is excluded. For the purposes of this study book, we can limit our consideration to the capital markets, where stocks and bonds are traded, and focus on only two aspects: shareholder return and the cost of capital.
Shareholder return
Shareholders can earn returns in two ways: from the dividends they receive from the company, and from the change in the market value of their shares which they can sell at any time. By setting these two components against the price at which the shares were bought, the return on a share can be assessed as,
Return on Share = Total Dividend Paid on that Share + (Selling Price - Buying Price) Buying Price
Of course, the return can be and normally is evaluated on an annual basis by using the market price at yearly intervals, Annual Return = Annual Dividend + (Closing Price - Opening Price) Opening Price
By multiplying the share price by the number of shares issued by a company, the market value of its equity can be calculated. The book value of equity in the company is the shareholders funds figure in the balance sheet. This figure is the total amount raised in cash through the original issue of the share plus the accumulated retained profit and reserves it does not reflect the rise in the price of the share as a result of subsequent trading in the capital market. The two values are therefore incomparable.
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In the UK, the market value of a company is about three times its book value on average. Since the market data is more representative of shareholders real interest, the investor ratios which we described in Section 3 need to be supplemented. You may recall that return on equity related earnings to the book value of equity, but a more realistic indicator of shareholder return would be based upon the market value of equity: this is called the earnings yield. Similarly, the amount of dividend can be compared with the market value: this is called the dividend yield. Commonly both are calculated on a per-share basis, Return on Equity = Earnings Yield = Dividend Yield = Profit after Tax 100% Shareholders' Funds Earnings per Share 100% Share Price Dividend per Share 100% Share Price
Now, it is reasonably argued that investors consider a share price in terms of its earnings and the growth likely in those earnings in other words, a combination of current performance and future potential. This means that, Share Price = Earnings per Share 1 Earnings Yield
The reciprocal of earnings yield is called the price-earnings ratio and this is the leading indicator of potential return. Look at Table 5.1. This indicates the importance attached to measures of shareholder return. The fourth column shows the share price in pence (100 pence to the ). Note that the level of a price relative to its peers is meaningless, but you can compare the level within its range over the last year (shown in the first two columns). The largest three companies (in bold) are all trading toward the bottom end of their range. Column 5 shows the change over the latest day: Chemring, in particular, has been the object of selling activity. The next column shows the dividend yield: British Aerospace produced a 3% yield (around the markets average), Hampson paid none at all. This may be because it has retained profit to help fund acquisitions: its price-earnings ratio (in the final column) is the highest rating in the sector.
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Aerospace & Defence 450 1355 195 187 382 490 1052 1115 535 500 314 548 134 104 273 329 831 826 420 337 BAE Systems Chemring Cobham Hampson Meggitt Rolls-Royce Smiths Grp Ultra Elctrncs UMECO VT Group 341.2 1320.0 158.0 155.5 284.2 421.5 881.5 987.0 449.8 487.0 0.8 32.5 0.5 1.5 1.8 0.0 1.5 1.0 5.2 0.0 3.0 0.9 2.2 0.0 2.7 0.0 3.4 1.7 3.2 2.2 15.2 23.9 14.9 28.9 14.2 15.6 16.0 18.3 14.6 19.6
Table 5.1 Share performance data for companies in the defence sector (source: The Independent, August 10, 2006).
Illustration
Lets return to the NARC example which we used in Section 3. Assume that NARCs share price was 200p at the end of 2002, up from 120p a year earlier, Table 5.2 shows the effects that this would have on NARCs performance. The halving in gearing has reduced risk (more than calculated using book values). This, together with the increased profitability on a rationalised asset base, has excited market interest and boosted the p/e ratio. Despite the rise in profits after tax and dividends, however, yields have fallen because the markets expectation of the company is much higher.
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2002 results Return on Equity Earnings per Share 200 = 1100 2,000,000 = 2,000,000 10p 100 = 200p 100,000 2,000,000 100 = 200p 200p = 10p 1200 = ( 4000 + 1100 ) 18% 10p
Earnings Yield
5%
6.3%
Dividend Yield
2.5%
3.8%
Price/Earnings Ratio
20x
16x
24%
50%
Table 5.2 Effects of ratio analysis for NARC using market data.
Cost of capital
Since the majority of trading activity on a stock market is secondary (i.e. the sale of used shares from one investor to another), changes in share price do not directly affect the company. Only when capital is raised or retired does the share price have a direct consequence in the amount of cash raised or repaid. One might therefore expect the price performance of a share subsequent to its issue to have little significance to the financial management in a company. This is not so. Most companies want to enhance their shares price (agency theory), and the Board is keen to avoid the displeasure of its shareholders (especially at the annual general meeting) and retain their loyalty. So the cost to the company of servicing equity finance is not regarded as the cash-driven stream of dividends its Board proposes. If the annual return is insufficient in relation to alternatives in the market, shareholders will sell their holding and the price will fall. Therefore the aim of a Board is to deliver sufficient dividends and capital gain to prevent this occurring. The cost of equity to a company is what is called an opportunity cost the return foregone by the shareholder in unpursued alternatives by not selling their shares. From this, a general principle is formulated of a companys relation to its shareholders,
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Cost of Capital to the Company = Return Required by the Investor As it is with equity capital, so it is with debt finance bond prices rise and fall like shares. For bank loans, the cost is equal to the risk-specific lending rate of the bank. Why is all this important? Well, the fundamental financial role for a Board is to ensure that, Returns on Productive Investment (i.e. its products, services, products) the Return that can be Earned by Investors in Projects of Equivalent Risk
Therefore, the Board can use the cost of capital as a basis for evaluating all its productive investment opportunities. That way, it ensures that the return from the use of funds exceeds the cost of funding. You will see how this is applied in strategic decisions in Section 6, next. Since most companies are funded from a pool of different types of funds, the cost of capital is an average of the cost of all the individual sources weighted by the amount of each that is used. As debt finance is cheaper than equity (and the cost is tax deductible), gearing is an important influence on the overall cost of capital, and the merit of applying market values in its calculation is considerable. You do not need to be able to calculate the cost of capital for this module of your studies, just understand its relevance to financial decisions for now.
Value-based measures
The importance of shareholder return, when coupled with shareholder activism in the 1990s, found expression in a series on new measures that were value-based. In Chapter 2 of his book, Collier describes many of these measures, but you simply need to recognise what they have in common and why conventional accounting parameters were found wanting. If the primary financial aim of companies is to increase the wealth of their shareholders, and the primary component in that wealth is a capital gain (and not a dividend distribution), then companies should adopt parameters that are more closely aligned with shareholder value. Since this is based on future expectations of financial performance, then we need to manage using future projections rather than accounting reports of the past.
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Accounting profits are short-term, ignore the risk involved in their achievement, and as we saw in Section 4 are more easily manipulated than cashflow. Balance sheets are an eclectically historic aggregation of past transactions and current judgements and severely understate the real value of most going concerns (as we saw earlier in this section). So value-based measures tend to have the following in common: they are aligned with, or are, actual representations of market value, they are current expressions of forecast performance, they are based on or are approximations of cashflow, they incorporate risk, as reflected in the cost of capital. Many techniques have been widely adopted, particularly among US companies and multinationals, but they all have limitations and their allure has been somewhat damaged by the fall in equity markets after the millennium. EVA, SVA, and CFROI [Note 11] all use a discounted cashflow as their vehicle, an important tool for strategic evaluation which we will explore in more conventional settings in the next section.
Theoretical Interpretation Value of equity Value of debt present value of future dividends present value of interest and repayments discounted at the yield to redemption present value of future cashflows value of the firm plus the value of any synergies
Market Interpretation share price x number of shares (market value) market value (MV) of debt plus outstanding loans, etc
MV of equity plus the value of debt what someone is willing to pay for control
Economic value
[11] EVA Economic Value Added; SVA Shareholder Value Added; CFROI CashFlow Return on Investment.
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Before we move on though, review Table 5.3. It attempts to define the different notions of value and how they are reflected in the market and captured in the books of account. The different interpretations that can be placed on a business that is a going concern is evidence enough that a balance sheet cannot attempt to represent value on this basis. The closest it comes is when another business is acquired (and a full economic value is paid after negotiation) where the payment cannot simply be represented by the tangible assets at a fair value. The excess is treated as goodwill and amortised over the estimated life of the acquisitions benefit to the company. Thus, intellectual capital (discussed in Chapter 7) is included in the accounts, but only when acquired, not when it is developed from within. The intellectual capital the people, organisation, systems, knowledge, and brands is what provides most companies with their potential and explains the major difference between market and book value.
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 2 Accounting and its relationship to shareholder value and business structure
Concluding Comments
The elaboration upon Collier, Chapter 2 given here is deliberate, to provide you with an adequate excursion into finance to better understand the limitations of financial accounting and to serve as an introduction to the management accounting sections of this study book. References and questions are limited in Collier (though you could try Questions 6.6 and 6.7 in his Appendix 1), so the following makes good this deficit.
References
Atrill, P. (2003), Financial Management for Non-Specialists, 3rd edition, Prentice Hall
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Gowthorpe, C. (2005), Business Accounting and Finance for Non-Specialists, 2nd edition, Thomson Learning Grundy, Johnson and Scholes (1998), Exploring Strategic Financial Management, Prentice Hall Neale and McElroy (2004), Business Finance: A value-based approach, Prentice Hall
Exercises
A solution to Exercise 5.1 is provided in Appendix A. 5.1 From the following data, calculate the return of capital employed, the return on equity, the earnings yield and the dividend yield:
capital & reserves long-term liabilities operating profit interest payable dividend cover price/earnings ratio
Ignore taxation. 5.2 Get the main business newspaper for your country and look at the stock market data. Find your best known clothes retailer and note its data in the catagories used in Table 5.1 earlier in this section. Compare the movement in its share price with the stock markets index over the last year, and its yield and p/e ratio with the sector average. Why is it divergent? If you cant offer plausible reasons, read business commentaries on the sector or visit the companys website and see if its annual report provides clues.
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2001 Number of shares in issue as at Jan. 31st (millions) Balance sheet (as at Jan. 31st), m Ordinary share capital (10 pence face value) Shareholders Funds 34 500 337
2002 331
2003 287
2004 265
2005 261
2006 246
33 547
29 275
27 155
26 276
25 256
Table 5.4 Selected share and shareholder information for Next (source: Next plc Annual Reports).
Over the past five years, there have been significant achievements by NEXT in many areas. Sales have almost doubled, accompanied by a doubling of profit and an even greater increase in earnings per share. During that time we have returned 1.4bn to shareholders through dividends and share
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buybacks. We have also succeeded in delivering excellent levels of capital growth through a rising share price. (Chairmans statement, Next plc Annual Report, 2006) From [Chairman] David Jones statement, the significance of share repurchase and earnings per share is evident. The two are related: with no change in profit, the buying back of shares reduces them in number and automatically causes an increase in earnings per share (EPS) dividend growth is shown in Figure 5.2. Achieve both at the same time as Next plc have done over the last five years and there is a compounded growth in EPS. But theres a catch: maintain growth in profit and the value of the company its market capitalisation is spread over a smaller share base, and so the price will tend to rise inexorably (see Figure 5.3). Each successive tranche of repurchases will cost more per share, and free cashflow has to keep pace with the growth in profit and with the growth in share price, otherwise, Next plc will have to borrow debt to finance the repayment of equity, and this will increase gearing and the financial risk to the shareholders, and that will put downward pressure on the share price.
44 41 35 31
Dividend per Share (pence)
27.5
2002
2003
2004
2005
2006
The share buy-back programme is a coherent financial strategy to deliver exceptional returns for its shareholders, but can only be sustained if operational growth remains lean in funding terms. The strategy shows no signs of abating, The authority to purchase shares is renewable annually and approval will be sought from shareholders at the Annual General Meeting in 2006 to renew the authority. (p10)
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but involves an increase in maximum borrowing powers from 1bn to 1.5bn, The proposed increase is required to give the Company sufficient headroom to develop its business and accommodate share buybacks (p14)
high = 1772
low = 700
Figure 5.3 Nexts share price in pence on the London Stock Exchange (source: www.citywire.co.uk).
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of 70% of the annual salary. Next plc must be at least the median company for any entitlement to arise. In the three year period leading up to January 2006, Next plc was ranked third or fourth in its peer group. a voluntary participation in a risk/reward investment plan involving contributory investment in financial derivatives whose return will depend on the level of Next plcs share price in 2009. [The] policy is structured to provide a mix of remuneration to ensure that no one component or measure dominates and that interests are aligned over different time periods with other employees and shareholders. (p20)
2001 Number of share options outstanding at January 31st (millions) Average exercise price 12.7 502p
Table 5.5 Nexts employee share ownership scheme (source: Next plc Annual Reports).
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Exercises
Now try these exercises. Outline solutions are given in Appendix B. (5a) Explain the meaning of the terms share price, exercise price, and face value. (5b) Explain the term market capitalisation and roughly calculate its latest value for Next using the tabulated and graphical data. (5c) Recalculate the gearing ratio using market values and contrast the level with the previous assessment in Section 3. Assume the market value of debt is close to its book value. (5d) Using the dividend and share price data, roughly assess the shareholder return over the five year period and its annualised equivalent (note that you will find this easier on a per share basis). (5e) Assume this annualised return is required by shareholders in future. If the after-tax cost of debt capital is 4%, what is Next plcs weighted average cost of capital? (5f) Undertake calculations that show how David Jones came to the figure of 1.4 billion.
(5g) To what extent do you think that the directors remuneration package has contributed to Next plcs financial performance? (5h) Assume you are an employee of Next plc and bought options in 2001, 2002, and 2003, exercised them after three years, and sold the shares on the open market. Perform rough calculations of the percentage gain you would have made on each of the three holdings. If you had subscribed to the maximum amount per month, what would your total gain have been?
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MN7006/D SECTION 6
Section 6
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classified, synthesised, analysed, and interpreted. It is primarily financial, but will have quantitative and qualitative content. It will use sources internal and external to the organisation, and its purpose and recipients may be at any level within that organisation. To plan and control activities, management accounts are normally prepared on a frequent basis, in detailed or summated form to suit the purpose, authority and comprehension of the recipient, but result in derived performance indicators that are aligned to factors critical to the activity concerned. For decisions, information is often uniquely devised to provide essential knowledge for the decision maker.
Decision theory
Figure 6.1 sets out the logical steps in the decision making process: in reality, many decisions are not comprehensively considered, are made under time pressure with incomplete knowledge, and omit one or many of the steps outlined: Step 0 when present, a problem requires the use of subjective judgement as to its urgency, priority and whether its potential significance merits the cost of determining and correcting its cause. the setting of objectives triggers decisions over the resources required for their achievement. No decision can be constructively made in the absence of objectives since no judgemental criteria will exist. Similarly, conflicting objectives lead to confusion. the identification of alternatives may be simple, may involve many in imaginative thought, or require a structured search. There are always alternatives, if only to do nothing. The availability and accuracy of data should be considered in the context of time and cost constraints. Invariably, some imperfection in the database will exist and the decision maker will have to judge the risk that any omission or fault would render a decision inappropriate or, at best, sub-optimal. if the data is financially quantifiable, this is often the simplest part of the process. There is usually an appropriate technique or model available for the evaluation (we will examine one of these later in this section).
Step 1
Step 2
Step 3
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Step 4
this is to ensure that objective criteria are met if not, then further iterations of Steps 2 and 3 should occur, or the process be abandoned. this is the planning and control process, further explored in Section 9.
Step 5
problem recognition
Problem Analysis
assess priority
define objectives
identify alternatives
ascertain data
Decision Taking
implement
feedback
Step 5
Step 4
Step 3
Step 2
Step 1
Step 0
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Decision relevance
The fundamental quality required of management accounting information is its relevance to the decision context. Historic costs and book values prepared on a going-concern basis mis-inform when used in a decision about factory closure, plant replacement, acquisition, pricing, capacity planning, etc. In fact, the use of any routine cost or profit data is fraught with danger because accountants attribute nominal charges like depreciation and central overheads. Decisions are always about the future and therefore only the incremental financial consequences of taking or not taking a decision are relevant. In practice, this means cashflow. When faced with a decision, ask the question, What additional cash will flow into and out of the business if we do this?
Characteristics of decisions
The nature of decisions, and the management accounting information that supports them, is heavily dependent upon the level within an organisation at which they are taken. Robert Anthony [Note 12] suggested that organisational management can be classified into three components: strategic planning the setting of aims, strategies and policies to meet the organisations vision, management control resource acquisition, deployment, co-ordination, monitoring, operational control organising and monitoring of specific tasks. The problems encountered in routine operations (e.g. the rejection of a credit card at an EPOS machine) are repetitive, and decisions can be programmed (e.g. training check-out operators as to their response) because outcomes can be predicted. In this way, operational control can be viewed as a feedback system (see also Section 9 later) where a deviation from the standard process occurs and corrective action is taken to return the system to equilibrium (e.g. the sale is refused or alternative payment arrangements made).
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Strategic planning, except in extremely stable business environments, involves an act of faith in the future that the vision is approximately correct and the strategies devised to achieve goals in the context of that vision are successful. A high degree of uncertainty exists in the picture that the vision portrays, the organisations position in it, and markets, competitive and regulatory responses to the strategies. The strategic decision is unprogrammed, as the outcome cannot be predicted with any certainty. It is for this reason that strategic planning is often emergent or incremental (see Colliers discussion in his Chapter 14) in that it is a small step away from the present the known. The significant value of forward-looking, external, qualitative information is obvious in this regard. Management control has elements of both strategic planning and operational control, but its forward horizon is often defined by the budget, and its external interaction limited to contractual interactions with customers or suppliers. Traditionally, management accounting concentrates upon managements internal control of resources budgeting (see Section 9) and costing (Section 8) and insufficient attention has been paid toward pricing (Section 7) and leading indicators of performance (Section 10). These are now being addressed in a forward-outward re-orientation that will assist strategic decision making. These three components are contrasted further in Table 6.1.
Strategic Planning Organisation level Type of problem Nature of decision Characteristics of information required top, central environmental uncertainty big, long-term, futuristic aggregated, predictive, external, risk-based, contingent
Management Control middle, divisional systemic getting, using, optimising boundaried, current and short-term, internal and tactical, approximate
Operational Control bottom, local irritations mechanistic, reactive detailed, current, internal, certain
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organising in a global marketplace. You are expected to recognise that such techniques exist and can be drawn upon to provide more relevant information for strategic decision making. Strategic management accounting techniques exhibit: an external focus that stresses relative financial performance: - in markets, e.g. monitoring market size and share for competitive position, brand valuation, - for customers, e.g. customer profitability analysis, assessing the cost of product attributes, - for competitors, e.g. benchmarking and industry comparison, analysing competitive advantage through the value chain, a forward looking perspective with an emphasis on value and risk, e.g. value-based management techniques (as in Section 5), target costing (see Section 7), project, not period, orientation, e.g. life cycle analysis (see Section 7), investment appraisal (see this section), a combination of monetary and non-financial parameters, e.g. balanced scorecard (Section 10), the performance pyramid and performance prism, total quality management and just-in-time philosophies (see Section 8).
Investment appraisal
The financial evaluation of productive investment opportunities is commonly termed investment appraisal, and it is commonly used in decisions to buy fixed assets since their benefits flow over many years (and are thus strategic purchases). It can however, be applied to any project, including a product launch, marketing campaign, and even corporate acquisitions. Most of Colliers Chapter 14 is devoted to an explanation and detailed illustration of the four main investment appraisal techniques used by organisations. You have already met return on investment (as an accounting ratio in Section 3), but its validity for investment appraisal is flawed because it ignores value and risk. We shall concentrate here upon discounted cashflow, and the net present value (NPV) technique in particular.
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NPV has the important merit of being able to indicate those productive investments that generate returns greater than the cost of their funding. It therefore satisfies the primary financial criteria for strategic decision making. NPV represents the theoretical change in the current economic value of a business resulting from an investment in its future. It converts projected cashflows into a present value by reducing them by a charge which represents the risk-adjusted cost of capital. To see how this is done requires a minor diversion into the time value of money. Put simply, $1 today is worth more than $1 in the future since inflation will reduce its spending power in terms of goods and services, and its value could have been increased through investment over the intervening period. This is an opportunity cost, since we are not able to use the $1 to, for example, buy things whilst the money has, for example, been lent to someone else. Thus, we make a charge for that loss of liquidity. We will also require compensation for any price inflation which erodes the purchasing power of the money lent when it is finally returned if it is returned. And risk is the third reason for making a charge risk of non-payment, a risk that will depend on the riskiness of the use to which the money is put. Since the growth rate of money supply (inflation) and the availability of credit (liquidity) will be consistent across an economy, it is the perceived risk of a business and the projects in which it invests that will determine a credit rating and thus the price of the funds that are lent to its management. As first discussed in Section 5 then, the cost of capital incorporates a risk assessment and communicates a benchmark, above which productive returns must be earned in order that economic value is created. Interest is charged on a compound basis that is, it is added to the principal sum borrowed. The interest paid on $1 over a year @ 12% is as follows, simple interest interest compounded annually interest compounded quarterly interest compounded monthly $1 0.12 $1 0.121 $1 0.034 $1 0.0112 = 12 cents = 12c = 12.55c = 12.67c
and the resulting compounded amount (i.e. $1.1267) is called the terminal value. Rather than compounding amounts forward to determine a terminal value, investment appraisal takes future cashflows and discounts them back to their present value. This is so that the change in value is expressed in terms of the time at which the decision is made. Discounting cashflows is valid for
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short-run decisions (i.e. less than a year), but since the effect of the time value of money becomes immaterial, tends not to be used. The technique is often applied to long-term decisions on a project-by-project basis where the periodicity of compounding adopted is conventionally a year, Present Value = Cashflow y (1 + Discount Rate) y
where y is the year 1, 2, 3, etc. the present year being equal to 0. A discounted cashflow table is usually constructed on a spreadsheet. The time of decision is set at year 0 and the initial investment and subsequent cashflows tabulated. The discount factor is then calculated for each year and multiplied by the cashflow in that year to determine its present value. Table 6.2 provides a fairly typical layout.
Year 0 1 2 etc
Discount Factor =1 = 1 (1+Discount Rate) = 1 (1+Discount Rate)2 etc, with power = year NPV =
PV Column 2x3
sum
The sum of all the present values is the net present value of the investment opportunity. If the NPV is positive, then the project is financially viable; if negative, not. The discount rate which results in an NPV of zero is called the internal rate of return and indicates the break-even point in terms of the cost of its funding. An illustration based on Project 2 in Colliers Chapter 14 is shown in Tables 6.3 and 6.4, and Figure 6.2.
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Year 0 1 2 3 4 5
Present Value 125,000 31,145 27,715 24,663 21,947 19,530 Net Present Value = 0
Table 6.3 Cashflow table, Project 2 (see Colliers Table 14.7 where the discount rate is 12.4%).
60,000 40,000 Internal Rate of Return = 12.4% 20,000 0 0% 20,000 40,000 60,000 5% 10% 15% 20% 25% 30% 35% Discount Rate
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Here the IRR is 12.4%. If the cost of capital upon which the discount rate is based is lower than 12.4%, the NPV is positive and the productive return exceeds its cost of funding. As the discount rate increases, the NPV falls further. Note that investment appraisal techniques that employ discounting use the projected cashflows of a project and not future profits. Profits are accrued, include arbitrary allocations like depreciation, but ignore working capital which requires funding. Cashflows occur at discrete intervals and can represent any monetary consequence relevant to a strategic decision.
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 14 Strategic investment decisions
Concluding Comments
Work your way through the three-project example in Collier, Chapter 14 and note that the four different techniques provide inconsistent signals over the viability of and ranking between the three. This is because of theoretical limitations with the techniques which are discussed in the chapter. You should remember that NPV will provide a correct indication for a strategic decision in virtually all contexts and is therefore the approach that should be consistently adopted. To practice your knowledge of investment appraisal techniques, attempt Question 14.5 using the discount factors provided in the table at the end of Colliers Chapter 14. Then set up a discounted cashflow table on a spreadsheet using Question 14.1 in his Appendix 1, using the formulae provided in this section to calculate a discount factor based on the cell containing the discount rate. You will be able to calculate an accurate internal rate of return for the project by trial and error: if the NPV is positive, increase the discount rate until the NPV becomes zero; if negative, reduce the rate. Questions involving the relevance of financial information occur throughout Colliers Appendix 1, but Questions 10.4 and 11.6 are particularly useful.
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The technology
Dynamic demand control is a technology that can be incorporated into electrical appliances which enables them to provide important services to the power grid such as peak load management and second-to-second balancing of supply and demand. The governments Department for Environment, Food and Rural Affairs has already funded a laboratory test of dynamic demand control refrigerators by Intertek. A fridge needs electricity, but it doesnt really care exactly when it gets it. Fridges have large thermal storage. It should be possible to provide the same stabilising service to the National Grid more cost-effectively
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using dynamic demand fridges. This means such a fridge could earn money throughout its life. Any electrical appliance that is time-flexible (in other words, is not too sensitive to when its energy is delivered) could be used. These could include industrial or commercial air conditioners, water heaters and refrigeration. Thousands (and eventually millions) of such loads acting in aggregation could provide an extremely simple and cost-effective way of helping to manage the power grid. To date, Dynamic Demand has focused its attention on the potential for such services in relation to domestic and industrial refrigeration. Research is becoming available which indicates that an aggregation of such intelligent loads could be extremely beneficial, for example by smoothing out the minute-to-minute and hourly variations in demand on the grid. This would replace certain types of back-up generation and hence increase efficiency. In future, the technology could be used to smooth the supply from renewable power. This could theoretically allow a greater amount of renewables to be connected.
The economics
At every second of every day, the National Grid must ensure that electricity supply precisely matches the continually changing demand. Although most of the large changes in demand are predictable (such as the peak which occurs around 6pm each day, when people all over the country get home from work, switch on lights, and turn on many electrical appliances), there are continuous smaller fluctuations which are essentially random. And there is also always the possibility that a sudden large fluctuation could occur at any time if a power line or generating station fails. For these reasons, the National Grid pays for reserve which involves certain power plants running at reduced output so they are able to inject extra power into the grid as it is needed. The National Grid also has to pay for some of these generators to go into a special response mode whereby they continually change their power output to respond to random changes in demand. These so called ancillary services are expensive. Response alone costs in excess of 80m per year and is likely to increase in price. Also, the need for these services will increase because of the added unpredictability of renewable energy sources. Dynamic Demand Control could provide many if not all of these services for a fraction of the cost. Instead of the supply responding
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dynamically to unpredicted changes, certain sections of demand react instead. This means, in principle, for example, if a refrigerator manufacturer incorporated cheap controllers into their units, they could be earning millions each year from the National Grid; with only a tiny increase in the unit cost. Not only that at the same time they could help the shift towards greater use of renewable energy and help reduce carbon dioxide emissions from the operation of the power system. The potential of this technology is a reduction in CO2 emissions of the order of 2 megatons a year.
Political support
The Climate Change and Sustainable Energy Bill, which carries a clause requiring the Government to report on the potential for dynamic demand technologies, passed its final stage in Parliament today (June 20th 2006). the Bill says, The Secretary of State must, not later than 12 months after this section comes into force, publish a report on the contribution that is capable of being made by dynamic demand technologies to reducing emissions of greenhouse gases in Great Britain.
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For the European Union, the target was a reduction of 8% on 1990 levels. Carbon dioxide (CO2) is one of the most significant pollutants, and the EU allocated emission allowances that reflect its overall target amongst member nations, who in turn allocate them to industry. 12,000 industrial plants have individual allowances within the EU, amounting to about half the total CO2 emissions produced. In 2005, the EU set up an Emissions Trading Scheme where these allowances could be traded on the European Climate Exchange (ECX). The carbon price is the price of an allowance to emit one metric tonne of carbon dioxide, and futures contracts in these allowances are available up to the year 2012. During 2006, the carbon price fluctuated widely between 10 and 29 Euros () and futures prices as at September 2006 were as shown in Table 6.5.
Year Price
2006 12.00
2007 12.50
2008 15.50
2009 16.00
2010 16.50
2011 17.00
2012 18.00
Megawot supplies 50% of the UKs electricity using a combination of gas and coal-fired power stations. As gas is currently cheaper and less pollutive, the base demand for electricity is provided by this fuel, leaving older, less efficient coal-fired plants to meet the peak load. Megawots heavy reliance upon fossil fuels means that it breaches CO2 emission allowances and therefore has to purchase carbon credits (i.e. spare allowances) on the ECX, and these represent a cost to its business. With rising demand for electricity, Megawots cost of compliance with emission allowances will rise further though of course, it benefits from the profit made in supplying the additional electricity. With rising public concern over climate change, Megawot as a major emitter of greenhouse gases has been recently subject to organised protests outside some of its coal-fired power stations. Adverse media coverage has damaged its image. Megawot sees the dynamic demand legislation and technology as providing it with the scope to meet its supply obligations to the national grid and balancing its load, thus reducing its dependence on coal-fired electricity generation, and consequently its need for CO 2 emission allowances. Megawot is willing to make a substantial contribution to a European consortium of fridge manufacturers who are adapting the freely available dynamic demand technology. It is expected that this technology can be incorporated into new fridge and freezer ranges from 2008. Recognising that the technology could make a considerable contribution to the UKs achievement of its national target under the Kyoto protocol, the government
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has agreed to prohibit the sale of new domestic refridgeration appliances without the technology from 2010. There are about 45 million domestic fridge/freezers in the UK. Their average life is nine years. Three million new appliances are sold every year.
Exercises
Now try these exercises. Outline solutions are given in Appendix B. (6a) Assume that every new appliance sold from 2008 is fitted with the device, that Dynamic Demands assessment of savings in CO2 emissions is correct, and that Megawot will continue to supply 50% of UK electricity generation. Work out the accumulated saving in CO 2 emissions for Megawots output between 2008 and 2022. (Note, a megaton = one million tonnes.) (6b) Evaluate the saving in carbon credits that would otherwise have to be purchased (in ) based on the futures prices from the ECX. Assume the annual increase will continue until the year 2022. These represent cashflow savings to Megawot over the fifteen year period. (6c) Megawots cost of capital has been stable at 10% since the year 2000, but the share price has been in decline as concerns have grown about the amount of investment needed in clean technologies with no commercial gain. Megawot believes that the dynamic demand technology will be regarded as a cheaper way to meet its obligation and reduce its business risk. It therefore intends to use a discount rate of 10% in its evaluation of the potential cashflow savings. Calculate the present value of these savings over the 15 years to 2022 to determine the maximum sum it should be prepared to contribute to the European consortium development. (6d) Identify potential inaccuracies in your evaluation. (6e) What other strategic considerations would bear upon Megawots decision to support this initiative? Consider the commercial future of its coal-based plants, its social responsibilities, and other strategic alternatives.
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MN7006/D SECTION 7
Marketing Decisions
Section 7
Marketing Decisions
Learning Objectives
This section primarily concerns itself with pricing. The second and third objectives in the Module Outline are particularly pertinent: to critically question the parameters under which accounting information has been provided and to call for appropriate accounting data. After studying this section and its reading, you should: understand the limitations of cost-based pricing, understand the impact of volume and life cycle on costs, prices and cashflows, and appreciate economics and market-based approaches to pricing.
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ROCE =
You will also recall that margin is a useful indicator of profitability as it relates costs to sales, Gross Margin = Sales - Cost of Sales 100% Sales
Accountants attribute costs to the sales to which they relate (Section 2), but the basis of attribution varies [Note 13] so external users cannot be sure what these costs contain. Some of these costs vary with the volume sold (e.g. the purchase price of goods sold in retailing or wholesaling), but others are more fixed in behaviour (e.g. depreciation, rent, administrative staff) and are only partially affected by changes in volume. This is good when sales are rising as the effect of (operational) gearing means that there will be a greater than pro-rata increase in profit. However, if sales fall a business with a substantial proportion of fixed costs can easily find itself making a loss. It is obviously important to know the break-even point in sales above which profits are made. For individual products, the break-even point can be expressed in terms of units of product sold because, Sales = Volume (in units) Selling Price (per unit) For internal purposes, the analysis of cost can reflect its behaviour in relation to volume and accountants use the concept of contribution to depict this, Sales - Variable Costs = Contribution Contribution - Fixed Costs = Profit thus, Contribution = Fixed Costs + Profit So, if sales of $1m are made on volumes of 50,000kg, where the variable cost is $8 per kg and fixed costs are $400,000,
[13] Common approaches include marginal costing, full (or absorption) costing, activity based costing, and throughput accounting.
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Contribution = $1m - (50,000 $8) = $600,000 [or $12 per kg] = $400,000 + $200,000 profit The break-even point is where contribution equals fixed cost, in this case $400,000, $400,000 = 33,333kg in volume $12 per kg = 666,666 in sales From these linear relationships, charts can be drawn which depict the break-even point for a business or a product. Examples of these and the associated formulae are provided in Colliers Chapter 10. This is useful for marketers as they can target a minimum volume to be sold in a campaign, however, this assumes that the selling price will not deter customer demand. How do we set the price?
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A full cost basis threatens to make a selling price uncompetitive because of the following circular logic. In the example, fixed costs are $400,000 on volumes of 50,000kg and the overhead absorption rate would be 400,000/50,000 or $8 per kg. When added to the variable cost of $8, a full cost of $16 requires a mark-up of 25% to reach the selling price. Now, say demand was to fall to 40,000 kg at this price. At this volume the absorption is only 8 40,000 or $320,000 and the fixed costs of $400,000 are not fully recovered. So accountants will increase the absorption rate to 400,000/40,000 or $10 per kg, and the full cost will rise to $18 per kg. Applying the established mark-up of 25% to this figure would drive the selling price up to $22.50. So, at a time when falling demand is undermining profitability, there is a pressure from cost accounting to increase selling price an action likely to exacerbate the trend in demand!
sales
Profit
total costs
Volume
Volume
Accounting has traditionally over-simplified the relation between volume, selling price and profit. The break-even charts in Collier, Chapter 10 are actually based upon economic theory: the left side of the upper part of Figure 7.1. Economic theory recognises the price elasticity of demand and that the marginal cost (of an additional unit) will fall with an organisation's learning curve and economy of scale. This means that selling prices are not constant and fall to stimulate demand until sales reduce because the increase in volume does not compensate for the reduction in price. Sales therefore reach a peak beyond which price increases result in negative marginal revenue. The theory indicates that profits are maximised when the increase in cost of selling an
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additional unit is greater than the increase in sales generated, i.e. optimal volume occurs where, Marginal Revenue = Marginal Cost Collier accepts that, CVP is used by accountants in a relatively simple manner and identifies a relevant range on the graphs within which linear interpolation is practicable. Marketing decisions, and pricing in particular, require a more sophisticated contribution from management accounting. Profits, we have learnt, vary in a partial, non-linear manner in relation to volume sold. Profits also vary over time, in that passage through a products life cycle will create different economic and competitive opportunities and pressures upon demand, pricing and cost structures. This is examined now, though you will find the life cycle in Colliers Chapter 11, which forms the core of Section 8 of this study book.
sales
profit risk
development
saturation
research
launch
growth
birth
decline
cashflow
maturity
death
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Up to the launch of the product, cash flows out to fund product development, equipment, marketing, and stock. Financial risks rise over this period in parallel with funding. If the launch is successful, business risks abate but cashflow remains neutral because growth will require expanded facilities and working capital. During this period, selling price and profit per unit is highest as the product has market leadership and demand outpaces supply. Competitors will enter the field at discount prices and force margins down until the market is saturated. Working capital remains constant and no further investment will be made into product or process and cash is harvested. During decline, volumes fall suppressing sales, and profits remain lower than cashflow because development costs and fixed assets are being depreciated or amortised over the products commercial life. It is evident then, that prices and costs are dynamic over time and are not simply subject to the influence of volume. The ability to command high prices results from product leadership or significant market share and these advantages are likely to decline in time as competitors respond and demand is satiated. Unit costs reduce with experience, value engineering and economies of scale, but competitors following up the innovator will seek to reduce the cost base further. Product innovations which enable a dominant market share to be established offer the best chance of securing the high price needed to recoup marketing and research and development costs. The majority of unit production costs are committed once design is complete, so value analysis involving the marketing functions understanding of what customers will value in the product and cost analysis of various process and supply chain configurations at the design stage is critical. In evaluating commercial development, management accountants must not take a static view of cost or advocate cost-plus pricing: a discounted cashflow over the life cycle should be used and the decision made contingent upon the net present value. In this way, changes in price, cost and volume can be accommodated in the evaluation as well as investments in fixed and working capital. Where the life cycle is expected to be short or the entry barriers to competitors are minor, the key aim should be to recover the cash costs incurred in the pre-launch stage rapidly. Finally, given that selling prices will inexorably fall, it is important not to under-price at product launch and to recognise that unit cost reduction must keep pace with this fall so as to protect margins for as long as possible.
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Target costing
Target costing is an approach to pricing which incorporates the effect of the life cycle on margins. Figure 7.3 shows the price and cost of one unit of an innovative product. Both fall, the former from the launch date, the latter from a prototype, until the mature stage of the life cycle is reached. At this point, supply meets demand, selling price is stable, and competitors who have developed similar products must be profitable to participate in the market. Target costing assumes that the level of this profit will equate to the average return on investment of the sector, and that by deducting this margin from the forecast long-run price a unit cost can be targeted. If the product team believe that cost can be reduced to the target cost in the time it takes to reach maturity, then the product is viable and should be launched. To recover development costs, a minimum margin must be maintained on the planned cost reduction so that selling prices are also planned starting at maturity and working back to a market-skimming price at launch. The direction of the arrows on the price and cost curves indicates this process.
Money
unit cost
Launch
Maturity Time
Market pricing
For most businesses, products are not innovative or covered by patent, and face many substitutes in the market: they do not possess significant market share (and hence market power) and are price followers. The pricing decision
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is a tactical one, but always made with regard to the prevailing price in the market. An example of this is a loaf of bread offered by a bakery. If products have real or perceived attributes that differentiate themselves from others, there is scope for pricing at a premium to the market average (e.g. organic food). The building of brands and niches is a way of achieving this: a niche is a small market segment where local dominance is possible (e.g. luxury brands in travel accessories). Differential pricing is possible where markets can be segmented by time, geography, quantity, etc. (e.g. the rail fare for commuting and off-peak periods). Penetrative pricing is used to rapidly establish a presence by under-cutting existing prices in an undifferentiated market (e.g. low-cost airlines), but deep pockets are necessary to withstand losses whilst share is being built. This might be a particularly attractive approach where the market is set for growth (e.g. cell phones), or economic potential is substantial (e.g. China). From these illustrations, it is evident that there is a wide range of pricing strategies available, and whilst price is but one component in the marketing mix, it is of central importance to profitability. From the discussion in this section, it should also be evident that cost-plus pricing is discouraged, and that the role of management accounting is to ensure that any pricing strategy will cover costs over its term.
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 10 Marketing decisions
Concluding Comments
Collier exhibits some of the scepticism about the usefulness of accounting teaching toward pricing that is liberally displayed in this section. Remember the limitations as you work through his exercises on break-even and contribution analysis. Ignore the short section on transfer pricing, but the SuperTech example is particularly informative as it demonstrates the use of publicly available accounting data to inform a
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tactical decision. Questions 10.3, 10.10, 10.11, and 10.12 in his Appendix 1 offer you adequate practice in the calculation of marginal costs, mark-up, and break-even points.
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(Eurac) that has not previously sold into the UK market. Pearl has received a design specification that will require it to commit considerable resources to re-engineer for chip production. Eurac initially requires 300,000 units in 2009, but the market in subsequent years could rise dramatically. It is expected that other governments will follow the UKs lead as a way to meet their Kyoto commitments, and many ecologically-concerned consumers elsewhere in the world are also demanding dynamic demand models. Pearl has costed the design and production engineering resource required at HK$1.5 million. The metallic, silicon and other raw materials are standard for micro-chip manufacturer and minimal in cost some HK$2 per unit; protective packaging, a further HK$1. Shipment and air freight cost to the EU for batches of 1,000 of these small, light-weight components is HK$5,000. Micro-chips are manufactured in a highly automated, sterile environment, the cost of which is almost wholly fixed. Pearl attributes a portion of this fixed cost to each production order in Euracs case, it would be HK$12 million.
Exercises
Now try these exercises. Outline soloutions are given in Appendix B. (7a) Assuming Pearl prices its micro-chip in line with the Korean company, calculate the contribution per unit, the net profit margin, and the break-even point in units. Pearl wishes to recover the cost of design and engineering over the first years order. The exchange rate of the Hong Kong dollar to the Euro is 10HK$ = 1. Interpret your result. Should Pearl accept the order? (7b) By 2009, the Korean company will have established market leadership with a 20% share. The UK market is 3 million units with a further 1 million in other EU countries and 1 million in the rest of the world as the potential of the technology attains wider recognition. It is forecast that the demand outside the UK will rise by 500% next year and will continue to grow until 2017 at least. The mature market price of dynamic demand chips is forecast to be 3. Because of past over-ambitious investment, the global micro-chip industry has significant under-utilised capacity and pricing is competitive. Average net margins are low (4%), and returns on investment are barely covering the cost of capital. Dynamic demand technology will help redress the imbalance between supply and demand. Pearl Delta Manufacturing has the capacity to produce 4 million micro-chips per annum on a two-shift system. It is currently operating
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at 75% utilisation, including the Eurac order. If Pearl operated three shifts, what would be the maximum annual production of dynamic demand devices? Assuming Pearl could find orders to utilise this uplifted capacity and that 24 hour working would increase fixed costs by only 10%, what would the fixed cost per unit become? If the Eurac orders size and variable costs are generally representative but subsequent design and engineering costs could be halved per order, what would the total unit cost of a dynamic demand micro-chip fall to? (7c) If Pearl is to fill this capacity, it will have to make approaches to a wider range of refridgeration appliance manufacturers. With consideration to the size of the market, the profile of the life cycle, and its position in the market, would you advise Pearl to take this strategic step? If it enters the broader market, what pricing strategy should Pearl adopt? Consider cost plus approaches, target costs, and the Korean companys price setting capability. Note that there is no single correct solution. The Euro and sterling have appreciated against the Hong Kong $ over the last year. What implication might this have strategically for Pearl Delta Manufacturing?
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MN7006/D SECTION 8
Operating Decisions
Section 8
Operating Decisions
Learning Objectives
This section continues the theme of Section 7 in critically examining management accounting practice in different contemporary contexts. After studying this section and its readings, you should: appreciate how resource management is supported by accounting, understand the innovative effect of TQM and JIT philosophies upon management accounting, and recognise the problems associated with accounting for services.
Resources
Operating decisions are about resources. They are about how management select and organise resources to most effectively meet output requirements. What are these resources? They can be referred to as the five Ms: money, manpower, materials, machines, and managers.
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In more informative terms, resources include: physical infrastructure, including equipment, technology, software and systems, bought-in supplies and services, staff, outsourced personnel, and their intellectual capital, funding for fixed and current assets, and for innovation and development. Resources are a means to an end, and so anything that is harnessed to achieve organisation aims is a resource. In businesses, the outputs are sold and resource management aims to deliver customer value and profit. In not-for-profit bodies, outputs are public goods and resource management aims to deliver value-for-money and efficiency.
Farming
Harvesting
Wholesaler
Canning
Processing
Restauranteur
Retailer (Grocer)
Consumer
Figure 8.1 A simplistic value chain for the food processing industry.
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The value chain, described in Colliers Chapter 11, is a useful tool for examining how resources are deployed and which activities are performed within or external to the organisation. The purpose is to ask, Why are we doing it and why are we doing it that way? If an activity does not create value, or creates insufficient value, then we should consider re-engineering it. If a resource is not economic or appears less efficiently employed than by a competitor, we should seek an alternative source or apply a different technology. Consider food processing Figure 8.1 shows a simplistic industry value chain. The blocks and arrows show value-adding activities. The blocks include organic produce from the farm gate to prepared meals at hotels (which may have been bought in cook-chill packs). The arrows range from herding cattle to market to pizza deliveries. Is each activity undertaken by a separate entity? Why do some companies vertically integrate to different degrees and over different ranges of the supply chain? Why do some outsource their logistics while others have their own fleets? Why are some farms heavily mechanised whilst others use manual labour? Why do some restaurants employ full-time staff whilst others use casuals? Why do some processors out-source their support functions? By observation, research and analysis, we can form views of the relative costs of operations and the value added at each stage of the chain. This informs the strategic engagement of activities and resource dependencies. Not-for-profit organisations (NFPOs) do not sell their primary outputs and Michael Porters value chain is rarely applied (although it could be). However, they should seek to provide value-for-money and this can be assessed by peer comparison and trend analysis. A simple input-process-output model will illustrate, as seen in Figure 8.2.
Resources (money) INPUT Economy (cost per unit) PROCESS Efficiency (output/input)
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Resources, which cost money and can be costed, are inputs to the process that creates the product or service for beneficiaries (the public good). Unlike commercial businesses who strive to stimulate demand but have readily available resources, NFPOs have insatiable demand but limited resources. So there is no market parameter (e.g. profit) to judge performance, and output is assessed in terms of whether it has met organisational goals, i.e. its effectiveness. Resources are invariably limited by funding, but can be assessed in terms of the cost per unit of resource used (economy) and benchmarked. NFPOs can be economical but ineffective, and they can achieve their goals at huge expense, so value for money is measured in terms of some measure of their output in relation to cost input: this is their efficiency. To understand the model, consider the treatment of lung cancer. A measure of economy is the daily cost per patient; effectiveness can be measured in the survivorship rate after five years; efficiency can be measured in the average treatment cost per survivor.
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costs and their consequent relative profitability has been questioned. Absorption on the basis of the volume of production will understate the cost of complex products manufactured in short-runs and overstate the cost of simply designed, large batches. Advocates of activity-based costing argue instead that it is activities rather than volume that drives cost and overhead costs should be attributed to the main activities (rather than functions) of an organisation. They should then be absorbed into products using multiple criteria rather than solely a volumetric parameter. Marginal costing, which you first met in the last section, classifies resource costs according to whether they vary with production volumes. In practice this means that treatment of direct costs is similar to absorption costing. However, marginal costing ignores fixed overhead costs when costing a product, writing them off against profit in the period in which they occur. This will result in a lower value of finished stock and different profits being reported than with the other approaches. Nevertheless, decisions about volume changes (as we saw with break-even analysis), product prioritisation, or resource constraints can only be made using marginal costing. This is because fixed costs, by definition, wont change and are irrelevant to a decision and only marginal costing recognises this. Similarly, decisions about whether to outsource parts of the manufacturing process can only be made when the contribution foregone toward fixed costs is considered. Examples of these decision scenarios are provided in Collier, Chapter 11.
[14] Examples of these technologies are computerised design and manufacture, robotics, automated material handling, flexible manufacturing systems, and manufacturing resource planning.
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Just-in-time (JIT)
primary product manufacturer retailer customers
Production Push
supplier base
JIT purchasing
JIT production
customer
Demand Pull
JIT has literally turned traditional manufacturing and costing orientations inside-out. Historically, economy of scale dictated large batches where raw materials and components were gathered together, pushed down the production line, placed into stock and then sold. Production pushed sales
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activity (see Figure 8.3). Batch or mass production requires the line to be operating close to capacity, tying up substantial capital in an array of plant, work-in-progress, and finished stock. The potential for obsolescence is high. With the arrival of advanced manufacturing technologies, set-up times could be dramatically reduced with automated tool changing and process software. Flexible manufacturing systems meant that one machine possessed the functionality of many, and the length of the line could be reduced and machines clustered in complementary cells served by multi-skilled artisans and automated material handling systems (i.e. conveyors, pallets, and fork-lifts). Production cycle times could be dramatically reduced and the prospect of making to order became realistic, providing suppliers could deliver stock as required. External electronic data interchange provided the capability to interrogate suppliers materials management systems and trigger delivery and replenishment. JIT uses all these capabilities to pursue the goal of manufacturing to customer order where that orders triggers a requirement in finished stock, a routing through the manufacturing process, and a parts list to be satisfied by upstream processes and suppliers. All this has to be incredibly rapid, flexible, and of perfect quality since any component failure will delay the entire assembly. Demand sucks the product along its supply chain. Accounting documentation cannot keep pace with this speed and actual costs are largely irrelevant since they would not be known until long after the product had been delivered. Moreover, costs are largely irrelevant since the installed capacity is fixed, the cells of direct workers are salaried, and only the bought-in supplies will vary with volume sold. The key financial need is for throughput to be high and, as with a pipeline of fixed diameter, this means that the speed with which products flow through the process is critical. Conventional costing priorities had to shift, as seen in Figure 8.4.
Priority 1 2 3
Inventories stocks of raw material, work in progress, and finished goods are fundamentally antithetical to JITs philosophy as they provide a safety net for failure to seamlessly link the supply chain to demand. They therefore
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inhibit the maximisation of throughput and therefore profit. In JIT profit is an inverse function (f) of inventory such that, 1 Profit = f Production Cycle Time Profit = Throughput - (Fixed) Cost Throughput = Sales - Purchases Throughput Accounting Ratio = Throughput Production Cycle Time
Throughput accounting has evolved in response to the JIT philosophy and is a variant of contribution in marginal costing. Variable costs, when deducted from sales, leave contribution but only represent bought-in costs in throughput accounting because labour costs are fixed. Moreover, since inventories are absent, the bought-in costs are actually purchases from the supply chain. This simplifies accounting [Note 15] and enables management to concentrate upon filling capacity with products that have the highest throughput accounting ratio and removing bottlenecks in production flow. Cost management will focus on fixed costs and may use activity-based costing as it provides a better analysis of overhead and its causation. Finally, this re-orientation in management accounting priorities is coupled with non-financial indicators that support continuous improvement in process time (customer delivery time, production cycle time, supplier lead time), productivity (of machinery and labour), and quality.
Service environments
Management accounting has traditionally concentrated upon manufacturing, but service industries comprise an increasing, if not dominant, proportion of our economies. Some services, like professional advice or plumbing, can use
[15] Cost book-keeping does not try to represent transactions through the production process, but flushes aggregate purchases through the accounts when sales are made, reducing administrative costs. This technique is called backflush accounting.
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job costing. Mass services like energy distribution would benefit from throughput accounting. Retailers can take gross margin further by adopting direct product profitability which attributes the costs of space and time in stock turnover and merchandising. However, none of these techniques deal with the distinguishing feature of services which is, unlike products, they are qualitative in nature and cannot be stored until required. Fitzgerald et al (1991, as referenced in Collier, Chapter 11) developed the results and determinants framework to address this deficiency. The framework has multiple dimensions to reflect the breadth of factors involved in operating decisions in a service environment. The key premise is that four factors quality, flexibility, utilisation, and innovation determine the resulting competitive and financial performance of the organisation. The four determinants have a close similarity with important features of advanced manufacturing environments in that quality is critical to sustaining customer loyalty, utilisation is an imperative in a fixed and costly infrastructure (e.g. a shop), and innovation and flexibility of resources are essential to adapt to emerging market needs. Competitiveness stresses the relative market share and position that we acknowledged as being significant in Section 7. Finally, financial parameters include profitability, liquidity and capital structure. Liquidity (see Section 3) comes with the vulnerability from immediate consumption, and capital structure is a reflection of the risk involved in funding a fixed infrastructure.
Key Reading
Now read the following chapters from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 11 Operating decisions Chapter 13 Accounting decisions
Concluding Comments
Questions 11.2, 12.3, 12.7, and 13.10 in Colliers Appendix 1 offer you a range of operational decision situations to examine. Collier covers a lot of ground in Chapter 11 and most of the content is addressed in this or the previous section. I
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have, however, enlarged upon his fleeting reference to the JIT philosophy because of its contemporary importance. Colliers Chapter 13 is included in this section, but most of it is about accounting technicalities and, in my view, irrelevant to your role as managers. You might find the paragraphs on activity-based costing useful, but the main reason for its inclusion are the paragraphs at its end concerning contingency theory, management accounting in Japan, and behavioural implications of management accounting. Behaviour has a key significance in budgeting which is the subject of the next section.
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In (very) simple terms, Pearls process involves the activities depicted in Figure 8.5. (For an error-free interpretation, visit the demonstration at http://www.appliedmaterials.com/HTMAC/animated.html). Pearls micro-chips are made from silicon with layers of nano-scale circuits, separated by intervening
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insulation, and inter-connected at specific points on each circuit by copper links. Silicon is a semi-conductor, in that it can be an insulator or, when activated by ion implantation, a conductor. Circuits are photographed onto successive layers and their three-dimensional form revealed by etching. The underlying raw material is a 25cm diameter silicon wafer which is purchased by Pearl and from which up to 1000 micro-chips can be obtained. Euracs dynamic demand specification enables 500 to be made from each wafer, but each requires five layers of circuitry. Pearls traditional market for audio devices require only two layers, but are larger and only 200 can be produced from a single silicon wafer. This contrast has important implications for production scheduling and cycle times as the copper inter-connections of the Eurac chips place greater demands upon the deposition process. The validity of the engineered design, accuracy of the process, and reliability of the materials used are critical to sustained use of a micro-chip. Pearl Delta Manufacturing is proud of its quality certification and uses six sigma as a philosophy and statistical tool. Testing in its manufacturing process comprises the identification of physical defects at each stage in layer formation and inter-connection, and in individual testing of each completed micro-chip. This occurs after they have been cut from the wafer and takes the form of insertion into an electrical wiring loom that mimics the inputs/outputs of a Eurac refridgerated appliance under power from a public grid. Every micro-chip that is produced is subjected to this application test, and six sigma criteria have been fulfilled on the initial order for 2009. The availability of each process for production depends upon set-up times, preventative and incidental maintenance. Most processes have a single computer-controlled machine, but others have two, partly because of need and partly because of advances in technology. These include deposition of conductive and insulating film, etching of photo-resistant chemicals, ion implantation, and testing which requires different rigs for each user application. Based on the planned three-shift working for 2010, the following annual capacities are available: deposition patterning etch ion implantation annealing defect review scanning cutting 10,000 hours 7,000 hours 12,000 hours 8,000 hours 4,000 hours 6,000 hours 5,000 hours
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Micro-chips for audio and dynamic demand applications have different process cycle times. The average time in hours needed for a silicon wafer of each type in each process up to cutting is shown in Table 8.1.
Audio Wafer (hours) Deposition Patterning Etch Ion implantation Annealing Defect review scanning Cutting 0.2 0.1 0.2 0.3 0.1 0.1 0.1
Dynamic Demand Wafer (hours) 1.1 0.3 0.5 0.5 0.2 0.3 0.1
Exercises
Now try these exercises. Outline solutions are given in Appendix B. (8a) Pearl is reviewing its planned use of capacity in 2010. It assumes that the volume of audio micro-chips will continue at their current level of 2.7 million units per annum. This should enable it to produce 3.3 million dynamic demand units on a three-shift system. Calculate the utilisation of each process based on these volumes and the capacities provided above. Is the planned production volume possible? Which process is a bottleneck? (8b) The contribution from the sale of a dynamic demand micro-chip was calculated in Part II of the case study at HK$42 per unit. The equivalent contribution of an audio micro-chip is only HK$20 per unit. If the deposition process is the bottleneck, it constrains the raising of production volumes if demand is in excess of that planned. Calculate
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the contribution of each type of micro-chip in relation to this limiting factor. Should the level of production of audio micro-chips be reduced in order to meet excessive demand for dynamic demand devices? (8c) The average selling price of an audio micro-chip is HK$33 and its cost is HK$30. A Shanghai manufacturer has offered to supply them for HK$25. Pearl would have to spend an additional HK$1 on testing to assure their quality and the supplier has agreed to replace any defective chips free-of-charge. Should Pearl accept this offer? (8d) A new machine that would increase deposition capacity by 50% could be bought for HK$50m. If the additional capacity could be wholly devoted to manufacturing dynamic demand devices would this solve the problem? What else might need to be done? (8e) Do Pearls operations lend themselves to the application of a Just-in-Time philosophy?
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MN7006/D SECTION 9
Budgeting Decisions
Section 9
Budgeting Decisions
Learning Objectives
This section addresses the second and fourth objectives in the Module Outline: to critically question the parameters under which accounting information has been provided, and to understand the relevance and limitations of accounting data. After studying this section and its reading, you should: understand the purpose and process of budgeting, understand its relation to strategic planning and organisation management, appreciate its technical and behavioural limitations, and be able to compile a simple budget.
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targets and other strategic initiatives. Budgets differ from forecasts because they convey intent. Budgets may serve one or many of the following purposes: planning resource allocation (to meet strategic objectives), co-ordination and communication (to integrate activities and provide direction), motivation (to achieve targets), control (by analysing variations in performance from that planned), evaluation of managerial performance (or unit or process performance). In many cases, these purposes may be in conflict.
Control theory
Budgeting is probably the quintessential activity associated with management accounting practice. The notion that the future actions can be objectively controlled is a comforting one. One that is based on the planning model being an accurate predictor the feed-forward system and management being able to correct any subsequent deviation from the plan the feedback system shown in Figure 9.1.
feed-forward
Strategic Plan
feed-back
budgetary control
Actual Performance
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The characteristic of feed-forward systems like budgeting is that the model is run iteratively until the predicted outcome is as desired: in other words, that deviations from plan are anticipated in advance of them occurring (ex-ante). In contrast, feedback systems wait until actual outcomes have been measured, deviations analysed, and causation corrected so that subsequent outcomes return to plan (ex-post). The budgeting process is a feed-forward system, proactively attempting to turn intentions into reality. Budgetary control is reactive, explaining variances from budget in the expectation that by changing inputs (the amount or allocation of resources) or process (utilisation/efficiency of operations or marketing activities), future outcomes (profit) will converge upon plan. Budgeting systems, like organisations, are cybernetic and vulnerable to changes in their environment and so it is commonplace for actual experience to cause the model itself to be modified because it is inaccurate. Theoretically, this phenomenon is regarded as a double feedback loop because the standard against which actual outcomes are compared is itself being altered. This has important implications for the usefulness of budgets during the control period for which they were prepared (see later). Chaos theory, however, teaches us that to try to force convergence in dynamic situations can either lead to stagnation or a complete loss of control.
Budget preparation
The budgeting process is described by Collier in Chapter 16. The process itself sits in three contextual frameworks: a time framework: - budgets should be part of the wider strategic planning process where strategies are formulated to achieve organisational aims and evaluated in a medium-term financial plan. The budget should be aligned with this plan and represents an annual step along the strategic journey. - the budget itself will be subject to discussion months before the start of the year to which it refers. Once agreed, it has to be phased over control periods (usually months) so that actual results can be compared as they emerge. Only then is the control budget issued to those responsible for its delivery.
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- during the control period, reports are generated to provide feedback (budgetary control). - as the budget becomes increasingly out-of-date, exercises are commonly undertaken to re-forecast the end-of-year position. This does not mean that the control budget itself is modified, although it might be. an organisational framework: - the motivational purpose of budgeting involves the setting of targets for individual managers and so the structure of a budget replicates the structure of organisational responsibility. - if hierarchies are organised by function, resource departments will be designated cost centres and the marketing function has sales targets. If a product-based organisational form is adopted, profit centres will exist. If a divisional structure is present, then responsibility for sales, costs, and certain assets will lead to a budget not dissimilar to the principal financial statements covered in Section 2. The division is designated an investment centre and is commonly targeted on RONA. - managers in charge of these budget centres will normally participate in the preparation of their own budgets and negotiate the targets with their seniors. This does not mean that some budgets may be set from above or targets imposed on those individuals responsible for delivery. a technical framework: - rests with the budget co-ordinator (i.e. the management accountant) who seeks to ensure that all budget participants have a clear understanding of organisational goals, strategies, macro-economic assumptions, reporting formats and timescales. - sets the sequence with which subsidiary budgets are prepared to ensure that they will come together to form an integrated whole. It avoids, for example, a production manger budgeting close to capacity where the marketing function predicts demand for only 75% of the output. Figure 9.2 shows how these three contexts shape the preparation of the budget. The result is validated against the outline parameters set by the Board or budget committee which will, at a minimum, mean meeting the key performance indicators envisaged in the strategic planning process. If it fails, then a re-examination of subsidiary budgets occurs that can involve arbitrary
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cuts in discretionary areas of cost. Finally, the budget is submitted for approval.
Strategic plan
Organisational framework
Technical framework
Budget Co-ordinator
projections
modelling
review priorities
Master Budget
validation
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debtors sales production volume purchases materials personnel labour payments overhead investment depreciation fixed assets creditors receipts stock
resource budgets
profit budget
cash budget
balance sheet
Budgetary control
Control Budget Sales Material Costs Gross Profit Labour Costs Depreciation Overhead Profit Units Produced Units Sold 20,000 8,000 12,000 5,000 500 5,500 1,000 2000 2000 Actual Result 21,200 8,700 12,500 5,250 500 5,350 1,400 2200 2200 Variance 1,200 700 500 250 0 150 400 (F) (A) (F) (A) (F) (F)
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Budgetary control is the feedback of actual results against the budget. Reports are frequently produced in the form shown in Figure 9.4 where the control budget is compared with actual, and a variance identified. It is important that such reports are timely, even if that requires a sacrifice in terms of absolute accuracy, that they reflect the area of control of the recipient, and that a commentary is provided with recommended actions to correct adverse variances and exploit those that are favourable. In Figure 9.4, profit is 400 higher than budget with adverse variances on material and human resources and a favourable position on overhead. Depreciation is a fixed charge. Lets assume that 50% of labour varies with volume and overheads are absorbed on labour cost. You will note that the volume produced and sold has increased by 200 units and we would expect a related increase of 10% in all variable costs. If the control budget is flexed by the actual level of output, a different picture emerges, as seen in Figure 9.5.
Control Budget Sales Material Costs Gross Profit Labour Costs Depreciation Overhead Profit 20,000 8,000 12,000 5,000 500 5,500 1,000
Output Variance 2,000 800 1,200 250 0 275 675 (F) (A) (F) (A) (A) (F)
Variance 800 100 700 0 0 425 275 (A) (F) (A) (F) (A)
With the sales increase of 10%, we would have expected a profit of 1,675 (the flexed budget) and an increased contribution of 675. The sales variance has reversed showing that selling prices were cut (800A) to obtain the greater volume (2,000F). Savings were made in material costs (100F) either through reduced consumption, or because they were cheaper. The adverse 250 variance in labour cost reported originally is entirely due to output and productivity is as budgeted. Overall costs have been well managed. This example illustrates the importance of adjusting the control budget by the actual level of activity before any informative conclusions can be drawn about the variances.
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It is not appropriate in this text to develop the analysis further as accountants will undertake this but, as managers, you should expect a variance analysis to: identify cause and responsibility, classify the amount according to volume, price and efficiency factors, and provide the basis for decisions about revising targets, reconfiguring the process and resources, or even changing the model.
Criticisms of budgeting
The criticisms levelled at budgeting are technical and behavioural in nature. Conventional control budgets are: fixed (there is no flexibility to cope with a change in output volumes), periodic (set for a year with a defined end date), and incremental (based upon last years actual plus a percentage). These characteristics tend to inhibit opportunist, profit-conscious actions and direct managerial attention on short-term operations, limit innovation whilst sustaining non-value adding activities. Alternatives to these three conventional forms are: flexible budgets as demonstrated previously. rolling budgets where a 12 month horizon is maintained by preparing budgets every quarter; as a control budget for the next three months, with out-quarters as outline forecasts. This approach overcomes the inherent obsolescence in an annual budget and ensures management are forward-looking. zero- or activity-based budgeting (ZBB/ABB) whilst budgets based on standard costs offer an objective or engineered basis for calculating budgets for direct costs, they cannot overcome incrementalism in overhead. ZBB and ABB require the justification of discretionary expenditure by the budget holder the former from a zero-base (no preconceptions), and the latter by linking activities to the chain of value.
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The behavioural consequences of budgeting stem from its role in placing responsibility for achievement with the management hierarchy, and especially from its link to personal reward. True, this is can be motivational if genuine participation and ownership is enabled and a constructive response to uncontrollable variances is present, but often budgets are imposed or negotiations subject to obfustication and deception in order to create a cushion for under-performance. Too often, there is a blame culture where adverse variance attribution is avoided and causation disguised. The beyond budgeting round table advocates an enlightened approach to the process involving greater devolution and discretion. Some major organisations have gone further and eliminated budgeting altogether. Jack Welch, ex CEO of General Electric, The budget is the bane of corporate America. It should never have existed. A budget is this: if you make it, you generally get a pat on the back and a few bucks. If you miss it, you get a stick in the eye or worse making a budget is an exercise in minimalisation. Youre always trying to get the lowest out of people, because everyone is negotiating to get the lowest number. Budgeting decisions are about how you do it and why you are doing it, but the most fundamental decision is whether you should do it at all.
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 16 Budgeting
Concluding Comments
As previously stated, work through the examples of budget preparation in Collier, Chapter 16 and pay particular attention to the cash budget, which is the most important in practice. Then attempt Questions 16.2 and 17.1 in Colliers Appendix 1.
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Pearl: Budgeting
Pearl: Budgeting
Pearl continues to prepare for 2010. Its optimism about the dynamic demand market has been encouraged by a dramatic increase in requirement from Eurac, a substantial purchase order from a US fridge/freezer manufacturer, and enquiries and requests for quotations. In short, it appears that demand is currently exceeding supply. Prices have remained stable since 2008, and show no sign of falling over the coming year. Pearl has priced its dynamic demand micro-chips at HK$45 a 10% discount on the market leader with no currency risk. Table 9.1 shows Pearls projected sales for chips over the four quarters of 2010.
Pearl has raised the prices of its audio chips to HK$35 per unit, and expects average contribution to rise to HK$22. The variable cost of the Eurac order provided in Part II of this case study remains valid for the supply of dynamic demand micro-chips. To cope with the expansion, Pearl has ordered a new deposition machine for HK$50m which will be installed during the second quarter. It has also improved the productivity of its ion implanter by a technical upgrade from the manufacturer. Other capital expenditure of HK$20m is expected during the first half of 2010. The effect of these investments will be to provide adequate capacity for the projected demand, but the annual depreciation costs for the fabrication facility will rise to HK$125m. Staff costs are projected to be HK$30m and other overhead HK$8m.
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Exercises
Now try these exercises. Outline solutions are given in Appendix B. (9a) Evaluate the projected operating profit for the year overall. (9b) Pearls balance sheet at the start of 2010 is shown below:
HK$m Fixed Assets (net book value) Stock micro-chips awaiting despatch raw materials Debtors Cash Current Assets Bank Overdraft Creditors Current Liabilities Capital Employed Long-term Debt 415 20 2 60 18 100 (15) (15) 500 (300) 200 Ordinary Share Capital Reserves Acc Retained Profit Shareholders Funds 50 70 80 200
The new deposition machine will be leased over a four year period at quarterly payments of HK$4m. The remaining capital expenditure will be met from internal cashflow. A third of the long-term debt is due to be repaid in September 2010 and interest payments of HK$31m on outstanding loans are anticipated during the year. Customers take 90 days on average to settle their debts. Stock and creditors are expected to maintain the levels shown in the opening balance sheet. Prepare a cash budget for 2010.
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(9c) It is the end of 2010. Actual results for the fourth quarter have just become available:
Quarter 4, 2010 Sales Variable cost Depreciation cost Staff cost Other cost Operating Profit Budget, HK$m 86 18 33 8 2 25 Actual, HK$m 83 19 33 9 2 20 Variance, HK$m 3 (Adverse) 1 (A) 1 (A) 5 (A)
The volume of micro-chips sold at 2 million was as budgeted, but because of a Christmas surge in sales of a new audio device, production had to be switched away from dynamic demand micro-chips which fell to 1.2 million. Prepare a flexed budget for the last quarter and reassess the variances.
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MN7006/D SECTION 10
Performance Management
Section 10
Performance Management
Learning Objectives
This section addresses the second objective in the Module Outline: to critically question the parameters under which accounting information has been provided and recognise the implications of this process and its content. After studying this section and its reading, you should: understand the influence that performance metrics have upon management behaviour, especially in a decentralised context, calculate the two principal measures of divisional performance, and understand how perspectives in the balanced scorecard inter-relate.
Dimensions of performance
The review of management accounting concepts in the second half of this study book has been necessarily selective in order to display the scope for decision support available to management. We have seen how context both in the decision and the organisation shapes the relevance of information and takes it beyond the financial, to the quantitative and the qualitative. We have
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seen how the three principal statements of external reporting reappear at the summit of the internal pyramid of management information. Monitoring corporate performance respects shareholder interests through use of these statements, and the adoption of criteria that reflect their goals (as seen in Sections 3 and 5). The internal monitoring framework is therefore aligned to the objectives of the organisation and the factors critical to successfully executing its strategy. As explained in the last section, budgets are short-term paths along a strategic route and feedback provides regular reports upon strategic progress. Thus corporate performance management combines forward, leading indicators which are often non-financial in nature with historical financial reports. An example of this principle is the results and determinants framework described in Section 7; another the balanced scorecard is explored here. If the same performance parameters are consistently applied throughout the organisation, the actions and decisions of managers are more likely to be congruent with the direction set at the top. To reinforce this, the remuneration of individual managers is often linked to the performance of the organisational unit for which they are responsible (see Figure 10.1).
Corporate Goal
feed-forward
Individual Goal
feed-back
Individual Performance
Individual Reward
This approach to performance management is apparent where organisations adopt a divisional structure. The implications on managerial behaviour of using corporate accounting ratios to measure the performance of the division and its manager are examined later in this section.
Balanced scorecard
Probably the most well-known multi-dimensional performance framework, the balanced scorecard is a generic model developed from empirical
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business practice by Robert Kaplan and David Norton in the early 1990s [Note 16]. It adopts four perspectives which are argued as having to be in balance for successful strategic development. Each perspective contains goals and derivative performance measures linked to the overall vision of the organisation. They also contain targets and initiatives to reflect progress along the strategic paths to that vision (see Figure 10.2).
Figure 10.2 The balanced scorecard model (after Kaplan and Norton, 1996).
The financial perspective ultimately represents the shareholders interest, but it is recognised that shareholder value is driven by customer satisfaction. This perspective, in turn, is driven by the excellence of internal business processes and both are supported through new products, technology, and organisational learning. Results in each of the three other perspectives are thus successive, leading indicators of the financial result. Illustrative measures or criteria include: financial perspective return on investment, economic value added, customer perspective market share, retention rates,
[16] As described in The Balanced Scorecard, published in 1996 by Harvard Business Press.
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internal business perspective quality, productivity, innovation and learning rate of innovation, time to market, competences. These might be routinely reported at Board level, but one of the characteristics of the scorecard is that it can be cascaded down the organisation so that each function and even individuals have a version that reflects their specific contexts, but still retain the four perspectives. After all, every organisational unit can develop, has a core role which it provides to a customer (albeit an internal one), and has a financial cost or value. In particular, corporate parameters are mirrored where an organisation is divided into strategic business units.
(a) centralised
(b) divisional
strategy makers
managers
divisional manager
operations
The overall rationale behind this decentralised structure is to differentiate the focus on commercial operations for, say, a brand from that on strategic activity at corporate headquarters. This approach to organisational form is in sharp
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contrast to the unitary hierarchy characteristic of functional structures where there is a greater penetration of operational decision making at the top. Decentralisation, however, places significant responsibility on the role of the divisional manager as the principal link between headquarters and the divisional unit, between the strategic and the operational. Decision making will be much quicker and responsive to external markets at divisional level than in a unitary structure, but the autonomy that facilitates this can also lead to parochial actions that are not in the best interests of the overall company. So there is a paradox at the core of decentralisation: divisional empowerment is both motivational and dysfunctional. Just as with agency theory and the relationship between shareholders and the executive Board, the Board strives to ensure that divisional managers act in a manner that does not disadvantage the company as a whole. The role of management accounting is thus important in setting protocols for the pricing of inter-divisional work and defining the boundaries of divisional responsibility. The bases upon which the performance of the unit and its manager are monitored may well differ because the cost of the remaining centralised functions (e.g. IT services) are attributed to the division even though its manager has no control over them. Table 10.1 illustrates how performance can be differentiated between the divisional unit and its manager. The total profit includes a full attribution of cost, irrespective of source, and would be the benchmark for comparing performance against other divisions. The controllable profit represents the scope of autonomy of the manager and would be used for the setting of personal targets and individual reward.
Controllable Sales Variable costs Contribution Divisional overhead Central services cost Operating profit Managerial Performance Divisional Performance 25 100 (30) 70 (45)
Uncontrollable
(47) (8) 15
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In addition to sales and operating costs, assets will be assigned for divisional use buildings, plant, inventories but monetary assets and liabilities relating to divisional receipts and payments may rest with a central credit management function. Strategic and working capital finance will remain with HQ and the division will be funded from a corporate treasury. The divisional balance sheet will thus have an abbreviated form and will represent the net asset value and the central funding. The division can therefore be regarded as an investment by corporate HQ, designated an investment centre (see Section 9), and charged with making a return on the funds invested. Recalling the book-based accounting ratios in Section 3, the relevant measure is return on capital employed, appropriately reduced in scope and termed return on investment. The calculation and consequences of adopting this and a competing measure, residual income, are now explored.
Return on investment is the divisional operating profit divided by the divisional asset base. The net margin in Table 10.1 is 15% (15100). Lets assume it has equipment with a net value of 30 (and a remaining life of 3 years), and stock and work-in-progress with a value of 45. Its assets are 75 and the units ROI will be 20% (1575) as seen in Table 10.2. If the HQ treasury can source funds at a cost less than the ROI of 20%, the division will continue to enjoy investment.
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A divisional manager can increase ROI by: increasing profit or reducing assets, increasing profit by more than an increase in assets, reducing profit by less than a reduction in assets. However, with a conventional depreciation policy, the manager can increase ROI by also doing nothing! Assume the depreciation charge included in controllable divisional overhead in the example is 10 (fixed assets of 303 years life left). Now, it could be argued that operating profits would fall off because maintenance costs would rise but, in the short run, this tactic will raise divisional ROI and the managers ROI.
Year 0 Investment Annual cashflow Annuity Factor [Note 17] Present value 1.00 (21) (21)
Total (20) 30
We saw from Section 6, that strategic investments should be evaluated using the NPV technique. Lets assume the division can buy a machine that would cost 21 and increase annual cashflow by 10 for three years (see Table 10.3). The Treasury could find funds for this at 12% interest. The present value of this investment is 3 (positive) and it should be undertaken. However, its immediate effect on ROI is to reduce it to 19%. This is because the ROI on the new machine is 14% (profit of 10 7 depreciation = 3 assets of 21). So, the divisional manager will not want to make a viable investment because its return, whilst higher than the cost of capital, will lower the existing divisional return. This is an illustration of dysfunction from decentralisation. 17 ROI is, however, widely-adopted. It is a relative measure that facilitates inter-divisional comparison, irrespective of size. It ignores the time value of money and the cost of funding the asset base and therefore lacks a benchmark.
[17] An annuity is a constant annual sum. Rather than multiply the same amount by different discount factors in successive years, it is quicker to multiply the annuity by the sum of the discount factors.
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Year 1 Total assets (opening value) Interest rate Notional capital charge Cashflow Depreciation Operating profit Residual income (RI) Discount factor (12%) Present value Net present value 21 12% 2.5 10 (7) 3 0.5 0.9 0.4
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Residual income does suffer from the same disadvantage as ROI in that it will naturally rise as assets depreciate (as in Table 10.2) and discourages investment, however, this can be overcome by writing down the value of fixed assets using the annuity depreciation method. The calculation is complex and it is unnecessary for you to be aware of anything other than it produces a consistent RI over the life of the asset and therefore does not distort decision making. A summary of the results using this technique is shown in Table 10.5.
Year 1 Total assets (opening value) Interest rate Notional capital charge Cashflow Depreciation Operating profit Return on investment (ROI) Residual income (RI) Discount factor (12%) Present value Net present value 21 12% 2.5 10 (6.2) 3.8 18% 1.3 0.9 1.1
Year 2 14.8 12% 1.8 10 (7.0) 3.0 21% 1.3 0.8 1.0
Year 3 7.8 12% 0.9 10 (7.8) 2.2 28% 1.3 0.7 0.9 3
The residual income is constant at 1.3, unlike the return on investment which still rises over the three years, although at a reduced rate than if a conventional depreciation policy had been used. Residual income is thus the recommended criteria for divisional performance management.
Performance review
WYMIWYG is an oft recounted acronym that means What You Measure Is What You Get. Performance measures influence behaviour, so influence performance. From the market-based measures of Section 5 and the accounting ratios of Section 3 to the budgetary targets of Section 9 and the
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internal parameters of Section 10, accounting records the score, changes the score, affects the score. The notion of agency extends from shareholder to manager to employee to stakeholder, but the agent in possession of greater information is able, if it chooses, to circumvent or manipulate the parameters of control for personal advantage. The design of performance management systems has to be carefully considered in this light and customised to context and culture. This is also true of the information needed to support decisions in Sections 6, 7 and 8 where the essential quality is relevance to the decision situation, its timing, and the knowledge, responsibilities and attitude of the decision maker. The Economist once stated profit is opinion [Note 18], but so are asset values, liabilities, share prices and costs. There is no absolute truth in any financial number or accounting statement; there is simply a professional view of what is fair, reasonable, and useful. Once you recognise this, then the inaccuracy inherent in much information is easier to accept. Non-financial and qualitative data adds depth and context to a financial analysis. Leading indicators forewarn and therefore better equip us to make a decision about the future. Externally sourced data equips us to perform more competitively. Accounting for Managers suggests that you, as future recipients of accounting reports, manage the information that accounting provides.
Key Reading
Now read the following chapter from the module companion textbook, Accounting for Managers by Paul Collier: Chapter 15 Performance evaluation of business units
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Concluding Comments
Collier conveys the behavioural implications of the choice of performance measure and the price at which supplies are transferred between divisions in Chapter 15. Read through the Majestic Services example and examine the analysis of transfer pricing: this is a complex area where the conflict between divisional autonomy and corporate interests can rarely be completely overcome. The questions in Colliers Appendix 1 provide useful practice on the calculation of ROI and RI and its effect on management behaviour.
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Exercises
Now try these exercises. Outline solutions are given in Appendix B. (10a) Draw up a balanced scorecard for Pearl Delta Manufacturing. Key performance criteria for each perspective should be aligned with organisational aims and strategies. Explain your choices. (10b) The two founders are concerned, but not entirely surprised, by the exit strategy of the AV company. Li recognises that sale of their 50% stake could present an uncertain and unwelcome future for the close-knit group of staff that have been established. Li proposes that Pearl be split into two divisions, the first responsible for manufacture (MA) and the second for design and engineering (DE). MA is capital intensive, whilst DE is labour intensive and could be divested from the Pearl company if necessary. Inoue is close to retirement and is happy to manage manufacture, leaving Li with control of the intellectual capital vested in the DE division. Each division will draw upon its counterparts resources, but the arrangement does not preclude either division from undertaking work for independent parties. The profit and capital employed of Pearl Delta Manufacturing have been allocated between the two divisions as shown,
DE division, HK$m 9 64
Calculate the return on capital employed and residual income for each division. (10c) Explain why divisionalisation and the use of divisional performance measures like ROCE and RI could give rise to conflicts within Pearl Delta Manufacturing, giving three illustrative examples. How might these conflicts be overcome?
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MN7006/D APPENDIX A
Appendix A
[19] pp. 124132 of International Accounting, 5th edition, published by Pearson in 2005.
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4.3
The first steps toward regulation on corporate governance were taken in 1998 by the Confederation of Indian Industries in its published Code of Conduct, but it was not until 2000 when the Securities and Exchange Board of India made listing subject to meeting the requirements of its Report on Corporate Governance. This has recently been strengthened, but it falls short of western practice in that there is no specific emphasis upon risk management and the suitability of internal control mechanisms. There is a requirement for 50% representation of independent directors and the establishment of four committees, three of which have similar roles to those covered in the Section, and a corporate governance committee responsible for setting the ethical conduct of business affairs. Whilst there is no separation of the Chairman/CEO role, there are restrictions on the number of committees upon which any one director can sit. The liaison between the Board and the shareholders is also more formalised, including the requirement for a Shareholders/Investors Grievance Committee. Indian practice appears to share some commonality with the UK system in that it is self-regulatory and not statutory, and requires a going concern declaration. Compliance with the listing requirement is, however, made the subject of audit certification.
Section 5
5.1 ROCE = Operating Profit Capital Employed
Capital Employed = Capital and Reserves + Long-term Liabilities = $4m + 1m = $5m ROCE = $1m $5m
= 20%
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ROE =
Earnings = Profit after Tax = Operating Profit - Interest Payable = $1m - $0.1m = $0.9m Shareholders Funds = Capital and Reserves ROE = $0.9m $4m
= 22.5%
Earnings Yield =
= $10.8m
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Dividend Yield =
Dividend Cover =
Dividend =
= 4.2%
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MN7006/D APPENDIX B
Appendix B
or Long-term Liabilities + Capital and Reserves = 462m + 256m = 718m Comparative figure for 2005 was 709m. Capital employed is stable.
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(2c) Shareholders funds is the accumulated wealth of the shareholders as reflected on the balance sheet. It is the total of capital and reserves, and as such includes: the original capital issued by the company at the price at which it was issued, the accumulated retained profits (i.e. the annual profit left after distribution of the dividend), accumulated reserves. Accumulated reserves can reflect many things, but include gains or losses not passed through the profit & loss account. This could arise through the disposal of an asset (e.g. a building) for a price that differs from its book value. It can also arise where book values are continually updated to reflect their realisable value in the market (e.g. financial investments). (2d) In Nexts case, there is a significant negative balance on reserves (of 1.5 billion). This is largely due to the repurchase programme where shares were bought back from the market by the company at prices considerably in excess of those at which they were originally issued. The nominal value of a Next plc share is 0.10. Lets assume it was issued at that price and then repurchased at a market price of 5.00. The book-keeping entries would be: CR Cash DR Share Capital DR Reserves 5.00 0.10 4.90
Since the balance on capital is normally a credit, this will result in a reduction in reserves and even, as in Nexts case, negative reserves. (2e) The immediate cash position of a company should take account of any bank overdraft because this is recallable without warning. For Next, it has cash of 70m with an overdraft of 31m, and thus net cash of 39m. In 2005, the bank overdraft was lower and the net position was 50m. It should be noted that a 100m bank loan was taken out in 2006, but since this is only withdrawn if there is a breach of the loan contract, it should not be treated as a deduction from cash even though it is repayable within the ensuing year.
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(2f)
Assets are payments that are expected to bring future benefit. Pre-payments are in advance of the period in which they will be treated as a cost an example might be a quarterly rental for the use of premises.
(2g) A non-current liability is an obligation to make payments after a year into the future; it is for this reason often termed a long-term liability. A pension obligation occurs where there is an anticipated deficit on a pension fund that is the responsibility of the employing organisation to make good. This occurs where the actuarial assessment of future benefits to current and past employees exceeds that of the re-invested value of currently accumulated contributions. (2h) Average Life = Original Cost Annual Depreciation 643 81
= 8 years
Average Age =
= 3.6 years (2i) By comparing the net additions (i.e. additions minus disposals) in the year to the asset base at its start, an indication of the growth in investment is possible. For plant and fixtures, additions of 179m out-weighed disposals (20m) by 9:1 and showed a net growth of 25% on the opening gross book value of 643m. If wear and tear is taken into account (by using the written down value), the growth rate is even higher at 27% ([179 20 65] 347). This could be compared with the growth in sales of 9%, or even the growth in retail space (14%), and indicates Next plc is financially supporting its growth strategy.
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However, there have been no additions to freehold or leasehold property in fact there have been disposals so it is likely that Next has changed the policy on the ownership of retail space and is renting new premises. (2j) Property prices tend to rise and have done so dramatically in the UK over the long term. A policy that depreciated freehold buildings by 2% per annum is therefore likely to severely understate the realisable value of retail premises. Given the cost of such premises is stated as 76m and that acquisition could have been made 20 years ago, it is possible that sale could add substantially to shareholders funds.
(2k) Next plc has cash in hand, current assets that cover current liabilities, and fixed assets that cover the debt finance (i.e. the loan and the bond). The growth in fixed assets and stock is adequate to keep pace with the growth in sales, and there is no sign of under-capitalisation (i.e. insufficient capital to fund productive investment for the future). The shareholders funds figure (of 256m) is low for a 3bn turnover business, but the cause of this has already been explained (in Question 2c). Providing retained profits sustain their current level, there appears to be no problem in meeting the longer-term liabilities and the balance sheet looks strong.
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there are no anomalous increases in interest or tax, and so earnings are marginally up, the cashflow statement shows a managed position 12m movement in a 3bn turnover business; the free cashflow of 230m after re-investing in operations has been used to pay dividends and repurchase shares, both of which are discretionary activities, in reviewing the detail of cashflows, note the expected increases in stock, debtors, and creditors (because of business growth), but reference to the balance sheets opening and closing levels suggests the circa 20% rise in debtors is excessive perhaps management have granted more lenient credit terms, use of a bank loan is evident from the cashflow statement, but the balance sheet shows that it is repayable within the year and will constrain managements ability to repurchase shares in the coming year, no other inconsistent movements are evident in the balance sheet, but the (high) level of other creditors and accruals is intriguing the notes do not provide an adequate explanation as to what they might be. (3b) Net Margin = Next Retail = 320 = 14% 2217 Operating Profit Sales
Next Retail =
Next Directory = 9%
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Next sourcing = 16% Ventura = 12% Asset Turnover = 2217 = 0.8 2905 Sales Assets
Next Retail =
Next Directory = 0.6 Next sourcing = 3.3 Ventura = 1.4 UK = 2.1 RoEurope = 3.3 Middle East = 5 Asia = 0.2 Margins are highest in the retail and directory businesses, but their ROCE is poor because of the low asset turnover. Given the inflated attribution of assets, it is difficult to judge the efficiency of these operations it is particularly surprising that Directory has the lower asset utilisation given the potential for more rapid stockturn and the lower spatial requirements in this business. Asset turnover is highest in Europe and the Middle East but, without data on margins for these market segments, their comparative profitability cannot be judged. The results for Next sourcing are not reliable because its sales are internal and therefore subject to artficially set transfer prices. It is evident that investment is being concentrated on the Retail business in the UK, but the relative level is greatest in Europe and Asia. The Asian market is a recent initiative, but the amount of assets is very high if it is a franchised operation.
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(3c) Measures: Debtor Settlement Period = Debtors 365 Sales 415 365 3106
Acid Test =
Gearing =
213
Interest Cover =
Return on Equity =
= 1.27 per share (for 2006) = 1.17 per share (for 2005) The first two measures are indicators of liquidity. The average settlement period of Nexts customers has extended since 2005. The acid test has also deteriorated, although it is strictly an examination of monetary assets and liabilities and more would need to be known about the nature of other creditors, accruals, and liabilities due within the year. In the context of the clothing industry, stock can be more readily converted into cash through
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discounting. With cash in hand and a 450m draw-down facility, liquidity is unlikely to present a problem for Next plc. The second pair of measures relate to risk. Gearing has risen, but the cover for interest on debt is generous. Equity has been artificially reduced by the repurchasing policy of management, and the asset base of the balance sheet can support more debt if necessary. Technically, gearing is high but the risk is being controlled by Nexts management. The final pair represent shareholder returns and it is in these that the benefit of the repurchase policy is evident. ROE is high and increasing as earnings rise and shareholders funds fall. Similarly, the persistent reduction in the number of shares in circulation automatically puts upward pressure upon eps.
Section 4 Next and the Impact of Governance and International Accounting Standards
(4a) A judgement on the impact can only be made on the comparative figures since the results for the year ended and as at January 2006 have been solely prepared under IFRS, and we do not know what they might have been under UK accounting standards. The overall impact on both the balance sheet and the profit & loss account appears to be negligible, though the deferred adoption of IFRS7 does involve what was a materially significant amount 44m or 16% of the shareholders net asset value. Of the changes implemented, the small net change hides substantial movement in the classification of assets and liabilities: in particular, fixed assets have risen by 6% and long-term liabilities have risen by 14%. Given that the historical cost convention is common to both approaches, the inference from Next plcs statement is that the changes are due to where fair values and not historical cost has been applied (the main impact is actually due to restatement of pension fund liabilities). As we saw in the BP example, the application of different standards can result in a different picture being painted of a companys financial position and can therefore alter the viewers perception of that position.
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(4b) Going-concern is an accounting convention explained in Section 2. It is the presumption that there is no known impediment to the business continuing to trade in the future fundamentally, that there is no risk of insolvency. This means that asset values are justified by their potential to generate future commercial returns and liabilities that would arise in the event of difficulty are not recognised. The liquidation value of a business is likely to be much less than even its historic cost as many of its assets are specific to the business context. In Nexts case, its fixed assets include high street property and vehicles which have general utility and, in the case of the owned property, would fetch a value greater than historically reported. However, as with any fashion business, the carrying value of its stock is vulnerable and could require heavy discounting to liquidate though there is a readily available market. Its debtors are its customers and include store card finance they are not going to be susceptible to a write down any greater than is usual through consumer credit risk. If Next were not a going-concern, the major implication would be on liabilities related to closure. (4c) The following list is not exhaustive: comply or explain principle Next have complied, going-concern declaration, three independent review committees, non-executive meetings without any executive influence, separation of role of chairman and CEO, affirmation of reasonable effectiveness of internal controls, considered use of auditors beyond compliance work (not compliant with SOX), demonstration of shareholder communication, evidence of a coherent strategic planning framework, fair treatment of shareholders in the selectivity and timing of announcements (avoidance of insider trading), transparency of governance practices (through the website),
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formal review of Board effectiveness, various risk management dimensions (this point is enlarged in Question 4d). (4d) COSO Framework steps: (1) Control Environment: The Board is responsible for major policy decisions whilst delegating more detailed matters to its committees and officers. The Board promotes the development of a strong control culture within the business. The Board sets guidance on the general level of risk which is acceptable and has a considered approach to evaluating risk and reward. The system of internal control is designed to manage, rather than eliminate, the risk of failure to achieve business objectives and can only provide reasonable and not absolute assurance against material misstatement or loss. (2) Risk Assessment: During the year the Board addressed the business risks which had been identified as key, taking into account any changes in circumstances over the period. (3) Control Action: These (NEXT Brand) meetings cover all business aspects of risk management in respect of the NEXT Brand, including product, sales, property, warehousing, systems and personnel. The Groups management structure and timely and continuous monitoring of key performance indicators provide the ability to identify promptly any material areas of concern. Business continuity plans, procedures manuals, and codes of conduct are maintained in respect of specific major risk areas and business processes.
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(4)
Control Information: Key performance indicators are monitored daily and weekly (at the NEXT Brand meeting).
(5)
Monitoring: The Board confirms that it has carried out a review of the effectiveness of the Groups system of internal control covering financial, operational, compliance and risk management. The audit committee also reviews the effectiveness of the risk management process.
(4e) The forum is purely internal and has a Board presence only bi-annually. To be genuinely engaging in social responsibility, participating external representatives of stakeholder groups, including environmental advisors and pressure groups, would be expected. The aspects represent an appropriate range of CSR dimensions. The key facts and figures only headline information is contained in the study book and therefore the following critique is limited to the selection of data that has been highlighted by Next plc. Economic no comment is made regarding Next plcs contribution to the countries in which it operates. FTSE4GOOD whilst a listing is commendable, the index is essentially designed to exclude corporate investments in unethical areas (e.g. tobacco, defence, etc.). Suppliers the presence of a Code of Practice is commendable but hardly unusual for a high-profile company. The extent of audit and adoption is not encouraging less than 30% of factories in less than 40% of countries. Why do Next plc not ensure that all suppliers are Code of Practice approved prior to engaging in business? We dont know how many suppliers there are, but if the number of factories is indicative, then it may be that the supplier base is too large for Next plc to develop deep partnerships based on dimensions beyond product quality and price. Customers are these volume-based criteria really measures of responsibility toward customers?
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People the illustrative statistics on maternity leave and pension facilitation are encouraging. Community that Next plc engage in supporting communal projects is commendable. Taken together, the financial contribution amounts to 0.6% of earnings. Environment Next plc has a range of initiatives relating to reducing the impact of its business operations on the environment. We should note that less than a quarter of its stores actually engage in recycling. Next plc evidently recognise a responsibility toward society and the environment. Whether the data demonstrates an adequately socially responsible attitude is a matter of individual opinion. Next plc have yet to publish their third CSR report. (4f) Agency theory defines the primary external relation of a company with its shareholders. It asserts that management acts as the agent of shareholder interest and suggests measures by which managerial interest is aligned, incentivised, and constrained by various mechanisms (e.g. share option arrangements). Stakeholder theory advocates a wider duty to all who affect or are affected by the aims and operations of the company. Its advocacy is either based on the ethical conduct of business relations with society, or that engaging stakeholders is instrumental in delivering financial rewards to all, including shareholders. Next plc defines its stakeholders very narrowly suppliers, customers, employees but these do represent Michael Porters chain, through which value is created. They are therefore the instruments of financial reward for shareholders: sales, margins, productivity, profit, dividends. Whether treating them fairly and honestly is a minimum condition or a motivating force for their engagement is arguable. Moreover, whether fairness and honesty are sufficient qualities for an ethical approach is highly questionable. It is suggested that, from the balance of policies and statements made throughout their published reports, Next plc are very shareholder centred.
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This contrasts with a gearing based on book values of 61% and would lead to an entirely more relaxed conclusion about the financial risk of Next plcs capital structure. (5d) Share price in 2001 is about 10, so there is a gain of 7 over five years. In addition dividends of (27.5 + 31 + 35 + 41 + 44 =) 178.5 pence have been declared. In total, a return of 8.785 on an investment of 10, or 88%. This can be annualised by taking the fourth root of 1.88, which is 1.17 or 17% pa. (5e) The 400m debt costs 4%, the 4.2bn equity costs 17%. The weighted average is, (400 4 ) + (4200 17) = 165% . (400 + 4200)
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(5f)
2006 Shares in issue (m) Shares repurchased (m) Average share price 246.2 14.8 15.00 2005 261 4 14.00 2004 265 22 10.00 2003 287 44 9.00 2002 331 5.5 9.50 2001 336.5
2006 Buyback payment (m) Dividend per share Dividend payment (m) 222 0.44 108
2002 52 0.28 91
Total 946
488 1434m
(5g) There is a very significant alignment between the package and the characteristics of financial performance. One incentive specifically targets earnings per share, whilst the other targets share price relative to the sector. Taken together, they can increase salary by 170%. In addition there is a further share price growth driven incentive. The package has obviously been designed to fit the financial objectives of Next plc but, with its singular pursuit of eps growth, is it possible the financial strategy has fitted the package? (5h) Average exercise price in 2001 was 502p, and these could be exercised in 2004 when shares were about 1000p for a gain of about 100%. For 2002, exercise price was 606p, and the 2005 share price was 1400p for a gain of 130%. For 2003, exercise price was 701p, and the 2006 share price was 1500p for a gain of 115%. If an employee had contributed 250 per month or 3000pa, then the total gain would have been, 3000 345% = 8700
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Total number of appliances Annual saving per appliance Megawot market share Futures price
Year
Number of appliances
Futures price
Cash savings
Discount factor
Present value
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 3,000,000 6,000,000 9,000,000 12,000,000 15,000,000 18,000,000 21,000,000 24,000,000 27,000,000 30,000,000 33,000,000 36,000,000 39,000,000 42,000,000 45,000,000 1,500,000 3,000,000 4,500,000 6,000,000 7,500,000 9,000,000 10,500,000 12,000,000 13,500,000 15,000,000 16,500,000 18,000,000 19,500,000 21,000,000 22,500,000 66,667 133,333 200,000 266,667 333,333 400,000 466,667 533,333 600,000 666,667 733,333 800,000 866,667 933,333 1,000,000 15.50 16.00 16.50 17.00 18.00 19.26 20.60 22.05 23.59 25.24 27.00 28.89 30.91 33.07 35.38 1,033,333 2,133,333 3,300,000 4,533,333 6,000,000 7,703,375 9,615,600 11,757,551 14,152,004 16,823,795 19,800,000 23,110,125 26,786,313 30,863,571 35,380,009
1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0.263 0.239 939,394 1,763,085 2,479,339 3,096,328 3,725,528 4,348,354 4,934,323 5,484,984 6,001,831 6,486,301 6,939,779 7,363,598 7,759,041 8,127,343 8,469,693
Thus accumulated savings are 8,000,000 tonnes. (6b) Accumulated carbon credits are 212,992,342. (6c) Maximum contribution to European consortium is 77,918,921.
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(6d) The replacement rate of existing fridges is partly due to the incremental price of new appliances. The futures price has been highly volatile and will be inaccurate, however, even in 2006, carbon credits have risen to as much as 29 per tonne so the projection may not be unrealistic. Cost of capital could vary substantially over the 15 year period. (6e) This initiative will reduce the need for Megawots coal-fired generation which is good in ecological and image terms, though not necessarily in commercial terms. The initiative is aligned with Megawots social responsibility aims. Is this the best use of 78m (ca 50m) that Megawot could make in this respect? Alternative investments could include clean technologies to reduce the ecological impact of burning fossil fuels or renewables (e.g. wind turbines).
Selling price = 5 10 = HK$50 Therefore, Contribution = HK$42 per unit And, Total Contribution = HK$42 300,000 units = HK$12,600,000 Now, break-even occurs where contribution equals fixed cost, Fixed Cost = HK$12m + HK$1.5m = HK$13,500,000 Operating Loss = HK$900,000 Sales = HK$50 300,000 units = HK$15,000,000 Net Margin = Profit = 6% Sales
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So, Break-even (in units) = Fixed Cost Contribution per Unit HK$13.5m = 321,429 units HK$42
Contribution is positive so, providing Pearl has sufficient capacity to manufacture the order, it should be accepted. The fixed cost is so great that it results in a loss, but at least HK$12m of this cost would have occurred anyway. Given that the potential UK market could sustain Eurac for many years, the initial design and engineering cost could be spread over many orders ignoring it would have resulted in a profit on this order. The break even point is only 20,000 units above this first order, and if Euracs market entry is successful, then this point could be easily reached. Pearl should take a strategic view of this order as it enables it to enter a new market with substantial potential. (7b) Two-shift capacity is 4m units and current production 3m. Three-shift capacity would be 6m and therefore maximum production of dynamic demand chips would be 3m plus 300,000, or 3.3 million. Pearls attribution of fixed cost for 300,000 units equals HK$12m. As overall production is 3m units, Pearls total fixed costs are HK$120m. These will increase by 10% to HK$132m. Spread over 6m chips, the fixed cost per unit is, HK$132m = HK$22 per chip 6m chips Unit Cost (design and engineering) = HK$1.5m = HK$2.5 2 300,000
Other Variable Costs = HK$8 per unit Therefore, Total Costs (per unit, revised capacity) = HK$22 + HK$2.5 + HK$8 = HK$32.50 This is a fall of over HK$20 from the unit cost of Euracs order of HK$53.
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(7c) The global market currently (the year in the question is 2009) is 5m units; by the next year it will rise to 30m units, and will not reach maturity for another nine years after that. There is substantial demand potential, but even in 2010 Pearl could only achieve a maximum 11% market share (3.3m / 30m). It is a price follower. Providing it can maintain a cost profile that is below the market leaders, a wider participation in the market is rational. However, it should attempt to identify scope for product differentiation by focus on market segments so as not to precipitate a hostile reaction from the main micro-chip suppliers to the market. Projected unit cost is HK$32.50. Average industry margins are 4%. Therefore the minimum price that Pearl should consider is approx HK$34. Market leader prices are at 5 (or HK$50 equivalent), but these can be expected to fall as competitive pressures build and product maturity is approached, when a long-run price of 3 is anticipated. Pearl has to price under the market leader, but should reject a penetrative pricing strategy (i.e. a deep discount) as it hasnt the capacity to achieve a dominant market share. Pearl should initially aim to widen its market presence at over 4 and be prepared to reduce this as general market prices fall. Pearl should exit the market before maturity unless it can replace (or expand) its manufacturing capability for a lower investment than is currently the case, or otherwise reduce its fixed costs.
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Time per Three shift audio capacity wafer Audio total (hours) (hours) (hours) Deposition Patterning Etch Ion implantation Annealing Defect scanning Cutting 10,000 7,000 12,000 8,000 4,000 6,000 5,000 0.2 0.1 0.2 0.3 0.1 0.1 0.1 2,700 1,350 2,700 4,050 1,350 1,350 1,350
Time per dynamic demand wafer (hours) 1.1 0.3 0.5 0.5 0.2 0.3 0.1
Dynamic demand total (hours) 7,260 1,980 3,300 3,300 1,320 1,980 660
Total requirement (hours) 9,960 3,330 6,000 7,350 2,670 3,330 2,010
Intended volume of production is just within the capacity of the deposition processes. (8b)
Per micro-chip Audio contribution Dynamic demand contribution $20 $42 Per wafer $4,000 $21,000 Per hour in depostion $20,000 $19,091
No. Slightly more contribution to profits is made by devoting the deposition process to audio micro-chips. (8c) The total cost is irrelevant in a make or buy decision, since fixed costs will not be saved. Contribution would fall from HK$20 per unit to HK$7 (33 25 1).
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Pearl should reject the offer as the contribution foregone would not be compensated by allocating freed capacity for dynamic demand chips. (8d) A new machine would increase deposition by 5000 hours per annum. With a contribution per hour of HK$19,091, the machine would pay for itself in less than a year. However, the bottleneck would shift to ion implantation as shown in the table:
Time per Three shift audio capacity wafer Audio total (hours) (hours) (hours) Deposition Patterning Etch Ion implantation Annealing Defect scanning Cutting 15,000 7,000 12,000 8,000 4,000 6,000 5,000 0.2 0.1 0.2 0.3 0.1 0.1 0.1 2,700 1,350 2,700 4,050 1,350 1,350 1,350
Time per dynamic demand wafer (hours) 1.1 0.3 0.5 0.5 0.2 0.3 0.1
Dynamic demand total (hours) 8,800 2,400 4,000 4,000 1,600 2,400 800
Total requirement (hours) 11,500 3,750 6,700 8,050 2,950 3,750 2,150
Only 700,000 additional dynamic demand micro-chips could be sold per annum before ion implantation became the constraint and deposition would only be 77% utilised. However, if the capacity of ion implantation could be raised at the same time by a quarter, a more balanced throughput would result in over 2 million additional micro-chips being produced. (8e) Not particularly. Raw materials are not diverse, have common use, and are a relatively minor cost, so JIT purchasing has few advantages. The cost of a stock-out in copper or silicon wafers is huge because of the delay to manufacturing processes. It is these processes where value is added and batch manufacture is essential to limit the cost of setting up. Once produced,
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micro-chips would not be supplied individually or even in small batches given their size, weight, and nature of transportation. Pearls micro-chips are, in any case, bespoke and supplied to customer order.
HK$ million Sales Variable cost dynamic demand audio 36.8 31.2 68 Depreciation cost Staff cost Other cost Operating Profit 125 30 8 60 291
(9b) Pearls cash budget for 2010 is shown below. Note that Year End debtors will be equal to fourth Quarter Sales such that, Year End Debtors = (1.6m HK$45) + (0.4m HK$35) = HK$86m
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60 125
26 Operational cashflow Capital expenditure Lease finance Debt repayment (100 + 3 x 4) Interest payments 159 70 50 112 31 4 Opening cash balance Closing cash balance 18 14
(9c) Flexed budget figures for the fourth Quarter of 2010 would be as follows.
Flexed budget, HK$m Sales dynamic demand (1.2m x HK$45) audio (0.8m x HK$35) 54 28 82 Variable cost dynamic demand audio 9.6 10.4 20 Depreciation cost Staff cost Other costs Operating profit 33 8 2 19
Variance, HK$m
86
4(A)
18 33 8 2 25
2(A) 6(A)
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Flexed budget, HK$m Sales dynamic demand (1.2m x HK$45) audio (0.8m x HK$35) 54 28 82 Variable cost dynamic demand audio 9.6 10.4 20 Depreciation cost Staff cost Other costs Operating profit 33 8 2 19
Variance, HK$m
83
1(F)
19 33 8 2 21
1(F) 2(F)
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Perspective Financial
Criteria shareholder value cash generation net margin market share average unit selling price %tage failure of micro-chips in use Six Sigma failures plant utilisation staff satisfaction kaizen indicators rate of innovation design-production cycle time
Customer
The above selection is illustrative. Its choice is based upon the following logic: the first two financial criteria attempt to address the competing aims of the shareholders and the third is a key parameter in the industry (as indicated in Part II of the case material on pricing). the first two customer criteria also reflect the industry and, in particular, the impact of the life cycle on Pearls market niche. The third is a critical parameter for durability of the chip in use. It might represent the number of warranty claims received, the average number of failures per million supplied, or the life before failure occurred. Any failure is likely to trigger investigative action in order to identify and attribute responsibility for its cause. the first of the internal process parameters is again related to quality, but is a statistical measure aimed at reducing failures to less than 1 in 3.4 million. The second is an indicator of capacity, the importance and financial implications of which were demonstrated in Part III of the case material. The third recognises the importance of human resources in the context explained in Part V it might take quantitative form (e.g. absenteeism), or be qualitative through a survey of staff attitudes, or meaningful staff suggestions toward continuing improvement. Given the small number of staff, it is likely that informal monitoring will be adequate.
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the first criterion continues the theme of continuous improvement by monitoring the number of initiatives. In a leading technology business, the rate and speed of innovation is critical to sustained success and these make up the remaining criteria. (10b) First,
MA division Profit, HK$m Capital employed, HK$m ROCE (Profit Capital Employed) 51 436 12%
DE division 9 64 14%
Also, Residual Income = Profit - Notional Capital Charge Notional Capital Charge = Capital Employed Cost of Capital
MA division Cost of Capital Notional Capital Charge, HK$m Residual Income, HK$m 10% 43.6 7.4
(10c) Conflicts will arise if either of the founders adopts a parochial attitude where the interests of a division supercede those of Pearl as a company. This will be aggravated if ROI or RI performance criteria are regarded as targets, and start to influence performance and actions. This is possible because both divisions returns are greater then the costs of funding their asset base, but MA produces a higher RI but lower ROI than DE. Examples of conflicts could include: investment in a financially viable machine that temporarily reduces ROI or RI (especially likely in the MA division), the acceptance of a manufacturing order by MA from an external design party which would breach capacity constraints, the subcontracting of design engineering by the MA division or manufacture by the DE division,
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insistence on a transfer price that makes an external quote uncompetitive in the market. To overcome these potential problems, divisional performance criteria should not be used as targets, monitoring devices, or as bases for remuneration incentives. Issues and opportunities should always be discussed from the perspective of Pearl Delta Manufacturing, and continuing liaison should be maintained between Inoue and Li and their personnel.
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