mark plan and examiner’s commentary - · pdf file · 2017-04-20this is the...

Professional Stage - Business Strategy - December 2012

Copyright © ICAEW 2012. All rights reserved of 25

MARK PLAN AND EXAMINER’S COMMENTARY

The mark plan set out below is that to be used to mark these questions. Markers are encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication. More marks are available than could be awarded for each requirement, where indicated. This allows credit to be given for a variety of valid points which are made by candidates. The answers provided are more comprehensive than would be possible in the time available even from the best candidates. They have been prepared to reflect the wide range of possible answers and judgements that could be made by candidates.

Question 1 – Grassgrind Garden Mowers plc

General comments This is the mini case and also the data analysis question. The scenario relates to a company manufacturing lawnmowers (GGM). The company manufactures two types of upmarket, petrol-powered mower for use by UK households: tractor mowers and conventional mowers. The company is subject to a take-over bid by BB, which the GGM board is defending. A key issue is the proposed future strategy of BB, in comparison to the defensive strategy of the existing GGM board. The candidate is in the role of a business adviser for the accountants (PP) representing the existing GGM board. PP has been asked to prepare a report evaluating GGM and aspects of the bid strategies. More specifically, candidates are required to:

(i) analyse the performance of GGM, and of each of its two products, in the financial years 2011 and 2012;

(ii) determine the current UK market share of GGM, highlighting any problems that arise in defining market share in order to produce a useful figure;

(iii) explain the competitive positioning of GGM in the UK mower market, and assess how this has changed between 2011 and 2012;

(iv) compare the growth strategy of the GGM board with that of BB. Make relevant calculations and refer to appropriate strategic models.

In addition, candidates are required to explain the ethical issues that arise for GGM from a request by a potential new overseas customer to modify its mowers, but which may call into question health and safety aspects of the mowers.

(a)(i) From: Business Adviser To: GGM independent report to shareholders Date: XX December 2012 Subject: Assessment of strategic plans

2011 2012 2011 2012

Conventional Tractor Conventional Tractor

mowers mowers mowers mowers

Total Total

INCOME STATEMENT

£ £ £ £ £ £

Revenue 3240000 5400000 2952000 5076000 8640000 8028000

Variable cost 1944000 2700000 1771200 2820000 4644000 4591200

Contribution 1296000 2700000 1180800 2256000 3996000 3436800

Fixed cost 911250 303750 885600 338400 1215000 1224000

Profit 384750 2396250 295200 1917600 2781000 2212800



Profit/revenue % 11.9 44.4 10.0 37.8 32.2 27.6

% change in revenue

-8.9 -6.0

-7.1

% change in vc

-8.9 4.4

-1.1

% change in contribution

-8.9 -16.4

-14.0

% change in FC

-2.8 11.4

0.7

% change in profit

-23.3 -20.0

-20.4

% change in volume

-8.9 4.4

2011 Conventional mowers

In 2011 conventional mowers made a contribution per unit of £160, giving a contribution margin ratio of 40%. The profit per unit after allocating fixed costs was £47.50, giving an operating profit margin (using the method of allocation of fixed costs adopted by GGM) of only 11.9%. This reflects a high proportion of fixed operating costs in the cost structure and therefore a high degree of operating gearing. In drawing any conclusions about the performance of each product, however, the validity of the operating profit figures depends largely on the validity of the method of fixed cost allocation. While all such allocations are arbitrary (to a greater or lesser extent) the allocation by unit of output seems to be inappropriate in determining a cause and effect relationship between fixed operating costs and production activity. This is particularly the case as the tractor mowers are significantly larger, and probably more time consuming to produce, meaning it is likely they will require more fixed costs. Based on the information available, it is not possible to produce an accurate allocation (eg using activity based costing) but a better measure might be sales value (as suggested by the CEO), rather than sales volume, as this gives some recognition to the relative scale of productive activity per unit.

On this basis, the following revised data would be produced: 2011 2012 Conventional

mowers £

Tractor mowers

£

Conventional mowers

£

Tractor mowers

£

2011 Total

£

2012 Total

£

Contribution 1296000 2700000 1180800 2256000 3996000 3436800

FC by value 455625 759375 450081 773919 1215000 1224000

Profit 840375 1940625 730719 1482081 2781000 2212800

Operating profit/revenue 25.9% 35.9% 24.8% 29.2% 32.2% 27.6%

Compared to the volume based method of allocation, the operating profit of conventional mowers in 2011 has more than doubled from £384,750 to £840,375. In terms of viability, contribution is the most valid measure in the short term, as the issue of allocation of fixed costs is avoided. On this basis, the conventional mower creates a healthy £1,296,000 contribution in 2011, making it viable. This generates a reasonable operating profit margin of 25.9%.



Tractor mowers In 2011 tractor mowers made a contribution per unit of £1,000 giving a contribution margin ratio of 50%. The profit per unit after allocating fixed costs was £887.50 giving an operating profit margin (using the method of allocation of fixed costs adopted by GGM) of 44.4%. As already noted, this reflects the rather favourable treatment of tractor mowers using the original fixed cost per unit allocation method. Using sales value, rather than sales volume, to allocate fixed costs, this gives a rather less favourable, though still profitable, picture for tractor mowers. Operating profit margin is now somewhat lower at 35.9% than it was under the original allocation method, although it is still higher than the operating profit margin of the conventional mowers. Other costs The operating cost and profit figures are only part of the picture in measuring performance. After taking account of finance costs the business may not be profitable at all. More information is needed in this respect. Overall company profit While the allocation of fixed operating costs is arbitrary at unit level, the overall cost and profit at company level is the same irrespective of the allocation method. While such costs may not be avoidable in the short term, in the longer term it is essential that they are covered in order to sustain the business. Nevertheless, overall operating profit of £2,781,000 has been generated on revenue of £8,640,000. This generates a healthy operating profit margin of 32.2% in 2011.

2012 Conventional mowers

There has been no change in the selling price or in variable cost per unit of conventional mowers between 2011 and 2012. The key change affecting performance has therefore been a fall in sales volume of 8.9%. As selling prices have not changed, then sales revenue has also fallen by 8.9%. The impact of fixed operating costs on conventional tractor profitability in 2012 is twofold. First, total operating fixed costs have risen by 0.7%, so the pool of costs to be allocated has increased. Second, the volume of conventional mowers sold has decreased, while the number of tractor mowers sold has increased. As a result, the proportion of the fixed overhead pool allocated to conventional mowers has fallen. The net effect of this for conventional mowers (under the existing allocation method) is that while fixed operating cost per unit has increased from £112.50 to £120 (+6.7%), the total fixed operating cost allocated to conventional mowers has decreased from £911,250 to £885,600 (a fall of 2.8%). As already noted, the method of fixed cost allocation used by the company based on volumes is questionable. The revised sales value based allocation method shows that the overall fixed costs allocated to the conventional product fell from £455,625 in 2011 to £450,081 in 2012, a reduction of 1.2%.

Using these revised fixed cost allocations the operating profit margin has fallen from 25.9% in 2011 to 24.8% in 2012. The primary causal factor explaining why this has occurred is the fall in sales volume. Tractor mowers In 2012 the key factors affecting the change in profitability of tractor mowers were: (i) a 10% reduction in selling price from £2,000 to £1,800; and (ii) an increase of 4.4% in sales volume from 2,700 to 2,820. Variable costs per unit were unchanged.



The reduction in selling price may be causally linked to the increase in demand (downward sloping demand curve) but other factors may also have been relevant in that we do not know what would have happened to demand if the price had remained unchanged (see below). Overall, in consequence of the price decrease and sales volume increase, revenues have fallen by 6% from £5.4m in 2011 to £5.076m in 2012. To the extent that the volume change was due to the price change, this would imply that demand is inelastic. As a consequence, the price reduction strategy could have significantly contributed to the fall in revenue of the tractor product in 2012 compared to 2011. The increase in fixed costs of 11.4% has also contributed to the reduction in profit of the tractor range. Profitability of the tractor mowers has fallen as a result of the reduction in revenues. Using the sales volume basis for fixed cost allocation, operating profit has decreased by 20% from £2,396,250 to £1,917,600. Using the sales value basis for fixed cost allocation, operating profit has decreased by 23.6% from £1,940,625 to £1,482,081. Comparison of the conventional and tractor range performance

Both conventional and tractor ranges have suffered a significant reduction in profit in 2012 compared to 2011 under both allocation bases. In absolute terms, tractor mowers are more profitable than conventional mowers measured by both profit and contribution – although a more detailed review of overhead cost drivers may alter the data significantly. The cause of the fall in profit for the tractor range may be largely endogenous ie choosing internally a price reduction strategy. It may therefore be within the company’s control to reverse this price increase and restore future profitability to 2011 levels. Overall profit Overall operating profit has fallen by 20.4% from £2,781,000 in 2011 to £2,212,800 in 2012 (irrespective of the cost allocation method used). While the fall is substantial, the company remains reasonably profitable with an overall operating profit margin on revenue of 27.6%. If the price reduction is reversed, then some of the fall may be recovered in 2013.



Examiner’s comments Requirement (a)(i) requests candidates to analyse the performance of GGM, and each of its two products, in the financial years 2011 and 2012. The majority of candidates answered this question in the report format that was required. The overall analysis of performance varied significantly from candidate to candidate. The higher scoring candidates used a variety of ratios such as change in revenues, profit margins and contribution. These data were used, in part, to explain the impact of the decrease in sales of conventional mowers. Also, the sales price of tractor mowers had reduced and, as a consequence, they had experienced an increase in sales volume. Some extremely good answers were produced in this respect, with candidates using price elasticity of demand to demonstrate the relationship between volume and price and thereby identify causal factors to explain the changes occurring in the data. Only a minority of candidates developed their answers further and calculated the reallocation of fixed costs on a sales value basis. Most candidates calculated ratios for each of the two types of product separately and for the company as a whole for each year. This gave a structure for them to undertake further analysis. The key issue which most candidates identified was the fact that tractor mowers were more profitable, but were aimed at a niche market. At the other end of the spectrum, the weaker candidates merely copied out the sales and cost figures from the question and made a vague attempt at analysing profitability. For these candidates there was normally no consideration of the relationship between price and volume, nor of the impact of changing the current method of allocation of fixed costs. The lowest scoring candidates merely made assertions describing the changes in ratios, with little, if any, attempt at an analysis of causality. Some candidates spent too much time discussing market share in this section, rather than in (a)(ii).

Total possible marks Maximum full marks

17 15



(a)(ii)

Market share can be determined in terms of volume of sales or by sales value. Which is selected would depend on the purpose for which the analysis is being used. A further issue is in defining the market. The broadest useful definition is likely to be the UK mower market. As GGM does not currently produce other powered garden tools and equipment then taking this wider definition does not seem appropriate. Within the mower sector there are various sub-sectors eg type of cutting blade; tractor and conventional; or method of power (petrol, electric, battery and hand-propelled). The level of sub-analysis which would be appropriate could depend on a number of factors but one key issue would be whether consumers would readily substitute one good for another (eg it carries out the same function and is in the same price range). On this basis one could argue that the tractor mower is different from conventional mowers on the grounds of price and function in its suitability only for large gardens. Taking the market split of tractor and then conventional mowers, a sales volume analysis of market share is as follows:

2011 Forecast 2012 Conventional

mower Tractor mower Conventional

mower Tractor mower

GGM (units) 8,100 2,700 7,380 2,820 Market (units) 1.5m 30,000 1.5m 30,600 Market share 0.54% 9% 0.49% 9.2%

In terms of sales value, market share is as follows:


mower Tractor mower Conventional

mower Tractor mower

GGM Revenue (£) 3,240,000 5,400,000 2,952,000 5,076,000

UK market at retail prices (£s) <W1>

360,360,000 35,640,000 367,640,000 36,360,000

UK market at wholesale prices (£s) <W2>

288,288,000

28,512,000 294,112,000 29,088,000

Market share at wholesale prices

1.1% 18.9% 1.0% 17.5%

Total market share at wholesale prices

2.7%

2.5%

<W1> The UK market for mowers, by value, amounted to £396m in 2011 and £404m in 2012. Tractor mowers make up 9% of this market. However these are retail prices.

<W2> Retail prices are reduced to 80% (ie 1/1.25) to obtain wholesale prices.

Thus GGM has a very small share of the conventional mowers market at around 1%, but a reasonably significant share of the tractor mower market.

A further analysis could be of petrol-powered mowers alone but this might not add much to the usefulness of the information if petrol and electric mowers are close substitutes.

Note: the UK mower market share relates to the goods sold in the UK; as opposed to the UK mower industry, which is the goods manufactured in the UK.



Examiner’s comments Requirement (a)(ii) asks candidates to determine the current UK market share of GGM, highlighting any problems that arise in defining market share in order to produce a useful figure. Most candidates attempted to determine market share for both products in terms of sales volume and sales value. Only a minority correctly adjusted for differences between wholesale and retail prices, and many ignored this issue altogether. Similarly, only a minority of candidates made a decent attempt at explaining the key problems in defining the market.


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(a)(iii)


mowers Tractor mowers Conventional

mowers Tractor mowers

GGM Average price (per Question)

£400 £2,000 £400 £1,800

Retailer price x 1.25

£500 £2,500 £500 £2,250

UK MARKET

UK market at retail prices (£s)

360,360,000 35,640,000 367,640,000 36,360,000

Market (units) 1.5m 30,000 1.5m 30,600 Average price £240 £1,188 £245 £1,188

Conventional mower market GGM is a minor participant in the UK conventional mower market with a market share of around 1% in both value terms and volume terms. This places it in a weak competitive position in this market. The fall in conventional mower sales revenue in 2012 and the reduction in market share indicates a worsening of GGM’s competitive positioning in this market. In volume terms, a decrease from 0.54% to 0.49% implies a worsening in competitiveness. The fall in conventional mower sales revenue in 2012 and the reduction in value-based market share may indicate a worsening of GGM’s competitive positioning in this market. Indeed, reduced conventional mower sales volume occurred despite no change in selling price by GGM and with competitors increasing selling price from an average of £240 in 2011 to £245 in 2012 (2%). Within the conventional mower market, GGM is placed very much towards the quality end as its price of £400 becomes a retail price of £500 with a 25% mark up, which is more than double the market average of £245 in 2012. Its competitive position therefore needs to be considered against rival companies who also operate in the niche up-market sector of the conventional mower product market.

GGM may have suffered with consumers downgrading their purchases to cheaper products in the recession.



Tractor mower market GGM is a significant player in the UK tractor mower market with a market share of 17.5% in value terms in 2012. This places it in a strong competitive position. The fall in tractor mower sales revenue in 2012 and the reduction in value-based market share may indicate a worsening of GGM’s competitive positioning in this market. However, in volume terms, an increase from 9% to 9.2% implies an increase in competitiveness on this basis at least. Within the tractor mower market, GGM is placed very much towards the quality end as its price of £2,000 in 2011 is higher than the market average of £1,188 even allowing for differences between retail and wholesale prices. Even in 2012 with the price reduction to £1,800 it is still significantly higher than the market average. Its competitive position therefore needs to be considered against rival companies who also operate in the same niche up-market sector of the tractor mower product market. The tractor mower range has increased sales volume by 4.4% in 2012. As already noted, part of this may be due to a price reduction. However there has also been market expansion of 2% in volume terms. So while GGM has increased sales this is partly due to market expansion and partly due to lower prices. Note that the average market price has been constant so GGM has lowered price and has captured more market share but reduced profit in the process. Note also that as GGM has reduced price and is part of the market, then if the overall average market price has remained constant, on average competitors must have increased prices.

Overall competitive positioning

In the UK market revenues amounted to £404m in 2012.

GGM’s revenue is £8.028m, but when adjusted to retail prices it represents £10.035m.

GGM does not export outside the UK, so this is their total revenue. In terms of global sales therefore, GGM may overall be a small participant in the global industry and suffer competitive disadvantage in the UK market against international competitors from relative diseconomies of scale.

Examiner’s comments In requirement (a)(iii), candidates were asked to explain the competitive positioning of GGM in the UK mower market and to assess how this has changed between 2011 and 2012. Most candidates answered this question by starting with Porter’s generic strategies then making an attempt to link this with the scenario. Most did this by considering the two products separately. A significant number of candidates said that the positioning was ‘stuck in the middle’ with regards to the tractor mower as they were reducing the price, but still trying to promote a quality product. Candidates also used other models such the BCG matrix and Bowman’s Clock. Very few candidates presented decent numerical analysis to this requirement. Most commented on the change in price of the tractor mower, but only stronger candidates commented on the fact that the average market price had also fallen.


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(a)(iv) GGM board’s strategic plan The Ansoff matrix is a useful model for identifying growth opportunities. There are four routes to growth in the model’s two-by-two matrix of Products (new and existing) and Markets (new and existing). The expansion strategy proposed by the GGM Board is one of product development in the Ansoff model. This means developing and launching new products into current markets. The strength of this proposal is that GGM has experience and understanding of buyer and consumer behaviour in this market sector. Customers for the new products (petrol-powered garden tools and equipment including hedge trimmers, strimmers, chainsaws) are likely to be the same garden centres and DIY centres that already purchase the GGM mowers. GGM may therefore have knowledge of the customers, and trust from the customers. Economies of scope may also occur in distributing goods to common locations, which may reduce common costs. In terms of manufacturing capability there appear to be common elements and therefore core competencies in production that can be exploited to gain competitive advantage. This is likely to include using a smaller scale version of the petrol engines used on the mowers, but also other aspects such as cutting blades for hedge trimmers and chainsaws. In terms of the size of market, the UK garden tools and equipment market is larger than the mower market as mower sales make up only “about 45% of the overall gardening equipment industry.”



Data analysis

Low demand Estimated demand High demand

Volume (units) 20,000 25,000 30,000

Price £150 £150 £150

£000s £000s £000s

Revenue 3,000 3,750 4,500

Variable cost (1,800) (2,250) (2,700)

Contribution 1,200 1,500 1,800

Fixed cost (1,400) (1,400) (1,400)

Profit (200) 100 400

Profitability At the expected level of demand, the GGM board proposal makes a profit. However at only £100,000 this is extremely modest and will only relatively marginally add to the company’s current profit for 2012 of £2,212,800. Even at the top end of the estimation range it will only add £400,000 a year to profit, and there may be a low probability to this level of demand occurring. Unless there are synergies with existing production, the new strategy would not add significantly to profit and growth. Indeed, as a measure of the scale of new activity, profit in 2011 was £2,781,000 and so profit fell by £568,200 in 2012. This fall would not be made good by the new project even at the top end of the range of estimates. Risk A key feature of the new project is that it carries risk. In particular, while the contribution margin is high at 40%, there are also high fixed costs, making the operating gearing high. This is illustrated in the above table which shows that, in the worse case scenario, if sales volumes fall by 20% an operating loss of £200,000 will be made. The break even revenue is: £1.4m/0.4 = £3.5m Thus, the margin of safety from the ‘most realistic estimate’ is only £250,000 of sales. Therefore if sales fall by just 6.7% below the most realistic estimate, no profit will be made. A key issue in assessing risk therefore is how probable it is that sales will fall to this level. While the market researchers indicate some uncertainty with respect to sales volumes this is only one variable. Other estimates are also likely to be surrounded by some uncertainty (eg price, variable cost, fixed costs). Conclusion This project does not look to be sufficiently profitable to improve growth significantly and contains risks which may reduce future profits. While most competitor mower manufacturers also produce petrol-powered garden tools and equipment, and qualitatively it seems a reasonable proposition for GGM, quantitatively, based on the data provided, it does not seem a way forward for GGM. Indeed, had it been so, perhaps the company would have entered this market some time ago.



BB’s strategic plan The expansion strategy proposed by BB is also one of product development in the Ansoff model in respect of UK sales. However, there is also an element of diversification in the Ansoff model in respect of US sales. This involves moving away from core activities and developing new products for new markets, which involves the greatest risk of all strategies. It requires new skills, new techniques and different ways of operating. This is reinforced as not only has GGM not used battery technology before, but BB has not made mowers before. A further way of viewing the potential acquisition is from BB’s perspective. It is continuing a policy of downstream vertical integration. In terms of UK sales there are similar advantages as the GGM board proposal (albeit with a different type of new product). There are economies of scope in distribution to the same customers, and there may be some common core competencies (eg the blades) with existing production methods and, although the battery element is new to GGM, it is core to BB. At a marketing level however there are differences. In the BB case the new products are being separately branded so there is little reputational impact from the existing GGM brand. However BB may not be known in the UK, and consumer recognition in this market needs to be established. The key advantage is that this proposal gives access to the US market through BB. However while BB operates in the US, it does not sell mowers in the US so the advantage of having BB to exploit its home market may be limited.

Data analysis

High cost Est cost Low cost

Volume 20,000 20,000 20,000

Price £500 £500 £500

£000s £000s £000s

Revenue 10,000 10,000 10,000

Variable cost (7,000) (7,000) (7,000)

Contribution 3,000 3,000 3,000

Fixed cost (3,000) (2,000) (1,000)

Profit nil 1,000 2,000

Taking the data provided at face value, the BB proposal is far more profitable than the GGM board proposal and even at the lower end of the estimation range it does not make a loss, managing to break even. However this data has been provided by BB as part of its take-over bid hence a degree of professional scepticism needs to be applied to these estimates. Due diligence procedures will be needed to ascertain their validity. The range of variation of fixed costs is considerable and yet only point estimates are given for all the other variables. Additional work is needed to ascertain why the variation is so high for fixed costs and no range of estimates is provided for other variables. A further note of caution is that, unlike the GGM board’s proposal, the BB plan is to produce more mowers. It may therefore be that consumers will buy the battery-powered mowers instead of buying a GGM petrol-powered mower. Due to this substitution, the sales noted above therefore may not be entirely incremental to the company.



Conclusion Leaving aside these reservations, if the figures are valid, then the BB proposal looks to be a more substantial contribution to growth. Tutorial note: Candidates may instead/also use other models such as the Lynch Expansion method matrix. The Lynch model is another two-by-two matrix of company growth (organic growth and external development) and geographical location (home (domestic) and international).

Examiner’s comments

In requirement (a)(iv) candidates were asked to compare the growth strategy of the GGM board with that of BB, make relevant calculations and refer to appropriate strategic models.

Again, the standard of answers here varied significantly between the stronger and weaker candidates. There was data in the question in terms of best case, worst case and estimated demand which could have been used to analyse each strategy. Only the better candidates used the information to compute the profit under the different scenarios and then went on to compute break even and sensitivity analysis.

The majority of candidates tended to use the Ansoff model. The Lynch model was also used in the stronger answers to analyse the difference between the two strategies in terms of discussion of expanding internationally. In terms of the BB strategy, the use of the highest and lowest cost estimates was often ignored in favour of using the expected cost. For the most part, candidates concluded that the BB strategy was the most attractive because of the exposure to overseas markets.

Hardly any candidates expressed any sort of professional scepticism about the data presented by BB.


14 12

(b) Ethics pertains to whether a particular behaviour is deemed acceptable in the context under consideration. Here the issue is that Hetty’s government has different laws for health and safety than the UK, but the underlying reasons for having the safety guard remain the same. In making a decision as to how to proceed, GGM may find it helpful to apply the Institute of Business Ethics three tests:

Transparency

Effect

Fairness Transparency - would GGM mind people (existing customers, suppliers, employees) knowing that it has manufactured potentially dangerous equipment, even if it were legal . This test is partly about whether GGM’s corporate ethics are open and transparent in its actions, rather than just what they claim in ethical statements. Effect – whom does the decision affect/hurt? GGM stand to gain a major order if they are willing to control costs (by omitting the safety guard) and lower price. In the short term GGM would be making more profit as a consequence of the order. However GGM risk reputational damage if it came to light it had manufactured unsafe goods and there may be repercussions in terms of lost customers in future. Other losers would be any customers of Hetty (or other users of mowers) who got hurt in the event of a safety incident.

The ethical issue here is that GGM needs to recognise that, as a business, it has an obligation to the public interest and its wider stakeholders to behave responsibly. The requirement and expectation to make profits need to be constrained by these obligations, but such issues may themselves impact on long term profit.



There may also be certain industry codes of conduct that apply, and consequences from a breach of these, irrespective of where the items are sold. Fairness – would the decision be considered fair by those affected? The issue for GGM is that they are being asked to manufacture mowers in the knowledge that they might cause harm. Should someone be badly hurt as a result of its actions, it is unlikely that they would perceive GGM’s actions as fair, particularly if GGM was seen to have gained financially by winning more business. Honesty A final issue is one of honesty and professional scepticism. GGM should take legal advice regarding the legality of the modification being considered in order to substantiate the assertion that any such modification would be legal in Hetty’s home country. Response GGM may believe that, even if the deal would be in its short term commercial interests, the additional profit is not worthwhile given the breach of corporate ethics that would be involved, even if no safety incident ever transpired from the modification. One possible course of action would be to insist on fitting the safety guard but to offer a lower price anyway and thereby take a reduced profit per unit. However, GGM may feel that it is not in its interests to do business with a client of this nature even under these conditions.

Examiner’s comments Requirement (b) asked candidates to explain the ethical issues arising from a request to modify its mowers for a potential export contract. Answers to this requirement varied but were, on the whole, disappointing. Candidates tended to approach this requirement in terms of a transparency, fairness and effect framework. What candidates did not then develop, however, were the next steps or draw any sort of conclusion. A significant number of candidates mentioned the ICAEW code of ethics, self-interest and integrity. This question did not focus on the code of ethics as the client (from whose perspective the ethical issues are being considered) may not have any ICAEW members. Rather, the question required candidates, in a commercial scenario, to assess the legality and ethics of the proposal and the corporate social responsibility of GGM as a company. The weakest candidates failed to see the issues at the corporate level and instead presented an answer as though it was an individual’s ethical issue. Only some candidates gave sensible business advice, such as providing the mowers with the safety guard but not charging for this feature in the price, in order to break into that market. Instead they just stated that the contract should be refused. Whilst the approach to ethics has improved significantly over the years, there is still an inability of candidates to apply ethical principles to business situations.


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Question 2 – Care 4U

General comments The scenario in this question relates to a private company which owns a large chain of retail pharmacies. It has a good reputation but it has had problems retaining and motivating individual salaried pharmacists. There are also issues regarding the manner in which the outlets should be controlled and managed. The board has proposed two alternative strategies to expand the chain, to attract pharmacists and increase motivation. These proposed strategies have been identified as: (i) franchising; and (ii) shared ownership.

(a) Strengths

C4U sells essential products for both prescription items and over-the-counter (OTC) medicines so market demand is likely to be robust to changes in the economy and (for the market as a whole) price inelastic.

C4U has a significant number of outlets providing scale economies for purchasing (enabling discounts from pharmaceutical suppliers), IT (the centralised system is likely to be mainly a fixed cost enabling additional outlets to benefit at near zero marginal cost) and other central operational services (such as central administration which is likely to have a significant fixed cost element).

There is a history of sustaining growth through good management which has a track record of competence.

Funding available for expansion means the company has significant liquidity which lowers financial risk and provides opportunities for growth.

Good reputation as community pharmacies with free tests, screening and advice increases goodwill and enables a loyal customer base to be established of regular customers/patients

Good control through the IT system means the performance of the business is monitored and controlled at the level of each individual pharmacy.

Weaknesses

There is a shortage of well motivated pharmacists who are good managers which means that, whilst the technical functions may be competently carried out, the same people may not have the key business skills to build revenue and control costs at the pharmacy level of the organisation which is the key interface with customers.

There are problems retaining pharmacists. This leads to retraining costs and the continued losses of a key human resource. The temporary nature of the employment may mean pharmacists have a low level of long term commitment to C4U.

Generous salaries need to be paid to pharmacists which increases the cost base significantly and reduces profit.

Opportunities

Increases in new drugs becoming available will mean that demand will increase both in terms of volume

and, to the extent that new drugs are more expensive, may increase price

Pharmacy retailers have exited the industry thereby reducing competition from that source as there are fewer competitors remaining in the industry. There is therefore the opportunity to capture the markets of those leaving the industry

Capacity to charge in future for provision of advice, which is currently given free

Sell whole business to a large national chain

Expand through acquisition



Threats

Deregulation has made C4U susceptible to price competition for OTC drugs from supermarkets and other large companies in the industry who have scale economies and common costs with other functions in the store.

Supermarkets are opening more in-store outlets offering increased non-price competition for all drugs. This competition comes in the form of 24 hour opening, convenience (shopping anyway for other goods), car parking out-of-town, scale of facility (and therefore range of items held in inventory giving choice).

The prescription drugs market is susceptible to government regulation in terms of contractual conditions. Changes in such regulations are a risk to C4U.

Government funding cuts will put pressure on prices paid to pharmacies in terms of the products that they will fund and the prices they are willing to pay for drugs and pharmacy services.

Other goods sold by pharmacies are non-essential and are more susceptible to a sustained economic downturn and to competitive forces from a wider range of competitors outside the pharmacy sector.

Alternative distribution channels for OTC are likely to be an increasing threat to high street pharmacy retailers (eg on-line sales, drug stores (OTC drug only shops)).

Conclusion Key factors are:

Reductions in government expenditure are key as this puts pressure on pharmacies for their main source of income which makes up 80% of revenue and if recoveries from government are reduced, with constant costs, then severe pressure is put on profits. Any cuts are also likely to be sustained as governments continually look to reduce public sector expenditure.

Competition from supermarkets which: are pervasive in most regions; are instantly recognisable by consumers; have the ability to be low cost providers and tend to be trusted as providers of services (including healthcare).

Examiner’s comments Requirement (a) asks candidates to prepare a SWOT analysis. Attempts at this requirement were generally good, with candidates demonstrating a strong understanding of the SWOT model and using the information in the question to produce high scoring answers. The key strengths and weaknesses identified centred around the brand name, the established reputation and the good IT control system, together with the problems in staff retention and the lack of management experience from the pharmacists. The opportunities and threats were not as well identified, although the majority of candidates did manage to identify that the main opportunity was the increase in new drugs, whilst the main threat was government spending cuts. Some candidates attempted to use the PESTEL model, despite the question specifically asking for a SWOT analysis. It was quite surprising that a number of candidates failed to summarise the key issues from the SWOT analysis despite the requirement specifically requiring a conclusion.


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(a)(ii)

Profitability

Profit shares for average size pharmacy (first 5 years)

Total C4U’s profit under franchising

C4U’s profit under shared ownership

Revenue 600,000 30,000 (ie 5%)

Operating costs (80%) (480,000)

Operating profit (20%) 120,000

Management fee (under shared ownership option only)

(20,000) 20,000

Net profit 100,000 50,000

Up-front payment (amortised over 5 years)

5,000 -

Annual profit to C4U 35,000 70,000

Total profit for C4U (over 5 years)

175,000 350,000

Franchising

The up-front cash payment for the franchisee, averaging £25,000, is small by comparison to the shared ownership scheme which averages £40,000. However, with franchising, this payment would be recognised as revenue for C4U (amortised over 5 years) whereas the initial cash payment under the shared ownership scheme is a capital payment and would never be recognised in C4U’s profit.

The up-front payment is small by comparison to the initial cost of opening a pharmacy so there is a small initial stake by the franchisee. This means that C4U has a high capital stake with franchising and may therefore expect a higher absolute level of profit to earn the same % return on investment. Over the five year period the net cash investment by C4U for an average pharmacy under the franchise arrangement is £175,000 (£200,000 purchase price - £25,000 upfront fee). This is fully recovered according to the above table in terms of C4U’s share of profits over the 5 year term (although this is not the case after tax and interest). After 5 years C4U has all rights to the pharmacy business and the full profit stream. Meanwhile however there is an annual interest cost to C4U from providing the funds.

Shared ownership

C4U would receive the management fee in addition to the 50% share in profit, but the profit share is determined after the deduction of the management charge so in effect C4U is incurring half the cost of its own management charge.

As noted above, the additional capital stake is not recognised in C4U’sprofit.

The profit of the shared ownership scheme is overstated compared to the franchise arrangement as the revenue from intensive support is included but the incremental central costs in providing that support is not included.

The net cash investment by C4U for an average pharmacy under the shared ownership scheme is £160,000 (£200,000 opening cost - £40,000 pharmacist contribution). This is more than fully recovered according to the above table in terms of the C4U’s share of profits over the 5 year term which amounts to £350,000. In this case profit will continue after the 5 years under the same arrangement unless one party decides to buy out the other.

As with the franchise arrangement, there is an interest cost to C4U in providing the initial funds to set up the pharmacy company. However to the extent that the interest is also a cost to pharmacy companies, it is an income to C4U, half of which is in effect paid by the co-owner.



Comparison The above table shows that the profit per annum with the shared ownership scheme is double that of the franchise arrangement. At first sight this may suggest that the shared ownership route is better but:

The start-up period may be a period of low profits as a new pharmacy business tries to become established against incumbents. If some costs are fixed this might mean low (or even zero) profitability in the short term, hence there may be little (or no) profit share for C4U at first with shared ownership. In contrast, under a franchise agreement at least some profit will be earned by C4U from a 5% share of revenue plus the amortised upfront franchise fee.

The above table assumes that total revenue would be the same under either ownership choice. However if the incentives for the franchisee or the share ownership partner differ between the two options (see section below) then different levels of revenue may be generated from the same pharmacy and thus different levels of profit earned for C4U.

The franchise profits are only for a period of 5 years after which full ownership can revert to C4U if it so choses. After the 5 years the profit stream to C4U would therefore be £120,000 per annum. Thus a lower short term profit will be compensated by higher long term profit with the franchise scheme compared to the shared ownership scheme

For both schemes, profits are likely to be overstated as there are likely to be additional central costs, interest and tax which are not reflected in operating profit

There may be some depreciation on the pharmacy outlet property.

Control and management

Franchising

Control is exercised loosely by C4U through the franchise agreement contract. This is more on a negative basis in preventing certain courses of action (eg complying with contract terms to avoid damaging the brand) rather than on a positive basis in promoting positive actions.

Autonomous management. Franchisees appear to be largely autonomous in being able to decide whether to accept or reject advice and support.

Each pharmacy is separately managed so diversity of approach and management styles may develop between pharmacies.

Some degree of auditing will be required by C4U in order to gain assurance regarding disclosed revenue figures to verify that the correct 5% franchise payment is being made. This will require direct access, or third party access, to accounting records and accounting systems.

After 5 years, ultimate control reverts to C4U at which time it can choose to change or adapt the management style selected by the franchisee.



Shared ownership

While the day to day management of pharmacies rests with the co-owner (the pharmacist), C4U manages and monitors the performances of individual pharmacies by providing “intensive support advice, administration and IT facilities” to the company which would be “a compulsory part of the agreement so C4U can manage the performance of its investment.”

Thus, while the co-owner takes the day to day decisions, they have a high degree of monitoring by, and accountability to, C4U.

If performance is poor and interest cannot be paid, ultimate control also rests with C4U, as the holder of the loan can force the company into insolvency.

Incentives

Franchising

The contract is only 5 years, so franchisees will not have an incentive to build long term reputation.

Even if a pharmacy performs badly and makes an operating loss, C4U still receives 5% of revenue so there are strong incentives for the franchisee to perform well and increase profit.

Franchisees have incentives to reduce costs as this will increase profit but C4U will not take any share of this as they only have a share of revenues. This may incentivise franchisees to be efficient, but may also incentivise them to reduce quality.

Shared ownership

The co-owner earns a salary and retains a half share of profits after management charges and interest. They are therefore incentivised to increase profit.

The initial contribution by the co-owner pharmacist (£40,000 on average) is at risk if the venture fails and thus this provides an incentive to succeed.

If the business succeeds then the co-owner pharmacist has an opportunity to buy out the other 50% at a fair value. There is thus the chance of owning his/her own business. However the more successful the pharmacy becomes the greater the cost of the buy-out. This may give a disincentive to over-performing while the pharmacy remains in joint ownership.



Examiner’s comments Requirement (b) requests candidates to compare the two strategies for expansion by considering: operating profit: control and management; and incentives. Candidates produced few calculations in answering the operating profit part of this requirement, opting to spend more time on the discussion aspects of the question in respect of control and management and incentives. Where calculations were performed, many candidates treated the upfront payment of £25,000 as a cost in the first year and did not amortise it over five years as expected. This led to a computed profit of £5,000 according to the franchising agreement in the first year. Other errors included: not recognising 5% of the revenue; under the shared ownership arrangement attributing C4U 80% of the profit, rather than 50%; and not thinking about ‘profit’ by recognising the full cost of the PPE as an expense. It was clear from the answers produced, that candidates were familiar with how a franchising agreement operated, but often the comments were general and not applied to the scenario. Also, there was a lack of understanding of the nature and implications of the shared ownership arrangement, with candidates failing to grasp the fact that it gave a significant amount of control and accountability to C4U. Answers to the incentives part of the question were often relatively brief, with candidates identifying that under the franchising agreement, the pharmacists still received 5% of revenues whereas under the shared ownership, the co-owners would be entitled to a half share of profit. Overall, the information in the question could have been better used. Many answers to this part were very brief and did not compare the two strategies in sufficient detail or with sufficient insight.


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Question 3 – The Mealfest Corporation

General comments The listed company in question owns a chain of mid-market restaurants controlled from Germany, but also located in France, Switzerland and the UK. The company was originally centrally controlled and had homogeneous prices for all restaurants across Europe. At the beginning of 2012 it restructured, forming a separate division for each country. After the restructuring the prices were homogeneous within countries, but not between countries. The Mealfest board now wishes to monitor the success of the new structure and strategy.

(a) Organisational structure Pre-2012 MC is a multinational corporation. As such, its structure needs to consider not only operational size and diversity, but international variations in culture, taste, economic conditions, currencies, laws and regulations. The centralised nature of the organisational structure prior to January 2012 is in danger of ignoring, or minimising the significance of, these cross border variations. Arising from this, there are a number of detailed issues with this structure and method of performance measurement (aside from the matters relating to foreign exchange rates highlighted by the finance director which are dealt with later below):

Pre-2012 there was a very flat structure with each of 100 restaurants reporting performance directly to head office. This gives a wide span of control where head office staff in Berlin can have little knowledge of all local conditions and the causes behind the changes in the three performance metrics.

The structure is also highly centralised with the key decisions relating to pricing, food sourcing and staff being taken centrally in Berlin. This may give economies of scale and discounts but narrows variety (eg different national cultures and food type preferences).

There are differences in laws and regulations with regard to employment and social security law. Apart from Switzerland, the other four countries are in the EU which reduces, but does not remove, employment law differences. Specifically, national regulation issues include the following: the minimum wage differs between countries; social security payments vary; rights of employees from outside the EU to work in the EU differ; employees rights on redundancy or dismissal differ.

It is unclear whether the performance of (i) the restaurants or (ii) the restaurant managers is being evaluated, or both.

To the extent that it is the restaurant managers that are being evaluated, then they have little control over profit other than the volume of sales/customers. Menu prices, staff allocation, staff pay and sourcing of food are all fixed centrally. Restaurant managers are therefore being held responsible for matters beyond their control if they are being monitored as a profit centre.

Centralised decisions fail to take account of local conditions. If, in a particular country, there is high unemployment, then staff may be recruited at lower pay than if labour market conditions are competitive.



Post-2012 The two key changes post-2012 are:

a change in the degree of centralisation of decision making which is now at national level rather than corporate level (international).

additionally measuring performance at divisional level rather than only at restaurant level. The decentralisation of decision making to national level reduces the issues arising from cultural, economic and legal differences. However, there may still be many of the above differences in cultural taste and prosperity within countries, as well as between countries. In terms of measuring performance at divisional level, this seems more appropriate as most of the key decisions are now being taken at this level eg pricing (see below) and staffing, so the division is a profit centre (and also a revenue centre) and has control over most of the elements contributing to profit. The exception is food sourcing which remains at corporate level and is therefore an element of performance outside the control of divisional heads. Other than revenue and profit, a third performance metric is return on assets. To make this a more valid element of performance evaluation, the divisional manager would need control over new investment and divestment (ie an investment centre). This is not the case, even under the post-2012 regime. Exchange rate issues

MC’s primary currency appears to be the euro. Germany and France have the euro as their currency so sales in these countries are not directly affected by currency translation. Food purchases from France and local labour in these countries are also payable in euro. In the UK and Switzerland fluctuations over the year in exchange rates mean that the euro value of sales revenue is likely to change subject to macroeconomic influences, rather than just decisions at restaurant or divisional levels. Wage costs are in the same currency as revenues and so provide some natural hedging. Given that food costs are in euro, this makes the euro denominated profit in UK and Swiss restaurants even more volatile than their revenues. Given that performance comparisons are in euro as a common currency, the profit of a division or a restaurant is heavily dependent on the strength of the national currency, as well as the underlying performance of the business. In measuring the return on assets in the UK and Switzerland, consideration also needs to be given to the exchange rate at which assets are translated.



Pricing Pre-2012 Pre-2012 pricing exhibits three characteristics:

the pricing decision is centralised

prices are uniform across all four countries

prices are only reset once a year Centralisation Centralisation means that pricing decisions fail to take account of local information which may be available to restaurant managers, but local conditions are unlikely to be known centrally on an up to date basis for all 100 locations in Europe. As a consequence, pricing decisions are unlikely to take account of local tastes and needs that customers may report back to individual managers. Uniformity of pricing

Uniform pricing means that MC does not take account of local competitive conditions. This means that the company does not practise price discrimination by taking advantage of variations in price elasticity between either national markets or local restaurant markets. Reset once a year Prices are uniform within the year which means they lack inter-temporal flexibility. As an example, if there is seasonality, then prices would not reflect this. This might be particularly relevant where there is large tourist market in summer, but many fewer tourists in winter, generating different demand dynamics. Post-2012 Of the three characteristics noted above, the third point remains the same (ie set only once a year) hence the problems (eg seasonality) are unchanged. The first two issues (centralisation and uniformity) have changed and the underlying issues may have been moderated, but they have not been removed. Centralisation The degree of centralisation has been reduced from being company-wide to each national division. This is an improvement in terms of devolved decision making, but divisional managers might still not be aware of the local competitive conditions facing each restaurant manager. Uniformity of pricing There is still uniformity within countries, even though variations are permitted between countries. The issues here relating to a lack of price flexibility are reduced, but variations within a country in terms of competition, prosperity and taste can still be significant, leading to geographical variations in demand and price elasticity and a continued absence of exploiting price discrimination. Exchange rate issues Under the pre-2012 system of pricing, exchange rate variations have caused volatility in menu prices in the UK and Switzerland. Such exchange rate movements are likely to reflect macroeconomic conditions rather than the conditions in the restaurant market and may thus be distortionary, leading to arbitrary and suboptimal pricing. Under the post-2012 system, there is discretion at national level to set prices and so the impact of exchange rates can be considered by divisional managers. A factor in this would be the relative rates of inflation in the UK and Switzerland compared to eurozone countries.



Examiner’s comments Requirement (a) asks candidates to compare pre and post 2012: (i) organisational structure and performance measurement; and (ii) pricing strategies. Answers tended to be brief and concentrated on the fact that pre 2012, the structure was highly centralised and flat, whereas post 2012, the decentralisation of decision making eliminated some of the cultural differences previously experienced. There was normally little or no reference to the impact of exchange rate fluctuations and resulting issues in terms of revenue differences between countries and the impact on performance assessment. Although candidates acknowledged that within the different structures the performance would be assessed in terms of revenue and profits, very few considered return on assets. In terms of pricing, candidates did not really seem to know how to approach the question and this often led to brief, unstructured answers which did not focus on the differences between the pre and post 2012 position, but instead merely repeated from the question that there had been a move from a centrally fixed pricing system to one now fixed at national level by divisional heads. There was very little analysis of how this would affect the behaviour of managers and customers or of exchange rate risk.


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(b) Benchmarking compares the use of assets across the firm or across the industry and indicates best practice to show where assets might be better used to achieve sustainable competitive advantage (SCA). One definition of benchmarking is ‘The establishment, through data gathering, of targets and comparators, through whose use relative levels of performance (and particularly areas of underperformance) can be identified. By the adoption of identified best practices it is hoped that performance will improve.’ By comparing procedures and performance, internally and externally, MC can understand how to move towards best practice by learning how to reduce costs, improve service delivery in restaurants and thereby improve market positioning to align with market leaders in the sector. There are four different types of benchmark that can be used: internal; competitive (industry wide); activity (best in class); and generic. Internal (or historic) – internal benchmarking could be at the level of comparing individual restaurants or divisions with each other to determine those that are under- or over-performing. Comparisons of restaurants could be intra-country or company-wide. It may be however that certain restaurants are best at one function (eg food quality) while other restaurants are better at a different function (eg quality of service or ambience). Historical comparison also looks at performance over time to ascertain trends/significant changes, etc. Internal benchmarking is however restrictive as it could be that MC is generally under-performing and the true benchmark of best practice is to be found within external competitors who are out-performing MC. Competitive (industry-wide) – this benchmark compares the performance of the restaurant or the division with equivalent units in other firms in the same industry or sector. This may assist MC in ascertaining ways to improve performance. Comparing the performance of a division with a rival restaurant company in the same market sector may be possible if the rival is a company that is restricted to one country. In this case the published financial statements are likely to provide relevant data to compare key financial performance indicators. They may also provide some narrative information to evaluate non-financial performance indicators. Obtaining information about the performance and functions of rivals at the individual restaurant level is more challenging, as there is less information in the public domain. Industry publications and associations could be possible sources alongside informal contacts in the industry and personal visits to rivals. If the whole national industry is under-performing, international comparisons may be more useful so comparisons could also be made with restaurants in other national markets (eg the US). Activity (best in class) – compares with best practice in whatever industry can be found eg could compare MC table booking systems with online booking system for hotels or airline seats to ascertain whether there is scope for improved efficiency. Similarly, the levels of service could be benchmarked against other industry service practice (eg first class airline travel; hotel reception); food preparation could be compared to cookery competitions or the best home cooking. Generic – against a conceptually similar process eg compare food preparation to the treatment of VIPs at visits and events. Food hygiene could be compared to a hospital operating theatre.



Examiner’s comments Requirement (b) asked candidates to explain how benchmarking may be used to evaluate performance of divisions and of individual restaurants. A good knowledge was shown of the nature of internal, competitive, activity and generic benchmarking, with the majority of candidates displaying an understanding of each. However, answers’ application to each type to the scenario tended to be very general with insufficient consideration of the circumstances of the scenario. Some candidates went on to use a balanced scorecard approach, identifying CSF’s and KPI’s. Whilst this identified some reasonable points, this approach was neither necessary nor entirely suitable for this requirement.


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