BIRMINGHAM CITY BUSINESS SCHOOL
UNDERGRADUATE/POSTGRADUATE DEGREES
COURSEWORK FRONT SHEET
MODULE TITLE: MBA Managing Financial Performance
MODULE CODE: ACC7004
LECTURER: Dr Philip Talbot
ISSUE DATE: 4.02.2013
HAND IN/PRESENTATION DATE: 15.04.2013
HAND BACK DATE: 20.05.2013
Learning outcomes and pass attainment level:
· Enable students to develop a critical understanding of the main financial objective of the firm and the constraints which impact on that objective.
· Introduce students to the need for accounting information for management attention and to some basic concepts and ideas such as problem-solving, planning, control and decision-making
· Introduce students to the main theories and concepts upon which a firm’s investment and financing decisions are founded, and their applications in practice.
· To introduce students to the financial reports of various types of business entities, the use of accounting ratios, their interpretation and limitations
The assessment for this unit is this one coursework assignment. The required mark has been set at 50%.
This is an individual assessment requirement. There is no objection discussing the content and approaches to be adopted in the final submission you must make 100% your own work. Plagiarism and copying will not be tolerated and may lead to subsequent penalties being imposed.
There are three separate questions. All three questions must should be attempted and submitted together on numbered pages. Your answers should be prepared and submitted in Word format. Excel spreadsheets may be used but must be pasted into the Word document and not submitted separately. This should be carefully checked before submission for the use of appropriate and acceptable grammar. The correct use English spelling is to be employed throughout and no other. All submissions must be page numbered and contain your student ID number.
When determining the amount of effort and words for each section of the assignment it will be advisable to examine the weighting of the marks allocated to each question. If any part of the assignment is ignored then this reduces the maximum marks that could be potentially be earned.
The word limit to any potential narrative question in the third section will be a maximum of 1,500 words excluding the bibliography.
The assignment will require a considerable personal investment of time and effort. This is an individual assignment and all calculations, analysis and narrative submitted must be your own work.
The following matrix has been included to help guide you.
Section A
Section B
Section C
1a. Financial Analysis (39%)
2a. Marginal Cost Statement-Original Contract (14%)
3a. Research (20%)
Fail
Lack of breadth and depth of financial analysis techniques
Accompanied by incorrect formulae, calculation without explanation and poor layout
Failure to produce of a clear and comprehensive Marginal Income Cost Statement without identifying and separating out variable costs, fixed costs and contributions within the limiting factor and across the product portfolio
Intermediate calculations not or inaccurately provided.
Failure to engage with the topic and lacking credible academic argument. No evidence of research other than internet sites of dubious quality. Poorly structured with inadequate grammar
Bare Pass
Evidence of some financial analysis techniques but with errors of formulae and calculation with insufficient explanation and adequate presentation
Partial production of a comprehensive Marginal Income Cost Statement partially identifying and separating out variable costs, fixed costs and contributions within the limiting factor and across the product portfolio
Intermediate calculations partially and/or inaccurately provided.
Partial engagement with the topic with some limited evidence of research. Grammar, structure and layout adequate.
Above Average Pass
Wide range of financial analysis techniques evident supported by full disclosure of formulae and accurate calculation in clear format.
Production of a clear and comprehensive Marginal Income Cost Statement clearly identifying and separating variable costs, fixed costs and contributions within the limiting factor across the product portfolio.
Intermediate calculations accurately provided.
Identifying the arguments surrounding the topic with reference to credible academic citations that are fully referenced in a bibliography
A structured, coherent narrative employing above average grammar and evidencing student research
1b. Narrative Analysis (11%)
2b. Marginal Cost Statement-New Contract (9%)
Fail
Not presented in business report format with no supporting appendices. Descriptive rather than analytical. Poor narrative structure and inadequate grammar lacking an overall knowledgeable synthesis
Inaccurate revised production schedule to maximise returns without clear supporting calculations. Failure to produce an analysed Marginal Cost Income Statement across the portfolio and not identifying variable costs, fixed costs, contributions and the revised overall profit
Bare Pass
Attempt at a business report format with some supportive appendices. Mainly descriptive with some attempt at synthesis. Grammar and structure being adequate.
Partial identifying revised production schedule to maximise returns with some supporting calculations. Partially producing an analysed Marginal Cost Income Statement across the portfolio identifying variable costs, fixed costs, contributions and overall revised profit
Above Average Pass
In business report format and coherently structured and supported by referenced appendices. Effectively synthesises the calculative narrative into an informed narrative
Identifying revised production schedule to maximise returns with clear supporting calculations. Producing an analysed Marginal Cost Income Statement across the portfolio identifying variable costs, fixed costs, contributions and overall revised profit
2c. Decision Making (7%)
Fail
Mainly descriptive without reasoned conclusions on the overall contract decision without consideration of financial and non-financial implications
Bare Pass
Partially based reasoned conclusion on the contract decision with some financial and non-financial implications
Above Average Pass
Rationally based conclusion on contract decision with comprehensive evaluation of the financial and non-financial implications.
Q1
Presented below are the annual financial statements of Clinton Cards Plc for the financial years 2009 to 2011.
Required:
Prepare a business report for the board of directors which analyses the performance of Clinton Cards Plc over the financial period 2009-2011 by using all of the financial information provided and, recommend what the directors should do to address the company’s position.
(50% Marks)
Appendix 1
Clinton Cards Plc
Statement of Comprehensive Income as at 1st August
2011
2010
2009
£000’s
£000’s
£000’s
Revenue
364,218
394,007
345,200
Opening Inventory
37,653
36,217
49105
Purchases
363138
366,810
306447
Closing Inventory
43,202
37,653
36,217
Cost of Sales
357,589
365,374
319,335
Gross Profit
6,629
28,633
25,865
Other operating income
94
148
68
Administrative expenses
-13,850
-11,609
-10,276
Loss on plant disposal
-985
-1469
-1824
Profit on acquisition
13460
Impairment plant and property
Operating Profit/loss
-8,112
15,703
27,293
Finance income
96
253
386
Finance costs
-2,992
-3,149
3,089
Loss on financial instruments
-824
430
Profit on financial instruments
356
Write down of property
-10
-7
68
provision discount
Profit /Loss before taxation
-10,662
11,976
24,092
Income Taxes
-1,428
3,646
113
Profit/Loss from continuing
-12,090
8,330
23,979
operations
Loss from discontinued operations
-2943
-952
-57,619
Profit/loss for the period
-15,033
7,378
-33,640
attributable to owners of the company
Other comprehensive income
Loss Currency translation differences
-233
-92
-4
Total comprehensive income/expenses
-15,266
7,286
-33,644
Clinton Cards Plc
Statement of Comprehensive Position as at 1st August
2011
2010
2009
£000’s
£000’s
£000’s
Non Current Assets
Goodwill
17,326
17,326
17,326
Intangibles
1,750
1,750
1,750
Property, plant and equipment
48,729
58,162
65,204
Deferred tax asset
172
411
Total non-current assets
67,805
77,410
84,691
Current Assets
Inventories
43,202
37,653
36,217
Trade and other receivables
18,917
17,882
19,418
Derivatives
250
Current tax asset
886
Cash and cash equivalents
19,673
7,225
9,056
Total current assets
82,678
62,760
64,941
Total Assets
150,483
140,170
149,632
Equity and Liabilities
Called up share capital
20,693
20,693
20,693
Share premium account
5,873
5,873
5,873
Capital redemption reserve
50
50
50
Currency translation reserve
233
325
Other reserves
308
308
308
(Accumulated losses)/retained earnings
-3,951
11,082
3,704
Total equity
22,973
38,239
30,953
Non Current Liabilities
Deferred tax liabilities
1,289
Provisions
2,772
1,909
1,298
Deferred income
9,025
9,417
7,868
Total non-current liabilities
13,086
11326
9166
Current liabilities
Borrowings
53,527
41,566
56,581
Trade and other payables
55,458
47,370
51,265
Derivative financial instruments
218
574
Tax liabilities
456
1,301
Provisions
5,221
639
366
Total current liabilities
114,424
90,605
109,513
Total liabilities
127,510
101,931
118,679
Total equity and liabilities
150,483
140,170
149,632
Financial Information
Company share price and FTSE 100 Index as at 1st August
Year
2009
2010
2011
2012
2013
Share Price
In pence
27.09
35.00
12.50
6.75
6.75
FTSE 100
4682.50
5397.10
5774.40
5712.80
6682.00
Q2
Belling Company Ltd manufactures three types of ceramic coffee percolator, the Basic, Deluxe and the Premium models. The maximum market demand and resource requirements of each of these products are shown below. The percolators are made from an advanced heat-resistant material that gives the firm a competitive advantage. An e-mail from the purchasing manager has informed you that, because of a problem with the supplier, it should be assumed that the half year’s supply of this special material is limited to 28,000kg.
Belling Company Ltd operates on a just-in-time production (JIT) method so that opening and closing inventory levels are zero.
The sales director has already accepted an order for 1,000 Deluxe percolators that, if not fulfilled, would incur a financial penalty of £2,000. This order is included in the Deluxe’s maximum market demand figure.
Belling’s directors need to know whether they should go ahead and satisfy the contract and then prioritise production in the normal way or whether it should consider breaching the contract and incurring the penalty.
Budgeting Data for first half year 2013
Basic
Deluxe
Premium
Maximum demand (units per year)
4,500
2,000
4,000
Special ceramic material used per kettle (kg)
2.00
5.00
8.00
The financial out turns for the previous two half years is as follows;
First Financial Half Year 2012
Basic
Deluxe
Premium
TOTAL
Sales in units
4100
1800
3600
£
£
£
£
Sales
114800
93600
302400
510800
Costs
Raw materials
41000
45000
144000
230000
D Labour
8200
7200
28800
44200
Overheads
60800
42400
56800
160000
Total Costs
110000
94600
229600
434200
Profit/Loss
4800
-1000
72800
76600
Second Financial Half Year 2012
Basic
Deluxe
Premium
TOTAL
Sales in units
4600
2200
4325
£
£
£
£
Sales
128800
114400
363300
606500
Costs
Raw materials
46000
55000
173000
274000
D Labour
9200
8800
34600
52600
Overheads
64800
45600
62600
173000
Total Costs
120000
109400
270200
499600
Profit
8800
5000
93100
106900
Required
Prepare a product analysed and total marginal cost income statement for the first half year of 2013 assuming that the Deluxe contract is honoured.
Prepare a product analysed and total marginal cost income statement for the first half year of 2013 assuming that the Deluxe contract is not honoured.
Advise the company what action they should undertake based on your analysis above
(30% Marks)
Q3
A firm has a role to play in the economic system if transactions can be organised within the firm at less cost than if the transactions were carried out through the market. The limit to the size of the firm is reached when the cost of organising additional transactions within the firm exceed the cost of carrying out the same transaction through the market.
Coase, R, H., (1937), The Nature of the Firm, Econimica
Critically discuss how the current trend amongst Western European based international companies in order to co-ordinate and standardise their finance and accounting functions across their companies’ is to outsource their routine finance activities to a third party supplier in relation to Coase’s arguments and that of Oliver Williamson (1981).
As an alternative Western European companies could establish a centralised Shared Service Centre (SSC) instead of continuing with multiple geographical accounting offices. The initial formation however, would be expensive and time consuming however, this option it is argued could ensure greater control over operations.
Required
Discuss the relative merits and drawbacks of Western European Companies outsourcing their finance function to a third party provider compared to establishing and centralising the finance function in a dedicated SSC with reference to Coase and Williamson.
(20% marks)
Total 100% MARKS
Model Answers
AQ1
Report
From: Financial Analyst
To: Board of Directors Clinton Cards Plc
Subject: Financial Performance Analysis 2009-2011
Date: 29th May 2012
Introduction
In compliance with your instructions I have undertaken a financial analysis of the company’s performance for the three financial periods 2009-2011. This comprises both a financial ratio analysis and a trend analysis of the audited published financial statements. The analysis has been mainly undertaken on the pre-exceptional figures to identify the underlying core performance trends of above average performance.
Profitability
The most recent financial statements give rise to concern of the profitability of the company. The latest period analysis reveals a substantial decline in overall profitability with a negative ROCE being realised after two previous periods of high returns when compared to the CIMA performance benchmarks indicating a high risk. This decline has occurred despite the trend of increased revenue streams being matched in 2010 by a parallel rise in the cost of sales indicating that these costs had been passed on to the customers. The trend of sales revenues has declined in the last financial period but cost of sales have fallen by a lesser proportion resulting in faltering gross profit margins unable to cover operating expenses leading to reported loss in 2011. This is alarming as in the previous financial periods of 2009 and 2010 above average ROCE returns were recorded as were operating profit margins. This recent dramatic decline is also mirrored in the return on assets which has become negative because of the recorded loss although profits were falling previously but this has become substantial during in the last financial period. The asset turnover has been maintained only due to the rationalisation of the asset base demonstrated in the vertical and horizontal trend analyses which have fallen by 20% over the three years.
Liquidity
The trend analysis has shown a growth in current assets principally in the proportion of inventory held and cash arsing from the sales of non-current assets and which have become greater in the last period than the non-current assets. The large cash growth has arisen from the disposals of non-current assets. However the trend in current liabilities had increased due mainly to a combination in the proportionate growth of short-term borrowing and trade payables that has compromised the short term solvency of the company.
The short term solvency of the business as measured by the working capital ratio has been high risk by standard benchmarking over the three periods indicating insolvency although it may be the norm for the business sector if it was supported by growing revenue streams. However, the quick ratio has declined substantially and is below 0.2 to 1 that benchmarks indicate higher levels of inventory are been held as sales demand is growing insufficiently. The inventory turn has increased to 44 days from the previous improvement to 37 days leading to the higher inventory accumulation caused by management inefficiencies coupled to the falling the falling demand.
Efficiency
The level of trade receivables is more or less stable and the company’s credit control has improved whereas the payables have witnessed an upward trend to 56 days approaching 2009 levels. This indicates a positive cash flow although any further deterioration may damage supplier relations and invoke retaliation once the company’s poor financial performance becomes known
The cash operating cycle measures the time between paying out cash for the purchases of inventory, and receiving cash for the subsequent sale. The company’s cash cycle has remained steady in the last two periods with a slight decline and currently remains favourable in the short-term because payments are being delayed.
2011
2010
2009
Finished Inventory period
44.10
37.61
41.40
Receivables collection
18.96
16.57
20.53
Payables payment period
(56.61)
(47.32)
(58.60)
Operating Cash Cycle in days
6.45
6.86
3.33
Gearing
The balance sheet gearing position remains at high risk as it is above average benchmarks and it has increased with the company reliant on short-term borrowing. The business had reduced its long-term debt which it may have found difficult to secure given its financial performance.
However, the ability to service the debt from operating profit streams had dropped significantly interest cover has dropped alarmingly and it now cannot service its debt from its operating profit, i.e.
Year
2011
2010
2009
Interest cover
Operating profit /loss finance costs
(2.71)times
(£8112)m / £2992m
4.9 times
£15703m / £3149m
8.8 times
£27293m / £3089m
The 2011 financial statements reveal that the company fortunately had high cash balances from its non-current asset disposals that could meet interest payments albeit within the short -term.
Given the current lack of profitability, and the fear that profitability might deteriorate in future, this will impact on the company’s share price and market capitalisation.
Financial – Share Price
The share price originally recovered in 2010 arising from the reported increased profits and indeed the company outperformed the FTSE 100 Index. This proved only a temporary trend and the poor results and the extent of the losses reported in 2011 led to the collapse the share price as market confidence in the ability of the company’s management to redress the situation disappeared.
Later movements of the share fell even further so that the company’s market capitalisation has fallen 80.71% since its peak in 2010 and has fallen well below the overall market movement as reflected in the FTSE100
Company Share Price Trend Movement and FTSE100 Trend
Year
2009
2010
2011
2012
2013
Share Price
100%
129.20%
4.48%
2.49%
2.49%
FTSE 100
100%
115.26%
123.31%
122.00%
142.70%
Conclusion
The main areas of concern regarding Clinton Cards Plc current position are:
Low profitability
High levels of cash, making Clinton Cards Plc an attractive takeover target,
Poor management of working capital, and the risk that supplier relationship might be strained.
Clinton Cards requires urgently needed addressing these issues if it is to escape the downward spiral towards corporate failure. Ominously the dramatic downfall of the share indicates that the market regards the company as unsalvageable and is most likely to be no longer a going-concern and the share represents its asset break-up value.
Appendix 1
Clinton Cards Plc
Financial Ratio Analysis
Ratio
Formulae
metric
2011
2010
2009
CIMA Average
Benchmark
Profitability
Overall ROCE
PBIT x100
%
-10.60%
19.68%
31.18%
8%-11%
Cap Employed
Return on Assets
PBIT x100
%
-5.39%
11.20%
18.24%
Total Assets
Asset Turnover
Revenue
x
2.42
2.81
2.31
Total Assets
Net profit
NP before int and tax
%
-2.23%
3.99%
7.91%
3%-10%
margin
Revenues
Gross Profit
Gross profit x 100
%
1.82%
7.27%
7.49%
margin
Revenues
Liquidity
Working
current assets /
x:1
0.72
0.69
0.59
1-1.5
capital ratio
current liabilities
Acid test
ca’s – inventories
x:1
0.34
0.28
0.26
0.75-1.25
ratio
current liabilities
Efficiency
Receivables
Trade receivables x365
days
18.96
16.57
20.53
55-85 days
collection days
sales
Payables
Trade payables x 365
days
56.61
47.32
58.60
45-60 days
payment days
cost of sales
Inventory
Cl.Inv. x 365
days
44.10
37.61
41.40
turnover
cost of sales
Growth
Gearing
Fixed int cap x 100
%
69.97%
52.08%
64.64%
33%-47%
capital employed
Appendix 2
Clinton Cards Plc
Statement of Comprehensive Position
as at 1st August
Vertical Trend Analysis
2011
2010
2009
Non Current Assets
Goodwill
11.51%
12.36%
11.58%
Intangibles
1.16%
1.25%
1.17%
Property, plant and equipment
32.38%
41.49%
43.58%
Deferred tax asset
0.12%
0.27%
Total non-current assets
45.06%
55.23%
56.60%
Current Assets
Inventories
28.71%
26.86%
24.20%
Trade and other receivables
12.57%
12.57%
12.98%
Derivatives
0.17%
Current tax asset
0.59%
Cash and cash equivalents
13.07%
5.15%
6.05%
Total current assets
54.94%
44.77%
43.40%
Total Assets
100.00%
100.00%
100.00%
Equity and Liabilities
Called up share capital
13.75%
14.76%
13.83%
Share premium account
3.90%
4.19%
3.92%
Capital redemption reserve
0.03%
0.04%
0.03%
Currency translation reserve
0.17%
0.22%
Other reserves
0.20%
0.22%
0.21%
(Accumulated losses)/retained earnings
-2.63%
7.91%
2.48%
Total equity
15.27%
27.28%
20.69%
Non -current liabilities
Deferred tax liabilities
0.86%
0.00%
Provisions
1.84%
1.36%
0.87%
Deferred income
6.00%
6.72%
5.26%
Total non-current liabilities
8.70%
8.08%
6.13 %
Current liabilities
Borrowings
35.57%
29.65%
37.81%
Trade and other payables
36.85%
33.79%
34.26%
Derivative financial instruments
0.14%
0.41%
0.00%
Tax liabilities
0.33%
0.87%
Provisions
3.47%
0.46%
0.24%
Total current liabilities
76.04%
64.64%
73.19%
Total liabilities
84.73%
72.72%
79.31%
Total equity and liabilities
100.00%
100.00%
100.00%
Appendix 3
Clinton Cards Plc
Statement of Comprehensive Position
Horizontal Trend Analysis
2011
2010
2009
Non Current Assets
Goodwill
100.00%
100.00%
Intangibles
100.00%
100.00%
Property, plant and equipment
74.73%
89.20%
Deferred tax asset
41.85%
Total non-current assets
80.06%
91.40%
100.00%
Current Assets
Inventories
119.29%
103.96%
Trade and other receivables
97.42%
92.09%
Derivatives
Current tax asset
Cash and cash equivalents
217.24%
79.78%
Total current assets
127.31%
96.64%
100.00%
Total Assets
100.57%
93.68%
100.00%
Equity and Liabilities
Called up share capital
100.00%
Share premium account
100.00%
Capital redemption reserve
100.00%
Currency translation reserve
Other reserves
100.00%
(Accumulated losses)/retained earnings
-106.67%
299.19%
Total equity
74.22%
123.54%
100.00%
Non -current liabilities
Deferred tax liabilities
Provisions
147.07%
Deferred income
114.71%
119.69%
Total non-current liabilities
142.77%
123.57%
100.00%
Current liabilities
Borrowings
94.60%
73.46%
Trade and other payables
108.18%
92.40%
Derivative financial instruments
37.98%
Tax liabilities
35.05%
Provisions
1426.50%
174.59%
Total current liabilities
104.48%
82.73%
100.00%
Total liabilities
107.44%
85.89%
100.00%
Total equity and liabilities
100.57%
93.68%
100.00%
Appendix 4
Clinton Cards Plc
Statement of Comprehensive Income
1st August
Vertical Trend Analysis
2011
2010
2009
Revenue
100.00%
100.00%
100.00%
Cost of Sales
98.18%
92.73%
92.51%
Gross Profit
1.82%
7.27%
7.49%
Operating Profit/loss
-2.23%
3.99%
7.91%
Profit /Loss before taxation
-2.93%
3.04%
6.98%
Profit/Loss from continuing
-3.32%
2.11%
6.95%
operations
Total comprehensive income
-4.19%
1.85%
-9.75%
/(expense) for the period
attributable to owners of the
company
Appendix 5
Clinton Cards Plc
Statement of Comprehensive Income
1st August Horizontal Analysis
2011
2010
2009
Revenue
105.51%
114.14%
100.00%
Cost of Sales
111.98%
114.42%
100.00%
Gross Profit
25.62%
110.70%
100.00%
Operating Profit/loss
-29.72%
57.53%
100.00%
Profit /Loss before taxation
-44.26%
49.71%
100.00%
Profit/Loss from continuing
-50.42%
34.74%
100.00%
operations
Total comprehensive income
-45.38%
121.66%
-100.00%
/(expense) for the period
attributable to owners of the
company
AQ2
Separating out the overheads cost structure – High/ Low method
Overhead Cost Structure
Basic
Deluxe
Premium
Units
High
4600
2200
4325
Low
4100
1800
3600
Difference
500
400
725
£’s
High
64800
45600
62600
Low
60800
42400
56800
Difference
4000
3200
5800
VC £’s/Units
8
8
8
Fixed cost
total ohd
64800
45600
62600
less VC
36800
17600
34600
FIXED COST
28000
28000
28000
Belling
Contribution per unit
Basic
Deluxe
Premium
Mat’s in Kgs
2
5
8
£
£
£
£
£
£
Sales
28
52
84
Var Costs
D Mat’ls
10
25
40
D Labour
2
4
8
Var Ohds
8
20
8
37
8
56
CPU
8
15
28
Contribution per limiting factor (kgs)
4
3
3.5
Priority Ranking
1
3
2
Assuming Deluxe contract is honoured
Demand in Units
4500
2000
4000
per half year
Production Schedule
Units
Kgs
Total Kgs
Cumulative
Kgs
Deluxe
1000
5
5000
5000
Basic
4500
2
9000
14000
Premium
bal fig
1750
8
14000
28000
max
Belling
Marginal Cost Income Statement
First Half 2013
Assuming Deluxe Contract Honoured
Basic
Deluxe
Premium
TOTAL
Unit Sales
4500
1000
1750
£
£
£
£
£
£
£
£
Sales
126000
52000
147000
325000
Var Costs
D Mat’ls
45000
25000
70000
140000
D Labour
9000
4000
14000
27000
Var Ohds
36000
8000
14000
58000
90000
37000
98000
225000
Contribution
36000
15000
49000
100000
Fixed Overhead
84000
Profit
16000
Assuming contract dishonoured
Demand in Units
4500
2000
4000
per half year
Production Schedule
Kgs
Units
Kgs
Total Kgs
Cumulative
Basic
4500
2
9000
9000
Premium
2375
8
19000
28000
max
Deluxe
0
5
28000
Belling
Marginal Cost Income Statement
First Half 2013
Assuming Deluxe Contract Dishonoured
Basic
Deluxe
Premium
TOTAL
Unit Sales
4500
0
2375
£
£
£
£
£
£
£
£
Sales
126000
0
199500
325500
Var Costs
D Mat’ls
45000
0
95000
140000
D Labour
9000
0
19000
28000
Var Ohds
36000
0
19000
55000
90000
0
133000
223000
Contribution
36000
0
66500
102500
Fixed Overhead
84000
Profit
18500
Decision
The revised production plan ignores the Deluxe contract increases contribution by £2,500, which exceeds the £2,000 financial penalty for breaking the contract. In simple financial terms, there is a net gain of £500 for failing to honour the contract and redirecting scarce resources. Indeed, as long as the penalty is less than £2,500, it would be financially worthwhile for Belling Company Ltd to breach the contract.
However, this fails to reflect a range of non-financial factors that have financial implications needs to be considered if a good decision is to be made. Key issues to consider in this case include:
The customer retention, whose contract Belling have reneged on, which may become permanently lost business
Leakage of the news of Belling’s failure to fulfil a contract if it became common knowledge in the trade, may damage the company’s reputation and the consequent loss of goodwill could amount to in the long term to far more, in terms of lost sales and contribution, than the immediate net gain of £500.
The decision to manufacture only two types of percolator instead of three products may have a harmful effect on customer loyalty and sales demand.
The long-term effects of vacating the market for Deluxe kettles invites Belling’s rivals to fill the gap created and thus gain market share.
Belling will need to get to discover the reasons for the material shortages. So, working from the revised plan, if the company is able to find extra material from elsewhere, then clearly it should do so, as long as the premium for each kilogram (the cost over and above that already being paid) is less than £3.50. Since the contribution per kilogram of material used in producing the premium percolator is £3.50, this would make it worthwhile to obtain material from an additional supplier(s) if quality can be ensured.
AQ3
After the Great War (1914-1918) the role of the company within society was critically debated. These debates posed awkward questions, about why did companies exist and who were they run for and what the position of the workforce in a company is (Micklethwaite and Wooldridge, 2003:111). The most prominent economist engaged in this debate was Ronald Coase, (1937), whereby he attempted to explain why the economy had moved beyond individuals selling goods and services to one another. He located the answer within the imperfections of the market and he adjudged it as being particularly related to transaction costs. These were the costs that sole traders might incur in obtaining the most preferential deal and co-ordinating processes such as manufacturing and marketing and arguably now accounting and finance with the advances in IT and communication infrastructures.
Coase stated that transaction costs would arise for a company from acquiring information, product pricing, and the payment of commissions or even reaching a point where a contract could be constructed. The consequence of long runs and repetitive transactions would he asserted become significant and so some other form of transaction other than a free market mechanism was desirable. Coase’s arguments required of the company to do things more efficiently than the open market (Micklethwaite and Wooldridge, 2003:127).
Coase’s work has been refined further through the work of Oliver Williamson, (1979 and 1981). Williamson suggests that organisations have to choose between two alternative mechanisms to control its resources and operations. These are;
Hierarchy Solutions whereby management choose to own the assets and/or employ the staff directly and use the policies and procedures of the firm to control their use and performance. Vertically integrated companies are those which have a high reliance on the managerial hierarchy for control or,
Market Solutions whereby management choose to buy in the use of assets or staff externally under a formally negotiated contract
Transaction costs arise at the interface between economic agents, particularly between stages in a production or supply process, i.e. third parties supplying the accounting and finance function. In addition to the normal cost on external suppliers, a market solution for an input or service in addition to the price for the bought in transaction it will incur the following transactions,
Negotiating and drafting the contract
Monitoring the suppliers’ compliance with the contract with regard to quality, reliability, invoicing etc…
Pursuing legal actions for redress due to non-performance
Penalty Payments and cancellation payments if the firm seeks to revise the contract
These costs and risks assumed by both parties to the contract will be increased by two further factors labelled “Transaction Cost Risks”
Bounded Rationality – When the contract is negotiated both parties are unable to predict how the contract will unfold or predict the future, e.g. the levels and volumes of accounting and finance work expanding or contracting in the future. This leads to detailed contract negotiations and interpretation issues that increase transaction costs. Legal enforcements would further increase the transaction cost from two specific types of risk
Opportunistic Behaviour – When each agent is seeing to pursue their own economic self-interest and thus contract weaknesses could be exploited for individual benefits (e.g. a minor change in accounting and finance work specification could permit a supplier to exact higher prices because the buyer is bound by the contract to purchase the services). This will lead to expensive variations in contract terms or damage claims for breach of contract
If these transactions costs become too high then the firm may reduce these by bringing the function in-house under direct managerial control, i.e. a Shared Service Centre (SSC) a hierarchy solution. The final decision will be base on management’s requirement to minimise costs. Therefore Coases’s premise is that companies make sense when the transaction costs associated with buying things on the market exceed the hierarchical costs of maintaining a bureaucracy, then modern technology is generally shifting the balance of advantage away from companies and towards markets and individuals (Micklethwaite and Wooldridge, 2003:175-6). Coase and Williamson’s ideas were empirically tested by Joskow (1987: 168) and he concluded that buyers and sellers make longer commitments to the terms of future trade at the contract execution stage and, rely less on repeated bargaining, when the relationship –specific investments are more important.
The merits of the outsourcing option a market solution therefore would include the fact that Western European companies could draw on the expertise of a company already established in the field of transaction processing and financial reporting. It would be standardised, streamlined and make use of the latest technology. The phenomenon of outsourcing to a third party provider has been described as a transformational phenomenon and largely successful but not without risk (Nolan and McFarlan, 1995:160-162).
If Western European companies decided to outsource offshore to an emerging country, significant savings prima facie might be made in terms of wage costs and cost of premises. A large, experienced supplier might be able to offer a higher quality service than is possible in house because of the ability to make use of expertise or technologies not readily available to Western European companies. It could arguably allow Western European companies’ senior finance people to focus on the creation of value.
The drawbacks of outsourcing are largely to do with the problems of ensuring control and the associated issue of retaining confidentiality of sensitive financial data that could lead to opportunistic behaviour by the agent.
There would also be a potentially large problem if things do not work out with the supplier and Western European companies, having dismantled its existing in house finance provision, has to seek a replacement supplier so that hierarchical solutions no longer are readily available.
By comparison, the merits of setting up a hierarchical dedicated SSC are that Western European companies would enjoy complete control of its Finance and Accounting processes and be in a better position to ensure that confidential items remain confidential. These European companies would avoid the risk involved in contracting out the processing of key financial data.
A dedicated SSC also shares some of the advantages discussed above in respect of outsourcing. By centralising its Finance and Accounting operations, the European companies can reduce head count. It can save on cost of premises because most finance staff will now be accommodated in a single location. Related to this, it can choose the location where labour and other costs are lowest or alternatively where highly qualified staff and the most favourable location for a centre are available. One reason for choosing a particular location for instance could be a favourable tax regime.
There is also the advantage that, in working with other functions such as sales, marketing, Research and Development or production, finance staff within the SSC is relating to members of their own organisation and is more likely to share a common organisational culture. There is likely to be a common understanding which would help problem resolution.
Finally an SSC can benefit from economies of scale. These could derive from learning curve effects, specialisation and from being able to afford to invest in a network system with a common database that provides interactive opportunities and the benefits of sharing data.
A major drawback in comparison with outsourcing however, is the initial setting up of an SSC. This will most likely require the engagement of an outside IT contractor to provide an Enterprise Resource Planning (ERP) system tailored to the needs of the European company and also a certain degree of upheaval as well as the considerable capital expenditure.
References
Coase. R, (1937), The Nature of the Firm, Econimica 4 (16), pp. 386-405.
Joskow. P (1987), Contract Duration and Specific Investments: Empirical Evidence from Coal Markets, The American Economic Review, Vol. 77, No.1, pp168-185.
Nolan. R and McFarlan F, (1995), Outsourcing, Harvard Business Review, Vol.73 (4), pp. 160-162
Micklethwaite. A, and Wooldridge. A, (2003), The Company: A Short History of a Revolutionary Idea, London, Weidenfeld and Nicholson.
Williamson, O, (1979), Transaction-Cost Economics: The Governance of Contractual Relations, Journal of Law and Economics Vol.22 No.1, pp.233-261.
Williamson, O, (1981), The Economics of Organisation: The Transaction Cost Approach, American Journal of Sociology, Vol. 87, No.3, pp.548-577.
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