AC3004 2009 May Answers Question 1 Strategy

(a) Using Porter’s five forces model as a basis, identify the main competitive forces of an
organisation you are familiar with and discuss the threat posed by each of these.
(16 marks)

Michael Porter’s `Five Forces Model’

Threat of New
Entrants

Bargaining Competitors in Bargaining

Power of the Power of
Suppliers Industry Customers

Threat of
Substitutes
1 mark for diagram
Key issues to consider:
Threat of new Entrants:
Barriers to entry to a particular industry typically include:
• High capital investment requirements for new firms and the benefits of economies of scale for
established firms;
• Setting up distribution channels;
• The experience curve - existing firms have the benefit of experience in the industry;
• Legislation or government action (e.g. Health and Safety legislation) which may be costly to implement
for new firms;
• Differentiation of products from the products of existing firms.

Power of Buyers - this can force selling prices down. Buyers are powerful when:
• There are few buyers and many alternative sources of supply for the product;
• Buyers can 'shop around' for the best price;
• Buyers can produce the product themselves.

Power of Suppliers - this can force costs up. Suppliers are powerful when:
• There are few suppliers and the cost of switching to alternative suppliers is high;
• Suppliers can produce end product themselves.

Threat of Substitutes - this means that customers can choose alternative products with similar properties
thus reducing sales volume. The threat of substitutes is high when:
• Customers can substitute the product for another;
• The product is not adequately differentiated from (is similar to) other products in the market?

Competitors in the industry - high competition in the industry forces prices down.
Competition is high when:
• There are few balanced competitors in mature market;
• Industry has high fixed costs and high turnover sought;
• Industry has over capacity to be exploited;
• Products are similar and there are low levels of differentiation;
• Exit barriers (the cost of pulling out) are high.

Up to 3.0 marks for each of the 5 competitive forces.

An excellent answer will demonstrate understanding and include a relevant example. Total 16 marks
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Question 1 Strategy cont.
(b) Again using organisation(s) of your choice discuss the possible strategies that this
organisation(s) could adopt to gain competitive advantage.
(9 marks)

Porter (1985) suggests there are three generic strategies available for an organisation to gain
competitive advantage.

i. Cost leadership – to become the lowest cost producer for the market as a whole.
Competitive advantage is gained by having lower costs than all competitors.

ii. Differentiation – is the exploitation of a product or service to make it unique in the market
as a whole. A firm must provide something unique that is of value to the purchaser and
therefore a higher price can be commanded.

iii. Focus – depends on segmentation and involves pursuing, within the segment only and can
be a strategy of cost leadership or differentiation.

a. Cost focus – specialises in a limited number of products in a selected segment of market.

b. Differentiation focus – involves selecting a segment of market and competing on basis of
product differentiation.

Up to 3.0 marks for each strategy.

An excellent answer will demonstrate understanding and include a relevant example

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Question 2 TQM

a. Total quality management (TQM) is a term that is used to describe a situation where all business
functions are involved in a process of continuous quality improvement.
1 mark
The key factors for the implementation of TQM are:
i. The focus should be on customer needs. This should not just represent the final customer. All sections within a
company should be seen as a potential customer of a supplying section and a potential supplier of services to other
sections.
ii. Everyone within the organization should be involved in TQM. Senior management should provide the commitment
that creates the culture needed to support TQM.
iii. The focus should be on continuous improvement. Continuous improvement seeks to eliminate non-value activities,
produce products and provide services with zero defects and simplify business processes. All employees, rather than
just management, should be involved in the process since employees involved in the processes are often the source of
the best ideas.
iv. The aim should be to design quality into the product and the production process. This requires a close working
relationship between sales, production, distribution and research.
v. Senior management should promote the required culture change by promoting a climate for continuous
improvement rather than imposing blame for a failure to achieve static targets.
vi. An effective performance measurement system that measures continuous improvement from the customer’s
perspective should be introduced. Simple non-financial measures involving real time reporting should be seen as a
vital component of the performance measurement system.
vii. Existing rewards and performance measurements should he reviewed to ensure that they encourage, rather than
discourage, quality improvements.
viii. Appropriate training and education should he given so that everyone is aware of the aims of TQM.
Up to 2.0 marks for each factor up to a maximum of 7 factors giving 14 marks.
An excellent answer will demonstrate understanding of the factor. Total 15 marks.

b. 1. Prevention costs - the cost of any action taken to investigate, prevent or reduce defects and failures.
Prevention costs include:
• Quality engineering
• Design and development of quality control equipment and inspection equipment.
• Maintenance of quality control equipment and maintenance equipment.
• Administration of quality control
• Training in quality control

2. Appraisal costs - The costs of assessing quality achieved. These costs include:

• Acceptance testing
• Inspection of goods inwards
• Inspection costs of in-house processing
• Performance testing

3. Internal failure costs — costs arising within the organisation of failure to achieve the
quality specified. These include
• Failure analysis
• Re-inspection costs
• Losses from failure of purchased items
• Losses due to lower selling prices for sub-quality products
• Costs of reviewing product specifications after failures

4. External failure costs — costs arising outside the manufacturing organisation of failure to achieve specified quality
(after transfer of ownership to customers).
Such costs include
• Administration and costs of customer complaints section
• Product liability costs
• Costs of repairing products returned from customers
• Cost of providing replacement items due to sub-standard products or marketing errors.

Up to 2.5 marks for each category of quality cost up to a maximum of 10 marks.

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Question 3 ROI & Galaxy

(a) The forecast for Guildford depot is as follows:

2009 (£) 2010 (£) 2011 (£) 2012 (£) Marks
Sales W1 216,000 237,600 248,292 235,877 3
Gross Profit W2 86,400 95,040 91,476 79,061 2
Overheads 70,000 70,000 80,000 80,000 1
Net Profit 16,400 25,040 11,476 (939) 1
Investment 100,000 75,000 50,000 25,000 1
ROI 16·4% 33·39% 22·95% –3·8% 1
Total 9 marks
W1
2009 2010 2011 2012
Sales Volume (units) 18,000 19,800a 21,780b 21,780
Sales Price (£) 12·00 12·00 11·40c 10·83d
Revenue (£)
(Volume x Price) 216,000 237,600 248,292 235,877
a:
18,000 (1·1) = 19,800
b:
19,800 (1·1) = 21,780
c:
12.00 (0·95) = 11.40
d:
11.40 (0·95) = 10.83

W2

Gross Profit
2009 40% (given). Total gross profit = £216,000 x 0·4 = £86,400
2010 40% (given). Total gross profit = £237,600 x 0·4 = £95,040
2011 (40 – 5)/100(0·95) = 36·8421052%
Total gross profit = £248,292 x 0·368421052 = £91,476
2012 (40 – 5 – 4·75)/(100(0·95)(0·95)) = 33·5180055%
Total gross profit = £235,877 x 0·335180055 = £79,061

Alternatively, given that variable costs are said to be constant over the four years, could calculate the variable cost in
year one and hold for the four years. Gross profit is then simply sales revenue less variable costs.
Variable costs in 2005:
£216,000 – 18,000 x VC = £86,400
VC per unit = £7·20
So year two gross profit will be:
£237,600 – 19,800 x 7·2 = £95,040

(b) In order for a bonus to be paid in 2012 an ROI of 15% is needed.

This implies a net profit of £25,000 x 15% = £3,750. 1 mark
Adding overheads of £80,000 to this net profit means that £83,750 of gross profit is needed. 1
At a gross profit % of 33·518% this implies sales of £249,866. 1

At a price of £10·83 this suggests sales volume of 23,072 units. 1

Total4 marks

(c) Performance statistics

2005 2006 2007 2008
ROI 13% 17·5% 16·7% 20%
Bonus paid? No Yes Yes Yes
Sales Growth – 0% –10% –5·6%
Gross margin 40% 35% 35% 30%
Overheads £67,000 £56,000 £53,000 £43,000
Net profit % on Sales 6·5% 7% 5·6% 4·7%
The performance of Liverpool can be assessed in various ways:

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Sales Growth

Sales revenue growth is most unimpressive. We are told that the market in which GALAXY operates is steadily
growing and yet the centre has shrunk in terms of sales over the last four years. This could be poor volumes or poor
prices achieved. Given the reducing gross margin (see below), then a reducing sales price is likely. It is possible that
Liverpool is subject to higher than normal
levels of competition.

Gross Margin

The gross margins have also shrunk. Reducing margins can result from sales price pressure or increases in the cost of
sales levels being incurred. Suppliers might have increased prices or labour could have got more expensive. The level
of margin has only reached the normal level once in the last four years. Clearly Liverpool is under performing.

Overhead Control

The one area that is impressive is the apparent ability of the business to reduce overheads as sales and margin have
shrunk. This is often difficult to do. It is possible that reducing these overheads could have contributed to the poor
sales performance, if (for example) quality has been affected, or one could say it reflects flexible management.

Net Margin

The net margin has also fallen, primarily due to falling gross margins as overheads have reduced. Clearly a
disappointing performance.

ROI

The ROI has improved in most years and has exceeded the 15% target in all but one year (year 1). This is simply due
to the reducing asset base as the stores assets have gradually been depreciated. Net profit levels have fallen overall
and yet ROI has increased.

It is hard to argue that the ROI figures properly reflect the performance of the centre. The ROI will tend to increase as
assets get older and this will distort the financial performance picture. In a period of falling sales and weaker margins
the manager of W has been awarded bonuses in three out of four years. This is hard to justify.

Performance calculations and discussion - up to 5 marks

ROI discussion up to 3 marks
Total marks 8

(d) The unethical manager would have needed to move profits out of 2006 and in to 2005. One immediate problem
here is having the information in good time to respond. The manager would have to be able to anticipate the 2005
poor result and the improvement in 2006. It is likely that such a manager would have to gamble at the end of 2005 and
make an adjustment in the hope of a better year in 2006. The manager need only move £2,000 of profit from 2006 to
2005 to achieve a 15% return in both years.

Possible methods of adjustment include:

Accelerate revenue: Sales made early in 2006 could be wrongly included in 2005. He could, for example, raise an
invoice before is normal, perhaps on the receipt of an order and before actual delivery. The invoice itself would not
have to be sent to the customer, merely filed until the second year had begun and delivery made.

Delay the recording of 2005 cost: A supplier’s invoice could be left unrecorded at the end of 2005, including it in
2006 expenses instead.

Understate a provision or accrual in 2005: This has the effect of moving cost from 2005 to 2006 (assuming that by the
end of 2006 the provision is correctly stated).

Manipulate accounting policy: Inventory values (for example) are easy targets for the unethical manager. If inventory
in 2005 could be overstated this would have the effect of increasing 2005 profits at the expense 2006 profits.

Up to 2.0 marks for each manipulation.

An excellent answer will demonstrate understanding of the manipulation

5
 Total marks 4

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Question 4 a) see spreadsheet

Question 4 b) Discuss the merits of your appraisal in part (a). (5 marks)

• Draws on forecast data as does all investment appraisal.

• Here only forecasting the next three years, thus not a long way ahead yet the cost of oil has
been very volatile over the last twelve months.
• One way of allowing for uncertainty about the future is to carry out some sensitivity analysis
using either method. The two methods are either change the value of a variable to achieve a
NPV of £nil or change all assumptions one at a time by the same percentage and observe the
effect on the NPV of the project.
• Another method of allowing for uncertainty is the three point estimate and then to calculate the
expected value. Here as always it is important to obtain the estimates from the expert manager
for that particular aspect of the business.
• Taxation has been ignored but the company will have to account for it assuming it will make
profits.

Here we are looking for a sensible discussion of investment appraisal for 5 marks.

Question 4 c) Discuss any non-financial factors that should be considered by TP plc when taking
such a decision. (5 marks)

The non-financial factors are often more important than the numbers.
Does the proposed investment have the support of the senior management team?
Is the acquisition in line with the company's strategy?

Here we are looking for a sensible discussion of any relevant aspect of the business for 5 marks.

Question 5 a) and b) see spreadsheet

Question 5 c)
Discuss the pricing strategies that should be considered when pricing new products
(10 marks)

Market based including skimming and penetration pricing.

Demand based including target costing.
Supply based approach including cost plus in all its forms.

Up to 2.5 marks for each pricing strategy.

An excellent answer will demonstrate understanding and include a relevant example

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Question 6 Answer
(a) Financial analysis
There are various financial observations that can be made from the data.

– Turnover is up 5% – this is not very high but is at least higher than the rate of inflation
indicating real growth. This is encouraging and a sign of a growing business.
– The main weakness identified in the financial results is that the net profit margin has fallen from
20% to 19.8% suggesting that cost control may be getting worse or fee levels are being competed
away.
– Profit is up 3.9%. In absolute terms profits are impressive given that Simon is sole owner of the
business..
– Average cash balances are up 5% – indicating improved liquidity. Positive cash balances are
always welcome in a business.
– Average debtors days are down by 3 days – indicating improved efficiency in chasing up
outstanding debts. It is noticeable that Britewite’s days are lower than the industry average
indicating strong working capital management. The only possible concern may be that they are
being particularly aggressive in chasing up outstanding debts.

Overall, with a possible concern about margins and low growth, the business looks in good shape
and would appear to have a healthy future
Here we are looking for a reasonable commentary on the financial performance - total 8 marks.

.
(b) Financial performance indicators will generally only give a measure of the past success of a
business. There is no guarantee that a good past financial performance will lead to a good future
financial performance. Clients may leave and costs may escalate turning past profits to losses in
what can be a very short time period.

Non financial measures are often termed “indicators of future performance”. Good results in these
measures can lead to a good financial performance. For example if a business delivers good
quality to its customers then this could lead to more custom at higher prices in the future.
Specifically the non-financial information relates to the non-financial measures within the
balanced scorecard.
Internal business processes are a measure of internal efficiency. Interestingly these measures can
indicate current cost efficiency as much as any future result.
Customer knowledge measures how well the business is dealing with its external customers. A
good performance here is very likely to lead to more custom in the future.
Innovation and learning measures the way the business develops. New products would be
reflected here along with indicators of staff retention. Again this is much more focused on the
future than the present.

Measuring performance by way of non-financial means is much more likely to give an indication
of the future success of a business. The extra non-financial information gives much greater insight
into key operational issues within the business and paints a bleaker picture for the future.
Here we are looking for a reasonable discussion f non-financial information- total 5 marks.

c) Internal business processes

Error rates
Error rates for jobs done are up from 10% to 16%, probably a result of reducing turnaround times
to improve delivery on time percentages. This is critical as users expect their treatments to be
successful. Britewite could be sued if clients’ teeth are damaged by mistakes.
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Customer Knowledge

Client retention
The number of clients has fallen dramatically – this is alarming and indicates a high level of
customer dissatisfaction. In a specialist business like this one would normally expect a high level
of repeat work. Clearly existing clients are not happy with the service provided.

Average fees
It would appear that the increase in revenue is thus due to a large increase in average fees rather
than extra clients – average fee is up from £600 to £775, an increase of 29%! This could explain
the loss of clients in itself, however there could be other reasons.

Market share
The result of the above two factors is a fall in market share from 20% to 14%. Looking at revenue
figures one can estimate the size of the market as having grown from £4.5m to £6.75m, an
increase of 50%. Compared to this, Britewite’s figures are particularly worrying. The firm should
be doing much better and looks to being left behind by competitors.

Learning and Growth

Non-core services
The main weakness of the firm seems to be is its lack of non-core services offered. The industry
average revenue from non-core work has increased from 25% to 30% but Britewite’s figures have
dropped from 5% to 4%. It would appear that most clients are looking for a wider range of
products but Britewite is ignoring this trend.

Employee retention
Employee turnover is up indicating that the staff are dissatisfied. Continuity of staff at a client is
important to ensure a quality product. Conservative clients may resent meeting a variety of
different people each year. Staff turnover is possibly a result of extra pressure to complete jobs
more quickly without the satisfaction of a job well done. Also staff may realise that the lack of
range of services offered by the firm will limit their own experience and career paths

Conclusion

In conclusion, the financial results do not show the full picture. The firm has fundamental
weaknesses that need to be addressed if it is to grow into the future. At present it is being left
behind by a changing industry and changing competition. It is vital that Britewite reassesses its
attitude and ensures that the firm has a better fit with its business environment. In particular they
should seek to develop complementary services and reduce errors on existing work.

Up to 3.0 marks for each aspect discussed.

An excellent answer will demonstrate understanding and include a supporting example.
Total marks 12