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Strategic Professional – Options
Advanced Performance
Management
(APM)
Specimen Exam applicable from
September 2019
Time allowed: 3 hours 15 minutes
This question paper is divided into two sections:
Section A – This ONE question is compulsory and MUST be attempted
Section B – BOTH questions are compulsory and MUST be attempted
Present Value and Annuity Tables are on pages 8 and 9.
Do NOT open this question paper until instructed by the supervisor.
This question paper must not be removed from the examination hall.
APM
The Association of
Chartered Certified
Accountants
APM ACCA
This is a blank page. The question paper begins on page 3.
It is now 1 September 20X5.
Required:
Write a report to the CEO of Iron Chicken to respond to her instructions for work on the following areas:
(i) the use of economic value added (EVA™) as the key performance metric at IC; (15 marks)
(ii) the current key performance indicators (KPIs) used by the company; (6 marks)
(iii) the three improvement projects; (15 marks)
(iv) the impact of the proposed new information system on the three improvement projects. (10 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer. (4 marks)
(50 marks)
5 [P.T.O.
Appendix 1
Economic value added Year ended 30 June 20X
$m Note Operating profit 551· Add back Non-cash expenses 15· Marketing capitalised 23·1 5 Less Tax 134·8 6 Lost tax relief on interest 24·5 7 –––––––– Net operating profit after tax (NOPAT) 430·
Capital employed From the statement of financial position 2,401·0 9 Marketing spend capitalised 23·1 5 –––––––– Adjusted capital employed 2,424·
WACC = (1/2 x 16%) + (1/2 x 6·8%) = 11·4%
EVA™ = NOPAT – (WACC x Capital employed) = 154
Assumptions and notes:
1 Debt/Equity 100·0% 2 Cost of equity 16·0% 3 Tax rate 30·0% 4 Cost of debt (pre-tax) 6·8% 5 There has been $23·1m of marketing spent each year for the last two years in order to build the brand of IC long term. 6 Tax paid in the year was $130m while the tax charged per the accounts was $134·8m. 7 Interest charged in the period was $81·6m. Lost tax relief on this interest was 30% x $81·6m. 8 The only research and development spending identified in the last five years was $10m expensed during this year on a new product. The product has not been launched yet. 9 Capital employed during the period (from the statement of financial position): Opening 2,282· Change in period 119· ––––––– Closing 2,401·
7 [P.T.O.
3 Company information Stokeness Engineering’s (Stokeness) mission is to provide world-leading, reduced-emission, fuel-efficient products for the motor industry in order to optimise shareholder returns. Stokeness has existed for only five years and is owned by its management and venture capitalists (VCs). The management were all engineers who had been working on the basic research associated with new fuel technologies and saw the opportunity to commercialise their expertise. Stokeness is highly regarded in the industry for its advanced, efficient fuel cell designs. As a result, the VCs were eager to invest in Stokeness and have assisted by placing experienced managers into the business to aid the original engineering team. New product development Stokeness is developing hydrogen fuel cells for use in powering large motor vehicles such as buses and trucks. They will replace standard petrol/diesel engines. The fuel cells have a clear advantage over these older technologies in having lower carbon dioxide (a greenhouse gas) emissions. The governments of many developed countries are keen to see cuts in such emissions and are supportive of a variety of possible technological solutions to this issue (such as fuel cells, electrical batteries and compressed natural gas). External business environment It takes five to ten years to develop a viable product for sale in this motor market. There are a number of companies developing fuel cells but Stokeness is believed to have a two-year lead over them and to be only three years away from commercial launch. Alternative power technologies like the hydrogen fuel cells would be fitted by the major international vehicle manufacturers into their vehicles for sale to their customers. The vehicle manufacturers will need to form a close partnership with any engine producer in order to make their technologies compatible and this has already begun to happen, with two of the major manufacturers signing deals with other engine makers recently. A major problem which needs to be overcome with any of these new technologies is that there must be an infrastructure accessible to the end users for refuelling their vehicles (as the petrol station chains do for petrol engine vehicles at present). Governments have indicated their desire to support the development of such technologies to address environmental issues and to try to establish new, high-value industries in their jurisdiction. They may do this through tax breaks and investment to support the development of the refuelling infrastructure. Production of Stokeness’ fuel cells uses a special membrane which requires rare and expensive elements. Also, it has partnered with two other engineering firms to subcontract the production of certain components in the fuel cell. Stokeness has had to share much of its fuel cell design with these firms in order to overcome certain engineering difficulties. Also, there are a number of start-up companies developing the other technologies mentioned previously, as well as large, existing diesel and petrol engine manufacturers who are constantly reducing the emissions from their existing engines. The VCs have stressed the need to analyse competition and competitive advantage in order to understand how to make the business profitable in the long term. The chief executive officer (CEO) of Stokeness wants to understand the external business environment and its effect on performance management.
Required: (a) Using Porter’s five forces model, assess the impact of the external business environment on the performance management of Stokeness and give a justified recommendation of one new performance measure for each of the five force areas at Stokeness. (16 marks)
(b) Discuss how the problems of defining the market in measuring a market share apply for Stokeness. (4 marks)
(c) Assess the risk appetite of the venture capitalists and discuss how this might impact on performance measurement at Stokeness. (5 marks)
(25 marks)
Present Value Table
Present value of 1 i.e. (1 + r )– n Where r = discount rate n = number of periods until payment Discount rate (r) Periods
- 1 0·990 0·980 0·971 0·962 0·952 0·943 0·935 0·926 0·917 0·909 (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
- 2 0·980 0·961 0·943 0·925 0·907 0·890 0·873 0·857 0·842 0·826
- 3 0·971 0·942 0·915 0·889 0·864 0·840 0·816 0·794 0·772 0·751
- 4 0·961 0·924 0·888 0·855 0·823 0·792 0·763 0·735 0·708 0·683
- 5 0·951 0·906 0·863 0·822 0·784 0·747 0·713 0·681 0·650 0·621
- 6 0·942 0·888 0·837 0·790 0·746 0·705 0·666 0·630 0·596 0·564
- 7 0·933 0·871 0·813 0·760 0·711 0·665 0·623 0·583 0·547 0·513
- 8 0·923 0·853 0·789 0·731 0·677 0·627 0·582 0·540 0·502 0·467
- 9 0·914 0·837 0·766 0·703 0·645 0·592 0·544 0·500 0·460 0·424
- 10 0·905 0·820 0·744 0·676 0·614 0·558 0·508 0·463 0·422 0·386
- 11 0·896 0·804 0·722 0·650 0·585 0·527 0·475 0·429 0·388 0·350
- 12 0·887 0·788 0·701 0·625 0·557 0·497 0·444 0·397 0·356 0·319
- 13 0·879 0·773 0·681 0·601 0·530 0·469 0·415 0·368 0·326 0·290
- 14 0·870 0·758 0·661 0·577 0·505 0·442 0·388 0·340 0·299 0·263
- 15 0·861 0·743 0·642 0·555 0·481 0·417 0·362 0·315 0·275 0·239
- 1 0·901 0·893 0·885 0·877 0·870 0·862 0·855 0·847 0·840 0·833 (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
- 2 0·812 0·797 0·783 0·769 0·756 0·743 0·731 0·718 0·706 0·694
- 3 0·731 0·712 0·693 0·675 0·658 0·641 0·624 0·609 0·593 0·579
- 4 0·659 0·636 0·613 0·592 0·572 0·552 0·534 0·516 0·499 0·482
- 5 0·593 0·567 0·543 0·519 0·497 0·476 0·456 0·437 0·419 0·402
- 6 0·535 0·507 0·480 0·456 0·432 0·410 0·390 0·370 0·352 0·335
- 7 0·482 0·452 0·425 0·400 0·376 0·354 0·333 0·314 0·296 0·279
- 8 0·434 0·404 0·376 0·351 0·327 0·305 0·285 0·266 0·249 0·233
- 9 0·391 0·361 0·333 0·308 0·284 0·263 0·243 0·225 0·209 0·194
- 10 0·352 0·322 0·295 0·270 0·247 0·227 0·208 0·191 0·176 0·162
- 11 0·317 0·287 0·261 0·237 0·215 0·195 0·178 0·162 0·148 0·135
- 12 0·286 0·257 0·231 0·208 0·187 0·168 0·152 0·137 0·124 0·112
- 13 0·258 0·229 0·204 0·182 0·163 0·145 0·130 0·116 0·104 0·093
- 14 0·232 0·205 0·181 0·160 0·141 0·125 0·111 0·099 0·088 0·078
- 15 0·209 0·183 0·160 0·140 0·123 0·108 0·095 0·084 0·074 0·065
Answers
Strategic Professional – Options, APM Advanced Performance Management (APM) Specimen Exam Answers
1 Report
To: Board of Iron Chicken (IC) From: A. Accountant Date: September 20X Subject: Performance management issues at IC Introduction This report evaluates the accuracy and assumptions used in the calculation of EVA™. It then suggests new KPIs for the current CSFs at IC. Finally it considers the impact of three quality improvement projects on these CSFs and a proposed new information system.
(i) Economic value added (EVA™) There are a number of errors in the existing calculation of (EVA™). These are described below and then the corrected EVA™ is calculated. Non-cash expenses are correctly added back to profit as such costs are treated as unacceptable accounting adjustments on a cash-based view. Marketing activities for long-term benefit are correctly added back as they generate future value for the business and so the prior year expenditure is also added in to capital employed. Research and development (R&D) expenditure should be treated as for the long-term marketing spending (note that there was no R&D expenditure in the prior year). The tax cost in the calculation should be the amount paid adjusted for lost tax on interest and not the adjusted amount of tax charged in the accounts. The WACC is incorrectly calculated as it should be based on the post-tax cost of debt. The capital employed figure should be based on the year start figure. Economic value added Year ended 30 June 20X $m Operating profit 551· Add back Non-cash expenses 15· Marketing capitalised 23· Research and development 10· Less Tax 130· Lost tax relief on interest 24· ––––––– NOPAT 445· Capital employed At 20X5 year start 2,282· Marketing spend capitalised from YE 30 June 20X4 23· ––––––– Adjusted capital employed at 20X5 year start 2,305· WACC = (1/2 x 16%) + (1/2 x 6·8% x (1 – 30%)) = 10·38% EVA™ = NOPAT – (WACC x Capital employed) = 206 The recalculated economic value added has increased from $154m to $206m which still indicates a positive position for the company as it adds to shareholder wealth. In addition to the corrections above, the following assumptions in the calculation require comment:
- There is an implicit assumption that accounting depreciation (included in operating profit) is equivalent to economic depreciation (which should be used for EVA™ calculations). This is questionable generally, although there is no information to allow a more accurate calculation. Also, there is additional marketing spending which will probably have a limited economic life in building the brand. No estimation of this life and the resulting additional economic depreciation has been attempted in the above calculation.
- It has been assumed that no amortisation needs to be charged on the research and development costs since the product has not yet launched. This is in line with the accounting treatment of such items.
(ii) Key performance indicators for the critical success factors Greater staff productivity The current measure of units produced per labour hour does not reflect the skill and effort which goes into producing different units. The products of IC range from complex to simple and so revenue per employee would better reflect the different skill levels involved in production.
(iv) New information system The move to a single database for the organisation will integrate the subsystems from different functions (such as production and sales). It will require existing systems to be networked and compatible or else be replaced. It will affect overall decision-making by improving the visibility of each function’s operations to the others and to the strategic decision-makers. This shift is often achieved by using an enterprise resource planning system and a strategic enterprise management system. The unified database will be critical in achieving the goal of JIT manufacturing as close links between production scheduling and demand forecasts will be required in order to match production runs with demand forecasts/orders. Also, the production schedules will need links to inventory levels in warehousing so that inventory is run down before new production is initiated. As closer communication with suppliers and customers will also be required, some change to existing information systems will be necessary in any case. It may be worthwhile to consider including electronic data interchange (EDI) in the specifications of the new system. In using kaizen costing, cross-functional communication will be important. The design team will need to communicate with the production team so that the design is more easily streamlined for production. The financial systems will need to be frequently updated for information from the quality circles as improvements are made. This will affect the kaizen cost targets which need to be continually monitored and new targets set regularly. Quality circles often involve groups from across the business and so a common information system will facilitate communications amongst them. The introduction of TQM will require clearer reporting of quality costs to assist in the on-going motivation of staff, which is often a problem in TQM. Informing the quality teams of the impact that increased prevention costs are having on lowering failure costs will be important in maintaining the push to zero defects. The quality improvements and changes to production processes will need to be communicated across IC’s different sites which the new database can facilitate. The nature of the data used in the current system is quantitative but with the new projects, there will be a need to communicate qualitative information, for example, relating to the nature of defects or the new production processes put in place. This will require a fundamental change to existing systems which again motivates the change to a new database.
2 (a) The results from both models indicate that Culam is not likely to become insolvent in the next two years. However, there are good reasons to question the applicability of these models to Culam’s business and so it would be dangerous to place too much reliance on these results. A quantitative model such as those presented here identifies financial ratios which significantly differ in value between surviving and failing companies. Statistical analysis is then used to choose the weightings for these ratios in a formula for a score which can be used to identify companies which exhibit the features of previously failing companies. Obviously, the company being analysed must be similar to those being used to build the model for the results to be relevant. The Altman Z-score was originally developed in the late 1960s and was based on data from US companies, primarily in the manufacturing sector. Therefore, there are three reasons to question the applicability of such data to Culam.
- The world economy has changed significantly since Altman’s original work. The data for this model is now nearly 50 years old.
- The economy of the USA may not reflect the market in which Culam works.
- The mining sector is not like general manufacturing, for example, it is highly capital intensive with long periods of no revenue generation. The Q-score model was based on recent data from Teeland businesses. As for the Z-score, Culam is not likely to be appropriately modelled by such data. The problems are:
- The Q-score is based on data for Teeland listed companies and Culam is a mining company with an unusual pattern of revenue and costs supplying a global market. It is therefore unlikely to be similar to the companies on the small Teeland exchange, both in its markets and its business model.
- If Teeland’s exchange is small, there may not be much data from failing companies on which to base the model. Neither of the models addresses factors which may have a large impact on Culam’s survival such as world commodity prices and foreign exchange rates.
(b) The lifecycle issues for Culam relate to the long timescale (23 years) for development and use of a mine and the uneven cash flows over this lifecycle. The initial development phase of two years will require large capital investments with no revenue being generated. There is then a 20-year revenue-generating phase followed by a final year of decommissioning costs with no revenue. This will impact on the Z-score by making the score very volatile as the mines go through the three phases of their lives.
- During the development phase, total assets are growing while revenue is zero. This will mean that the X5 variable will be zero and the X1 and X3 variables will be falling, thus lowering the score.
- During the working phase of the mine, the total assets will be static or falling (depending on the accounting for reserves) while the revenue is high.
- Finally, during the decommissioning phase, the assets will be falling and again there will be no revenue, so a low Z-score could be expected.
The fact that Culam has only four mines will mean that the phase of any one mine will have a significant impact on the score. If two mines are in development at the same time, then there is likely to be a large effect in lowering the Z-score. It will be the scale of the financial resources which Culam can call on over the life of the mines which will dictate its survival.
(c) The type of action which Culam’s board can take to reduce the risk of collapse of the business is to grow the business by buying or developing many more mines, so that the failure of any one project does not bring down the business. Staggering the development of the mines would also help to address this issue. The board could also seek to alter the proportion of revenues generated from long-term contracts rather than the more volatile spot market. By signing over more of the production to contracts of fixed revenues, the business’s cash flows will be more reliable. The board could learn from the mistakes of their competitors by avoiding over-priced acquisitions or other large project failures by performing suitable due diligence and risk analysis in advance of the investment. The board could be proactive in managing other major risks by using hedging techniques in order to reduce volatile revenues due to:
- foreign exchange rate changes when the costs of the mines will all be denominated in local currency; and
- commodity prices on the spot market. Although the use of such techniques will be limited by the availability of long-term hedging contracts.
3 (a) Porter’s five forces analysis
Threat of new entrants The threat of new entrants will be dictated by barriers to entry into the fuel cell market. These appear to be high, given the long timescale and the high levels of technical expertise required to develop a viable product. Also, the developer will need to have cultivated a strong relationship with the major vehicle manufacturers who will be the customers for the product. A suitable performance measure would be percentage of revenue derived from patented products to measure the legally protected revenues of the business and so indicate the barrier to entry. Stokeness will need to ensure that all technology developments are written up and assessed for their patent possibility. [ Other measures could include ratio of fixed cost to total cost (measures capital required) or customer loyalty (through long‑term contracts to supply fuel cells to manufacturers). ] Threat of substitutes The substitutes mentioned in the question are electrical batteries, compressed natural gas and improved existing diesel/petrol engines. However, it is clear that improved diesel/petrol engines would potentially have many lower barriers to cross as the technology is known to the car industry and the infrastructure exists to deliver the fuel to the end-users of the cars. The threat of each of these substitutes would be measured by an analysis of the comparative cost of creating a viable alternative to the fuel cell. The performance in terms of power output of the engine and emissions reductions compared to price would be critical. Management of this aspect will entail monitoring fuel prices in the market, reviewing the appropriate technical journals and attending conferences in order to identify these threats and their progress. This will require the input of both finance and engineering staff at Stokeness. Power of suppliers The suppliers have considerable power. There are rare raw materials used in production and the price and availability of these will dictate possible output levels for fuel cell producers. This is especially important, given the possibility of increased production which could flow if fuel cells become the dominant way to power vehicles in the future. There is a danger that the market in these materials is controlled by a few suppliers who can then dictate price. The engineering subcontractors will also have power through their knowledge of the design elements of Stokeness’ product. It will be important for Stokeness to protect this by legally enforceable non-disclosure agreements. There is a danger that this knowledge will lead the suppliers to consider pre-emptive forward integration by taking over Stokeness. The power of suppliers could be measured by estimating the cost of shifting to an alternative supplier, which could be considerable, given the innovative nature of the technology. These costs would have to include the damage to value from the delay that such a shift would cause. [ Other measures could include cost of suppliers’ product compared to total cost of the fuel cell, which indicates the importance of this component in production, and the number of suppliers as it indicates the level of competition in that market. ] Power of customers The customers are the major bus and truck manufacturers. Again, the customers will have a large degree of influence, given their size and limited numbers if Stokeness wants to access the world market. There will need to be a partnership between the fuel cell maker and the vehicle manufacturer in order to ensure that the technologies are compatible. There is the threat that these powerful customers will seek to take over Stokeness if its products prove successful; however, this may be an attractive exit for the shareholders depending upon the price offered.
Strategic Professional – Options, APM Advanced Performance Management (APM) Specimen Exam Marking Scheme
1 (i) Economic value added Calculation: 1 mark for each of: Research and development Tax paid Capital employed year start figure Non-cash expenses Marketing WACC Economic value added Conclusion Assumptions and corrections – up to 10 marks Maximum 15 marks
(ii) KPIs for CSFs Up to 2 marks per CSF Maximum 6 marks
(iii) Quality projects Definitions and descriptions up to 2 marks Analysis up to 6 marks per project Maximum 15 marks
(iv) New unified database Definition and general points up to 3 marks Interaction with each project up to 3 marks each Other comments up to 3 marks Maximum 10 marks Professional presentation: up to 4 marks Total 50 marks
2 (a) 1 mark for general interpretation of calculation 4 marks for general description of how a quantitative model works Up to 9 marks for problems with the models Maximum 10 marks
(b) 2 marks for general issues 1 mark for description of lifecycle 6 marks for impact of lifecycle on Z-score Maximum 7 marks
(c) Up to 2 marks on each improvement – 1 mark for the description of an improvement and 1 mark for the justification For example: Increase size of business – portfolio effect Use of fixed price contracts to avoid volatile commodity prices Use of FX hedging to avoid revenue volatility Learn from the mistakes of others – avoid big project failures Maximum 8 marks Total 25 marks
3 (a) Each force – up to 3 marks for assessment of impact of the external environment on performance management and 1 mark for an appropriate performance measure recommended Maximum 16 marks
(b) Problems of assessing market share – 1 mark per point Maximum 4 marks
(c) Assess risk appetite up to 2 marks Impact on performance measures up to 3 marks Maximum 5 marks Total 25 marks
