May 2008 Examinations Strategic Level Paper P6 – Management Accounting – Business Strategy Question Paper 2 Examiner’s Brief Guide to the Paper 13 Examiner’s Answers 14 The answers published here have been written by the Examiner and should provide a helpful guide for both tutors and students. Published separately on the CIMA website (www.cimaglobal.com/students) from mid-September is a Post Examination Guide for the paper which provides much valuable and complementary material including indicative mark information. © The Chartered Institute of Management Accountants. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recorded or otherwise, without the written permission of the publisher.

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Business Management Pillar

Strategic Level Paper

P6 – Management Accounting – Business Strategy

20 May 2008 - Tuesday Morning Session

Instructions to candidates

You are allowed three hours to answer this question paper.

You are allowed 20 minutes reading time before the examination begins during which you should read the question paper and, if you wish, highlight and/or make notes on the question paper. However, you will not be allowed, under any circumstances, to open the answer book and start writing or use your calculator during this reading time.

You are strongly advised to carefully read ALL the question requirements before attempting the question concerned (that is, all parts and/or sub-questions). The question requirements are contained in a dotted box.

ALL answers must be written in the answer book. Answers or notes written on the question paper will not be marked.

Answer the ONE compulsory question in Section A on pages 2, 3 and 4. The question requirements are on page 4.

Answer TWO of the four questions in Section B on pages 5 to 9.

Maths Tables and Formulae are provided on pages 10 and 11.

The list of verbs as published in the syllabus is given for reference on the inside back cover of this question paper.

Write your candidate number, the paper number and examination subject title in the spaces provided on the front of the answer book. Also write your contact ID and name in the space provided in the right hand margin and seal to close.

Tick the appropriate boxes on the front of the answer book to indicate which questions you have answered.

© The Chartered Institute of Management Accountants 2008

SECTION A – 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER THIS QUESTION

Question One Introduction

AAA is a small manufacturer of replacement machine components for machinery used in the mining and oil exploration industries. It is based in an African country. It was formed in 1952, as a partnership between two engineers, and incorporated in 1977. AAA now employs 120 staff, and has an annual turnover equivalent to one million US dollars. AAA is proud to offer the very highest levels of customer service. Much of the machinery used by AAA’s customers is quite old and, as a result, components are no longer available from the original equipment manufacturers (OEMs), most of which are large multinational companies. AAA mostly supplies parts directly to the end-users but also receives a small but significant proportion of its business from OEMs, who then supply the components to their customers.

The current business model

AAA has always run its business in a very traditional way. The sales manager receives most orders by telephone or fax. The order specifies the OEM part number that the component is to replace. If AAA has previously supplied that component, the sales manager checks the price list and tells the customer the price. AAA holds very low levels of finished goods inventory, and then only of the most commonly ordered components.

Where AAA needs to make a component for the first time, an AAA ‘estimator’ (a qualified engineer, responsible for producing an estimate of the material and labour involved in manufacturing the item) obtains the original drawings of the component, either from AAA’s extensive archives or from the OEM. The estimator then produces detailed engineering drawings, a list of materials and parts required, and an estimate of the labour hours likely to be used at each stage of the manufacturing process. The estimate is passed to a costing clerk in the accounts department who calculates the likely product cost (labour, materials and overheads), adds a ‘mark-up’ of 50%, and advises the sales manager of the price. If the customer accepts the price, an order is passed to the production department, which schedules and completes the work. If the actual cost of production is significantly different from that estimated, the price list is amended to reflect the actual manufacturing cost. Very occasionally, a customer sends (or brings in) an old component, which cannot be traced back to an OEM. The sales manager gives the component to an estimator, who dismantles the component and produces the necessary engineering drawings and estimate. This process is called ‘reverse engineering’, and is common in the component manufacturing industry. Reverse engineering currently accounts for about 5% of AAA’s business. When an order is fulfilled, the component is delivered to the customer, together with an invoice. Most customers pay within 30 days, by cash or cheque. AAA does not have a problem with bad debts. An increasing proportion of AAA’s business is now transacted in US dollars, as African currencies tend to be unstable. AAA prides itself on the personal service it provides. The close contact it has with its customers means that AAA receives a significant amount of repeat business. AAA has never advertised its services, but grew significantly until 2005 as a result of ‘word of mouth’ recommendations by satisfied customers. AAA, however, has not experienced growth for the last two years, although turnover and profit have remained stable. AAA uses only very basic Information Systems (IS), and reports its performance using a simple comparison between budget and actual, which is produced using a spreadsheet package. AAA’s accounting system is not automated, and transactions are recorded in traditional ledgers.

P6 2 May 2008

Project E: Computerised accounting and e-commerce systems

The sales manager of AAA has noticed that customers are increasingly mentioning that they would like to be able to order online. He knows that there has been a significant growth in business-to-business (B2B) e-commerce in recent years. The sales manager has recognised that in order to grow and to make a move into e-commerce possible, AAA’s accounting system will have to be updated to a computerised one.

Having spoken to a number of potential suppliers, the sales manager has now received a proposal from SSS, a local company, to supply tailored ‘off-the-shelf’ systems for both accounting and e-commerce. SSS has provided a detailed breakdown of its proposal, to be known as Project E, which is summarised below.

The sales manager believes that, following implementation of the new systems (likely to be 12 months from contract agreement) e-commerce should lead to an increase in the company’s turnover of 10% in its first year of operation. Thereafter, the turnover resulting from e-commerce should grow at a rate of 10% each year for the foreseeable future.

The sales manager also thinks that any increase in indirect costs as a result of this higher volume of business will be fully offset by a reduction in administration workload as a result of the new computerised accounting system. The gross margin earned from e-commerce business can therefore be used as the effective cash inflow for evaluation purposes. The current turnover of AAA is, as stated earlier, $1 million a year. The mark-up on products sold by e-commerce will be the same as at present (that is, 50%).

However, the sales manager thinks that a cautious approach should be taken to the evaluation of the proposal, and that any benefits after 5 years from implementation should be ignored. AAA has a weighted average cost of capital (WACC) of 15%.

The following information has been provided by SSS, the preferred systems supplier:

Project E Item

Timing

Cost US$

“Mage Gold” accounting package On agreement of contract 14,000 Tailoring of the above During the first 6 months 20,000 “SellitOnline” e-commerce package On agreement of contract 11,000 Tailoring of the above During the first 6 months 8,000 Populating the e-commerce database During the first 6 months 5,000 Training During months 7 – 12 10,000 Support Split over the five years following implementation 25,000 Hardware, networking and connection During the first 12 months 40,000 Broadband service costs Split over the five years following implementation 20,000 TOTAL COST

153,000

Note: You should assume that all cashflows arise at the end of the period to which they relate, for example ‘Tailoring’ at the end of 6 months, and ‘Training’ at the end of 12 months.

The requirement for this question is on the next page

May 2008 3 P6

Required: (a) Briefly explain how e-commerce has impacted on the way business is conducted.

(5 marks)

(b) Briefly discuss how a new Information Systems (IS) strategy might impact upon corporate, business and functional strategies.

(8 marks)

(c) Prepare a financial evaluation of Project E.

Note: You should ignore the effects of inflation and taxation. (12 marks)

(d) Evaluate the strategic and competitive benefits to AAA of the proposed e-commerce system.

(15 marks)

(e) Advise AAA, based on your answers to parts (a) to (d) above, whether or not to invest in the proposed e-commerce and accounting project.

Note: You are not required to reproduce the detail of your arguments from earlier parts of this question.

(4 marks) (f) Discuss how AAA might use its e-commerce system to increase the volume of

business from ‘reverse engineering’ projects. (6 marks)

(Total for Question One = 50 marks)

(Total for Section A = 50 marks)

End of Section A

Section B starts on the next page

P6 4 May 2008

SECTION B – 50 MARKS [the indicative time for answering this section is 90 minutes] ANSWER TWO QUESTIONS FROM FOUR Question Two CCC is an established company in public ownership comprising the following divisions; construction and building, engineering and machinery, real estate. Although the company has traded profitably, its earnings have been subject to wide variations and some of the shareholders are concerned about the Board’s policy of ‘conglomerate diversification’

In the last year the company had the following earnings figures;

Division Earnings $ million

Construction and building 50Engineering and machinery 20Real estate 30Group 100

Note: It should be assumed that the above divisional earnings are stated after tax.

Industry Current average market sector PE

Construction and building 8Engineering and machinery 13Real Estate 23

CCC is currently valued on the stock market at $1,000 million, and proposed / current dividends are approximately half analysts’ expectations.

Construction and building This activity represents the original business before CCC started to make acquisitions. The divisional management has described the business as ‘mature, stable, offering the prospect of modest but sustained growth’.

Engineering and machinery This activity represents the first acquisitions made by CCC whereby a number of small companies were bought and consolidated into one division. The divisional management has described the business as ‘mature but offering the prospect of profit growth of 10% per annum’. Additionally the division has a broad customer base servicing a number of government agencies – minimising the risk of cash flow problems.

Real estate This division represents the most recent acquisition made by CCC and has provided profit growth of over 20% per annum in the three years since it was formed. The divisional management, which is recognised as the most dynamic management team within CCC, feels that this rate of growth can be continued or surpassed.

HQ Organisation Each division has its own headquarters office in a different town and the group headquarters, which has the responsibility for raising capital and operating a group treasury function is also separately located. The group headquarters is located in the capital, is quite luxurious and has a staff of 50 including the main board directors. Group headquarters, and the staff, is funded by a management charge on the divisions.

The remainder of this question and the requirement are on the page

opposite

May 2008 5 P6

Investors An informal group of institutional shareholders, which holds approximately 20% of CCC’s equity has requested a review of the Board’s strategy and a rationalisation of the company’s portfolio. These shareholders feel that the Board of Directors has destroyed value and that the company should take the opportunity to dispose of the real estate division, reduce costs by closing the group headquarters and relocate the board and treasury functions to one of the divisional headquarters. This, they have said, would allow the company to pay a large, one off, dividend to reward shareholders for their tolerance of poor past performance.

The Board of Directors feels that the suggestions are unreasonable and that its strategy has served the best interests of all shareholders.

Required: (a) Explain the term ‘conglomerate diversification’.

(3 marks) (b) (i) Evaluate the comments made by the institutional investors that the Board ‘has

destroyed value’. (3 marks)

(ii) Evaluate the suggestions made by the institutional investors that

“the company should take the opportunity to dispose of the real estate division, reduce costs by closing the group headquarters and relocate the board and treasury functions to one of the divisional headquarters”.

(7 marks)

(c) Identify and evaluate alternative methods available to the Board for the disposal of the real estate division, should it decide to do so, and recommend the method of disposal most appropriate to CCC.

(12 marks)

(Total for Question Two = 25 marks)

Section B continues over the page

P6 6 May 2008

Question Three Based in a European country, BBB is a charity which raises funds to provide portable equipment to remove the poison arsenic from drinking water in villages, in less developed countries. Run by a Board of Trustees, the organisation operates on laissez faire management principles. There are few full-time paid employees and BBB is heavily dependent upon the work of volunteers. Although these volunteers are dedicated, many have said that they do not feel the organisation knows where it is going and have said that they are not confident about the future of BBB.

Funding comes from appeals to the general population, which are made through newspaper advertisements. BBB does not use the Internet to promote or raise donations and, generally, does not use available technology to any extent in its organisation. Additionally, BBB receives corporate donations, most of which come from old school friends of the trustees. There is no government funding.

Recently BBB has had difficulty in attracting donations and is at risk of not being able to carry on its work. The charity industry has become more competitive and many other organisations within it have become more aggressive in their marketing and promotion.

None of the Board of Trustees has a commercial background. The Chairman of Trustees has recently been to a number of conferences where the value of foresight and the need to conduct a frequent and thorough ‘environmental analysis’ have been discussed.

The Chairman has accepted that there is a serious gap in the knowledge that the trustees have about the environment in which BBB operates. Recognising that BBB needs a more proactive approach to the environment in which it operates, your help as a management accountant has been sought.

Required: (a) Discuss how conducting a frequent and thorough environmental analysis would help

the Board of Trustees of BBB.

(14 marks) (b) Explain the concept of foresight and two techniques for the development of foresight.

(5 marks)

(c) Discuss the difficulties that BBB might, as an organisation, experience in developing a process of environmental analysis.

(6 marks)

(Total for Question Three = 25 marks)

Section B continues on the page opposite

May 2008 7 P6

Question Four DDD is a biotechnology company which develops drugs. It was founded seven years ago by three scientists when they left the university medical school, where they had been senior researchers. The Company employs 10 other scientists who joined from different universities. All of these employees are receiving relatively low salaries but participate in a share option scheme. This means that when DDD is successfully floated on the stock exchange they will receive shares in the company.

DDD currently has a number of new, innovative drugs in development, but the earliest any of these drugs might come to market is two years from now. It is expected that there would be one successful drug launched in most years after that for at least six years. However, successful drug launches are never guaranteed, due to the speculative nature of biotechnology and the long period of clinical trials through which any new drug must pass. DDD has to invest a significant amount of resources into the development of each potential drug, whether they are successfully launched or not. Currently, it has 12 drugs in development, a number of which may not be successfully launched. Due to the speculative nature of the industry, companies such as DDD are unable to obtain bank loans on commercial terms.

DDD is funded by an exclusive arrangement with a venture capital company. However, there is only sufficient cash in place to maintain the present level of activity for a further nine months. The venture capital company owns 15% of the equity of the company. The rest is owned by the three founders. It has always been the intention of the venture capital company and the founders that, once the company has a sufficient number of drugs in production and on the market, the company would be floated on the stock exchange. This is expected to happen in five years’ time.

Recently there have been a number of approaches to DDD which might solve its cash flow problems. The three founders have identified the following options:

1. The venture capital company has suggested that it will guarantee the cash flow until the first drug is successfully launched in commercial quantities. However, it would expect its equity holding to rise to 60% once this offer is accepted.

2. A large pharmaceutical company has offered to buy DDD outright and retain the services of the three founders (in research roles) and a few of the staff.

3. Another biotechnology company has offered to enter into a merger with DDD. This company has also been established for seven years and has one drug which will be launched in six months. However, of the four other potential drugs it has in development, none are likely to be commercially viable for 5 years. This company would expect the three founders to stay with the newly merged company but feels a rationalisation of the combined staff would be needed.

As the financial advisor to the three founders you have been asked to comment on the approaches that have been made.

Required: (a) Describe the ‘Suitability, Feasibility and Acceptability (SFA) framework as used for

evaluating strategic options. (6 marks)

(b) Using the SFA framework, evaluate the strategic options identified by the founders. (12 marks)

(c) Identify and evaluate one other strategic option that the founders might pursue. (5 marks)

(d) Recommend the most appropriate strategic option based on your analysis above. (2 marks)

(Total for Question Four = 25 marks)

Section B continues over the page

TURN OVER

P6 8 May 2008

Question Five EEE is a divisionalised company, based in F, where it is quoted on the stock exchange. EEE manufactures and sells small electrical equipment products. As a country, F is more highly developed than the neighbouring countries. EEE has enjoyed a strong home market and has exported to the neighbouring countries.

EEE has had a reputation for producing high quality products. Recently, it has come under increasing competitive pressure from new, privately held, companies based in the neighbouring countries.

It appears that competitors based in these neighbouring countries have been selling lower quality products than EEE and have been undercutting it quite significantly in terms of price. Sales in both EEE’s home and export markets have been badly affected by the actions of these competitors in the neighbouring countries.

EEE has looked at a number of possible solutions to this situation and has decided to acquire a manufacturing company in one of the neighbouring countries and move all of its production there, completely closing the manufacturing division in F. This would mean that EEE would purchase one of the companies that has recently become a competitor. EEE would maintain its present divisionalised structure within its home country F and treat the acquired company as a new division.

The Board of Directors recognises the need to carefully select a suitable acquisition target company. The Board also recognises that careful consideration will need to be given to the most suitable approach to performance management once the acquisition has been made. The Board is considering an approach based on either Return On Investment (ROI) or Residual Income (RI).

Required (a) Advise the Board on what information would be required to assess the suitability of

an acquisition target.

(15 marks)

(b) (i) Discuss the difficulties that EEE may experience with the performance measurement of its divisions, post acquisition.

. (6 marks)

(ii) Discuss the disadvantages that EEE may experience if it chooses to use ROI as its primary performance measure.

(4 marks)

(Total for Question Five = 25 marks)

(Total for Section B = 50 marks)

End of Question Paper

Maths Tables and Formulae follow on pages 13 and 14 which are detachable

May 2008 9 P6

MATHS TABLES AND FORMULAE

Present value table Present value of $1, that is (1 + r)-n where r = interest rate; n = number of periods until payment or receipt.

Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 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 0705 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 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149

Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 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 0.079 0.065 16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054 17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045 18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038 19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031 20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026

P6 10 May 2008

Cumulative present value of $1 per annum, Receivable or Payable at the end of each year for n years

rr n−+− )(11

Periods Interest rates (r) (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606 16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824 17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022 18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201 19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365 20 18.046 16.351 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514 Periods Interest rates (r) (n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 7.793 4.611 4.439 13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730 17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775 18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812 19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843 20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870

FORMULAE Annuity Present value of an annuity of $1 per annum, receivable or payable for n years, commencing in one year, discounted at r% per annum:

PV = ⎥⎦

⎤⎢⎣

⎡

+− nrr ][1

11

1

Perpetuity Present value of $1 per annum, payable or receivable in perpetuity, commencing in one year, discounted at r% per

annum: r

PV1

=

May 2008 11 P6

LIST OF VERBS USED IN THE QUESTION REQUIREMENTS A list of the learning objectives and verbs that appear in the syllabus and in the question requirements for each question in this paper. It is important that you answer the question according to the definition of the verb.

LEARNING OBJECTIVE VERBS USED DEFINITION

1 KNOWLEDGE

What you are expected to know. List Make a list of State Express, fully or clearly, the details of/facts of Define Give the exact meaning of

2 COMPREHENSION What you are expected to understand. Describe Communicate the key features

Distinguish Highlight the differences between Explain Make clear or intelligible/State the meaning of Identify Recognise, establish or select after

consideration Illustrate Use an example to describe or explain

something

3 APPLICATION How you are expected to apply your knowledge. Apply

Calculate/compute To put to practical use To ascertain or reckon mathematically

Demonstrate To prove with certainty or to exhibit by practical means

Prepare To make or get ready for use Reconcile To make or prove consistent/compatible Solve Find an answer to Tabulate Arrange in a table

4 ANALYSIS How you are expected to analyse the detail of what you have learned.

Analyse Categorise

Examine in detail the structure of Place into a defined class or division

Compare and contrast Show the similarities and/or differences between

Construct To build up or compile Discuss To examine in detail by argument Interpret To translate into intelligible or familiar terms Produce To create or bring into existence

5 EVALUATION How you are expected to use your learning to evaluate, make decisions or recommendations.

Advise Evaluate Recommend

To counsel, inform or notify To appraise or assess the value of To advise on a course of action

P6 12 May 2008

The Examiner for Management Accounting – Business Strategy offers to future candidates and to lecturers using this booklet for study purposes, the following background and guidance on the questions included in this examination paper.

Section A – compulsory

Question One requirement (a) tests learning outcome B(v) ‘evaluate the impact of electronic commerce on the way business is conducted and recommend an appropriate strategy’ and the syllabus content ‘the impact of IT (including electronic commerce)on an industry’. Requirement (b) tests learning outcome D(iv) ‘evaluate and advise managers on the development of strategies for knowledge management, IM, IS and IT that support the organisation’s strategic requirements’ and the syllabus content ‘the purpose and contents of IM, IS and IT and the need for strategy complementary to the corporate and individual business strategies’. Requirement (c) tests learning outcome C(i) ‘evaluate strategic options’. Requirement (d) tests learning outcome B(vi) “evaluate the strategic and competitive benefits of IS/IT and advise on the development of appropriate strategies and the syllabus content ‘the impact of IT (including electronic commerce)on an industry’. Requirement (e) tests learning outcome D(v) ‘identify and evaluate IS/IT systems appropriate to the organisation’s strategic requirements and recommend changes where necessary’ and the syllabus content ‘non-financial measures and their interaction with financial ones’. Requirement (f) tests learning outcome D(iv) ‘evaluate and advise managers on the development of strategies for knowledge management, IM, IS and IT that support the organisation’s strategic requirements’ and the syllabus content ‘the purpose and contents of IM, IS and IT strategies and the need for strategy complementary to the corporate and individual business strategies’.

Section B – two questions from four

Question Two requirement (a) tests learning outcome C(i) ‘evaluate strategic options’ and the syllabus content ‘acquisition and divestment strategies and their place in the strategic plan’. Requirement (b)(i) tests the learning outcome D(i) ‘evaluate and recommend appropriate control measures’ and syllabus content ‘assessing strategic performance’. Requirement (b)(ii) tests the same learning outcome and syllabus content as (b)(i). Requirement (c) tests learning outcome C(ii) ‘ evaluate the product portfolio of an organisation and recommend appropriate changes to support the organisation’s strategic goals’ and syllabus content ‘acquisition and divestment strategies and their place in the strategic plan’.

Question Three requirement (a) tests learning outcome A(iii) ‘evaluate the nature of competitive environments distinguishing between simple and complicated competitive environments’ and the syllabus content ‘PEST analysis’ & ‘Porter’s Five Forces model and its use for assessing the external environment’. Requirement (b) tests learning outcome A(iii) as in (a) and syllabus content ‘qualitative approaches to competitive analysis’. Requirement (c) tests learning outcome D(vi) ‘discuss the role of change management in a strategic context’ and syllabus content ‘change management in a strategic context’.

Question Four requirement (a) tests learning outcome C(i) ‘evaluate strategic options’ and syllabus content ‘strategic options generation’. Requirement (b) tests learning outcome and syllabus content as in (a) above. Requirement (c) tests learning outcome C(ii) ‘evaluate the product portfolio of an organisation and recommend appropriate changes to support the organisation’s strategic goals and syllabus content ‘management of the product portfolio’. Requirement (d) tests the learning outcome as in requirements (a) and (b) above.

Question Five requirement (a) tests learning outcome A(v) ‘evaluate strategies for response to competition’ and syllabus content ‘qualitative approaches to competitive analysis’. Requirement (b)(i) tests learning outcome D(iii) ‘identify problems in performance measurement and recommend solutions’ and syllabus content ‘business unit performance and appraisal’. Requirement (b)(ii) tests learning outcome and syllabus content as (b)(i) above.

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The Examiner's Answers for P6 - Management Accounting – Business Strategy

SECTION A

Answer to Question One Requirement (a) E-commerce and business Electronic commerce (e-commerce) represents a fairly new method of conducting business transactions. In addition to buying and selling or exchanging products, it also facilitates the provision of services and information, usually through communication systems such as the Internet, intranets and extranets. The key drivers of e-commerce are that it has the potential to: • Provide a range and quality of services, meet customer demands, assist in retaining

customers and gain competitive advantage by maximising revenue.

• Improve the effectiveness, and reduce the cost, of supply chains.

• Improve knowledge management, cost reduction, differentiation and focus.

E-commerce has now impacted to such an extent that, in some cases, it is the only viable business model.

Requirement (b)

IS strategy and other strategies In theory, the IS strategy of an organisation is an example of ‘functional strategy’. As such, the IS strategy should be a tool to ensure implementation and achievement of the corporate and business strategies. For example, a business strategy of cost reduction might lead to an IS strategy of automation of core processes. However, it is increasingly common for IS strategy to ‘drive’ the organisation’s strategies in a way that most other functional strategies could not. As such, the IS strategy can become the ‘change trigger’ that requires a significant change in both the corporate strategy of the organisation, and other business and functional strategies. For example, the decision to adopt e-commerce as an IS strategy would have repercussions throughout the organisation: • At the corporate level, use of the Internet necessarily leads to a market development

strategy of ‘going global’.

• E-commerce might require a shift in business strategy from cost leadership to differentiation-focus.

• At the functional level, the logistics, accounting and/or production systems might have to change to meet the demands of e-commerce.

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There is, therefore, a complex relationship between IS strategy and corporate strategy. IS strategy can either be an implementation tool or a change trigger. Requirement (c) Financial evaluation (all figures in $000) T0 T0.5 T1 T2 T3 T4 T5 T6 Outflows Accounting system (14) Tailoring (20) E-commerce system (11) Tailoring (8) Database populating (5) Training (10) Hardware etc. (40) Support (5) (5) (5) (5) (5) Broadband (4) (4) (4) (4) (4) Total outflows (25) (33) (50) (9) (9) (9) (9) (9) Inflows Additional gross margin (W1) 33 37 40 44 49 Total cashflow (25) (33) (50) 24 28 31 35 40 Discount factor (15%) 1.000 0.933 0.870 0.756 0.658 0.572 0.497 0.432 Present value (25) (31) (44) 18 18 18 17 17 NPV (12) W1 Additional gross

margin (GM) (Assuming 50% ‘mark up’)

GM = $1 million x 1/3 = $333,333 Initial increase of 10% = $33,333, then compound growth at 10% p.a.

33 37 40 44 49 Notes: Cashflows are assumed to arise at the end of the appropriate period. Implementation complete at T1. Requirement (d) Strategic and competitive benefits of e-commerce The main strategic and competitive benefits to AAA are likely to be the following:

• To expand the marketplace to national and international. This is a potentially significant strategic benefit. The development of an e-commerce system will immediately mean that AAA becomes a global company. As mining and oil exploration are also global businesses, this should lead to the growth that AAA seeks. However, AAA must ensure that it has the capacity and operational systems to be able to respond to any increase in demand, as failure to meet customer expectations could lead to a loss of reputation. AAA must also recognise that an e-commerce system that prices products in US dollars might be unattractive to customers in Africa, and could lead to a reduction of ‘local’ business.

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• To decrease the cost of creating, distributing, storing and retrieving paper-based information. This is a potentially significant competitive benefit (assuming rivals do not offer the same services). It should be possible for AAA to archive all of its order, delivery, and specification data, and also (possibly) its engineering drawings. This should save time and cost in the sales and estimating functions, as storage costs would be vastly reduced and retrieval times speeded up. However, AAA would not be able to do this for any reverse engineering services, as each job is unique and there would be no drawings.

• To improve image, service and access to information. This is a potentially significant strategic and competitive benefit. E-commerce should improve response times and customer service levels, in addition to allowing most customers to ‘pick’ components from the website by OEM name and part number. Products requiring reverse engineering could not, of course, be ordered and purchased online. Improved response times would directly support the organisation’s strategy of ‘personal service’, but AAA must ensure that the e-commerce system is adequately supported by human customer service systems.

• To reduce the time between delivery and payment, and other administrative ‘drag’. Again, this benefit might be significant to AAA as it might find that customers are willing to pay ‘with order’ rather than 30 days after delivery. However, trade customers might prefer to have credit accounts, so any benefits might be reduced. If payment was taken with order, AAA would have to make it clear that delivery would not be, in most cases, ‘from stock’.

• To increase productivity and flexibility, and to reduce transport costs. Although this is a theoretical benefit of e-commerce, AAA currently appears to perform well in these areas. Any benefit might, therefore, be minimal.

• To allow the reduction of inventory and the development of ‘pull’ supply chain management. This is already the way AAA organises its business so, once again, any benefits might be marginal.

Note: Any five of the above, each clearly explained and evaluated, would be sufficient to earn full marks. Requirement (e) Recommendation The main arguments can be summarised as follows: • The e-commerce strategy seems to fit, both with AAA’s corporate strategy, and with the

general approach being taken by many business-to-business suppliers.

• If AAA was to adopt e-commerce, it would also have to change many other aspects of its business model. This might mean, for example, a move towards additional automation, or a need to re-engineer processes to speed response times.

• From the financial viewpoint, based on the information provided, the project shows a very small negative NPV. The savings in accounting costs have been used to offset the increased costs elsewhere in operations. (Note: a result such as this might equally be considered ‘marginal’).

• There are significant strategic and competitive benefits to be gained from the adoption of e-commerce, some of which (such as those relating to image and service level) have not been taken into account in the cashflow evaluation.

It is, therefore, recommended that AAA implements the e-commerce strategy, despite the fact that the financial evaluation provided shows a negative NPV. AAA must recognise that further investment might also be required to synchronise logistics, operations and administration with the new strategy.

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Requirement (f)

Reverse engineering The development of e-commerce might allow AAA to increase the amount of reverse engineering it carries out, despite the fact that such business could not be transacted online. AAA might consider the following:

• Any new e-commerce system could be used to advertise and promote the full range of services provided by AAA. Customers who purchase ‘off the shelf’ components might not be aware of the reverse engineering services provided by AAA.

• AAA might use an online chatroom or forum system to allow customers to share information between themselves, and with AAA technical staff. This would bring further opportunities to promote reverse engineering services.

• AAA could gather email addresses of customers, and ‘direct mail’ them with information and offers for reverse engineering services. Although some customers might see this as junk mail, they could be allowed to ‘opt out’ of receiving such material. Advertising by email is very cheap when compared to other methods.

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SECTION B Answer to Question Two Requirement (a) Conglomerate diversification, sometimes called unrelated diversification, is a strategy used by organisations that results in a conglomerate business. These organisations are, effectively, a collection of business entities without any operational or market relationship with each other. The only connection between those businesses is that the parent organisation believes that they are all capable of making profit, but that there is no business logic or synergistic effects derived from them being held in the same organisation. Conglomerates normally arise because acquisitions have been made to:

• Spread the risk of the firm across a wide range of products, markets and industries;

• Take advantage of purchasing poorly run businesses and, by the introduction of good management, turn them around to become profitable organisations. This can be done both with the intention of retaining them for the benefit of the shareholders or disposing of them subsequently for a capital gain;

• To migrate the business from mature, unattractive and declining industries into more attractive areas. By acquiring a new business in a new industry and growing it by using the cash from the declining business, the company will reduce its dependence on the old business and can then exit at the most appropriate time.

Requirement (b) (i) Workings Division Earnings

$ million Average market sector p/e

Market capitalisation $ million

Construction and Building 50 8 400 Engineering and machinery 20 13 260 Real estate 30 23 690 Total 1,350 Group 100 1,000 As the value of CCC is $1,000 million, it can be seen that there is some truth in the comments made about the ‘competence of the Board’ by the institutional investors. Were the divisions to be operating separately and quoted individually on the stock exchange their market capitalisations could total $1,350 million. This would represent a premium of $350 million over the current value of the group. However, this assumes that the individual divisions would achieve the same level of performance as the other companies in their industry sectors. But, with such a large difference in valuation between the individual divisions and the group as a whole, it is apparent that the board is destroying value and something must be done. (ii) Clearly something has to be done to satisfy the group of institutional investors and its request for a review of strategy. At the moment the group is described as informal but, if it becomes well organised and is able to convince other shareholders of its point of view, it could present a problem to the Board of Directors.

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Whether the disposal of the real estate division is in the company’s, or the shareholders’ best interest is not so clear cut. The real estate division is providing 30% of the earnings of the group and, in terms of market potential has both the highest p/e and the most confident comments from its management. By contrast, the engineering division contributes 20% of the overall earnings and offers only steady growth (again reflected in the p/e figures for the sector). Engineering does, however, have a number of government departments as customers suggesting some security of earnings. Construction and building contributes 50% of earnings and, although the forecast for the future is not as good as that for the other divisions, CCC would be unlikely to want to dispose of such a large proportion of its earnings. The fact that the headquarters is described as ‘quite luxurious’ does suggest that cost savings can be made in this area. The justification for locating the head office in the capital will need to be made in any case presented by the Board. It is possible that the office is there because of the need to be close to the stock market or financial analysts, but with modern means of communication this may not be necessary. Bearing in mind the difference of $350 million demonstrated above cost savings should be sought, and an effort made to reduce the management charge. When this is done, a higher dividend can be paid to the shareholders and may satisfy the institutional investors. Requirement (c) In the event that the Board of CCC decides to dispose of the real estate division, there are a number of approaches that could be taken. Complete Demerger The real estate division would become separately quoted on the stock exchange and have a separate listing. The existing shareholders of CCC would receive shares in the new company pro-rata to their original holding in CCC. This would not provide for a dividend to the dissatisfied shareholders since there would be no cash involved in the disposal. However, should they wish to realise cash they would be able to do so by selling their shares in the new company. This provides a way for shareholders to decide which part(s) of the business they wish to hold and an exit route for their investment in the remainder. From the perspective of CCC, the company would lose 30% of its earnings and this would be quite damaging as there would be no cash benefit and all financial improvement would need to be generated from cash savings by the closure and/or relocation of the group headquarters. Partial demerger Sometimes described as a spin off or equity carve out, CCC would sell part of the division but would maintain a majority shareholding. Although technically this is an initial public offering, realistically it should be considered as an asset sale to public shareholders as opposed to a single buyer. This would provide some funding to CCC which could be used to meet some of the demands of the dissatisfied shareholders but whether it would provide sufficient cash would depend upon the proportion of the division floated. There would be the advantage for CCC that not all of the earnings generated by the real estate division would be lost to the company. Ordinarily, partial demergers usually lead, after a few years, to either total disposals or buy backs and this would be an unusual approach to this particular situation. Sale as a going concern to another business The real estate division would be sold to a single buyer either for cash or for shares in the business that bought the division. Therefore, this approach could be used to provide CCC with cash to meet the requirements of the protesting shareholders. It would also provide an orderly transfer of business which could meet the needs of staff, customers and other stakeholders. This would be a relatively tidy approach for CCC and it is quite likely that the staff concerned would prefer this method of disposal. Again CCC would lose 30% of its total earnings.

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Liquidation of assets The real estate division would be closed and staff redeployed or made redundant. Assets would be sold off at market prices. This is likely to be slow and create bad publicity due to stakeholders’ interests not being met. It is also likely that the sale would not realise a significant value for the assets. Again, CCC would lose 30% of its overall earnings. Although this approach would provide funds for the protesting shareholders, it would not provide the maximum sum of money possible. Management buy-out (MBO) The existing management of the real estate division would raise the finance and buy the division. It might be necessary for CCC to make undertakings to assist this process such as underwriting loans or agreeing to support the division in other ways. As long as there are sufficient staff in the real estate division interested in this approach, it would be the best way for CCC to dispose of the division in terms of public relations and reputational capital with the majority of stakeholders. Whether a management buyout would raise as much funding as a de-merger, and therefore satisfy the needs of the protesting shareholders, is an issue that would need to be resolved. Management buy-in With this approach a group of people from outside the company would raise the funding in much the same way as the internal managers and would buy the division from CCC. The real estate division would, effectively, become a privately held real estate company. There might be some shares in the new company available to the existing staff of the division but they would not be in control as they would be with a management buy-out. In terms of satisfying the dissatisfied shareholders, the de-merger, the management buy-out and the management buy-in would seem to be the best approaches. However, of these the management buy-out would be the best approach from the perspective of the reputation of CCC. Answer to Question Three Requirement (a) There are two main models of environmental analysis that BBB would need to apply to the environment in which it operates. Firstly, Porter’s five forces model which considers

• rivalry amongst existing firms; • bargaining power of buyers; • bargaining power of suppliers; • threat of new entrants; • threat of substitute products or services.

This model is primarily used for commercial organisations but there is relevance for BBB in that there are clearly rivals, its buyers can be conceived of as the donors who get personal satisfaction, there will be threats from new entrants and there are many substitutes for making donations to charities. Thinking of the environment in these terms should help BBB to more rigorously identify changes which will impact upon it. Rivalry There will be other existing charities which are providing similar aid to disadvantaged groups in the less developed world – BBB should be more aware of those groups. It can monitor their fund raising campaigns to better time its own advertisements and possibly learn from the approaches used by its competitors.

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Buyers A closer look at its existing donors, particularly the corporate ones, to discover their values and why they give (and to who else they give) will help BBB better tailor its appeals. New entrants Monitoring the charity literature and the media in general for news of new charities starting to address the kind of issues that BBB tries to aid will make BBB better able to retain its donors. Substitutes Clearly donors, both individual and corporate, have other things they could do with their funds. A better understanding of those alternative uses will help BBB appeal to donors to continue giving. This will be particularly true of corporate donors where corporate social responsibility considerations will come into play. Those donors may well be convinced to give to BBB rather than to enter more directly into the area of philanthropy. Secondly, PEST analysis looks at the various influences on the environment in which the organisation operates:

• Political/legal influences • Economic influences • Social and demographic patterns and values • Technological forces.

It has been suggested that PEST is an insufficiently detailed acronym to describe the macroeconomic environment and that PESTEL, where the two additional letters describe Ecological and Legal factors, adds more depth. Practically this is irrelevant – as long as the organisation is aware of the need to monitor any important themes in the macro environment and changes to those themes. Political BBB currently receives no funding from governments and this may be because it has never attempted to or because of past government policy. Carefully monitoring this policy at both national and E.U. level may identify opportunities for BBB to start receiving government funding. Economic Economic influences will have an influence on BBB in that most charitable giving comes from discretionary disposable income and monitoring this will give a better idea when to launch appeals for funds. Monitoring bonus payments to those in the financial services industry and the profitability of individual firms might help target funding requests. Societal BBB would also benefit from considering the demographics of the groups from which it seeks donations. Particular segments of the community, for instance school children, may be more persuadable in terms of donations. Similarly, if there are large groups of Diasporas from the affected countries it may well be able to target them for donations. Technological In terms of technological factors BBB should be monitoring to see if there are more cost effective methods available to address the problem of arsenic in well water. Additionally, it should be looking for other ways to make its appeals for donations – at present it advertises in newspapers – the internet is well established now and may well provide a better way to attract donors. This would be particularly appropriate if it could persuade one of the corporate donors it was monitoring to fund a website for it. In summary, BBB needs to formalise the process of information gathering and processing within the company so that it is better able to react to the environment in which it operates.

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Requirement (b) Foresight has been described as the art and science of anticipating the future. The idea that an organisation can anticipate changes in its operating environment and prepare for the future has been suggested by a number of authors and organisations. There are a number of techniques which can be used to improve the foresight that an organisation demonstrates and these include:

• Issues analysis. Issues arise through the convergence of trends and events. A trend is a trajectory an issue takes because of the attention it receives and the socio-political forces that affect it. This convergence usually manifests itself because there are unfavourable events in the industry, there are sudden unanticipated events in the industry, public interest causes become more important or there is increased political pressure. The issues should be analysed in terms of their impact on the organisation and their probability of occurrence.

• Scenario planning. A scenario is an internally consistent, possible industry future – that is, a plausible picture of what an industry might look like in the future. Through a process of environmental analysis, identification of major uncertainties, identification of drivers and causal factors and then combining them into internally consistent and plausible stories, an organisation builds a number of alternative futures for its industry.

• Visioning. A possible or desirable future state of the organisation is developed as a mental image by the management of the organisation. This vision may start off as vaguely as a dream but should be firmed up into a concrete statement of where the organisation wants to be. The critical point is that the vision articulates a view of a realistic, credible and attractive future for the organisation, a condition that is better in some important ways than the current state of affairs.

• The Delphi method is a technique for the systematic solicitation of expert opinion. A carefully selected group of experts is asked about its insights about a particular future trend. Its responses are summarised and the results sent back to the respondents, who have the opportunity to re-evaluate their original answers based upon the responses of the group. This process is then repeated a number of times until a consensus view is established.

• Opportunity mapping. An opportunity map is a qualitative and experience-based analysis aimed at identifying gaps in the current environment in order to reveal new business opportunities. The analysis is often structured through a matrix of roles, career stages and tasks, or a description of activities, information sources and needs. Opportunity maps facilitate the discovery of desired characteristics of the organisation, and to support, enhance and change priorities and strategy development.

It would not be uncommon for an organisation to use a number of these techniques together. Note: to provide a more comprehensive answer for instructional purposes additional techniques have been described. An acceptable answer would only need to discuss two of the above techniques. Requirement (c) For BBB to develop a process of environmental analysis within its organisation there will need to be a clear idea of what the benefits are likely to be and the roles that people will need to play in the development. This means that there will need to be clear leadership from the trustees – this may not be present. One of the problems faced by BBB will be the lack of full time employees since all of these techniques are time consuming if not handled correctly.

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All of the techniques will involve the gathering and organising of a large quantity of information. BBB does not appear to be particularly up to date in terms of the technology aspects of its business – it chooses to advertise through newspapers rather than use the internet or some of the more up to date means of promotion. The laissez-faire approach to management would suggest that there is little formality in the way the organisation is managed. This means that managing the quantity of data and indeed the processes involved might be difficult. The lack of commercial experience of the trustees might also present BBB with some difficulty. Although commercial experience is not essential, a clear understanding of how the environment in which BBB operates is – this may well be absent. It is quite possible that the volunteers are a good source of information for BBB to capitalise upon. However, it is unlikely that BBB have the management skills in place to so do. There will need to be a change in the way the organisation conducts its business and it is not certain that the trustees are capable of overseeing that kind of change management process. This would suggest that BBB will find it quite difficult to develop an environmental analysis process within the organisation. Answer to Question Four Requirement (a) There are three tests in the Suitability Feasibility Acceptability framework used to evaluate strategic options. These are:

• The suitability test. This should be used to determine whether the option is the most appropriate given the circumstances in which the organisation currently finds itself. The primary considerations will relate to the firm’s particular strengths and weaknesses, any competitive advantage which it may be enjoying at this point in time, and the environment in which it is operating. Options should be considered in terms of how well they will capitalise upon strengths, cure weaknesses, reduce perceived threats and take up opportunities.

• The feasibility test. This test should be used to decide whether the organisation is actually able to carry out the suggested option successfully in terms of its resource capability and its previous track record in completing similar strategic options. An assessment should be made of the quality of the data that has been used to assess the suitability of the option.

• The acceptability test. This test should be used to assess the attractiveness of the particular option to the various stakeholders identified by the organisation. Any strategy which conflicts with the values and interests of powerful stakeholders is unlikely to be successful. The evaluation should be based on a thorough evaluation of all stakeholders in terms of their power, interests and values.

Requirement (b) Clearly the founders of DDD are faced with three options. Accept further venture capital Suitability. This option will allow DDD to carry on with the work it has been doing and launch at least one drug commercially. It corrects the weakness of limited cash flow but adds little to the company’s strengths. Certainly it will help it take up the opportunity of the first commercial

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launch and subsequent launches until the planned float in five years’ time. From that perspective this option is suitable. Acceptability. However, the acceptability of this option is not so clear cut. The founders will see a large reduction in their shareholding and there will also be a dilution of the rewards available to the employees once the company floats. Some of the employees may choose to leave if they feel that continuing to work on a low salary with a reduction in the promised reward in five years’ time is not worth it. As yet there are no customers to consider and in fact the relationship with any outside stakeholders is unlikely to be affected. The venture capital company must be happy with the option since it has suggested it. Feasibility. There are no problems with the feasibility of this option. Accept offer from pharmaceutical company Suitability. This option would allow the founders of DDD to carry on with their work – but in different circumstances, since DDD would cease to exist. Since DDD had an intent, if not a mission, to be an independent company until five years’ time when it is floated on the stock exchange, it could be argued that this option is not suitable. Acceptability. Much would depend upon the acceptability of the option to the founders. In terms of acceptability, there are a number of stakeholders who are not likely to be in favour of this option. The venture capital company is likely to be unhappy to see its investment in DDD to date sold to another company – particularly as it has offered an alternative solution to the issue faced by DDD. The founders themselves may not find this an attractive option since they have enjoyed the independence of working for themselves rather than for a large organisation as they all, originally, did. The employees may be in two minds about the situation. Although they will not gain large rewards in five years’ time when the company is floated (which isn’t guaranteed), something will have to be paid to them now in recompense for their share options and, additionally they may be employed by the pharmaceutical company on higher salaries. Feasibility. In terms of feasibility there are no issues with this option. Merger Suitability. In terms of suitability, this option might solve the short term problem of funding for DDD but not necessarily the combined organisation. DDD’s strengths in drug development will not be particularly enhanced since the other company has no drugs likely to be commercially available for a further five years, whereas DDD expects to launch one a year from year 3 onwards. It seems an uneven arrangement. It is not clear whether the other company intends to float in the same time frame as DDD and so this may not fit in with the intent of the founders. Acceptability. In terms of acceptability, the founders of DDD would again find that their autonomy was reduced and they would now be ‘sharing’ their company and the decision making with others. The employees would almost certainly not be happy with this option since it has already been suggested that the merged company would not need so many staff – some could be faced with redundancy. Those that were retained would be unlikely to receive higher salaries – the other company has fewer new drugs in the pipeline than DDD. The venture capital company which owns a share of DDD would also be concerned about the attractiveness of this approach. It might not wish to see its share of the new company reduced by the merger. Feasibility. In terms of feasibility, the first reaction is that there is no reason why DDD could not successfully pursue this option. However, there will be significant changes involved if it does so and, additionally, managing a merger process is quite difficult, even for management which has past experience of the process – the management of DDD do not have that experience. Requirement (c) An additional option which the management of DDD might choose to pursue is to reduce the number of drugs it has in development and divert the funds and staff to those drugs which are timed to come to market soonest.

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In terms of suitability, there is no certainty that this will release enough funding and staff time to cover the short-fall in research funding after nine months. There is also the decision as to which of the developing drugs to drop. As with all new drug development, there are no guarantees of a successful launch and there will be a degree of subjectivity in the selection of those developments to suspend. The decision process is likely to be quite emotional for some of the staff since they will be losing their ‘pet’ project and having to work on something different. In terms of acceptability, we have already talked about the employees. As regards the founders this would maintain their independence and would not allow the venture capitalist to increase its share of the company. As long as the correct selections of drugs to continue to develop were made, the intent to float should be achievable, but possibly not as soon as five years. The venture capital company would most probably be happy with this approach although it would also want to look carefully at the impact of the option on the time that DDD was able to go to the stock market. In terms of feasibility there is no reason why DDD could not take this approach. Requirement (d) Of the options available: Accept further venture capital – reasonably unacceptable to the founders and the staff.

Offer from pharmaceutical company – the most unacceptable offer to all stakeholders.

Merger – not the best option for the founders and definitely not for the staff.

Reduce number of drugs – the best option available and the least disruptive to the principal stakeholders. It should be recommended to the founders of DDD that they pursue the option to reduce the number of drugs in development. Answer to Question Five Requirement (a) Effectively EEE is looking to acquire a competitor and concentrate its manufacturing capability in the new company. This will then be operated as a division of EEE. EEE will need to conduct most of a competitor intelligence investigation. This can be described as follows; EEE should identify the current strategy of the companies that it wishes to consider as potential acquisition targets. Since it is currently being undercut by those companies that are exporting to F, it would seem that it is attempting a cost focus strategy. Resource considerations EEE will need to identify those firms which are capable of producing their products to a standard that is acceptable to the customers which EEE wishes to serve, or will need to change their product offering accordingly. Additionally, the target company should have an established market, and a significant market share, in its home country. It will be important to establish what the company actually does rather than what it says it is doing. EEE will need to conduct a rigorous audit of the resources and capabilities of the potential acquisitions.

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Although the potential target companies are competing with EEE there may well be differences in the products they are using to so do. There will need to be an audit of the products offered to ensure that they fit in with the standards that EEE wishes to continue to offer. Similarly EEE will want to audit the customers currently served by the target company to ensure that it would want to continue to service them. Some may be more profitable than others. The plant and equipment will need to be of an appropriate standard and have sufficient capacity to supply both EEEs present market and the existing market of the target company or, alternatively, capable of expansion to so do. If the current plant is of insufficient capacity the buildings would need to be of a size which could house new equipment. The staff working in the plant would need to be sufficiently skilled and of an appropriate age profile to work to EEEs standards. It might be necessary to hire additional staff to deal with any expansion that EEE had to make. If this were the case EEE would need to look at the local population to make sure those suitable new employees could be found. Strategic considerations EEE will need to identify the objectives of the stakeholders of the target company. It is important that it selects a company where there is a likelihood of a successful purchase. However, it is also necessary that it selects a company where those managers and staff which they would wish to continue to employ, are happy to work for EEE. The wishes of the owners of the privately held company should be determined. Whether they would wish to stay as part of the company or just take the proceeds of the sale and move on would be an important consideration. It will be important to determine the views of the management of the target company concerning the future of the industry in its markets. Although EEE will have its own views on the future of the market, the view from another perspective will be useful in EEEs decision making. EEE obviously thinks the market has a future otherwise it would not be considering the acquisition but the target company may see that the market is becoming less discerning and a cost focus strategy will be more appropriate. Control considerations The management structure and control systems would need to be sufficiently scalable to deal with the increased throughput. Additionally, they would need to be sophisticated enough to dovetail with the systems currently used by EEE. Supply chain considerations The supply chain network the target company was using would also need to be of sufficient capacity to supply the increased volumes required to supply both the existing market and all other markets that EEE wished to serve. The suppliers of the target company would need to have appropriate standards and capacity and the infrastructure to deliver the increased volumes. The location of the target company needs to be considered in terms of the available transport system and infrastructure to deliver to the existing markets of the combined company. Financial considerations EEE will need to look at the financial stability of the company it chooses to acquire. Although the companies are privately held there may well be financial liabilities which it will need to take on in the event of a takeover. Conclusion Many acquisitions fail because the acquiring company does insufficient pre acquisition screening of potential targets. This would be something that EEE must avoid.

P6 26 May 2008

Requirement (b) Part (i) Once the new subsidiary is established as part of EEE there will be a need to manage a multinational multidivisional company, an experience which EEE presumably has not had before. There are a number of difficulties that may be experienced regardless of the performance measures that EEE decides to implement. It will be worth remembering that there may well be different economic conditions in the different countries together with different legal frameworks. Additionally, there may be different trading conditions and cultures, although this may not be the case bearing in mind that the countries are adjacent. This may present problems to EEE in its choice of a performance measurement and management system, since the management of the new subsidiary may not be used to control of this kind. This may be exacerbated by the fact that the acquired company has previously been a private company. With this in mind, it is likely that EEE will decide to use a relatively straightforward technique initially. While EEE could adopt a simple profit based measure, ROI and RI are both superior techniques since they will both take into account the capital base employed in the division. However, there are a number of difficulties which both ROI and RI may cause since both are still essentially profit based measures.

• Managers may choose not to invest in the future since such lack of investment would reduce their capital assets and therefore improve their performance indicators.

• The figures presented by different divisions may not be comparable because of differences in accounting conventions concerning the valuation of assets and the classification of various categories of expenditure.

• The geographical location of the business may affect the cost of both investment assets and the returns recorded. This may well depend on the availability and cost of plant and equipment.

• Although EEE will have a common depreciation policy across the divisions the age of the assets used will affect the results and may distort comparisons.

• The use of financial control measures does not make it easy for the corporate centre to shape the future of the whole organisation. This will be particularly true if EEE decides to base the reward system of the divisions on these measures.

• By their nature these measures are historical and therefore not appropriate for guiding strategy making for EEE.

Additionally there are differences between ROI and RI which may help EEE decide which is the most appropriate.

May 2008 27 P6

Part (ii) Should EEE choose to use ROI as the primary performance measure, there are a number of disadvantages of which it needs to be aware.

• The use of ROI may lead managers to ignore profitable opportunities because their ROI is less than the ‘target’ or current ROI. This would not be the case with RI as long as the imputed cost of capital for the division was less than the return achieved by the opportunity.

• Managers may be encouraged to start a project that has a high ROI and which, therefore, increases the average ROI for the division even if the project does not cover the cost of capital. This would not happen with RI where the project would show a negative return.

• In general RI is more flexible than ROI since different imputed rates of interest can be used to reflect the different inherent risk of projects in different areas.

On balance, if EEE intends to use either ROI or RI rather than a more forward looking method, then RI will offer more flexibility but may need more explanation to the divisional managers.

P6 28 May 2008