Section A – This ONE question is compulsory and MUST be attempted
Flack Supermarkets (Flack) is a multi-national listed business operating in several developing countries. The business is divided into two divisions: Metro, which runs smaller stores in the densely populated centres of cities and Hyper, which runs the large supermarkets situated on the edges of cities. Flack sells food, clothing and some other household goods.
Competition between supermarkets is intense in all of Flack’s markets and so there is a constant need to review and improve their management and operations. The board has asked for a review of their performance report to see if it is fit for the purpose of achieving the company’s mission of being:
‘…the first choice for customers by providing the right balance of quality and service at a competitive price. We will achieve this through acting in the long-term interests of our stakeholders: earning customer loyalty, utilising all our resources and serving our shareholders’ interests.’
This report is used at Flack’s board level for their annual review. The divisional boards have their own reports. Also, there has been criticism of the board of Flack in the financial press that they are ‘short-termist’ and so the board wants your evaluation of the performance report to include comments on this. A copy of the most recent report is provided as an example at Appendix 1.
The board is considering introducing two new performance measures to address the objective of ‘utilising all our resources’. These are revenue and operating profit per square metre. The CEO also wants an evaluation of these two measures explaining how they might address this aspect of the mission, what those ratios currently are and how they could be used to manage business performance. There is information in Appendix 1 to assist in this work.
There have been disagreements between Flack’s divisional management about capital allocation. The divisions have had capital made available to them. Both sets of divisional managers always seem to want more capital in order to open more stores but historically have been reluctant to invest in refurbishing existing stores. The board is unsure of capital spending priorities given that the press comments about Flack included criticism of the ‘run-down’ look of a number of their stores. The board wants your comments on the effectiveness of the current divisional performance measure of divisional operating profit and the possibility of replacing this with residual income in the light of these problems.
As the company is opening many new stores, the board also wants an assessment of the use of expected return on capital employed (ROCE) as a tool for deciding on new store openings, illustrating this using the data in Appendix 2 on one new store proposal. The focus of comments should be on the use of an expected value not on the use of return on capital employed, as this is widely used and understood in the retail industry.
Finally, the CEO has proposed to the board that a new information system be introduced. She wishes to spend $100m on creating a loyalty card programme with a data warehouse collecting information from customers’ cards regarding their purchases. Her plan is to use this information to target advertising, product range choices and price offers more efficiently than at present.
Appendix 2 New store
The following data has been forecast by the marketing department for the new store based on Flack’s existing experience. There are three possible scenarios:
Write a report to the board of Flack to:
(i) Evaluate the performance report of Flack, using the example provided in Appendix 1, as requested by the board. (14 marks)
(ii) Evaluate the introduction of the two measures of revenue and operating profit per square metre, as requested by the CEO. (8 marks)
(iii) Assess the proposal to change the divisional performance measure.
Note: No calculations of the current values are required. (8 marks)
(iv) Calculate the expected return on capital employed for the new store and assess the use of this tool for decision-making at Flack. (8 marks)
(v) Explain how the proposed new information system can help to improve business performance at Flack. (8 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer. (4 marks)
Report
To: Board of Flack
From: A. Accountant
Date: June 2016
Subject: Performance reporting and management issues at Flack
Introduction
This report evaluates the current performance report for Flack and the introduction of two new performance measures. Then, the effect of a proposed change in divisional performance measure is assessed. Next, the use of expected ROCE for new store proposals is evaluated. Finally, the report explains how the proposed new information system can help to improve business performance at Flack.
(i) Performance reporting at Flack
The current report has a number of strengths and weaknesses. These will be discussed according to whether the report:
– addresses the mission.
– contains appropriate information for decision-making,
– shows signs of being short term and
– is well presented.
The current mission can be broken down into two parts:
– to be the first choice for customers and
– to provide the right balance of quality, service and price.
There are three strategies for achieving this mission, reflecting stakeholder concerns:
– earning customer loyalty,
– utilising all resources and
– serving shareholders’ interests
The report does not address the first part of the mission. This can only be measured using external data but the report is utilising only Flack’s internal data. This part of the mission relates to the first strategy to gain customer loyalty. Customer loyalty could be gauged through repeat purchases or market share information but neither is supplied. This is clearly important to a retailer and may be more easily gathered once the data from the new information system are available for inclusion in this report.
The report provides no measures of the balance of quality, service and price other than through the historic growth in revenue. It would only be through comparison with competitors or customer survey data that a picture of the mix of these qualities could be gained.
The second strategy of utilising resources requires that the key resources be identified. Clearly, the stores themselves (and thus the capital invested) are an important resource and the introduction of the revenue and profit per square metre and comparison with competitors will indicate the efficiency of their use. However, there are likely to be other important resources such as staff and no measure of their performance is offered. Staff costs are not shown in the trading account although a more sophisticated measure such as revenue per employee is a commonly used metric and would address this.
The report is much better on the third strategy of serving shareholder interests as it supplies two helpful measures: total shareholder return and return on capital employed. However, most shareholders will want comparison with benchmark returns within the retail sector and the market more widely, since these represent their alternatives.
The criticism of the company’s management as being short term is reflected in the performance reporting. The report only contains for comparison budget information and the previous year’s figures. There are no longer term forecasts or information on future capital investment. Also, there are few indicators which would be described as determinants of performance. These are often non-financial and focused on the external business environment (behaviour of customers and competitors).
As already noted, there is a significant gap in the information in the report as it contains no external information. Also, although revenue is broken down into broad product categories, no further information about growth within these categories nor the margins being earned is supplied. As a result, it could be questioned whether this break-down is worthwhile.
In terms of presentation, the data is clear and in a form which would be easily recognisable to those used to reading accounts. However, no narrative commentary is provided which would highlight the key features in the report such as major deviations from the budget or performance well outside industry norms. There should be a comment on each of the five areas within the mission and strategies as well as comments about specific, material issues arising in the period covered. The report could be made easier to read by reducing the volume of numbers present both by cutting out unnecessary measures (see earlier discussion of product categories) and also by rounding all figures to millions.
(ii) New asset utilisation indicators
Revenue and operating profit per square metre reflect the utilisation of the key capital asset used in their generation (the store). Therefore, they are directly addressing a major part of the aim of utilising all resources, however, they do not address all resources which the business uses. There are likely to be significant staff costs and so similar measures of revenue and operating profit per employee could also be introduced in order to reflect these human resources.
These measures reflect the importance of the use of the store’s space which is an area which the business does not give sufficient attention as is reflected in the problems with divisional performance measures. Focus on these measures will require addressing issues of volume of sales and the profitability of those sales. The two types of store at Flack will have different impacts on these measures. For example, the smaller Metro stores may be capable of earning higher margins as they are convenient to customers while selling lower volumes. The Hyper stores may concentrate on selling in volume to customers who come to buy in bulk. However, in terms of the overall performance of the business it is essential that Flack sells in high volumes as it is a low margin business but it must not sacrifice profitability, in effect buying customers’ revenue by selling at or near a loss.
(iii) Divisional performance assessment
The current measure of divisional operating profit reflects the trading in the period under consideration. Profit will link to the whole business’s operating profit which is the correct level to reflect the efforts of the divisional managers. However, this measure only indirectly addresses the capital being used by the divisions (depreciation charged to operating profit). This is distorting the behaviour of the divisional managers.
The managers are not investing in refurbishing their stores which is causing the press (and presumably customers) to notice their run-down appearance. This may reduce the depreciation charge against operating profit. They are prioritising new store capital expenditure over the refurbishment since they are not being charged for the use of that capital (financing charges are deducted after operating profit is calculated). This may not be optimal since small spending on existing capital assets often yields higher returns than new spending (which may be subject to greater risks).
The proposal to change the divisional performance measure addresses the issue of not reflecting the capital used since residual income (RI) deducts an imputed interest charge. Divisions can then be set targets in terms of their RI. The difficulties in calculating RI lie in correctly setting the imputed interest rate and calculating the capital being employed by the division. However, since both divisions are types of stores they will have similar assets and so the same rules can be applied to each to fairly calculate the capital used. An advantage of RI is that the imputed interest rate can be changed to reflect the different risks of the divisions. The two divisions here do not seem to have significant risk differences unless the geographical locations introduce these (city centres and city edges). However, it is worth noting that using RI can discourage investment. As net book values of assets fall over time, RI automatically increases and ‘do not invest’ could become an attractive option to the managers.
Overall, the proposed change addresses existing problems and would be considered a normal solution to measuring divisional performance in this industry.
(iv) Use of expected ROCE in new store appraisal
