Laurel and Parsley (LP) is an architectural consultancy firm, specialising in the design of large commercial buildings. Due to an economic recession, which began in late 2017, demand for LP’s services fell dramatically, and there was insufficient work for all of the firm’s consultants. LP’s chief executive officer (CEO) believes that the recession will be short and that LP should do all it can to retain its highly skilled and experienced workforce ready for when demand increases after the end of the recession. The rest of the board believe that the firm should cut the size of the workforce until that time, as LP already has an operational gearing ratio 50% higher than its main rival.
Despite the board’s objections, the CEO asked for LP to prepare bids for work on non-commercial building projects, which have so far been unaffected by the recession. Though LP had little track record in designing non-commercial residential buildings, it successfully tendered a fixed fee for the design work on a large housing development. As the finance director had been absent due to illness for a year, the CEO prepared and submitted the bid himself. To meet the tight deadlines for submission of the bid, this was done at a time when most of the board were taking their annual holidays.
It quickly became apparent that the staff resources required for the housing development project were much greater than the CEO had anticipated in the bid. In the rush to submit the bid and start work, staff were not given clear milestones for completion of the project, or individual performance targets. This has led to staff working long hours, morale has fallen, and several experienced employees have since left the firm. The project is well behind schedule, and LP’s client has said it will take legal action against the firm to recover any financial losses caused by the delay.
It has been suggested to the board that LP may be at risk of corporate failure, as it has score of 47 using the Argenti A Score model, which is shown in Appendix 1.
Using Argenti’s A Score model, evaluate whether LP is at risk of corporate failure.
The extent to which the Argenti A Score indicates corporate failure in LP
The Argenti A Score assigns scores to management defects and accounting defects, which are effectively weaknesses which can lead to failure, mistakes, and symptoms. Symptoms are indications that the business is actually failing. The resulting score indicates whether or not LP is or is not at risk of corporate failure. Between these two extremes, there is a grey area where further analysis is required to reach a conclusion. An A Score of 25 or above indicates a high risk of corporate failure. As LP’s A Score is 47, it is at high risk of failure.
Defects
The chief executive appears to be an autocrat, which is a management defect under the Argenti A Score model. LP prepared bids for work in areas it had little track record in, which was the strategy preferred by the chief executive, even though the rest of the board wanted to reduce the workforce to reduce operating gearing after the start of the recession. This suggests that the chief executive has a dominant influence over the rest of the board and that the board of directors is passive, which is another management defect.
The submission of the bid was done when most of the board members were on holiday, so in this respect too, the board was passive as it had no opportunity to discuss or review the bid. Similarly, the bid was made when the finance director was on long-term absence. An ineffective finance director is a management defect which increases the risk of corporate failure.
The fact that the amount of staff resources, and therefore cost, required to perform the work on the housing development was greater than anticipated was an accounting defect which increases the risk of failure.
Mistakes
LP undertook a large project in an area where it has little experience, and at a fixed fee. This was a high-risk venture, particularly as LP failed to set clear milestones for the project or put in place adequate performance management systems. This is a management mistake which, in the absence of suitable insurance cover, may mean LP is unable to meet any legal claims brought against it.
LP has an operational gearing ratio which is 50% higher than its nearest rival. Failing to address this high level of fixed cost, for example, by reducing the workforce for the duration of the recession, is also a management mistake which increases the risk of corporate failure.
Symptoms
Any symptoms of impending problems would indicate a high risk of corporate failure, even if LP’s A Score were to be below the maximum acceptable score of 25. The low staff morale, and staff leaving the firm due to working long hours with unclear individual performance targets, is a symptom that the firm is at risk of failure.
Advise LP what performance management systems are needed in order to improve performance in respect of each of the mistakes and symptoms you have identified in part (a).
Mistakes
The failure of the big project for the design work for the housing development, and the high operational gearing, are management mistakes which increase the risk of corporate failure. To improve performance in these areas, LP needs effective performance management systems.
(1) Failure of the big project for the design work for the housing development
LP should identify critical success factors (CSFs) for improvement in performance. Big projects, especially those which are outside LP’s usual activities should be fully scrutinised by the board, and the risks of the project thoroughly assessed. This would help prevent LP taking on projects for a fixed fee, where the costs of performing the work are poorly understood. The use of realistic budgets and clear project milestones would have helped identify that the major project was failing and allowed corrective action to be taken. Clear budgets and project milestones should be key performance measures to identify failure of the major project.
(2) Operational gearing
From the CSFs LP must develop key performance indicators (KPIs). The operating gearing is an obvious KPI to help reduce the firm’s high operating gearing. Cash forecasts would also help to identify and correct high operating gearing. Performance targets such as these should be clearly communicated and linked to employee rewards.
Symptoms
Clear milestones and performance targets were not set for the housing development project and the project has fallen behind schedule. This has led to low staff morale and to staff leaving the firm. All of these are symptoms of corporate failure.
Performance against the targets should be regularly monitored, for example, by using staff appraisals and surveys to monitor staff satisfaction. This could indicate where additional training or support is required.
Measuring staff turnover would help measure this symptom of corporate failure so that LP could try to identify why staff were leaving.
Evaluate the usefulness of using qualitative models such as the Argenti A Score in predicting corporate failure.
Advantages of using qualitative models in predicting corporate failure
The subjectivity of the A Score can be an advantage over quantitative indicators of corporate failure, as it allows the person calculating the A Score to use their own professional judgement in considering individual circumstances.
It also recognises factors which have been observed in failing companies and which often can be seen in organisations before they reach a terminal state.
The A Score model incorporates financial (such as the operating gearing ratio), and non-financial factors, which give a more holistic assessment of whether failure is likely than just looking at financial or non-financial factors alone.
Disadvantages of using qualitative models in predicting corporate failure
Calculating the A Score is subjective and requires experience and professional judgement, for example, in determining whether LP’s board is passive. In reality, passive will be on a scale rather than just passive or not, which also makes it difficult to compare the score between organisations.
The A Score focuses on internal factors, which limits its usefulness. The economic recession has had a serious impact on LP, which calculating the A Score alone would not consider. Further analysis of the external environment, such as using a PEST analysis, or calculation of competitors’ A Scores, would consider external factors in determining whether LP is at risk of corporate failure.
A limitation of the A Score model is that it is only a snapshot at a particular time and does not indicate when corporate failure may occur. Defects and management mistakes may take a long time before they lead to corporate failure. In LP, corporate failure may occur if it is subject to legal action for the delay of the housing project. Conversely, the recession may end and LP may no longer be at risk.
The fact that the A Score does not give a definitive indication of whether failure will happen may mean inappropriate decisions are taken as a result of the analysis. It must be considered whether the time and cost in calculating the score are justified by the benefit of doing so. The results of the A Score may be inconclusive and indicate that the subject is in the ‘grey area’. This will require yet further analysis before a conclusion can be reached. This does not appear to apply to LP which is currently clearly at risk of corporate failure using the A Score model.