Section A – This ONE question is compulsory and MUST be attempted
Monza Pharma (Monza) is a developer and manufacturer of medical drugs, based in Beeland but selling its products all over the world. As a listed company, the overall objective of the company is to maximise the return to shareholders and it has used return on capital employed (ROCE) as its performance measure for this objective. There has often been comment at board meetings that it is good to have one, easily-understood measure for consideration.
The company has three divisions:
– the drug development division develops new drug compounds, taking these through the regulatory systems of different countries until they are approved for sale;
– the manufacturing division then makes these compounds;
– the sales division then sells them.
Monza’s share price has underperformed compared to the market and the health sector in the last two years. The chief executive officer (CEO) has identified that its current performance measures are too narrow and is implementing a balanced scorecard (BSC) approach to address this problem. The current performance measures are:
– Return on capital employed
– Average cost to develop a new drug
– Revenue growth
The CEO engaged a well-known consulting firm who recommended the use of a BSC. The consultants began by agreeing with the board of Monza that the objective for the organisation’s medium-term strategy was as follows:
– Create shareholder value by:
Innovating in drug development
Efficiency in drug manufacturing
Success in selling their products
The consulting firm has presented an interim report with the following proposed performance measures:
– Financial: ROCE
– Customer: Revenue growth
– Internal business process: Average cost to develop a new drug
– Learning and growth: Training days provided for employees each year
The CEO and the lead consultant have had a disagreement about the quality and cost of this work and as a result the consultants have been dismissed. The CEO has commented that the proposed measures lack insight into the business and do not appear to tackle issues at strategic, tactical and operational levels.
The CEO has decided to take this work in-house and has asked you as the performance management expert in the finance department to assist him by writing a report to the board to cover a number of areas. First, following the disagreement with the consultants, the CEO is worried that the consultants may not have been clear about the problems of using the BSC in their rush to persuade Monza to use their services.
Second, he wants you to evaluate the choice of performance measures currently used by Monza and those proposed by the consulting firm.
Third, there has been a debate at board level about how ROCE should be calculated. The marketing director stated that she was not sure what profit figure (of at least four which were available) should be used and why, especially given the large variation in result which this gives. She also wondered what the effect would be of using equity rather than all capital to calculate a return on investment. Some basic data has been provided in Appendix 1 to assist you in quantifying and evaluating these possibilities.
In addition to these concerns, the board is considering introducing a total quality management approach within Monza. Obviously, quality of output is critical in such a heavily regulated industry where the products can be a matter of life and death. There has been discussion about testing this idea within the manufacturing division. The CEO wants to understand, first, the costs associated with quality issues within that division. To aid your analysis, he has supplied some detailed information in Appendix 2. Next, the board requires an outline evaluation of how a total quality management (TQM) approach would fit within the manufacturing division.
Finally, the drug development divisional managers have been lobbying for a new information system which will assist their research chemists in identifying new drug compounds for testing. The new system will need to be capable of performing calculations and simulations which require high computational power and memory but will also need to have access to external data sources so that these scientists can keep up with developments in the field and identify new opportunities. The CEO is worried about the cost of such a new system and wants to know how it would fit within the existing lean management approach within that division.
Write a report to the board of Monza to:
(i) Assess the problems of using a balanced scorecard at Monza. (8 marks)
(ii) Evaluate the choice of the current performance measures and the consulting firm’s proposed performance measures for Monza. (12 marks)
(iii) Evaluate the effect of choosing different profit and capital measurements for different measures of return on investment and recommend a suitable approach for Monza. (11 marks)
(iv) Analyse the current quality costs in the manufacturing division and then briefly discuss how implementation of total quality management would affect the division. (10 marks)
(v) Briefly advise on how the drug development division can aim to make the new information system ‘lean’. (5 marks)
Professional marks will be awarded for the format, style and structure of the discussion of your answer. (4 marks)
Report
To: The board of Monza
From: A. Accountant
Date: September 2016
Subject: Performance measurement and management issues at Monza
This report addresses the problems of using the balanced scorecard within Monza. The current and proposed performance measures are evaluated and the main current measure is discussed in detail. Quality costs and the new quality programme at the manufacturing division are analysed. Finally, the lean philosophy is applied to the new information system for the drug development division.
(i) Problems with using the balanced scorecard
The balanced scorecard (BSC) provides no aggregate or single summary measure of performance unlike the value-based approach. Also, there is no simple, direct link between shareholder value, the main objective of Monza, and the balanced scorecard measures.
The measures in the scorecard can conflict, for example, cost controls (financial perspective) can obstruct the investment needed in order to speed up manufacturing processes (internal business perspective). Overall, the measures should seek to align with the fundamental need to create shareholder value.
It can be difficult to select measures. In particular, there is the danger of losing sight of key information in a plethora of indicators. This may be an issue for Monza as it has only had three indicators in the past and this will now increase significantly (a potential of 12, if there is one for each level of management in the four perspectives).
There must be management commitment to the change to the scorecard. In particular, there must not be a return to a focus on the financial measures which have been used in the past at Monza. Management should acquire the expertise for understanding non-financial measures through training.
There are potentially significant costs in collecting the additional information which will be needed for the new performance measures. Many of the measures will be non-financial and so new information systems will be required to collect and record the data.
(ii) Choice of current and proposed performance measures
Current measures
The current measures are all historic, financial ones and so the BSC approach will bring a longer term view by using non-financial measures which consider those factors which might drive future growth, for example, those in the learning and growth perspective. The current measures do not directly link to shareholder value which appears to be the overall aim of the company. A measure such as economic value added would do this more effectively.
The three measures do give a broad view of financial performance. ROCE is a widely-used measure which it should be possible to benchmark against competitors. As far as the divisions are concerned, there is a measure of success in selling through revenue growth, though this may not be due to only the sales division but also the drugs brought to market by the development division. Average cost to develop a new drug is a financial measure of the development division’s performance but this does not measure its aim of innovation in development. Indeed, this measure may conflict with that aim as cost control of development may hinder innovative thinking. It would appear more appropriate to have a cost control measure associated with manufacturing as its goal is to be more efficient. The performance of the manufacturing division is only measured indirectly through its effect on the financial performance of the company as a whole.
Consultants’ proposed measures
The suggested measures do not seem to deviate much from the existing measures, though there may be an advantage in this as the new system would be using existing information systems and known measures in that case. However, this advantage is secondary to the need to find measures which will drive useful performance in the four perspectives.
The proposed measures from the consultants’ interim report mostly fit within the standard four perspectives of the BSC, although revenue growth is more appropriate as a measure from the financial perspective. Customer perspective measures should focus on the strategies which will achieve success in the eyes of the customers rather than just measuring the results of those strategies. Examples of this would be measuring the efficacy of the drugs which are developed by Monza or the reputation of Monza’s medicines among the medical community.
Taking the others in turn, ROCE does not seem to be directly linked to shareholder value as, for example, economic value added or net present value would be. ROCE considers the performance over the whole capital base while the shareholders will be more directly concerned with returns on their equity investment. As a profit-based measure, ROCE may also be failing to target cash-generation which is ultimately driving dividend payments and value creation for shareholders.
As already indicated, cost control in business processes is important but other measures of success such as time to market for the development of new products and quality initiatives should also be considered.
The fourth perspective is particularly relevant to a high-technology firm such as Monza. There will be considerable competitive advantage in having a highly skilled workforce, however, the measure proposed is imprecise as it values all training days, whether for knowledge workers or unskilled labourers, as equally valuable. Measures of the number of innovations within each division may be appropriate as these will be qualitatively different (new compounds developed, manufacturing quality improvements and sales techniques/initiatives developed).
Overall, the initial proposed set of measures does appear limited and does not address the overall aim of Monza or the problem of the narrowness of the existing set of measures.
(iii) Variation in calculating return on capital
