Section B – TWO questions ONLY to be attempted
Save Our Pets (SOP) is a charitable organisation which rescues unwanted or mistreated pets and finds new homes for them. It is located in five different sites around Asteria, where it is based. As a not-for-profit organisation, operational efficiency is crucial for it to be able to deliver effective services from its limited funding. Therefore, when procuring goods and services, SOP always selects the cheapest option which meets its requirements. However, in some instances, this approach has led to greater costs in the long term as a result of poor quality. There was also one recent procurement project where the selected supplier, despite being paid a large deposit, went into liquidation before delivering the equipment which SOP had ordered.
SOP is planning to implement a new enterprise resource planning (ERP) system, which will link the transaction processing systems of all functional departments at all sites. This will include the rehoming database, which includes details of all pets at all sites, allowing the different sites to search for suitable pets for potential customers. Although there are only a few appropriate systems on the market, SOP has identified and shortlisted three providers of modular packages which it believes could be easily adapted to meet its requirements. The shortlist was created using the price of the software as the sole criterion. There were three other suitable suppliers who were not shortlisted as their products were more expensive.
The board of SOP has provisionally decided to award the ERP system contract to a small software company, based in Asteria, called Itrus. At the board meeting convened to make the final decision, the financial director explained that Itrus offered the cheapest software solution, at a price of $200,000. However, the operations director was concerned about this selection, stating that, ‘selecting on the basis of price alone has not always worked for us in the past. I’m sure we should use more extensive selection criteria, particularly when selecting computer software. We need to look at a range of factors as well as price.’ After some discussion, the final decision on the contract was deferred. In the meantime, the board agreed that the company accounts of Itrus should be evaluated to assess its financial performance and the risk of it going into liquidation. Itrus has provided accounts for the last two years (see Figure 1) for the evaluation. It was also agreed that the operations director should define what factors, other than price, need to be taken into consideration when evaluating a potential software solution.
Figure 1: Itrus – Extracts from financial statements 2015 and 2016
Extract from the statement of financial position
Undertake a financial evaluation of Itrus, highlighting any areas of concern.
Although Itrus has provided its accounts, and a year-on-year comparison can be examined, it would also be useful to see industry benchmarks in order to compare. However, comparison between the two years will provide a basis for further evaluation.
Itrus is a relatively small company, with turnover of less than $1m and this has reduced by 5·75% in the last year. This alone may cause concern in SOP, given that the price for the system to be implemented has been quoted at $200,000, or 27% of Itrus’ total revenue for 2016. This may be beneficial, in that Itrus may focus their attention on such a key customer. However, it may also indicate that there is a lack of experience on major contracts such as this.
There are only 25 staff members and this has fallen 37·5%, from 40, in the previous year. The fall is likely to involve a redundancy programme, which could indicate a struggling company, or issues with staff motivation and morale, leading to a high staff turnover and an inability to recruit. Regardless of the reason, 25 staff members seems quite low to meet the needs of SOP and any other clients. Looking more closely, if we assume the staff allocation to contracts to be in line with contract size, this suggests that SOP could expect approximately seven staff to be allocated to their contract which should be reasonable. However, it does depend on how many of these staff are operational and how many have administrative roles. On an ongoing basis, there may be concerns about the ability to maintain the system, if employee numbers are falling.
Looking more closely at the financial data, we can observe the following:
Profitability
We can calculate three key profitability ratios from the data provided: gross profit percentage (GPP), net profit percentage (NPP) and return on capital employed (ROCE). None of these are looking good on initial examination. The ROCE has reduced from 11·8% to 6·8%. This means that the capital employed in the business is achieving lower returns over time. This is not necessarily a negative factor in the short term if it is as a result of greater investment in the business, but that does not seem to be the case for Itrus. Indeed, there appears to have been a disposal of non-current assets (from $80,000 to $50,000) as the reduction of 37·5% seems a little high to be as a result of depreciation alone.
The GPP and NPP are both falling too. GPP has fallen slightly from 6·4% to 6·1%, whilst NPP has almost halved from 2·8% to 1·6%. The NPP is as a result of increased finance costs (discussed further in the gearing section) and increased administration expenses. It would not be unreasonable to expect a decrease in other costs to occur with a decrease in revenue, so the increase of 25% in administration expenses warrants further investigation. It may be that these have risen in a bid to improve working capital management (see efficiency section below).
Efficiency
Itrus does seem to have improved its efficiency in all areas
There is an improvement in trade payables. The overall value of payables has dropped 73% in the last year, a much greater drop than the 5% drop in cost of sales. This has led to an improvement in payable days, dropping from 123 days to 35 days, a reduction of approximately three months. However, it may be that this is driven by suppliers demanding earlier payment, as the previous payable days of four months would be very high for most industries. This needs further investigation.
Trade receivables have also reduced, falling by 32%. This has led to a decrease in receivable days, from 128 days to 92 days. This is beneficial as it means that Itrus is collecting amounts due quicker and thus improving its working capital. However, it is still high, taking approximately three months to collect amounts owing. As this is higher than payable days, there is an overall negative impact on working capital.
The reduction in staff has led to improved revenue per staff member, although it still seems quite low, increasing 51% from $20,000 to $30,160.
Liquidity
Liquidity has improved greatly over the year, with the current and acid test ratios both increasing from 1·2:1 to 2·5:1. This is well above 1 and indicates that Itrus can easily cover its liabilities with its assets. This is mainly driven by the large decrease in trade payables.
Gearing
Taking long-term debt over total capital employed, the gearing ratio has increased from 28·5% to 35·7%. Whilst this does not seem particularly high, the increase could indicate a reliance on long-term debt to finance the activities of the business.
The long-term debt has increased by 47% which is worrying in a business with declining sales. Short-term borrowings have also increased 250%, although this is on a low starting value. These have led to an increase in finance costs of 50%.
Interest cover has reduced from 7·75 times to 3·5 times, which may start to concern the debt holders in the business. This also warrants investigation.
Summary
Although Itrus appears to be working hard at improving its efficiency and liquidity, the accounts do not appear to present a positive future. The reduction in non-current assets and staff as well as deterioration in key financial ratios should provide cause for concern. SOP should further investigate all the issues raised before making a decision to award the contract to Itrus.
In the context of SOP, discuss what other factors, other than the price of the software, need to be considered when evaluating a potential software solution.
Note: A description of the selection process itself is NOT required.
In addition to considering the price, a company should assess both the supplier and the product being offered when evaluating a potential software solution. Considerations regarding the product are varied, but should include both technical and functional requirements.
Product issues
Technical requirements
System interfaces – it has been stated that the system will link all transaction processing systems at all sites. SOP needs to take this into consideration when selecting the system: will it allow all these links as well as easily adapt to future required interfaces?
Transaction processing volume – as the system is to link all systems and sites, will it be able to cope with the volume of transactions required on a daily basis, without leading to a reduction in system speed?
User friendliness – the system should use familiar commands or be intuitive in nature to ensure that it does not lead to inefficiencies or errors on input. The charity relies on people to carry out the day-to-day operations, supported by the systems, so it is important that they find the systems easy to use. Given the decisions which will be based on the accuracy of these systems, the rehoming of animals to suitable homes, any errors are likely to have a negative consequence.
Functional requirements
Ultimately, the system must be able to carry out the functions for which it is being implemented. SOP has already discovered that there are not many suitable systems on the market to support their pet database and so they need to ensure that any system selected will adequately meet these needs.
Operational processes – the system should support all processes within SOP. For example, the rehoming process is the core activity and will follow a set approach. If the system requires a different workflow, then this should be assessed to ascertain whether it would be an improvement in processes or would be detrimental to operations.
Data transfer – SOP currently use transaction processing systems for different functional areas and these will be combined into a single ERP. The data between the two systems may be incompatible if they are not currently linked. SOP will need to assess whether the new system will allow the transfer of all data, whether directly or with some modification. If the latter, it will need to be determined whether the supplier would incorporate this into the implementation process.
Reporting – as a not-for-profit organisation, SOP will have its own unique reports, not commonly used in a corporate environment, e.g. number of pets rehomed in a month or how long each pet remains in the care of SOP before rehoming. It will be important that the system is able to provide such reports or will allow the users to query the database easily to provide any ad-hoc reports needed.
Supplier issues
Past experience – it has already been discussed that this contract would form a large proportion of Itrus’ revenue and it needs to be ascertained whether the company is more familiar with smaller projects, as opposed to a relatively large one like this. This is for a linked ERP system which would need to be adapted to SOP’s needs. Itrus, and the other suppliers, should be assessed to determine whether they have previous experience of doing this.
Previous clients – a good indicator of future performance is the satisfaction of previous clients. References for each of the potential suppliers could help determine not only satisfaction, but also previous relevant experience.
Approach to training and support – the introduction of a new system will require training of SOP staff as well as ongoing maintenance and development. SOP needs to request details of the provision of these from each potential supplier, and to determine the terms of the service level agreements (SLAs). There should be a shared understanding of the level and responsibility for any major financial commitments in the future, as well as expected response times to reported problems with the system.
Company culture – as a charitable animal rescue organisation, SOP is likely to have a strong company culture of shared beliefs. It will be important to them that any company working with them has a supportive culture to avoid clashes during the implementation process.
Given its past experiences with poor supplier selection, SOP should certainly review how it evaluates suppliers and the goods being offered, and should take the above factors into consideration.