ManAcc III June 2010 Exam: Question 3 Solution 40 Marks

a) Business units qualifying for a bonus: Marks

The Paper business unit has performed well according to the measures currently used and the plastic business unit has performed poorly. 1
OR
The Paper business unit is the only unit that would qualify for a bonus, as it has achieved both of the two performance measures as described below: 1

* The paper business unit is the only unit that has exceeded the expected ROI of 20%, which it has done by achieving an ROI of 25%. 1
* The paper business unit is the only unit that has exceeded the expected % contribution, which it has done by 2% (51% - 49%) 1
Max 3

b) Appropriateness of the performance measures selected:

The two performance measures currently used are one-dimensional as the company only uses financial accounting measures to evaluate performance. 1
OR
The two performance measures currently used are one-dimensional as the company has not incorporated any non-accounting or nono-financial measures. 1

Accounting measures often encourage decisions that maximise short term profitability only, at the expense of long term profitability. 1
These measures do not encourage goal congruence, as Pacnam wants the business units to expand and gain market share, however: 1
The paper unit has qualified for a bonus, yet if anything has contracted (gotten smaller) in the current financial year and lost market share. The opposite is true for plastic. 1
The expansion by the Plastic unit has had a negative impact on its ROI although the unit is in fact going to outperform the paper unit in the long-term. 1

Both performance measures are percentages and is not expressed as an absolute number (does not show the absolute profits of the units). 1
The performance measures do not incorporate a measure of risk. 1
The measures are accounting measures and can be easily manipulated. 1

ROI
It is difficult to compare two business units, as in this example, where one leases property, and one owns the property on which they operate. 1
Paper lease their manufacturing plant and their asset base is therefore understated compared to Plastic which owns 2 manufacturing plants. Hence, Paper’s ROI may be overstated. 1

The adverse effect of this measure is it may lead to management being unwilling to invest in viable projects as its shown by the reluctance of Para to accept the Krugersdorp project 1
OR
Managers will tend to reject investment opportunities that do not yield a ROI that is equal to or greater than the department's currenr ROI (even though it may be hood for the co' as a whole). 1

% CONTRIBUTED
Its not a fair measure as it does not take into account the volume of units sold, only contribution of those that are. 1
Maximising % contribution may even lead to the detriment of the company as lower quality RM are sourced and labour rates reduced in order to cut costs to meet % contribution targets. 1

If the selling price is determined by the market, then business units are effectively being evaluated on something that is not entirely within their control, which is not fair. 1

Paper has lost market share, but its % contribution is unaffected, therefore the decline in revenue and profit is not captured by this measure. 1
Plastic has gained new contracts & extended others, yet the new contract has a lower % contribution in order to secure it. Thus it has a lower net % contribution, despite great performance. 1

The company needs to include more measures to evaluate performance. These should include better financial measures than ROI and % contribution, as well as other non-financial measures. 1

Other valid point 1

Max 5

C) identification of additional performance measures

Pacnam Ltd should use more suitable financials measures to evaluate the performance of the two divisions. These measures could include:
- Market Share of each business unit 1
- Change in the market share of the business unit Increasing/decreasing) 1

- Growth in Revenue 1
- Growth in total assets 1
- Utilising the Variance Analysis Report to evaluate production efficiency/purchasing performance. 1

- Use EVA instead of ROI as it is a superior measure and more likely to lead to goal congruent decisions that maximise long term profitability 1
- Break ROI into the two components: asset turnover as well as profit margin (return on sales). 1

Pacnam Ltd should evaluate business units using non-financial measures,

as this is important to ensure that goal congruence is achieved & ensure that decisions maximise long term profitability. 1
Non- financial measures that are recommended are in the areas recommended by the balanced score-card. 0.5

Customer satisfaction measures: 0.5

- Customer satisfaction with the (a) product quality and (b) service offered by the business unit (e.g. measured by the number of complaints received). 1
- New customers secured during the year 1
- Existing customer contracts extended during the year 1
- Involvement in community upliftment projects 1
- Environmental projects undertaken, or reduction in environmental impact. 1

Internal measures of quality, efficiency: 0.5

- The variance report is probably a good means to evaluate this efficiency. 1
- Providing training to staff and finding ways to improve staff morale, which would increase the efficiency of the staff. 1
- Other measures to evaluate the quality of the product should be included, such as rework time. 1

Innovation measures: 0.5

- Innovative ideas introduced to enhance production capabilities or to secure new customers. 1
- Taking part in research and development in order to expand and grow. 1
- Investment in viable projects made during the year 1

Other valid point 1

Max 10

D) Evaluation of business units based on new financial performance measures

Business unit Business unit
2010 2009
Details Paper Plastic Paper Plastic
Revenue R 120 000 000 R 177 800 000 R 116 600 000 R 72 600 000 220000000
Cost of goods sold R 58 800 000 R 119 126 000 R 59 466 000 R 47 916 000
R 61 200 000 R 58 674 000 R 57 134 000 R 24 684 000 250000000

Net profit before tax R 30 600 000 R 44 005 500 R 31 423 700 R 18 513 000
Net profit after tax R 21 726 000 R 31 243 905 R 22 310 827 R 13 144 230

Total assets R 122 400 000 R 231 607 895 R 142 835 000 R 88 157 143
Current liabilities R 6 120 000 R 34 741 184 R 7 141 750 R 7 052 571

Market size (in terms of revenue) R 300 000 000 R 444 500 000 R 212 000 000 R 242 000 000

Market share 40% 40% 2

% Change in unit's market size 41.51% 83.68% 2
(Decrease)/ Increase in market share -15% 10% (From 55% and 30% respectively) 2

Growth in revenue 2.92% 144.90% 2

Growth in net profit after tax -2.62% 137.70% 2
Growth in total assets -14.31% 162.72% 2
EVA R 5 446 800 R 3 682 566 R 7 384 570 R 4 222 727 4
OR
EVA R 5 446 800 R 3 682 566 2

Decline in EVA -26.24% -12.79% 2

ROI split:
Asset turnover 98.04% 76.77% 2
Profit margin (ROS) 25.50% 24.75% 2

Using Financial Measures

The plastic business unit has clearly outperformed the paper business unit, and the reasons for this conclusion are below: 1

Market Share of each business unit: Plastic has grown their market share by 10% during the year, while the paper division has lost 15% of their market share. 1
OR
Plastic's market size (R value) has increased by 83.68%, while paper's has only increased by 41.51%. 1

Growth in Revenue: Plastic has increased revenue by 144.9% while the paper unit has only increased revenue by 2.92%. 1

The increase in revenue from the demand in cement bags is not sustainable due to the fact that the world cup construction is almost complete. 1
This coupled with the current economic downturn, is likely to mean the Paper unit's profits should decline even further in coming years. 1

Growth in total assets: The plastic unit has had a more than 162% increase in total assets, whereas the paper unit has had a 14.31% decline. 1
The latter is not in line with the company's expansionary goals. 1

Change in EVA: Although Paper has a higher net EVA, this EVA in 2010 has declined from 2009 by 26.24% while the plastic EVA only declined by 12.79%. 1
The paper unit's EVA has declined despite the decline in paper's asset base (above)- which emphasises the significance of the decline in value added. 1
The plastic unit's decline in EVA is mostly due to the massive growth in assets (above). 1
Therefore plastic weathered the economic downturn more successfully than the paper business unit. 1

Variance Report: The variance report shows that overall Plastic has achieved favourable variances, while paper has achieved an overall adverse variance. 1

Other valid point 1

Max 14

e) Evaluation of business units based on new non-financial performance measures

Customer satisfaction measures:
Customer satisfaction: Plastic has ensured that Koolgate is satisfied with the quality of the product as well as price and customer service, 1
while the paper unit has shown neglect regarding the quality of their product, and have not ensured the satisfaction of customers 1

This has lead to Cleenex sourcing their tissue boxes from elsewhere, and other tissue box customers may soon leave to. 1

Unilover may also have decided to change packaging type due to the quality problems experienced with the Paper unit's products. 1

Staff in the paper unit is on a "go-slow" strike, which could result in customer orders being late, poor customer service etc. 1

New customers secured: Plastic Unit has secured Unilover as a new client during the year, and extended their contract with Koolgate. 1

Existing customer contracts extended: Paper on the other hand has lost the Unilover contract, and 60% of the Cleenex contract, and no new contracts have been secured. 1

Involvement in community projects: Plastic is involved with the community of Meadowlands and this is an indication of how they want to uplift the community and create employment. 1
Paper instead, has created negative publicity for the company by not dealing the wage issues sensitively. 1

Reduction in environmental impact: Plastic has secured better quality raw materials that have reduced harmful emissions. Paper does not seemed to have made such progress. 1

Internal measures of quality, efficiency:

Variance report: The variance report is probably a good means to evaluate this efficiency. Other measures to evaluate the quality of the product should be included. 1

Production variance: The performance of the paper business unit, does not appear to be good as the overall net production variance is R1 376 000 adverse. 1
Production variance: The performance of the plastic business unit, appears to be good as the overall net production variance amounts to R980 000 favourable. 1

JIT: Introduction of JIT is expected to increase efficiency and processing time. This has been introduced by the Plastic Division, but not the paper division. 1
Plastic has introduced JIT and the benefits thereof seem to outweigh the costs to implement. 1

Wage disputes: Plastic unit has successfully dealt with the wage dispute, while the paper division has not resulting in negative publicity for the company as a whole. 1

Innovation measures: 1
Investment in viable projects: Paper has made no expansion during the year, while Plastic is opening a new plant in Eastern Gauteng & expanded capacity at one of its plants. 1

Innovative ideas: Plastic has undertaken research and development and has created and patented a new packaging flexible bag. No such development in paper unit. 1
The plastic division introduced JIT which greatly improved efficiency and showed initiative taken by Mr Santi. 1

Goal Congruence Plastic has recently installed additional capacity in plastic bottles and has undertaken a project to erect the manufacturing plant in Eastern Cape. 1
Plastic has therefore the expanded in line with the overall strategy of Pacnam, while Paper has acted in opposition to this policy. 1
Therefore Plastic should be rewarded and not Paper. 1

Other valid points 1

Interpretation of calculations Max 8

Total Marks for Question 3: 40 Marks