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Monitoring Test MT2C

Advanced Performance Management P5APM-MT2C-Z16-A Answers & Marking Scheme

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1

VIN CO

(a)

Ratios and statistics (i)

Return on capital employed

Operating profit ÷ capital employed × 100 $600,000 ÷ $4,000,000 × 100 (ii)

Return on sales (net profit percentage)

Operating profit ÷ Sales revenue × 100 $600,000 ÷ $3,600,000 × 100 (iii)

15%

17%

Asset turnover

Sales revenue ÷ capital employed $3,600,000 ÷ $4,000,000 (iv)

0·9 times

Average maximum bus capacity

Total number of passenger seats available ÷ number of buses 1,920 seats ÷ 40 buses (v)

48 seats per bus

Average bus occupancy

Total number of passenger km travelled ÷ (Total km travelled × Average maximum bus capacity) 39,000,000 km ÷ (3,250,000 × 48 seats) × 100% 25% of maximum capacity (vi)

Average km travelled per litre of fuel

Total km travelled ÷ Total fuel consumed 3,250,000 kilometre ÷ 764,705 litres (vii)

4·25 km/litre

Average fuel consumption per passenger kilometre

Total fuel consumed ÷ Total number of passenger kilometres travelled 764,705 litres ÷ 39,000,000 passenger kilometres 0·020 litres per passenger km (viii)

Average number of fatal accidents per million passenger kilometres

Fatalities ÷ Total number of passenger km travelled 1 ÷ 39 m passenger kilometres 0·026 fatalities per million passenger km (b)

Reasons why Vin Co’s fuel consumption is higher than the industry average 

Vin’s buses operate at only 25% capacity, this means that the fuel cost per bus km is spread over fewer passengers.



Vin’s kilometres travelled per litre of fuel are lower than the industry average. This could be due to it operating a city service. Even if it operated at industry average levels of bus occupancy its fuel consumption per passenger kilometre would still be higher.

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2

(c)

Meaning of terms Internal benchmarking refers to comparisons being made between divisions of the same company. If Vin operated bus services in other cities it could compare their performances. Internal benchmarking can also be taken to mean comparison with another organisation in the same industry, in this case another bus operator, perhaps in another city. Functional benchmarking (also known as operational or generic benchmarking) involves comparisons with the performance of external practitioners of similar functions. These practitioners need not be in the same industry. Vin could, for example, compare the fuel consumption of its vehicles with those of a road haulage company. Competitive benchmarking involves comparisons with the performance of a direct competitor. In the case of Vin, a comparison could be made with the performance of another operator in the same city. This may prove difficult, as the information required is often commercially sensitive and may be difficult to acquire. Strategic benchmarking takes place at the highest levels of performance measurement (such as company-wide return on capital employed, market share etc) and is aimed at prompting strategic change. Strategic benchmarking seeks to compare the strategies of the originator with those of competitors, in order to more closely identify where competitive threats and opportunities may lie in the longer term.

2

LANAKAI INDUSTRIES

(a)

Calculation of EVA Net operating profit after tax (NOPAT) (W1) Finance charge (W2) Economic Value Added

$000 64,340 (24,808) ––––––– 39,532 –––––––

2

WORKINGS (1)

NOPAT

Profit after tax Add: After tax cost of interest (9,575 × (1  35%)) NOPAT (2)

$000 58,116 6,224 ––––––– 64,340 –––––––

2 1

Finance charge Capital $000 141,846 68,638 15,045 ––––––– 225,529 –––––––

Equity capital Long term debt Loan notes payable Total capital at start of year

Finance charge for the year is the capital × weighted average cost of capital = 225,529 × 11% = $24,808

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3

2

1 ——— 8 ———

Tutorial note: When calculating the finance charge, some analysts use capital employed at the end of the year. However, in P5 exams to date, and in the examiner’s article on this topic, capital at the start of the year was used. It is debateable whether the loan notes payable should be included as part of capital employed or not. Here, as it is stated that the loan notes will be re-issued on redemption, they are effectively part of financing. However, full credit should also be given for answers where loan notes payable are not included as part of capital employed provided that some justification is given for this. (b)

Meaning of EVA  EVA is a performance measure in which a charge for financing the assets of the company is taken into account. It recognises the fact that providers of both equity finance and debt finance expect a return on their investment, and unless the profits of the company are equal to, or greater than this required return, the company is actually destroying value. The principal behind the calculation of EVA is relatively straightforward: Net operating profit after tax (NOPAT) – finance charge. The finance charge is calculated by taking the total capital employed of the company, and multiplying by the weighted average cost of capital. This finance charge therefore included the return required by both providers of equity capital as well as the providers of debt capital. This is in contrast to the traditional income statement in which the cost of debt finance is taken into account, but the cost of equity finance is ignored. If the EVA so calculated is greater than 0, it means that the profits generated by the company are greater than the return required by the providers of finance. Investors will therefore be pleased with the performance. In calculating NOPAT, some adjustments are made to the accounting profits to try to achieve the “economic” profit rather than the financial profit, on the basis that financial profits are not a reliable indicator of the true economic performance of a company.

3

BOLONDIA HEALTH AUTHORITY

(a)

Meaning of the terms Tutorial note: Only FIVE problems were required to be explained. Tunnel vision means undue focus on performance measures to the detriment of other areas that are not measured. This can be a problem in traditional budgetary control systems, where managers focus on reducing costs, and ignore areas such as quality that are important, but not measured. Sub-optimisation is where management focus too much on some targets, leaving other measured targets not achieved. It is similar to tunnel vision; the difference being that even the objectives that are neglected are measured. Misinterpretation involves failure to recognise the complexity of the environment in which the organisation operates. Management focus on those areas of performance that have been identified, but fail to see the bigger picture. For example, a higher mortality rate in one hospital may be caused by external factors such as pollution, or demographic factors in the area that the hospital serves, rather than being caused by poor quality of medical treatment. Myopia refers to short-sightedness leading to the neglect of longer-term objectives. An example would be cutting back on research and development expenditure to reduce costs.

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4

Measure fixation means taking actions to achieve a target, without achieving the underlying objective that the target is designed to measure. For example, a large audit firm not allowing students who fail mock exams to sit the final ACCA exam in order to improve the measured pass rates. This improves pass rates without improving the quality of the exam preparation that the pass rates are designed to measure. Misrepresentation refers to the tendency to indulge in “creative” reporting in order to suggest that a performance measure result is acceptable. For example “Recent analysis of customer feedback forms indicate that only three of our customers are dissatisfied. This indicates that the level of service is satisfactory”. If the three dissatisfied customers account for a majority of sales, then this situation could be far from satisfactory. Gaming is where there is a deliberate distortion of the measure in order to secure some strategic advantage. This may involve deliberately under performing in order to achieve some objective. Goal incongruence means that the performance indicators chosen are not consistent with the underlying objectives of an organisation. A common example is setting targets for managers based on profits. This causes managers to take actions that will improve profits regardless of whether this is consistent with the objectives of wealth maximisation (e.g. by investing in projects where the profit achieved is not sufficient to provide the return on capital required). (b)

Issues raised by the internal auditors of Bolondia Health Ignoring hygiene to improve theatre utilisation This appears to be a classic case of tunnel vision. Management are focussing efforts on one area that is measured, at the expense of another measure that is not. Sadly this has catastrophic implications. Not accepting referrals from doctors to improve utilisation of operating theatres This is an example of measure fixation. The hospital in question is clearly determined to ensure that waiting lists at that hospital do not exceed two months, and have found a way of achieving this by distorting the measure, rather than actually reducing the time from referral to treatment. Not authorising the purchase of a new scanner This particular action illustrates two problems: (1)

It is an example of goal incongruence; failing to invest in a life saving machine will probably mean that the hospital is not able to maintain its position as the leading cancer hospital in Bolondia. Thus the finance director’s decision is not consistent with the objectives of the hospital.

(2)

The finance director’s decision could also be seen as an example of tunnel vision or sub optimisation (i.e. focusing on financial objectives at the expense of other important objectives).

Refurbishing the wards This appears to be an example of gaming. The reason for the refurbishment appears to be to ensure that the budget is not cut in future years, rather than because the refurbishment was actually necessary.

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5

Marking Scheme

1

VIN CO

(a)

ROCE ROS Asset turnover Average bus capacity Average bus occupancy Average km per litre of fuel Average fuel per passenger kilometre Fatalities per passenger kilometre

(b)

1 mark per reason

(c)

2 marks per explanation

2

LANAKAI INDUSTRIES

(a)

See marking guide next to the solution

(b)

Taking into account the cost of equity and debt finance Overall formula of EVA Explanation of finance charge Mentioning economic profits rather than accounting

Marks

1 1 1 1 2 1½ 1½ 1 –––

10 2 8 ––– 20 –––

8

3

BOLONDIA HEALTH AUTHORITY

(a)

Up to 2 marks for explanation of up to five of the terms

(b)

1 mark for “correct” identification of which problem is illustrated by each issue Up to 1 mark for explaining why

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Marks

6

1 1 1 1 –––

4 ––– 12 –––

10

4 4 –––

8 ––– 18 –––...