APM SLIDES LECTURE 1

ACCA
APM LECTURER:
Munyaradzi Dera
ACMA, CGMA, B.Sc.
Honours Economics
Email:
mdera@gmail.com
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+27 73 665 6728

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SYLLABUS
STRUCTURE

SYLLABUS STRUCTURE
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SYLLABUS STRUCTURE
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SYLLABUS STRUCTURE
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ACCA ADDITIONAL RESOURCES

ACCA ADDITIONAL RESOURCES - CBE
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Advanced Performance Management

ACCA ADDITIONAL RESOURCES - Study Hub
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ACCA ADDITIONAL RESOURCES - SH
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ACCA ADDITIONAL RESOURCES - SH
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ACCA ADDITIONAL RESOURCES - SH
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ACCA APM
LECTURE 1
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Main capabilities
On successful completion of this exam,
candidates should be able to:
A. Use strategic planning and control
models to plan and monitor
organisational performance.
B. Apply a range of professional skills
in addressing requirements within
the Advanced Performance
Management exam, and in
preparation for, or to support, current
work experience
C. Identify and evaluate the design
features of effective performance
management information and
monitoring systems and recognise
the impact of developments in
technology on performance
measurement and management
systems.
D. Apply appropriate strategic
performance measurement
techniques in evaluating and
improving organisational
performance
E. Advise clients and senior
management on strategic business
performance evaluation and on
recognising vulnerability to
corporate failure.
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F. Employability and technology skills

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Chapter 1
Introduction to strategic management accounting
EXAM-FOCUSSED/LEARNING OUTCOMES:
1. Explain the role of strategic performance management in strategic planning and
control.
2. Discuss the role of performance measurement in checking progress towards the
corporate objectives.
3. Compare planning and control between the strategic and operational levels within
a business entity.
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4. Discuss the scope for potential conflict between strategic business plans (longterm)
and short-term localised decisions.
5. Evaluate how models such as: SWOT analysis, PEST, BCG, Balanced
scorecard, Porter's generic strategies and 5 Forces may assist in the
performance management process.
6. Apply and evaluate the methods of benchmarking performance.
7. Discuss how the purpose, structure and content of a mission statement impacts
on performance measurement and management.
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8. Discuss how strategic objectives are cascaded down the organisation via the
formulation of subsidiary performance objectives
9. Apply critical success factor analysis in developing performance metrics from
business objectives.
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10. Identify and discuss the characteristics of operational performance.
11. Discuss the relative significance of planning against controlling activities at
different levels of the performance hierarchy.
12. Explore the role of the management accountant in providing key performance
information for integrated reporting to stakeholders.
13. Assess the appropriate benchmarks to use in assessing performance.
14. Assess the statement 'what gets measured gets done' in the context of
performance management.
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Bruns and Scapens includes management structures
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Section A – This ONE question is compulsory and MUST be
attempted
1 Thyme Engine Products (Thyme): Company information
Thyme manufactures jet aircraft engines for the commercial aircraft
market. This is a worldwide business although Thyme’s production and
development are all based in the country of Beeland. Thyme is a listed
company 01 and its stated overall objective is to be ‘a world-class jet engine
manufacturer trusted by our customers to deliver excellent products’. Its
promise to its shareholders is that it will maximise their returns. The
strategy to achieve this is to use world-class engineering to design engines
and high quality production and customer service in order to drive
profitable growth.
Thyme’s share price has recently suffered as a result of the failure of a new
engine design which led to large cash losses and a difficulty in obtaining
new financing. There has also been a bribery scandal involving a senior
manager and one of its key customers. As a result, a new chief executive
officer (CEO) has been employed and she has begun a major review of
systems at Thyme.
The first area which the CEO wants to examine is the information given to
the board for strategic decision-making in both the planning and controlling
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of the business. The government of Beeland has been encouraging
information sharing between businesses and has recently sponsored
awards for management accounting. The winner of the engineering sector
has produced a sample dashboard template (with dummy figures) for an
annual review and this is given in Appendix 1. The CEO realised that the
winner had a very similar overall objective and strategies to Thyme and
wants to know what it is about this dashboard that helped it win the award.
She does not want a new dashboard for Thyme at this stage but there may
be some useful, specific comments to make about the contents of the
dashboard given Thyme’s recent problems.
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1 Thyme Engine Products (Thyme): Company information Continued
The CEO has also recently been reading about integrated reporting and
in the light of this review of the dashboard, the CEO has also asked for
your views on how integrated reporting might impact on the type of
information prepared by the company’s management accountants.
As high quality engineering products lie at the heart of Thyme’s
competitive advantage, there has been a total quality management (TQM)
approach to the management of all resources and relationships
throughout the business. Thyme currently has a project under
consideration to develop a new simple jet engine which would compete in
the crowded market for small corporate jets. In order to compete in this
market, it is believed that a target costing approach to this new engine
would be beneficial. The CEO wants you to calculate the target cost gap
for the new engine using the data in Appendix 2. Next, she wants to know
how the use of target costing would fit within the existing TQM approach
for this new engine.
The new engine project has further raised the profile of quality as a broad
issue at Thyme and the CEO wants your advice on the costs associated
with quality. She needs to know the cost of each of the four categories of
quality costs. She has gathered data in Appendix 3 for this exercise. She
is happy that she has identified that prevention costs are complete but is
worried that some of the possible costs for the other three categories are
missing and needs suggestions of cost areas to be examined to identify
these missing items. Finally, she needs advice on the relative importance
to Thyme of each of the four categories.
Required:
Write a report to the CEO of Thyme to:
(i)
(ii)
Evaluate why the dashboard in Appendix 1 was award winning, as requested
by the CEO. (15 marks)
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Explain broadly the role of the management accountant in providing
information for integrated reporting. (6 marks)
(iii) Calculate the target cost gap for the new engine (using Appendix 2) and
assess how the use of this target cost will fit within the TQM approach. (12
marks)
(iv) Categorise and calculate the costs of quality at Thyme (given in Appendix 3).
Suggest cost areas to be examined as required by the CEO, and evaluate the
relative importance of each category to Thyme. (13 marks).
Professional marks will be awarded for the format, style and structure of the
discussion of your answer. (4 marks)
(50 marks)
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Ganymede University (GU) is one of the three largest universities in Teeland, which
has eight universities in total. All of the universities are in the public sector. GU
obtains the vast majority of its revenue through government contracts for academic
research and payments per head for teaching students. The economy of Teeland
has been in recession in the last year and this has caused the government to cut
funding for all the universities in the country.
In order to try to improve efficiency, the chancellor of the university, who leads its
executive board, has asked the head administrator to undertake an exercise to
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benchmark GU’s administration departments against the other two large universities
in the country, AU and BU. The government education ministry has supported this
initiative and has required all three universities to cooperate by supplying
information. The following information has been collected regarding administrative
costs for the most recent academic year:
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The key drivers of costs and revenues have been assumed to be
research contract values supported, student numbersand total staff
numbers. The head administrator wants you to complete the
benchmarking and make some preliminarycomment on your results.
Required:
(a)Assess the progress of the benchmarking exercise to date,
explaining the actions that have been undertaken and those that are
still required. (10 marks)
(b)Evaluate, as far as possible, Ganymede University’s
benchmarked position. (15 marks)(25 marks)
(a)Assess the progress of the benchmarking exercise to date, explaining the actions that have
been undertaken and those that are still required. (10 marks)
The benchmarking process is often described using seven steps. The following are the steps
with the current state of the exercise:
1. Set objectives and decide the areas to benchmark: GU has set the objective of
improving efficiency and is benchmarking all of its administration operations relating to
teaching and research.
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2. Identify key performance drivers and indicators: The performance drivers have been
provided and the indicators are based on the activity per driver. The drivers might be
improved by distinguishing between teaching staff and administrative staff.
3. Select organisations for benchmarking comparison: The government selected the
three largest universities for benchmarking which excludes five other smaller universities.
This can be justified if the large universities cover similar teaching and research areas
while the smaller ones are narrower in focus (for example science and engineering
subjects only). However, it may be that there are examples of good practice in university
administration that will be missed as a result of restricting the exercise. It might be sensible
to include foreign universities in the exercise. Differences in the mix of subjects researched
and taught might also affect the results (e.g. managing teaching facilities in engineering
and law will be different).
4. Measure performance of all organisations involved in benchmarking: The basic data
has been gathered as required by government. This step would normally be more complex
in a private sector situation as commercial secrecy would hinder the sharing of information.
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5. Compare performances: This is the stage that has been reached. See answer to part (b)
for results.
6. Specify improvement projects: The results of the comparison should lead to
identification of areas for improvement. If GU is not demonstrating leading performance
then it should send staff to the top performer to identify their best practice processes and
devise projects to implement these at GU.
7. Implement and monitor improvements: Management should perform a post-project
review in order to identify if the improvement has achieved or exceeded its goals and
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consider lessons that have been learned from the project.

(b)Evaluate, as far as possible, Ganymede University’s benchmarked position. (15
marks)(25 marks)
In accounting services, all the universities perform broadly in
line. BU has achieved a small 3·5% advantage over the others.
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In human resources management, BU is 22% more costly
which is surprising given the larger staff numbers at BU over
which to spread such a central cost.
In IT management, there is some variation of performance with
BU costs being 10% lower than GU’s. These variations may
well be due to the subjects being taught (for example,
universities that are more orientated to science and technology
will probably demand larger computing resources).
In general services, all the universities perform broadly in line.
AU has achieved a small 3% advantage over GU.
Research categories are considered per $000 of contract value supported. Teaching
facilities and student support are considered per student. Other categories are considered
per staff member.
From the results, it can be seen that GU is best at controlling costs associated with research
contracts and it has the highest research funding ($185m). This may indicate that the
government monitors such cost control and that GU should ensure its continued good
practice in this area. AU spends most per student on its teaching facilities and student
support although it has the smallest number of students. It might be expected that this
would lead to higher student enrolment which may imply that student enrolment is not
significantly dependent on these factors. However, lower drop out rates and higher student
pass rates and future success in gaining employment may reflect the more expensive
teaching environment at AU. These quality measures are not being reflected in the
benchmarking exercise.
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It is necessary to give a warning about the difficulty of
comparing the performance of the universities due to
differences in location and the mix of subjects taught and
researched.
(Tutor note: the comments on accounting and general services
are not significant and so not necessary in a good answer.
They are included for completeness.)

(i)
Explain broadly the role of the management accountant in
providing information for integrated reporting. (6 marks)
There is no standard format for integrated reporting. However, there
are changes in focus of the company’s reporting which will require the
input of the management accountants of that business.
Integrated reporting has a focus on opportunities and risk, how
resources are allocated and performance both recent historic and
expected in the future.
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There are six capitals involved in value creation including traditional
tangible and financial assets but also including human, intellectual,
environmental and social assets.
For the management accountant, these newer forms of capital will
require information systems capable of capturing and processing
such non-financial measures.
The forward-looking nature of such reporting will require more
information of a forecast nature (with the accompanying requirement
to understand their estimating assumptions).
The more strategic view which integrated reporting intends to give
also requires reporting on factors which drive long-term
performance.
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A key part of the integrated report is linking performance to strategic
goals and the ability to create value. This will require a less
structured and more contingent approach to reporting. In other words,
proforma reporting must be better tailored to the specific business’s
situation.
However, it is considered a key requirement of such reporting that it is
concise and so the management accountant must help to ensure that
only the key information is reported. It can be seen that the dashboard
discussed in the above section of this report achieves many of these
requirements.
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Chapter 2
Environmental influences
EXAM-FOCUSSED/LEARNING OUTCOMES:
1. Evaluate how models such as:
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• SWOT analysis,
• PEST, Boston Consulting Group,
• Balanced scorecard,
• Porter’s generic strategies and
• Porter’s 5 Forces
may assist in the performance management process
1. Discuss the ways in which stakeholder groups operate and how
they influence an organisation and its performance
measurement and performance management systems (e.g.
using Mendelow's matrix).
2. Discuss the social and ethical issues that may impact on
strategy formulation, and consequently, business
performance (e.g. sustainability).
3. Assess the impact of different risk appetites of stakeholders on
performance Management
4. Evaluate how risk and uncertainty play an important role in long
term strategic planning and decision-making that relies upon
forecasts and exogenous variables.
5. Apply different risk analysis techniques in assessing business
performance such as:
• Maximax,
• Maximin,
• Minimax regret and
• Expected values
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3. Sberry: Company information
Sberry manufactures products which have a short lifecycle due to
technological obsolescence. It aims to keep each product in production for
at least 18 months so that it can recover the high cost of product
development and make an acceptable profit before the product becomes
obsolete. Sberry has always manufactured its products in its home country
of Deeland, from where all materials are also sourced.
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Sales opportunity in Kayland
An opportunity has been identified to export one of three newly developed
products, Red, Blue and Green, to Kayland, due to citizens’ increasing
levels of income there. The rate of technological obsolescence is slower in
Kayland than in Deeland. The estimated levels of demand, selling prices
and costs of the three products are shown in Appendix 1.
Stakeholders’ views on the risks of the Kayland opportunity
Three of Sberry’s key stakeholder groups, employees, directors and
shareholders, have been consulted for their views on the proposal to export
to Kayland and, in particular, on which of the three newly developed
products to export there.
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The employees have a cautious approach to the proposal following the
recent failure of another product launch. That product was withdrawn as it
breached poorly understood safety regulations and a number of employees
lost their jobs as a result.
The directors, all of whom are individually wealthy, have served on the
board for many years and are keen to earn the large bonus which is
currently offered solely on the total profit made by the new product over its
lifecycle.
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Sberry: Company information continued
The shareholders neither avoid nor seek risk, but they are
keen that the company considers the external environment
in Kayland in order to maximise performance there,
whichever of the products is chosen to be exported. They
have asked for a PEST* analysis of the environment in
Kayland to be produced. A first draft of this has indicated
that the exchange rate between the Deeland dollar (D$) and
the Kayland dollar (K$) is a key economic factor which may
affect performance.
*Political, economic, socio-cultural and technological
Required:
(a) Advise which of the three newly developed products
each of the three key stakeholder groups would choose
to export to Kayland based on their respective risk
appetites. (14 marks)
(a) Explain the problems of using the risk and uncertainty
analysis techniques which you have used in part (a). (5
marks)
Notes to the appendix
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Development costs are sunk costs and can be ignored.
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The estimated product life of each of the three products is the same and the total demand is
for the whole life of the product.
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The current exchange rate between the D$ and the K$ is D$1·00 = K$2·00. Sberry’s
finance director has estimated that over the life of the product there is a 75% probability that
the average exchange rate of the D$ will strengthen by 10% against the K$, and a 25%
probability that the average exchange rate of the D$ will weaken by 10% against the K$.
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At the current exchange rate, 50% of the total costs for each product is for materials which
are imported from Kayland and invoiced in K$. There will be no opening or closing inventory,
whichever of the three new products is chosen.
(b) Advise the shareholders how analysing the external
environment in Kayland using a PEST analysis can help
Sberry maximise its performance there.
You are NOT required to produce a PEST analysis. (6
marks) (25 marks)
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Required:
(a) Advise which of the three newly developed products each
of the three key stakeholder groups would choose to
export to Kayland based on their respective risk appetites.
(14 marks)
3 (a) Employees
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Employees are cautious about the proposal to export to
Kayland, and are risk averse. They would use the maximin
rule, which is the choice of product with the best of the lowest
outcomes. In this case, this is Blue.
Directors
Directors are paid a high bonus dependent on profitability of
the product chosen. As they have served on the board for
many years, there appears to be little chance that they would
be removed by making a poor choice. They are risk seekers,
and will use the maximax rule, that is, the choice of product
with the best possible outcome. In this case, this is Green.
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Shareholders
Shareholders are risk neutral. They will choose the product
with the highest expected value; in this case this is also
Blue, which has an expected value of D$82,728.
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3c) Advise the shareholders how analysing the external environment in Kayland using a
PEST analysis can help Sberry maximise its performance there.
Identifies opportunities or threats:
2b) Explain the problems of using the risk and uncertainty analysis techniques
which you have used in part (a). (5 marks)
Maximin (best of the lowest outcomes), as preferred by the employees, can
be an excessively risk averse approach.
As Sberry’s products have short product lives, it must constantly develop
new products, so some commercial risks will have to be taken.
Maximax rule, which the risk-seeking directors prefer, has the problem that it
may be overly optimistic. Product choices with the maximum reward or
profits may also be riskier, and could mean that directors take risks which
exceed the shareholders’ risk appetite so as to earn high bonuses.
A problem with both approaches is that ignore the probability of the outcome
actually occurring.
Expected value
This is not a possible outcome and will never occur in practice, it is simply a
long run statistical average assuming if the decision is repeated many times.
Sberry may have developed many products, but it has no experience of
forecasting exchange. It relies estimates of probabilities, such as for average
exchange rates, which may be subjective or difficult to make!
Analysing the external environment in Kayland will allow Sberry to identify opportunities
and threats. It can maximise performance by taking actions to exploit opportunities,
such as developing the new products to take advantage of growing income levels and
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obsolescence in Kayland.
A draft PEST analysis has indicated that the exchange rate between D$ and K$ is a key
economic factor affecting performance. By identifying this, Sberry can act to maximise
performance, such as by analysing the effect of exchange rates on profits of the new
products or hedging against adverse exchange rate movements.
A thorough analysis of safety regulations in Kayland may prevent the problems which
occurred with the failure of the previous product launch.
Identifies CSFs, KPIs and helps set targets
PEST analysis can help identify critical success factors (CSFs) and key performance
indicators (KPIs).
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Having identified product safety as a legal factor affecting performance, a CSF may be to
abide by safety regulations in Kayland. The number of breaches of safety
regulations would be a suitable KPI.
The PEST analysis can be used to set targets appropriate for the environment in
Kayland. A CSF for Sberry is that it produces products for long enough to recover their
development costs and make an acceptable profit. A target for the KPI of length of time
in production could be 24 months in Kayland, where technical obsolescence is slower,
rather than the target of 18 months in Deeland.
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Section A: THIS ONE question is compulsory and MUST be attempted
1 Mackerel Contracting (Mackerel) : Company information
Mackerel is a listed defence contractor working mainly for its domestic government
in Zedland. You are a consultant brought in to advise Mackerel on a number of
issues facing the company. The board need a report from you:
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• outlining the external factors affecting the profitability of a potential new contract
and how these factors can be built in to the choice of the design budget which is
ultimately set,
• advising on a proposed change to the company’s information systems and
• advising on suitable performance measures for Mackerel.
Firstly, Mackerel is currently considering tendering for a contract to develop a new
armoured personnel vehicle (APV) for the army to protect its soldiers during
transport around any future battlefield. The invitation to tender from the government
specifies that the APV should take two years to develop and test, and be delivered
for a full cost to Mackerel of no more than $70,000 per unit at current prices.
Normally, government contracts are approximately priced on a cost plus basis with
Mackerel aiming to make a 19% mark-up.
At the last briefing meeting, the institutional shareholders of Mackerel expressed
worry about the volatility 0 of the company’s earnings (currently a $20.4m operating
profit per annum) especially during the economic downturn which is affecting
Zedland at present. They are also concerned by cuts in government expenditure
resulting from this recession. The Zedland minister for procurement has declared ‘In
the current difficult economic conditions, we are preparing a wide ranging review of
all defence contracts with a view to deciding on what is desirable within the overall
priorities for Zedland and what is possible within our budget.’ The government
procurement manager has indicated that the government would be willing to commit
to purchase 500 APV’s within the price limit set but with the possibility of increasing
this to 750 or 1,000 depending on defence commitments. In the invitation to tender
document, the government 06 has stated it will pay $7.5m towards development and
then a 19% mark-up on budgeted variable costs.

1 Mackerel Contracting (Mackerel) : Company information Continued
Mackerel’s risk management committee (RMC) is considering how much
to spend on design and development. It has three proposals from the
engineering team: a basic package at $7.5m (which will satisfy the original
contract specifications) and two other improved design packages. The
design packages will have different total fixed costs but are structured to
give the same variable cost per unit. It is believed that the improved
design packages will increase the chances of gaining a larger government
order but it has been very difficult to ascertain the relevant probabilities of
different order volumes. The RMC need a full appraisal of the situation
using all suitable methods.
Finally, the chief executive officer (CEO) of Mackerel believes that this new
information system will provide the opportunity for a change in how performance is
evaluated within the company. The company’s mission is to maximise shareholder
wealth and currently, the board use total shareholder return (TSR) as an overall
corporate measure of performance. The CEO has asked you consider the general
impact of the new information system and also, how profit based measures such as
return on capital employed (ROCE) compare to newer measures such as economic
value added (EVATM)
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with regard to meeting the overall goals of Mackerel and its
external measure of performance.
The risk manager has gathered information on the APV contract which is
contained in appendix A. She has identified that a major uncertainty in
pricing the vehicle is the price of steel, as each APV requires 9.4 tonnes
of steel. However, she has been successful in negotiating a fixed price
contract for all the steel that might be required at $1,214 per tonne. The
risk manager has tried to estimate the effect of choosing different design
packages but is unsure of how to proceed to evaluate the different
options.
Secondly, the board is also considering a change to the information
systems at Mackerel. The existing systems are based in the individual
functions (production, sales, service, finance and human resources).
Currently, reports are submitted by each function and then integrated at
head office into the board papers that form the main strategic information
system of the company. The board are considering the implementation of
a new system based on an integrated, single database that would be
accessible at any of the company’s five sites. The company network
would be upgraded to allow real-time input and update of the database.
The database would support a detailed management information system
and a high-level executive information system.
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Required:
Write a report to the board of Mackerel to:
(i)
(ii)
Analyse the risks facing the management of Mackerel
and discuss how the management team’s attitude to
risk might affect their response. (9 marks)
Evaluate the APV project using metrics and methods
for decision-making under risk and uncertainty. and
assess the suitability of the different methods used.
(19 marks)
(iii) Recommend an appropriate choice of method of
assessing the project and therefore, a course of
action for the APV contract. (3 marks)
(iv) Evaluate the potential impact of the introduction of
the new executive information system on operational
information gathering and strategic decision-making
at Mackerel.
(8 marks)
(i)
Assess how profit based measures such as return on
capital employed (ROCE) compare to newer
measures such as economic value added (EVATM)
given Mackerel’s overall goals. (7 marks)
Question 1 includes professional marks for the format,
style and structure of the discussion of your answer. (4
marks)
(50 marks)
1. Write a report to the board of Mackerel to:
(i) Analyse the risks facing the management of Mackerel and discuss how the
management team’s attitude to risk might affect their response. (9 marks)
To: Board of Mackerel Contracting
From: A Accountant
Date: XX XXX 20XX
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Subject: APV contract, new information system and performance measurement
Introduction
Mackerel has to make a decision on which level of design expenditure and so on
which type of APV to tender. This choice will be dictated by the objectives of the
business and its appetite for risk.
(i)
Risks and risk appetite for APV contract
It is natural to assume that the main objective of a business is the maximisation of
shareholder wealth and in the context of the APV project the main measure of
performance will be the profit made on the contract as this will drive the earnings
over which the institutions are concerned.
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However, in a decision where there is risk and uncertainty, the company also has to
decide on its appetite for risk. Risk appetite is usually divided into three categories:
• risk averse individuals tend to assume the worst outcome and seek to minimise
its effect
• risk seekers are interested in the best outcomes and seek to maximise their
returns under these circumstances
• risk neutral individuals are interested in the most probable outcome
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The risks for Mackerel arise from uncertainties in its external
environment. The key stakeholders in this situation are the
government (the customer) and Mackerel’s shareholders. The
other factor giving rise to uncertainty is the forecast price of steel,
the main raw material in the APV’s construction.
The shareholders have indicated a concern over earnings volatility
and so seem to be risk averse. This is commercially sensible in a
recessionary situation where the company’s survival could be
placed at risk if a large project (such as the APV) were to fail. The
project can be seen to be large for Mackerel as the expected profit
is $5m if package 1 is chosen and this is material when compared
to the current operating profit of $20.4m.
A risk averse approach might also be called for where winning the
bid could lead to additional future work so that securing a deal is
more important than optimising profit. This appears to be the case
here as the government is the major customer of Mackerel.
The demand level for the APV is also uncertain as the recession
could lead to cuts in government expenditure. Defence spending is
often considered more discretionary than spending on public
services (such as pensions) especially if there is not an immediate
threat of conflict. Thus, it has been difficult to predict the
probabilities of the different demand levels. Given that there are
significant fixed costs of design and development, these different
levels have a material impact on the return from the project.
These problems in quantifying the level of risk will affect the choice
of method of analysing the return from the contract. Mackerel
should evaluate the contract using different methods and come to
a conclusion based on the most appropriate one for its objectives
and risk appetite.
A further source of risk is the danger of cost over runs. If successful in its tender,
Mackerel will be working towards a fixed price for the contract ($7.5 m + budgeted
variable cost per unit plus 19%). Any over runs of actual cost as compared to budget will
reduce the profit margin earned.
A major cost risk is the cost of the primary raw material of production (steel). However,
this has been fixed by the forward purchase of the steel for the contract. This has
eliminated the risk of price fluctuations during the contract.
(ii) Evaluate the APV project using metrics and methods for decision-making under risk
and uncertainty. and assess the suitability of the different methods used. (19 marks)
Risk evaluation methods and results As was stated earlier, it is natural to assume that the
main objective of the business is the maximisation of shareholder wealth and in the
context of the APV project the main measure of performance will be the profit made on
the contract. Although discounted cashflow would be a superior approach, there is
insufficient data available here to calculate it.
The first priority is too ensure that the contract complies with the government requirement
of a maximum per unit cost of $70,000 to Mackerel. The results per the Appendix 2 are:
This complies with the contract specifications. The total profit for each design package
under the different demand levels is calculated at the Appendix 2 as:
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There are four possible approaches to selecting a package. The methods depend
on the information available and the risk appetite of the decision-maker.
If we assume that there is insufficient information to make an estimate of the
probabilities of the different demand levels then we are making a decision under
uncertainty and there are three common methods of approach which depend on
the risk appetite of the decision-maker (maximax, maximin and minimax regret). I
have calculated payoff and regret tables in Appendix 1.
The results can be summarised as follows:
• Risk seekers and the risk averse will use profit under the different demand
scenarios to make the appropriate choice. Risk seekers will aim to maximise
the possible returns from the different demand scenarios. The maximax method
would be appropriate in this situation and here the company would be advised
to choose design package 1 which will have a maximax profit of $9.1m.
• Risk averse decision-makers will aim to maximise the minimum possible returns
from the different demand scenarios. The maximin method would be
appropriate in this situation and here the company would be advised to choose
design package 1 which will have a maximin profit of $4.6m.
• Pessimistic decision-makers will choose to focus on the lost profit (regret)
compared to the best choice under that demand scenario. They aim to
minimise the maximum level of regret that they can suffer under any demand
scenario. This minimax regret method shows the company would be advised to
choose design package 1 which will lead to no regret.
These conclusions should not be surprising as design package 1 has considerably
lower fixed costs and yet is scalable to cope with all levels of demand.
A risk neutral manager does not take an optimistic or pessimistic stance. They will
choose the option that yields the maximum expected value. This method depends
on the use of probabilities for each of the outcomes. The risk manager has
attempted to quantify the probabilities of the different levels of demand given the
different design packages employed.
It would be wise to involve both the design and sales teams in these estimates
as such estimates are usually highly subjective and a broad canvassing of
opinion may help to gain more accurate values.
The estimated probabilities allow the calculation of an expected profit for each
choice of design package. Appendix 2 shows that the maximum expected profit
of $5.6m arises if design 2 is chosen. This is due to the much greater likelihood
of higher demand in that case. Design 3 does not seem to increase the
chances of higher demand sufficiently to outweigh the extra fixed cost of
$1.25m compared to design 2.
(iii) Recommend an appropriate choice of method of assessing the project and
therefore, a course of action for the APV contract. (3 marks)
In this situation, the choice of method will depend on the risk appetite of
Mackerel, whether this type of decision is likely to be repeated many times and
the accuracy of the probability estimates. As Mackerel shareholders seem risk
averse, the profit under the contract is significant compared to the operating
profit of the whole company and the economic environment is difficult so the
low risk method of maximin seems appropriate. The use of expected values
appears questionable as the probability estimates have not been widely
debated and in the current economic circumstances, the company’s survival
may be at risk and so the repeated trials necessary to make this method valid
may not arise.
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Design package 1 should be chosen as with unknown probabilities, it carries
the least risk. The company could seek to sharpen the probability estimates and
review the implications for company survival before considering the use of
expected values although there is the potential to make an additional expected
profit of $573k if we could justify choosing design 2 over design 1.
The risk over steel prices has been removed by using forward (advance)
contracts to cover the purchase of the material required. As steel is used in
many of the company’s products, this should be investigated as a general risk
management technique for the company.
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(i)
Evaluate the potential impact of the introduction of the new executive
information system on operational information gathering and strategic
decision-making at Mackerel. (8 marks)
The executive information system (EIS) will bring a number of benefits in
decision-making at the strategic level at Mackerel but at certain costs and
with certain problems at the operational and strategic levels. The key
danger is that the tangible increase in costs is not balanced by the
intangible (and difficult to quantify) benefits of the new system.
At the operational level, the data gathering will generate new costs as the
expectations of users for immediate update of the system drive demand
for less batch input of data. This problem represents an opportunity to
automate the input of data in order to fully benefit from real-time data
availability.
At the strategic level, the benefits relate to improved decision-making as
the EIS should allow drill-down access to the more detailed operational
records but the initial presentation of data should be based on the key
performance indicators for the company. This system should also be
linked to external data sources so that senior management do not fall into
the trap of only looking inwards in the organisation at the risk of ignoring
wider issues in the business environment (for example, the risks
associated with the APV contract such as the effect of the recession and
the attitude of government). These will represent new data sources and so
again increase the cost of the system.
The new system will increase the amount of information and analysis that
it will be possible for senior managers to perform. It will present
opportunities for better decision-making using the more up-to-date
information. However, it may present the problem of information overload
for senior managers. Therefore, the system will need to be designed to
give access to only those areas that it is appropriate for any given
manager to see.
The data used in decision-making will be more robust as a single database
will reduce the problem of redundancy where multiple copies of the same
data are held on different systems. This will remove the danger of
inconsistencies and reduce the storage required by the company. This
benefit will be felt at the tactical level of the company were such data
consistency will aid inter-functional communication.
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The EIS would allow access to decision support systems such as large
spreadsheet models built in order to pull data out of the database for use in
forecasting and appraising projects (for example, demand forecasting and
risk modelling of the APV contract).
The EIS will also give access to tactical information such as budgets in
order to help the executive control the business.
In order to gain the maximum benefit from the new system, executive
managers will need to be trained and this training should occur just before
the new system is available so that they are in a position to use it
immediately.
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v. Assess how profit based measures such as return on capital employed (ROCE)
compare to newer measures such as economic value added (EVATM) given
Mackerel’s overall goals. (7 marks)
The proposed new performance measures should be judged against the overall
mission which is to maximise shareholder wealth and so optimise total shareholder
return (TSR). It should be noted that TSR reflects both dividend returns and capital
gains and so deals with both the current performance of the business (current
dividend payments) and its expected future performance (as this dictates the share
price).
The return on capital employed (ROCE) is calculated on profit before interest and
tax divided by capital employed in a project or at the company as a whole. ROCE is
a simple, commonly used measure of performance. However, it can encourage
delays to investment in new assets since this measure improves as assets are
depreciated with age. ROCE has the disadvantage of being based on profit
measures of performance rather than cash. Measures such as NPV use cash flows
which are less subject to the interpretation of accounting rules and are more directly
aligned with shareholder interests. It is unclear that ROCE will align with the overall
performance measure of TSR since TSR depends on share price and dividends
paid. In particular, the fact that share price is based on a long-term view of dividend
prospects makes the use of short period-based measures (such as profit) less
valuable.
EVATM is an absolute performance measure. It involves a more complex
calculation than ROCE with many adjustments to the accounting figures of profit
and net assets, such as the use of replacement costs for asset values and
economic depreciation rather than accounting depreciation. Many of the EVATM
adjustments are intended to avoid distortion of results by accounting policies that
are present in ROCE. EVATM has the advantage that by treating certain costs as
investments it encourages appropriate capital expenditure.
However, EVATM depends on historical data while shareholders will be focused on
future performance. Thus, while EVATM is more directly aligned with the objective
of increasing shareholder wealth, it too falls short of measuring shareholders’
expectations which are present in the share price.
Conclusions
Given the current risk appetites of key stakeholders and economic
environment, it is recommended that the design package 1 for the
APV be chosen, as it carries least risk.
The new EIS represents an opportunity to gain considerable
strategic advantage provided the costs of the new system are
properly understood and controlled.
Neither ROCE nor EVATM represent a perfect match to the
company’s main external measure of performance (TSR) due to
their backward looking nature. However, EVATM may be closer to
the spirit of TSR in measuring increased shareholder wealth.
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END OF ACCA
APM LECTURE
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Valentine D. Nti, ACMA, CGMA, M.Sc., PMP®, MBA
Founding CEO, CharterQuest Professional Education Institute
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