Plan of attack
What's the worst thing you could be doing right now if this were the actual exam paper? Panicking, and getting yourself in a right old state? Yawning, because you're exhausted from too much late night, last-minute revision?
Wondering how to celebrate the end of the exam in 3 hours and 15 minutes time?
Well, they're all pretty bad. But what you should be doing is spending the first few minutes of the exam looking through the paper in detail, working out which questions to do, and the order in which to attempt them. So turn back to the paper and let's sort out a plan of attack.
First steps first
In our view, the compulsory Section A question is often the best place to start, since it is compulsory and accounts for 50% of the marks available in the paper. This means you cannot score enough marks to pass the paper without answering the Section A question.
However, make sure you look through the whole paper and carefully before starting in to answer any questions.
In the first five minutes of the exam, look through the case study scenarios and the question requirements and work out which questions you are going to attempt, and the order you are going to tackle them. We would then suggest you spend approximately the next five to ten minutes analysing the requirements of the Section A question and identifying the key issues in the scenario. Planning your answer is very important; don't just start writing your answer as soon as you open the exam paper.
If you are worried about the paper, it is likely that you believe the Section A question will be daunting. In this case you may prefer to do one, or both, of your optional (Section B) questions before tackling it. Don't however, fall into the trap of spending too long on the optional questions because they seem easier. Remember the Section A question accounts for 50% of the marks, so it is crucial to your chances of passing this exam.
It is dangerous to be over-confident, but if you're not too nervous about the exam, we suggest you should start with the compulsory Section A question. You know you've got to answer it, so you might as well get it over and done with straight away.
Make sure you address every requirement and sub-requirement in the questions, and also make sure you apply your answer directly to the scenario.
Remember that the basis of the P5 exam is analysis and application, not simply performance measurement. You are being tested on your ability to apply your knowledge to analyse and address the specific issues identified in a scenario.
The questions themselves
Question 1. The scenario introduces a company with two divisions, whose overall mission is to maximise shareholder wealth. However, the company currently uses ROI as its main measure of performance for the two divisions – but is ROI really the best measure to use in order to maximise shareholder value? This issue is one of the points which need to be evaluated in part (a), when you are asked to evaluate RI and EVA as alternative measures of divisional performance. However, note there are two distinct elements to part (a): evaluating the performance of the divisions; and discussing the measures which have been proposed for measuring that performance.
The second part of the question looks at issues to do with transfer pricing between the divisions. This part of the question involves a combination of calculation and discussion. You need to calculate the impact that the two different methods of transfer pricing will have on the division's profitability, but then evaluate the implications of this.
Information systems play an important role in performance management, because management are not able to get timely and relevant information about an organisation's performance it makes their job in controlling the
organisation and making strategic decisions much harder. Part (c) picks up on this point, by introducing the idea that JHK is considering a change to its information systems.
Parts (d) – (f) look at different issues in relation to benchmarking: what are the potential benefits from it, how can it be implemented at the company, and what problems might the company encounter when implementing it?
Question 2. The context of question 2 is how IT developments (specifically RFID technology) can be beneficial to a supermarket. In part (a) you need to consider two aspects of how the technology could be used: to improve the quality of management information available to managers, but also how it can directly help operational
performance; for example, by helping the supermarkets to manage their inventory more effectively. As such the focus of part (a) is how IT can help the supermarket improve its internal business processes, whereas part (c) of the question looks at how the supermarket can use IT to improve its relationship with customers.
Part (b) again picks up the idea that managers need information to make decisions, but in this case asks you to consider ways in which performance reports could be improved to provide managers with better information.
Question 3. One of the key features of modern performance measurement systems is that they are multi-
dimensional - in other words, they look at non-financial aspects of performance as well as financial ones. Question 3 looks at one such multi-dimensional performance measurement system: the performance pyramid. Part (a) should be a source of some relatively easy marks, because it is a test of knowledge, rather than your ability to apply your knowledge to a question scenario. However, in parts (b) – (c) you do have to apply your knowledge in order to assess how introducing the pyramid could be beneficial to XYZ. The final part of question (part (d)) requires you to assess the changes which might be required to XYZ's information systems to enable it to report on non-financial aspects of performance as well as the financial aspects of performance it currently reports on.
Question 4 looks at issues relating to corporate failure. The first part of the question looks at the underlying reasons which could cause businesses to fail, and then the second part looks at one of the models (Argenti's A score) which can be used for predicting corporate failure.
The second part of part (b) of this question, in effect, is looking at the advantages of qualitative models for predicting corporate failure compared to quantitative ones. By contrast, part (c) of the question highlights some of the potential difficulties with qualitative models.
However, being aware that their business is at risk of failure will only be useful to managers if they then take action to deal with the problems which are causing it to fail. Part (d) picks up on this point, by asking what measures the owners of a company deemed to be at risk of failure should take to deal with the problems the company is facing.
No matter how many times we remind you…
Always, always allocate your time according to the marks for the question in total and for the individual parts.
And always, read the requirements carefully and follow the requirements exactly. Part (a) of question 1, for example, requires you not only to evaluate the divisions' performance at JHK but also to discuss the measures which are being used to assess the divisions' performance. To score well in a question like this, it is vital that you address both parts of the requirement.
If you ran short of time on this exam, or struggled to interpret the questions, have another look at the guidance on Passing P5 in the front pages of this kit.
You've got spare time at the end of the exam…
If you have allocated your time properly then you shouldn't have time on your hands at the end of the exam. If you find yourself with five or ten minutes to spare, however, go back to any parts of questions that you didn't finish because you ran out of time.
Question 1
Text reference. Performance measures and divisional performance measures are covered in Chapters 9 and 10 of the Study Text. Benchmarking is discussed in Chapter 1.
Top tips. First, did you notice that you were required to write a report. There were 4 professional marks available for the format, style and structure of your answer – to score all of these marks it was essential that you wrote a report.
Part (a). The scenario identified three different measures which JHK could use to assess divisional performance (ROI, RI, and EVA) so this should prompt you to calculate the performance of both divisions using each of the three measures, and to think about the strengths and weaknesses of the different measures proposed. However, you also need to think about the controllable and uncontrollable costs which are included in these divisional performance measures.
Part (b) required a combination of calculations and commentary. The examining team commented that generally candidates were unwilling to back up their commentary with supporting calculations. Don't let your answer become a general discussion about transfer pricing. Make sure it is linked specifically to the service and M/S divisions identified in the question scenario.
Part (c) required you to evaluate the impact of the new EIS on performance management, not the potential difficulties with implementing the new EIS. In other words, your focus should be on how the EIS could help JHK's management control and improve the performance of the business.
In parts (d), (e) and (f) make sure that you are clear about the meaning and purpose of benchmarking. It is not primarily an exercise for comparing results with budgets or prior year, but rather for comparing performance with a 'best practice' organisation. Also, make sure you read the three parts of the question carefully to make sure you don't end up repeating yourself in different parts of your answer. Part (d) asks you about the potential benefits of benchmarking; part (e) then asks how it be introduced at JHK; while part (f) asks about the potential problems JHK could face when implementing a system of benchmarking.
Marking scheme
Marks (a) Calculations:
3 marks for calculation of ROI and RI (1 for controllable ROI; 1 for divisional ROI; 1 for RI)
3 marks for calculation of EVA ( ẵ mark each for: adjusting for other non-cash expenses; tax; depreciation treatment; NOPAT; WACC used;
EVA)
3
3 For assessing performance from the calculated numbers – 1 mark per
relevant point – up to 3
For comments on the performance measures – 1 mark per relevant point – up to 3
Total for part (i)
3
3 12
(b) For outlining the criteria for designing a transfer pricing system – 1 mark per point
Calculations:
Number of warranty repairs per year – 1 mark Cost per repair – 2 marks
Contribution under current agreement – 1 mark Contribution with market price – 1 mark Prices for breakeven under cost plus – 3 marks
Up to 3
Up to 7
Commentary:
1 mark per relevant point evaluating the current transfer pricing system at JHK – up to 4 marks
Total for part (ii) Up to 4
12 (c) 1 mark per relevant benefit from introducing the new executive
information system – up to 4 marks
1 mark per relevant difficulty or problem associated with introducing the new executive information system – up to 3 marks
Up to 4 Up to 3
6 Professional marks for presentation, style and structure of report 4
(d) For explaining the concept of benchmarking – 1 mark 1 For discussing potential the benchmarking which can be gained from
benchmarking – 1 mark per relevant point Up to 4 5
(e) 1 mark for each relevant step in the process of introducing benchmarking – up to 6
1 mark for other relevant factors to consider when introducing a system of benchmarking – up to 2
Up to 6
Up to 2 7
(f) For each relevant problem identified and discussed – 1 mark each Up to 4 4 Total = 50
To: Finance Director From: Ann Accountant Date: [Today's date]
Subject: Divisional performance and information systems
This report will evaluate the performance of JHK's divisions and will then consider some of the issues raised by the transfer pricing between the service and M/S divisions. It will finish by looking at the potential impact the proposed new information system could have on performance management at JHK.
(a) Divisional performance
Profitability – The two divisions are very different in size, such that the M/S division generates over 98% of the company's total revenue and operating profits. However, both divisions are profitable and make positive returns on investment (as shown in the Workings at the end of the first section of this Report.)
Return on Investment (ROI)
The workings in the Appendix show an overall division ROI (based on profit before interest and tax divided by capital employed) and an ROI figure adjusted to exclude re-allocated head office costs.
Controllable ROI – Apportioned costs account for approximately 10% of revenue in the M/S division, but only about 6% of revenue in the service division. The controllable ROI figure should exclude these apportioned head office costs, because they are not controllable at divisional level.
Comparison between divisions – Both divisions are generating a positive return on investment, although it is noticeable that the return form the M/S division is significantly higher than that of the Service division.
Nonetheless, the returns generated by both divisions are greater than the 9% which is JHK's current cost of capital.
ROI as a performance measure – ROI is simple to calculate and therefore is often used as a measure of performance. However, one of the main criticisms of ROI is that it can lead to short-termism and a lack of
asset replacement in the divisions, which may ultimately not fit with JHK's aim to maximize shareholder wealth.
Residual income (RI)
Absolute figure – Unlike ROI which looks at a percentage return on assets, RI provides an absolute figure for the income generated by each department, based on the profit figure less an imputed interest charge based on the capital employed by the division.
As the figures in the Appendix again show, both divisions generate a positive residual income.
However, given the difference in size between the M/S and the Service it is hard to use RI to compare the performance of the two divisions.
Profit-based measures – Both ROI and RI are both derived from profit measures of performance, but it is unclear how closely they link with JHK's overall performance measure of total shareholder return. This depends on share price and dividends paid, rather than just profit. Although there is likely to be a degree of correlation between profit and share price performance, this is not necessarily the case.
Economic Value Added (EVA) – EVA, like RI, is calculated by deducting an imputed interest figure from a profit figure. However, unlike RI which uses conventional accounting profits, EVA involves a more complicated calculation to try to avoid the perceived distortion of results by accounting policies. For example, marketing costs which have been charged as expenses in determining the accounting profits, may be added back under EVA if, in effect, they are investments which will generate future value.
The adjustments made to accounting profit in EVA mean that EVA is more directly aligned to JHK's objective of increasing shareholder wealth than either ROI and RI. Therefore, if EVA is adopted as a measure of divisional performance, this should help improve goal congruence between the divisions and the company as a whole.
Historical data – However, EVA is still ultimately derived from historical data (adjusted profit figures) so its focus will be different to shareholders who are ultimately concerned with future performance. Nonetheless, the adjustments to profit made in EVA are designed to make it a better guide of future performance than traditional profit-based measures.
Comparison between divisions – However, the size difference between the M/S and Service divisions at JHK means that EVA will not be suitable as a measure for comparing performance between the divisions, because it looks at absolute values rather than percentage returns.
Appendix Workings
M/S division Service
Controllable ROI (%)
Operating profit / Capital employed 386 / 1,294 6 / 38
29.8% 15.8%
Divisional ROI
PBT / Capital employed 301 / 1,294 5 / 38
23.3% 13.2%
RI ($m)
Operating profit 386 6.0
Imputed interest charge (@ 9%) (116) (3.4)
270 2.6
EVA ($m)
Operating profit 386 6.0
Add: non-cash expenses 4 0.3
Less: Tax (@ 30% of operating
profit) (116) (1.8)
NOPAT 274 4.5
Capital employed x WACC (@ 9%) (116) (3.4)
158 1.1
Notes
1 Notional cost of capital used as best estimate for WACC
2 Economic depreciation assumed to be the same as accounting depreciation (b) Criteria for designing a transfer pricing system
A transfer pricing system is a mechanism for charging for goods or services transferred between the divisions of a company, in this case for the warranty services provided to the M/S division by the Service division. If such a system were not in place, the Service division would not receive any income for the work it does for the M/S division. Equally, the M/S would not incur any costs for the warranty services carried out.
Performance evaluation – Transfer prices are necessary to prevent the warranty services having an unfair impact on the performance measures of either division, thereby meaning that divisional managers can still be assessed on the basis of divisional profit.
Divisional autonomy – By giving a price or a cost to the services transferred, transfer pricing allows the division managers to retain autonomy. For example, if the M/S division feels the proposed transfer price for warranty services from the Service division is more expensive than the price would be from an external service company, then the divisional managers can choose to buy the services externally.
Goal congruence – Transfer prices should be set so that divisional behavior is aligned to the best interests of the group as a whole. In this respect, the price should reflect the true cost (the opportunity cost) to the group of the transfer. For example, although the service division currently has capacity to cover all the existing work available, if the demand for out-of-service work increases and the service department needs to sacrifice revenue from this work in order to carry out the repairs under warranty guarantee, it is important that any such lost revenue is recognised in the cost of the internal work.
There are a number of possible ways of determining transfer prices, but here we are looking at market based pricing and cost based pricing as means of pricing the repair work the service division does for the M/S division under the warranties.
Market based pricing
Because there is already an external market price (of $200 per warranty service) has already been tendered, this can be used be used as the basis for a transfer price.
Divisional profits – If this were the case, the Service division's net profit from warranty repairs would fall from the current figure of $2.67m to $0.59m (see workings in Appendix). This suggests that, in terms of performance evaluation, the current $10m recharge seems to favour the Service division more than the M/S division, given the current levels of repairs.
Spare capacity – However, given that the Service division would left with spare capacity if it stopped carrying out the internal repair work, the fact that the market-based transfer price still generates it a profit (albeit a reduced one) should mean the division will continue to take on the work.
This position could change if the level of external work increases though. The out-of-warranty business generates higher margins, which would suggest the Service division should prioritise this work over the less profitable internal work. In which case, if the Service division may no longer have sufficient capacity to cover the internal work, and so would need to outsource it.
Outsourcing – The current proposal means that the Service cannot choose to outsource part of its warranty work: it either has to outsource all of it or none at all. Depending on the level of external demand, JHK may feel it necessary to adjust the market based transfer price in respect of this, to avoid a situation where the Service division outsources the warranty work but is then left with significant spare capacity because the increase in external demand is less than demand for warranty work foregone.
Moreover, JHK may also want to adjust the market based transfer price if it feels the warranty service is an important part of the company's overall offering to its customers. The warranty is currently an important selling point for JHK, but it may be unable to control the quality of the repair work if it is outsourced.
Cost based pricing
The warranties could also be charged in relation to the cost to the Service division of providing them, either at pure cost price, or with a degree of mark-up added to the cost.
An analysis of the Service division's costs per repair, (see workings in Appendix) shows that the current fixed price deal ($10m), with the current level of repairs, generates a significant profit for the division:
$2.67m.
Divisional profits – If the level of repairs remains at its current level (39,600 per year) then the service department would need to charge $253 per repair in order to maintain its current level of divisional profit.
However, it is unlikely that the managers in the M/S division would accept a cost above $200 given this is the cost they would have to pay if the work were outsourced.
Breakeven price – For the Service division to breakeven on the warranty work they do, a price of $185 should be charged. This would be acceptable to the M/S division because it means the cost of the work will be lower than if it were outsourced. This price may also be acceptable to the managers in the service division, because it covers their fixed overheads as well as their variable costs.
In this respect, the cost based pricing approach suggests that a price between $185 and $200 may be the best for JHK to choose.