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-3411950200OPERATIONAL CASE STUDY August 2018 EXAM ANSWERSVariant 3SECTION 1- BRIEFING PAPERCONSULTANT’S REPORT ON CHOICE OF INDUSTRY SECTOR TO TARGETThe decision criteria used:The maximax criterion is an optimistic approach to decision making where the alternative that maximises the maximum incremental profit achievable under each alternative industry sector will be selected. The maximum profit if we target industry sector I is D$1,400,000, D$1,200,000 for industry sector II and D$1,350,000 for industry sector III. Therefore, industry sector I should be chosen as this has the highest of all the maximum profits.Under the maximin criterion we select the alternative that maximises the minimum incremental profit achievable under each alternative industry sector: a pessimistic approach to decision making. The minimum profit if we target industry sector I is D$825,000, D$900,000 for industry sector II and D$800,000 for industry sector III. Therefore, industry sector II should be chosen because this had the highest of the minimum profits.Under the minimax regret criterion, the alternative that minimises the maximum regret under each alternative is selected. This is generally used where we want to avoid making an unwise decision. ‘Regret’ refers to the opportunity loss through having made the wrong decision. This is also where a pessimistic approach is taken to the decision. Looking at the regret table the maximum regrets are D$130,000 if we choose industry sector I, D$200,000 for industry sector II and D$100,000 for industry sector III. Therefore, we should choose industry sector III as this has the lowest of the maximum regrets.Other factors to be considered – consultant’s information:The accuracy of the decision depends on the accuracy of the information in the consultant’s payoff table. Their sampling methods, familiarity with the industry, their ability to track the accuracy of responses and convert these into relevant and accurate forecasts all need to be considered. We also do not have any indication of the probabilities of these various combinations occurring, which would enable a further dimension in the possible quality of the decision being made and a more insightful view.Other factors to be considered – operational manufacturing issues:One of the key areas here will be production capacity. Whilst there may be anticipated fluctuations in the production schedule over the year, from the established sales base and production budget, if the new expansion into the corporate market is a success, there may not be sufficient capacity to produce sufficient corporate tea bags. Currently there are options to expand production capacity by adding extra shifts to the production schedule. This should not be at the expense of regular maintenance schedules which may decrease reliability. Quality and potential production shortages must not be allowed to interfere with quality and reliability of our supplies to existing customers. If the expanded corporate business is successful other options to increase production may need to be considered. BUSINESS TO BUSINESS (B2B) MARKETINGWe have been fortunate to have our existing corporate customers because of the personal connections of our Managing Director. An expanded corporate market will however require that we expand our marketing activities to include a more business to business approach. At present we deal mostly with supermarket and wholesale buyers for our boxes of tea bags, whose main consideration is price and supply dates. In this respect we have a good base to move forward as we have experience of dealing with large and commercially powerful clients. Most of our promotional campaigns and advertising are aimed at the end consumer. In this respect we already have certain aspects of a B2B function. The key difference is that our products are not for the use of the supermarkets, they are only a link in the supply chain.The key aspects of business to business marketing will need to be addressed, not least that rather than just retailing our products the corporate customers will be using them in their service and supply processes. The national airline at present uses our product range as an element of its offering to its customers and likewise our tea’s reputation is important in the national parliament with exposure to many different clients.In this respect the key features that we will need to incorporate, and which will differ from our existing marketing is a close relationship between ourselves and the customer buyers, as already exists with Fred and the airline and the parliament. This will need formalising as our corporate business develops. Whilst useful to have the positive involvement of the Managing Director a more structured approach will be desirable as the corporate purchasers are making buying decisions for corporate not personal preferences. As such it is important to maintain personal contact with them and have a person they can liaise with as and when required.It is important to know these customers and build relationships with the buyers in these businesses. It is important to understand their requirements, and how we can help them by understanding their own strategies and how we can help them achieve these using our tea. Much closer relationships than in a customer marketing environment will be required. SECTION 2 - BRIEFING NOTE TO STEVE GOMEZMACHINERY BEING IMPORTEDExpenditure to be capitalised:The cost of the machinery asset should include its purchase cost, import duties and any directly attributable costs of making the machinery ready for its intended use. Purchase costs will include the D$ equivalent amounts paid to the supplier (see next section of foreign exchange implications). Given that we are importing this machinery, there might well be import duty payable and this will need to be established.Directly attributable costs will include the D$10,000 payable to the suppliers for installing and testing the machinery because this is necessary to make the machinery ready for use. There might well be other costs as well such as professional fees or delivery costs that can also be included.Effect of foreign exchange:When the machinery is delivered, we will translate the invoice value of B$1,000,000 at the spot B$/D$ exchange rate on that date. This will be the value of the purchase cost of the machinery recorded in our financial records. The corresponding accounting entries will be to cash for half of the amount and payables for the other half.Two months later when the second half of the invoice is due, we will need to retranslate the payable to the spot rate on that day. If the original payable is more than the retranslated payable there will be an exchange gain, which will increase profit. If the original payable is less than the retranslated payable there will be an exchange loss which will decrease profit. The adjustment of the payable has no impact on the value of the purchase cost recorded for the machinery asset. Determining depreciation:To determine the annual depreciation charge we first need to establish the useful economic life of the machinery. We expect it to last at least eight years and therefore this would be a sensible starting point.To determine the annual depreciation charge we will then need to calculate the depreciable amount which is the cost of the asset (as determined in the above sections), less any residual value that we expect at the end of its eight-year economic life (such as scrap value). There are two methods that we could use to spread this depreciable amount across the useful economic life: reducing balance or straight line. The reducing balance method charges a larger proportion of the depreciation in earlier years, whilst straight line will charge a constant amount every year. Which method we use will depend on how the economic benefits we derive from the machinery are consumed. This is likely to be on a reasonably equal basis over the eight years and therefore straight line is probably the most suitable method.FLEXIBLE BUDGETING Effect on the budget:Our budget for the year ended 31 March 2019, which includes the period in question, is based on the level of sales and production activity that we originally anticipated. As a result of expanding the corporate customer base and increasing production capacity both sales and production activity are going to be significantly higher than we originally thought. If our production costs were mainly fixed, a change in level of activity would not cause many problems for cost comparison against our original budget because we would not expect fixed costs to change with the level of activity. However, most of our production costs are variable in nature and therefore it would be meaningless to compare production costs for tea leaves, tea bag paper, direct labour and variable overheads against the original budget.Usefulness for planning and control:For planning purposes, for the period January to March 2019 it would be sensible to construct flexed budgets at different activity levels to show how revenues and variable production costs are affected by the activity level. We would then be able to more easily understand the impact of changing circumstances, especially if there is still some uncertainty over future demand and how much capacity will be gained from the new machinery.Flexing the budget also helps us to undertaken more meaningful performance evaluation and is something that we already do. After the budget period we always prepare our variance reports based on the budget flexed to the actual level of activity. This ensures that our variances compare like with like: changes in activity level are effectively taken out of the analysis and therefore do not cloud it.We have always encouraged management participation in our budget setting process, with the process linked to the various management responsibilities. It is also important that the use of flexible budgeting therefore is linked with the concept of responsibility accounting. Given our changed circumstances, a flexible budget will help us to make more valid comparisons. It would be unfair to evaluate managers’ performance against the original budget since we would expect changes in activity levels to result in a change in variable costs. A flexible budget is designed to show the allowed expenditure for the actual numbers of units produced and sold. Comparing a flexed budget with the actual expenditure will enable us to distinguish genuine efficiencies and inefficiencies.SECTION 3From: Finance Officer To: Jack Ford, Head of FinanceSubject: RE: New corporate customers and cost of qualityNEW CORPORATE CUSTOMERSAnalysis of financial information:Firstly, all of these customers are large businesses as shown by revenue and as such will potentially provide us with large orders, although care is needed as the sectors are unknown and we don’t know what would be considered normal for different sectors. Customer A has a quick ratio of significantly more than one (current asset excluding inventory much higher than current liabilities) and receivable and payable days which are in balance with each other. This gives an impression of a well-managed business from a working capital viewpoint. At 35 days, customer A looks to pay its payables in a timely fashion and hence we are likely to be paid on time.Customer B also has a quick ratio of just over one but appears to be relatively slow at both collecting money from its customers and paying its suppliers. This suggests that it may be relying on an extended payment period to fund the business. Care may be needed in dealing with customer B and we may need to agree our trading terms carefully with them.Customer C is the second largest business and as such may offer greater opportunities. Possible warning signs are that it has a low quick ratio with current liabilities greater than current assets excluding inventory. It is paying its payables relatively promptly at 30 days which is in line with our requirements. Customer D as the largest would appear to be a good prospect from a potential sales point of view, however from the information available it has a poor quick ratio and appears to collect its receivables much faster at 20 days than it pays its suppliers (90 days). Apart from potential issues of liquidity (it may be overtrading), it may also be using its relative size to dictate terms to suppliers and collect receivables quickly. As such caution is required in dealing with customer D, strict agreement to our terms would be required.Other financial information:Other financial information relating to the working capital of the companies will include a more detailed analysis of the current liabilities to identify those relating to payables and other creditors. We need to assess whether there are any significant commitments soon which might affect their ability to pay. For example, the latest financial statements might indicate that a significant bank loan is due for repayment or that they have recently entered into commitments that will affect cash flows soon.We should examine the statement of cash flows of the businesses over the year to establish whether they generate a positive cash flow (especially in relation to operating cash flows). We also need to establish the cash position of the customers. Are they consistently in an overdraft position or does it typically have high cash balances? QUALITY COST REPORTINGIncorrect machine setups:The incorrect set up of the machinery has resulted in tea bags reaching customers that are not properly sealed. This is an external failure because the faulty tea bags have reached our customers. The costs associated with this are the costs of any replacements as well as any potential impact on goodwill as a result of supply poor quality products.To stop this from happening we need to ensure that staff are properly trained to setup the machinery. The cost of training would be classified as a prevention cost.Inferior quality paper:The cost of the tea bag paper wasted as a result of accepting poor quality paper should be treated as an internal failure cost. We might also need to write off any remaining inventory of this paper and again this will be an internal failure cost.To guard against this happening again we need to review our suppliers and ensure that our suppliers are providing us with the best quality raw materials, especially for tea bag paper. In this way we can ensure that poor quality production is prevented, therefore the costs of carrying out these reviews would be a prevention cost.Ink on packaging:The costs associated with ink from packaging seeping into tea bags are external failure costs: external because the issue has only come to light as a result of customer complaints. The costs are the same as for the non-sealing tea bags: the cost of product replacement and the impact on goodwill. It is likely that this production issue will have a more significant impact on goodwill than the sealing issue because of the health hazard concerns.To stop this happening again we need to ensure that we inspect raw materials, and especially packaging, when it is first received at the factory. It is much harder to reject materials or to claim compensation from suppliers if we blindly accept the goods without some form of inspection. The cost of carrying out these inspections would include the staff time and any depreciation from new machinery needed and would be classified as appraisal costs. In addition, we need to ensure that we store our packaging inventory appropriately to prevent quality problems from occurring, any additional costs associated with this would be prevention costs.SECTION 4SALES VARIANCES FOR GREEN TEA 1,000 BAG PRODUCTSSales price:The favourable sales price variance for Healthy Blend indicates that the sales price we achieved for this blend was higher than the budgeted selling price of D$21.00 per box. Conversely, the adverse variance for Super Blend means that the sales price achieved for this blend was lower than the D$24.00 per box budgeted. Overall the impact of the reduction for Super Blend significantly outweighs the impact of the price increase for Healthy Blend.Possibly different corporate customers took different blends and those taking Super Blend were harder negotiators in terms of bulk discounts. The increase for Healthy Blend could be because these customers were more interested in the priority delivery service and perhaps the sales team were able to negotiate a higher price.Sales mix:There are no sales mix planning variances and therefore even though the market expanded, and we expected to sell more green tea, it was not expected that the ratio in which we sold Healthy and Super Blend would change. The adverse sales mix operational variance for Healthy Blend indicates that for our actual level of sales a smaller proportion were for Healthy Blend than we had budgeted. The favourable variance for Super Blend means that we sold proportionately more of this blend in the overall mix than we had budgeted.Overall the variance is favourable which means that the as a result of changing the mix, additional profit has been generated. We sold proportionately more than budgeted of the most profitable Super Blend (at a profit per box of D$7.84 compared to D$6.04 for Healthy Blend.Possibly, the reduction in selling price for Super Blend compared to a price increase for Healthy Blend resulted in a greater proportion of Super Blend being sold. It is likely that more bulk purchase discounts were negotiated for the Super Blend customers, leading to proportionally higher sales volumes.Sales quantity:The first point to note is both the planning and operational variances have been reported for the month of January following revision to the budget for sales volume. The planning variances capture the difference between the original budget that we had set and the revised budget, whilst the operational variances compare the revised budget to actual performance.The planning sales quantity variance is favourable which means that we revised our budget for both blends to reflect higher sales volumes. This corresponds to the significant increase in the corporate customer base brought about by the efforts of the sales team. The operational variance is also favourable which means that the corporate customer business grew even more than we anticipated; in other words, our sales team has been more successful than anticipated. However, it is possible that in January sales have been boosted by customers buying in bulk to secure discounts, which will have a detrimental effect on future months sales. It is perhaps too early to say that this operational variance is indicative of where sales might end up.HUMAN RESOURCE PLANNINGThe first stage in formulating an effective Human Resource Plan is to conduct a strategic analysis of the business. Since we haven’t produced anything along these lines before we need to look at the entire organisation from all aspects.Our strategic objectives have now changed to include expanded corporate markets. This also needs to be considered in the broader environment we are operating in which may indicate consumption trends and market influences such as the continuing trends towards green teas and infusions. Taken together these developments will form essential elements of our overall strategic analysis.The second stage of the process is to carry out an audit of our current numbers of staff and their skills. We should consider their skills in terms of both the current and future business requirements. We have a solid base of traditional skills, tasting and blending, but other areas to consider will be staff turnover, areas where overtime working is required and the potential for staff to develop.Having established our existing skill base, we should now consider the staff numbers currently available and potentially required, and the skills currently available and potentially required. Most specifically in terms of the expanded corporate business a mixture of skills is required. Skills associated with business to business marketing, will be needed to support the corporate customer base. Financial and customer monitoring associated with effective credit control and working capital management will be needed. Monitoring and administration of quality associated with the corporate business will require production staff familiar with several types of tea bag packing machinery. There may also be opportunities for expanded roles with green tea and infusions as these are also an expanding business area. Marketing and production expertise are likely to be required skills in promoting and ensuring quality production in these developing areas. The next stage is to fill these gaps. Are there internal transfers and moves which can accommodate at least some of these skill requirements? If so there may be training requirements which will need addressing and the possibility for job enlargement for some staff. However, as we are operating from an established and relatively small staff base it is more likely that we will have to fill some of these positions externally using a suitably targeted recruitment campaign.The final stage will be to review the success or otherwise of our plan. We need to ascertain that we have effectively closed the gaps with staff with the correct skills which will enable the company to develop its strategic plan as intended. ................
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