Accounting for Decision-Making

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Threads Limited

Key Financial Ratios for Threads Limited

THREADS LIMITED
2007 2008
Return on capital Employed (ROCE) (%) 24.50% 15.42%
Operating Profit Margin (%) 19.83% 13.92%
Gross Profit Margin (%) 42.37% 37.50%
Current Ratio 1.27 1.66
Acid Test Ratio 0.53 0.67
Settlement period for Trade Receivables (Days) 32 47
Settlement period for Trade Payables (Days) 94 115
Inventory Turnover (Times) 6.03 3.18

Comments on the Financial Performance of Threads Limited

In the case of Threads Limited the return on capital has been reduced to 15.42% for the year 2008 from 24.50% in the year 2007. This is evidenced by the fact that there is no remarkable increase in the turnover for 2008 and the profitability is also showing a declining trend for 2008. Therefore it can reasonably be stated that the company had not performed well during 2008 to provide better returns to the shareholders.

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The operating margin in the year 2008 has gone down by almost 6% for the year 2008 as compared to the previous year 2007. This implies that the company has not performed financially well during 2008 either due to low gross profit margins due to selling those products which have lower margins or the cost of buying/manufacturing have gone up in the year without corresponding increase in the prices of finished products. This has affected the gross profit margin resulting in lower operating profit. Liquidity Ratios are the ones that exhibit the short-term liquidity of the company (Investopedia, 2009). In most of the industries a current ratio of 2 is considered safe with which the firms would be able to meet their short term obligations without much difficulty. In the case of Threads limited the current ratio for is very low for the year 2007 (1.27). Although there is an increase in the ratio for 2008 up to 1.66 still the ratio cannot be said to represent a sound short-term financial strength of the company. The acid test ratio does not take into account the inventories into account as inventories cannot be realized instantaneously. The acid test ratios calculated for Threads imply that the company would find it difficult to meet its short term financial obligations and may have to resort to long-term financing for meeting the short-term obligations which is a dangerous sign as it may lead to bankruptcy of the company. Settlement period for accounts receivables and payables are important asset turnover ratios that indicate how effectively the firm utilized its assets (NetMBA, 2007). The increase in number of settlement days for payables implies that the company is delaying its payments to creditors because of liquidity problems. On the other hand the increase in the number of settlement days for receivables indicates that the company has resorted to more credit sales either for increasing its sales or it has liberalized the credit terms for trade debtors. Both these situations do not indicate a healthy financial situation for the company. The inventory turnover ratio indicates the effectiveness of the company in maximizing the sales by turning around the inventory. The ratio should be compared against industry averages. A low turnover implies poor sales and therefore the company accumulates inventory. This is also evidenced by the increase in stock level during 2008.

Media Publishers

Media Publishers
$ $
Listed bookstore Price 30.00
Book Store Margin 30% 6.92
Net Sales Price for Media Publishers 23.08
Variable Costs
Variable Cost 4.00
Royalty to Hoot Washington 15% on Net Sales Price 3.46
Total Variable costs 7.46
Contribution 15.62
Fixed Overheads 500000.00
Up-front Payment to Hood Washington 300000.00
Total Fixed Expenses 800000.00
A) (i) Break Even Volume (Units) 51223
Total Fixed Costs 800000.00
Targeted Operating Income 200000.00
Total Contribution Required 1000000.00
(ii) Number of Copies required to earn $ 200,000 operating Income 64029

Sensitivity Analysis

B) I Sensitivity Analysis – 20% Book Store Margin
Listed bookstore Price 30.00
Book Store Margin 20% 5.00
Net Sales Price for Media Publishers 25.00
Variable Cost 4.00
Royalty to Hoot Washington 15% on Net Sales Price 3.75
Total Variable costs 7.75
Contribution 17.25
Fixed Overheads 500000.00
Up-front Payment to Hood Washington 300000.00
Total Fixed Expenses 800000.00
Break Even Volume (Units) 46377
B) II Sensitivity Analysis – Listed Book Store Price $ 40 and Margin 30%
Listed bookstore Price 40.00
Book Store Margin 30% 9.23
Net Sales Price for Media Publishers 30.77
Variable Costs
Variable Cost 4.00
Royalty to Hoot Washington 15% on Net Sales Price 4.62
Total Variable costs 8.62
Contribution 22.15
Fixed Overheads 500000.00
Up-front Payment to Hood Washington 300000.00
Total Fixed Expenses 800000.00
Break Even Volume (Units) 36111

BIII Comments

There is a reduction in the breakeven volume units from 51,223 to 46,377 when the book store margin is reduced from 30% to 20%. A further reduction in the breakeven units happens when the net listed book store price is increased to $ 40 even when the book store margin is retained at 30%. The difference in the break even volume is caused by the contribution margin which is the basis for arriving at breakeven volumes and take managerial decisions on capacity utilization or product mix.

Case Study – HCC Industries

Executive Summary

HCC Industries a manufacturer of electronic connection devices and microelectronic packages operated with the stretch performance budget philosophy. This philosophy was based on the belief that aggressive targets would motivate the managers to perform at their highest possible levels. In the fiscal year 1988, the company decided to change to ‘Minimum Performance Standards’ (MPS) for improving the performance of the divisional managers. This paper examines the effectiveness of the MPS as compared with stretch performance. The applicability of MPS to different divisions and ways to improve the performance are also discussed.

Case History

HCC Industries was an industry leader in the manufacturing of electronic calculators with many of the company’s products being used in aerospace and military applications. The company operated with four divisions, each of the division’s performance put under the responsibility of a general manager with all of them reporting to the Chief Financial Officer Chris Bateman. The performance of the divisions were evaluated by stretch performance standards based on seven performance areas (i) profit before tax, (ii) bookings, (iii) shipments, (iv) returns, (v) rework aging, (vi) efficiency measured by net sales/number of employees, and (vii) delinquencies. Although profit was the most important consideration, good performance in all these performance areas were considered important. After the budget process, stretch performance standards are fixed after approval of the budgets by the board. The approved budgets became the evaluation standards for purposes of awarding incentive compensation to the divisional managers. In October 1986, the company’s COO Al Berger decided to introduce Minimum Performance Standards (MPS) instead of Stretch Performance standards for evaluation and incentive compensation to the divisional managers. MPS budgets were to be set so that the felt probability of achievements was 100%. In addition to the MPS, the managers were asked to set targets that reflected a performance level considered to be beyond normal capability.

Evaluation of MPS versus Stretch Performance

Thompson et al., (1997) observe that firms considering the implementation of high-stretch performance standards, one of the critical issues is the autonomy and empowerment that needs to be allowed to the employees over target setting. One of the forms autonomy/empowerment is allowing the employees to set their own performance standards. However there is always the likelihood that self-set standards may not be met by the employees up to the level required to meet the level of competition put forth by the competitors. The other way is that the organization may fix the stretch standards and announce it to the employees for follow up. In such an instance the standards might be rejected by the employees as the organization-set performance standards may not be realized (Brownwell & McInnes, 1986; Locke & Latham, 1990). However, the results may change because of different reactions based on management practices (Harrison & McKinnon, 1999). In the case of HCC Industries the divisional managers and other employees knew that the stretch performance targets were too optimistic and it does not harm if they missed the budget. Since the employees were covered under some bonus scheme even if they did not reach the set standards the stretch performance standards were not effective in inducing the employees to achieve the standards. On the other hand under MPS plans, the achievable targets are set by the managers and the optimistic level of extra performance is also fixed by the managers themselves. Apart from the monetary considerations, when the employees meet the standards set by them it acts as a morale booster for them. In HCC the payment of incentive was linked to the MPS as well as the additional performance achievement expected by the managers. This would normally induce the employees to perform better than under working under stretch performance standards.

Applicability of MPS to the Divisions of HCC

The divisional managers of the four divisions of HCC could not have expected their divisions to perform uniformly after the introduction of MPS target setting philosophy. In the Hermetic Steel division since Mike Pelta due to his conservative budgeting and past experience could expect the targeted 95% to 98% achievement of the set standards. Because of his attitude towards achieving the budget that not achieving the budget standards is a failure he was sure to meet the MPS.

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Carl Kaliah from Galsseal division would have achieved only 90% of MPS as his original commitment was a realistic one and when he revised, he was not sure whether the revised one could be achieved. His past record also showed that he was always in excess of stretch performance standards. Lou Palamara in the Sealtron division had an inherent inefficiency in the working of the employees of the division and there was also excess staff adding to the cost. It was necessary that Lou had to go for a staff reduction and a higher level of motivation to achieve the desired MPS. He was sure to achieve only 80 to 90% of the MPS fixed. In Hemrtite there were a number of reasons that Alan Wong would fall short of the MPS. He was new to budgeting for the division and there were no historical figures available for setting correct standards as the division was taken over just two years before. It was also true that Alan was too optimistic and the morale of the employees was low due to the fact that the division was making a loss so far.

Conclusion

It was a good decision that HCC changed the philosophy to MPS from stretch performance standards. The best way to make the divisions work towards achieving the MPS is to make the divisions individual profit centers with an allocation of corporate overheads and all other costs of quality issues to the division. This would enable the management to judge the performance of the divisions purely on the profits that the divisions make. It is also advisable to revise the incentive plans in such a way that divisional managers are rewarded not from the bonus pool but as a percentage of the PBT of the division as a whole. This would motivate both the employees and the managers to perform better.

Reference List

Brownwell, P. & McInnes, M., 1986. Budgetary Participation, Motivation and Managerial Performance. The Accounting Review, 61(4), pp.587-600.

Harrison, G. & McKinnon, J., 1999. Cross-Cultural Research in Management Accounting Control System Design: Review of the Current State. Accounting, Organization and Society, 24(5/6), pp.483-509.

Investopedia, 2009. Liqudity Ratio.

Locke, E. & Latham, G., 1990. A Theory of Goal Setting and Task Performance. Englewood Cliffs NJ: Prentice Hall.

NetMBA, 2007. Financial Ratios.

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Thompson, K., Hochwarter, W. & Mathys, N., 1997. Stretch Targets: What makes them Effective? Academy of Managment Executives, 11(3), pp.48-59.

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